10-K 1 d272123d10k.htm FORM 10-K Form 10-K
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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, 2011

 

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

For the transition period from                to                

Commission file number 1-10777

 

 

Ambac Financial Group, Inc.

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

(Exact name of Registrant as specified in its charter)

 

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

One State Street Plaza

New York, New York

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

(212) 668-0340

(Registrant’s telephone number, including area code)

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

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  ¨    No  x

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  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.  x

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

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

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

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

The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2011 was $31,604,423. As of March 9, 2012, 302,431,515 shares of Common Stock, par value $0.01 per share, (net of 5,585,249 treasury shares) were outstanding.

 

 

Documents Incorporated By Reference

None.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  
   Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of 1995      1   
PART I      

Item 1.

  

Business

  
  

Introduction

     3   
  

Business Segments

     4   
  

Investments and Investment Policy

     27   
  

Employees

     29   
  

Corporate Governance

     29   

Item 1A.

  

Risk Factors

     30   

Item 1B.

  

Unresolved Staff Comments

     43   

Item 2.

  

Properties

     44   

Item 3.

  

Legal Proceedings

     44   

Item 4.

  

Mine Safety Disclosures

     44   

PART II

  

Item 5.

  

Market for Registrant’s Common Equity Related Stockholder Matters and Issuer Purchases of Equity Securities

     44   

Item 6.

  

Selected Financial Data

     45   

Item 7.

  

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

     46   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     89   

Item 8.

  

Financial Statements and Supplementary Data

     96   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     206   

Item 9A.

  

Controls and Procedures

     206   

Item 9B.

  

Other Information

     207   

PART III

     

Item 10.

  

Directors Executive Officers and Corporate Governance

     208   

Item 11.

  

Executive Compensation

     221   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     226   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     227   

Item 14.

  

Principal Accountant Fees and Services

     227   

PART IV

  

Item 15.

  

Exhibits, Financial Statement Schedules

     228   
FINANCIAL STATEMENT SCHEDULES      235   
   Schedule I—Summary of Investments Other Than Investments in Related Parties      235   
   Schedule II—Condensed Financial Information of Registrant (Parent Company Only)      236   
   Schedule IV—Reinsurance      243   
SIGNATURES      244   


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

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

Any or all of management’s forward-looking statements here or in other publications may turn out to be incorrect and are based on Ambac Financial Group, Inc. (“Ambac” or the “Company”) management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) a plan of reorganization under Chapter 11 will not be consummated; (2) if Ambac is not successful in consummating a plan of reorganization under Chapter 11, it is likely it would have to liquidate pursuant to Chapter 7; (3) the impact of the bankruptcy proceeding on the holders of Ambac securities; (4) our dispute with the United States Internal Revenue Service may not be satisfactorily resolved; (5) the unlikely ability of Ambac Assurance Corporation (“Ambac Assurance”) paying dividends to Ambac in the foreseeable future; (6) adverse events arising from the Segregated Account Rehabilitation Proceedings, including the failure of the injunctions issued by the Wisconsin Rehabilitation Court to protect the Segregated Account and Ambac Assurance from certain adverse actions; (7) litigation arising from the Segregated Account Rehabilitation Proceedings; (8) decisions made by the Rehabilitator for the benefit of policyholders may result in material adverse consequences for Ambac’s securityholders; (9) potential of a full rehabilitation proceeding against Ambac Assurance or material changes to the Segregated Account Rehabilitation Plan, with resulting adverse impacts; (10) inadequacy of reserves established for losses and loss expenses, including our inability to realize the remediation recoveries or future commutations included in our reserves; (11) adverse developments in our portfolio of insured public finance credits; (12) market risks impacting assets in our investment portfolio or the value of our assets posted as collateral in respect of investment agreements and interest rate swap and currency swap transactions; (13) risks relating to determination of amount of impairments taken on investments; (14) credit and liquidity risks due to unscheduled and unanticipated withdrawals on investment agreements; (15) market spreads and pricing on insured collateralized loan obligations (“CLOs”) and other derivative products insured or issued by Ambac or its subsidiaries; (16) Ambac’s financial position and the Segregated Account Rehabilitation Proceedings may prompt departures of key employees and may impact our ability to attract qualified executives and employees; (17) 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; (18) credit risk throughout our business, including credit risk related to residential mortgage-backed securities, CLOs, public finance obligations and exposures to reinsurers; (19) default by one or more of Ambac Assurance’s portfolio investments, insured issuers, counterparties or reinsurers; (20) the risk that our risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss as a result of unforeseen risks; (21) factors that may influence the amount of installment premiums paid to Ambac, including the continuation of the moratorium with respect to claims payments as a result of Segregated Account Rehabilitation Proceedings; (22) changes in prevailing interest rates; (23) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting, required under the relevant derivative accounting guidance, to the portion of

 

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our credit enhancement business which is executed in credit derivative form; (24) changes in accounting principles or practices that may impact Ambac’s reported financial results; (25) legislative and regulatory developments; (26) operational risks, including with respect to internal processes, risk models, systems and employees; (27) changes in tax laws, tax disputes and other tax-related risks; and (28) other risks and uncertainties that have not been identified at this time.

 

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Part I

 

Item 1. Business

INTRODUCTION

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. On November 8, 2010, Ambac filed a voluntary petition for relief under Chapter 11 (the “Bankruptcy Filing”) of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). Ambac has continued to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court. The Company, as debtor and debtor-in-possession, filed a Plan of Reorganization on July 6, 2011, a First Amended Plan of Reorganization on September 21, 2011, a Second Amended Plan of Reorganization on September 30, 2011, a Third Amended Plan of Reorganization on February 24, 2012, a Fourth Amended Plan of Reorganization on March 9, 2012 and a Fifth Amended Plan of Reorganization on March 12, 2012 (such Fifth Amended Plan of Reorganization, as it may be further amended, the “Reorganization Plan”). The Reorganization Plan reflects a resolution of certain issues (the “Amended Plan Settlement”) among the Company, the statutory committee of creditors appointed by the United States Trustee on November 17, 2010 (the “Creditors’ Committee”), Ambac Assurance Corporation (“Ambac Assurance”), the Segregated Account (as defined below) and OCI (as defined below) (as regulator of Ambac Assurance and as Rehabilitator (as defined below) of the Segregated Account) related to (i) the net operating loss carryforwards (“NOLs”) of the consolidated tax group of which the Company is the parent and Ambac Assurance is a member (the “Ambac Consolidated Group”), (ii) certain tax refunds received in respect thereof (the “Tax Refunds”) and (iii) the sharing of expenses between the Company and Ambac Assurance. The terms of the Amended Plan Settlement are memorialized in that certain Mediation Agreement dated September 21, 2011 (the “Mediation Agreement”) among such parties. Refer to Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for further discussion of the Amended Plan Settlement. Ambac’s common stock trades on the over-the-counter market under the symbol ABKFQ.

Ambac Assurance is Ambac’s principal operating subsidiary. Ambac Assurance is a financial guarantee insurer which provided financial guarantees and financial services to clients in both the public and private sectors around the world. In March 2010, Ambac Assurance established a segregated account pursuant to Wisc. Stat. §611.24(2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities. The Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and to refer as well to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) commenced rehabilitation proceedings in the Dane County, Wisconsin Circuit Court (the “Rehabilitation Court”) with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit the OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. The Rehabilitator is Theodore Nickel, the Commissioner of Insurance of the State of Wisconsin. The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio caused downgrades of Ambac Assurance’s financial strength ratings from the independent rating agencies. These losses have prevented Ambac Assurance from being able to write new business. On April 7, 2011, at Ambac Assurance’s request, Moody’s Investors Service, Inc. withdrew its ratings of Ambac Assurance and each of its affiliates. As a result, as of April 7, 2011, Ambac Assurance is no longer rated by any of the independent rating agencies. An inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends, and as a result Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition, by the rehabilitation of the Segregated Account and by the terms of the Settlement Agreement (as hereinafter defined). It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future. Refer to “2010, 2011 and Recent Events” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K

 

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for further discussion of Ambac’s bankruptcy, the creation and rehabilitation of the Segregated Account and the Settlement Agreement with the counterparties of CDO of ABS transactions. Ambac Assurance is also restricted in its ability to pay dividends pursuant to the terms of its Auction Market Preferred Shares (“AMPS”). Refer to Part I, Item 1, “Business—Dividend Restrictions, Including Contractual Restrictions” of this Form 10-K for discussion of Ambac Assurance’s AMPS.

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

BUSINESS SEGMENTS

Ambac has two reportable business segments: Financial Guarantee and Financial Services. Each of these businesses is conducted by Ambac Assurance and/or its subsidiaries and is, therefore, subject to control of, or oversight by, the OCI and the Financial Services Authority (“FSA”). The FSA oversight relates to the activities of Ambac Assurance UK, Limited. As described above, our activities in these sectors have been limited to loss mitigation and the recovery of residual value in Ambac Assurance as a result of the deterioration of Ambac Assurance’s financial condition. Ambac is no longer originating or competing for new business and is currently managing the runoff of these portfolios. As such, the following descriptions of the Financial Guarantee and Financial Services segments relate to the existing portfolios in those segments.

Ambac provided financial guarantee insurance for public and structured finance obligations through its principal operating subsidiary, Ambac Assurance. Ambac Assurance’s financial strength ratings were downgraded by the independent rating agencies during 2008, 2009 and 2010 and as of April 7, 2011 Ambac Assurance is no longer rated. As a result of these rating agency actions, as well as investor concern with respect to Ambac Assurance’s financial condition, we have not written new business since mid-2008. As such, Ambac Assurance’s principal business consists of mitigating losses on poorly performing transactions (including through the pursuit of recoveries in respect of paid claims, litigation to recover losses or mitigate future losses, commutations of policies, and purchases of Ambac-insured obligations and repurchases of surplus notes issued by Ambac Assurance or the Segregated Account) and maximizing the return on its investment portfolio. Refer to Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for additional discussion of the establishment of the Segregated Account and the subsequent rehabilitation proceedings of the Segregated Account.

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

Financial information concerning our business segments for each of 2011 and 2010 is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Quantitative and

 

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

Financial Guarantee Segment

The financial guarantee segment includes insurance and other credit enhancement products, such as credit derivatives. Generally, financial guarantee insurance provides an unconditional and irrevocable guarantee which protects the holder of a debt obligation against non-payment when due. Pursuant to such guarantees, Ambac Assurance and its subsidiaries make payments if the obligor responsible for making payments fails to do so when scheduled. In some cases, the insured obligations permitted counterparties to assert mark-to-market termination claims; however, the assertion of any such mark-to-market claims has been enjoined by the Rehabilitation Court. See discussion of “Ambac Assurance Liquidity” in Part II, Item 7 included in this Form 10-K for further information.

Ambac’s financial guarantee insurance policies and other credit enhancement products expose the company to direct credit exposure to the assets supporting the obligations we insure or guarantee. In addition to such direct credit exposure, Ambac’s insured transactions expose us to indirect risks that may increase our overall risk. Such indirect risks include credit risk separate from but correlated with our direct credit risk, market risk, natural disaster risk, mortality or other non credit type risks.

Ambac Assurance derives financial guarantee revenues from: (i) premiums earned from insurance contracts; (ii) net investment income; (iii) revenue from credit derivative transactions; (iv) net realized gains and losses from sales of investment securities; and (v) amendment and consent fees. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 of this Form 10-K for further information. Prior to the discontinuance of the issuance of new financial guarantees, premiums for financial guarantees were received either upfront (typical of public finance obligations) or on an installment basis from the cash flows generated by the underlying assets (typical of structured finance obligations). Despite not underwriting new business, Ambac generally continues to collect premiums on its existing portfolio of guarantees that pay premiums on an installment basis.

Risk Management

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

Furthermore, by virtue of the contracts executed between Ambac Assurance and the Segregated Account, the rehabilitator retains the discretion to oversee and approve certain actions taken by Ambac Assurance in

 

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respect of assets and liabilities which remain in Ambac Assurance. As such, the following discussion of Ambac’s risk management practices is qualified by reference to the rehabilitator’s exercise of its discretion to alter or eliminate any of these risk management practices.

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

Portfolio Risk Management and Analysis

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

Analysts review, on a regular and ad hoc basis, credits in the book of business. Risk-adjusted surveillance strategies have been developed for each bond type with review periods and scope of review based upon each bond type’s risk profile. The risk profile is assessed regularly in response to our own experience and judgments or external factors such as the current market crisis. The focus of the surveillance review is to assess performance, identify credit trends and recommend appropriate credit classifications, ratings and changes to a transaction or bond type’s review period. If a problem is detected, the group focuses on loss mitigation by recommending appropriate action and working with the issuer, trustee, bond counsel, servicer and other interested parties in an attempt to remediate the problem and minimize Ambac Assurance’s exposure to potential loss. Those credits that are either in default or have developed problems that eventually may lead to a default, claim or loss are tracked closely by the appropriate surveillance team, senior risk managers and discussed at regularly scheduled meetings with CRM (see discussion following in “Credit Risk Management”).

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

 

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

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

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

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

In some transactions Ambac Assurance has the right to direct a transfer of servicing to an alternative servicer, subject to certain conditions. The decision to exercise this right is made based on various factors, including an assessment of the performance of the existing servicer as outlined above, and an assessment of whether a transfer of servicing may improve the performance of the collateral and reduce risk to Ambac Assurance. Ambac Assurance assesses potential transferee servicers through on-site servicer reviews and reviews of servicer financial information. Accordingly, Ambac Assurance has developed relationships with preferred servicers in the residential mortgage backed sector. Preferred servicers are selected through a formalized servicer review process that determines, among other key factors, the servicer’s ability and willingness to actively manage intense and proven loss mitigation activities on RMBS. On selected distressed or high risk RMBS, Ambac Assurance may decide to exercise its rights to direct the transfer of servicing to a preferred servicer. The transfer of servicing is done with the objectives of (i) minimizing losses and distress levels by deploying targeted and enhanced loss mitigation programs; (ii) increasing visibility to Ambac Assurance of all servicing activities that impact overall deal performance; and (iii) better aligning the servicer’s financial interest to the performance of the underlying deal through the utilization of performance based incentives. Ambac Assurance believes that the improved loss mitigation activities, alignment of interests and close monitoring of the preferred servicers constitute credible means of minimizing risks and losses related to selected Ambac Assurance insured RMBS.

A team of professionals has also been established to focus on recoveries from sponsors where Ambac Assurance believes that a material breach of representations and warranties has occurred with respect to certain RMBS policies. The team monitors monthly performance of the RMBS insured portfolio and uses criteria to determine which transactions to pursue with regard to such recoveries. The team engages experienced consultants

 

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to perform the re-underwriting of loan files and consult with internal and external legal counsel with regard to loan putbacks as well as settlement and litigation strategies (refer to Note 2 to the Consolidated Financial Statements included in Part II, Section 8 of this Form 10–K for further discussion on this topic).

Credit Risk Management

CRM manages the decision process for all material matters that affect credit exposures within the insured portfolio. While PRM is responsible for the credit analysis and the recommendation and execution of credit remediation strategies, CRM provides a forum for independent assessments and sign-offs and drives consistency and timeliness. The scope of credit matters under the purview of CRM includes amendments, waivers and consents, remediation plans, credit review scheduling, adverse credit classification and below investment grade rating designations, adversely classified credit reviews, sector reviews, and overall portfolio review scheduling. The decision process may involve a review of structural, legal, political and credit issues and also includes determining the proper level of approval, which varies based on the nature and materiality of the matter. Please refer to Note 2 to the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of the various credit classifications, including those on the adversely classified credit listing.

Adversely Classified Credit Review

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

Amendment, Waiver and Consent (“AWC”) Review / Approval

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

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

Financial Guarantees in Force

Financial guarantee products were sold in three principal markets: the U.S. public finance market, the U.S. structured finance and asset-backed market and the international finance market. The following table provides a breakdown of guaranteed net par outstanding by market sector at December 31, 2011 and December 31, 2010.

 

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Guaranteed net par outstanding includes the exposures of policies that insure variable interest entities (“VIEs”) consolidated in accordance with ASC Topic 810, Consolidation:

 

($ in millions)

   December 31,
2011
     December 31,
2010
 

Public Finance

   $ 176,817       $ 199,349   

Structured Finance

     55,145         73,799   

International Finance

     40,542         45,706   
  

 

 

    

 

 

 

Total net par outstanding

   $ 272,504       $ 318,854   
  

 

 

    

 

 

 

Included in the above net par exposures at December 31, 2011 and 2010 are $14,167 and $18,766, respectively, of exposures that were executed in the form of credit derivatives, primarily collateralized loan exposures. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data” for further discussion of credit derivative exposures.

U. S. Public Finance Insured Portfolio

Ambac’s portfolio of U.S. Public Finance exposures is $176,817 million, representing 65% of Ambac’s net par outstanding as of December 31, 2011. U.S. Public Finance consists of U.S. municipal issuances, including general obligations, lease and tax-backed obligations (including tax allocation bonds as described further below), health care, housing, public utilities, transportation and higher education, as well as certain infrastructure privatization transactions, such as toll road and bridge financings, public transportation financings, stadium financings, military housing and student housing. Public finance obligations are generally supported by either the taxing authority of the issuer or the issuer’s or underlying obligor’s ability to collect fees or assessments for certain projects or public services. See Note 6 to the Consolidated Financial Statements, located in Part II, Item 8 of this Form 10-K for exposures by bond type.

The table below shows Ambac’s ten largest Public Finance exposures, by repayment source, as a percentage of total financial guarantee net par outstanding at December 31, 2011:

 

($ in millions)

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

California State—GO

     A       $ 2,998         1.1

New Jersey Transportation Trust Fund Authority—Transportation System

     A+         2,058         0.8

Bay Area Toll Authority, CA Toll Bridge Revenue

     AA-         1,663         0.6

Washington State—GO

     AA         1,649         0.6

NYS Thruway Authority, Highway & Bridge Revenue

     AA-         1,624         0.6

MTA, NY, Transportation Revenue (Farebox)

     A         1,432         0.5

New Jersey Turnpike Authority Revenue

     A         1,264         0.5

Massachusetts School Building Authority, MA, Sales Tax Revenue

     AA         1,248         0.5

Massachusetts Commonwealth—GO

     AA         1,219         0.4

Los Angeles Unified School District, CA—GO

     AA-         1,072         0.4
     

 

 

    

 

 

 

Total

      $ 16,227         6.0
     

 

 

    

 

 

 

 

(1)

Internal 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 Assurance has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings,

 

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  a weighted average rating is used. Ambac Assurance 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 Assurance may have received premiums or fees.

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

Ambac’s portfolio of U.S. Structured Finance exposures is $55,145 million, representing 20% of Ambac’s net par outstanding as of December 31, 2011. Insured exposures include securitizations of mortgage loans, home equity loans, auto loans, student loans, leases, operating assets, collateralized debt obligations (“CDO”), collateralized loan obligations (“CLO”), and other asset-backed financings, in each case where the majority of the underlying collateral risk is situated in the United States. Additionally, Ambac’s Structured Finance insured portfolio encompasses both secured and unsecured debt issued by investor-owned utilities. Included within the operating asset sector are securitizations of aircraft, rental cars, shipping container and rail car fleets, franchise fees, and intellectual property. See Note 6 to the Consolidated Financial Statements, located in Part II, Item 8 in this Form 10-K for exposures by bond type as of December 31, 2011.

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

Structured securities are usually designed to help protect the investors and, therefore, the guarantor from the bankruptcy or insolvency of the entity that originated the underlying assets as well as from the bankruptcy or insolvency of the servicer of those assets. The servicer of the assets is typically responsible for collecting cash payments on the underlying assets and forwarding such payments, net of servicing fees, to a trustee for the benefit of the issuer. One potential issue is whether the sale of the assets by the originator to the issuer would be upheld in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or stayed from remitting to investors cash collections held by it or received by it after the servicer or the originator becomes subject to bankruptcy or insolvency proceedings. Another potential issue is whether the originator sold ineligible assets to the securitization transaction that subsequently deteriorated, and, if so, whether the originator has the willingness or financial wherewithal to meet its contractual obligations to repurchase those assets out of the transaction. Structural protection in a transaction, such as control rights that are typically held by the senior note holders, or guarantor in insured transactions, will determine the extent to which underlying asset performance can be influenced upon non-performance to improve the revenues available to cover debt service.

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

 

Servicer

   Bond Type    Net Par
Outstanding
 
($ in millions)            

Bank of America, N.A.

   Mortgage-backed    $ 7,122   

Residential Capital, LLC

   Mortgage-backed    $ 3,286   

Pennsylvania Higher Education Assistance Agency

   Student Loan    $ 3,236   

Wells Fargo Bank

   Mortgage-backed    $ 2,553   

Specialized Loan Servicing, LLC

   Mortgage-backed    $ 2,452   

CDO and CLO transactions involve the securitization of a portfolio of corporate bonds, corporate loan obligations and/or asset-backed securities. In June 2010, all CDO of ABS transactions, which included

 

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substantial exposure to residential mortgages, were settled. Please refer to “2010, 2011 and Recent Events” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for a description of the Settlement Agreement with respect to CDO of ABS and certain other CDO-related obligations.

The table below shows Ambac’s ten largest Structured Finance transactions, as a percentage of total financial guarantee net par outstanding at December 31, 2011:

 

($ in millions)

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

CDO of ABS < 25%

  A+   $ 1,692        0.6     CDO of ABS   

Wachovia Asset Securitization Issuance II, LLC 2007-HE2(2)

  BIG     1,371        0.5     Home Equity Loan   

Vermont Student Assistance Corporation Revenue Bonds(2)

  BIG     1,283        0.5     Student Loan   

Wachovia Asset Securitization Issuance II, LLC 2007-HE1(2)

  BIG     935        0.4     Home Equity Loan   

Ballantyne Re Plc(3)

  BIG     900        0.3     Structured Insurance   

The National Collegiate Student Loan Trust 2007-4(2)

  BIG     861        0.3     Student Loan   

Cendant Rental Car Funding

  BIG     820        0.3     Asset Securitizations   

Spirit Master Funding

  BBB     782        0.3     Asset Securitizations   

Michigan Higher Education Student Loan Authority(2)

  BIG     751        0.3     Student Loan   

Timberlake Financial, LLC

  BBB-     620        0.2     Student Loan   
   

 

 

   

 

 

   

Total

    $ 10,015        3.7  
   

 

 

   

 

 

   

 

(1) Internal 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 Assurance 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 Assurance 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 Assurance may have received premiums or fees. “BIG” denotes credits deemed below investment grade (e.g. below BBB-).
(2) Ambac Assurance has allocated all or a portion of this transaction to the Segregated Account.
(3) Insurance policy issued by Ambac Assurance UK Limited (“Ambac UK”).

International Finance Insured Portfolio

Ambac’s portfolio of International Finance insured exposures is $40,542 million, representing 15% of Ambac’s net par outstanding as of December 31, 2011. Ambac’s International Finance insured exposures include a wide array of obligations in the international markets, including infrastructure financings, asset-securitizations, CDOs, utility obligations, and whole business securitizations (e.g. securitizations of substantially all of the operating assets of a corporation). In emerging markets, Ambac had focused on future cash flow transactions from top tier issuers (structured transactions secured by U.S. Dollar and Euro cash flows generated from exports or payment remittances) and, to a more limited extent, on domestic securitizations. See Note 6 to the Consolidated Financial Statements, located in Part II, Item 8 in this Form 10-K for exposures by bond type as of December 31, 2011.

 

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

Ambac UK, which is regulated in the United Kingdom, had been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the United Kingdom (“UK”) and the European Union with $25,088 million of par outstanding at December 31, 2011. Geographically, Ambac UK’s exposures are principally in the United Kingdom and continental Europe. In 2009, Ambac UK’s license to issue new business was curtailed by the FSA, Ambac UK’s regulator. A result of the AUK Commutation Agreement as discussed in the “2010, 2011 and Recent Events” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, there is no portfolio risk transfer from Ambac UK to Ambac Assurance, and Ambac Assurance does not have any capital support obligation of Ambac UK. The portfolio of insured exposures underwritten by Ambac UK is now financially supported exclusively (all which are Ambac UK risks) by Ambac UK.

The table below shows our ten largest International Finance transactions as a percentage of total financial guarantee net par outstanding at December 31, 2011:

 

($ in millions)

  Ambac
Rating(1)
    Net Par
Outstanding
    % of Total
Net Par
Outstanding
    Country-Bond Type  

Mitchells & Butlers Finance plc-UK Pub Securitisation(2)

    AA-      $ 2,031        0.8     UK-Asset Securitizations   

Romulus Finance s.r.l(2)

    BIG        1,466        0.5     Italy-Airports   

Telereal Securitisation plc(2)

    A        1,410        0.5     UK-Asset Securitizations   

Punch Taverns Finance plc-UK Pub Securitisation(2)

    BIG        1,214        0.5     UK-Asset Securitizations   

Aspire Defense Finance plc(2)

    BBB        1,135        0.4     UK-Infrastructure   

Channel Link Enterprises(2)

    BBB-        1,129        0.4     UK-Infrastructure   

Regione Campania(2)

    BBB+        1,121        0.4     Italy-Sub-Sovern   

National Grid Electricity Transmission(2)

    A-        1,120        0.4     UK-Utility   

Ostregion Investmentgesellschaft NR 1 SA(2)

    BIG        952        0.4     Austria-Infrastructure   

Capital Hospitals plc(2)

    BBB-        941        0.3     UK-Infrastructure   
   

 

 

   

 

 

   

Total

    $ 12,519        4.6  
   

 

 

   

 

 

   

 

(1) Internal 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 Assurance 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 Assurance 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 Assurance may have received premiums or fees. “BIG” denotes credits deemed below investment grade (e.g. below BBB-).
(2) Insurance policy issued and guaranteed by Ambac UK.

Economic uncertainty in the European Union (EU), particularly Euro based countries, continues although member states have recently agreed to a bailout package for Greece (the worst affected country) to avoid imminent default on certain Greek debt due to mature in March 2012. A large percentage of Greek bondholders have agreed to take a significant reduction in the face value of the bonds they hold, with those bondholders not in

 

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agreement likely being forced to accept the proposal under Greek Law, although such discussions are ongoing. Widespread austerity measures are taking place throughout the region as countries look to take action to address fiscal deficits and implement balanced budgets. The prospects of economic growth in the region in the short to medium term may prove challenging due to these actions although this will differ from country to country.

Ambac UK, on behalf of Ambac Assurance and Ambac UK, manages exposures to sixteen transactions based in EU member countries (not including the UK), none of which relate to Greece. Four exposures, with net par outstanding of $1,335 million, are classified as sub sovereign/ municipal exposures that may be impacted should there be continued adverse financial developments in the relevant countries. Eight exposures, with net par outstanding of $4,437 million, are classified as infrastructure/ operating asset backed deals that are concession based where the underlying assets independently generate cashflow without operational reliance on the sovereign. Of the remaining four deals with net par outstanding of $978 million, two are CLOs that consist of various paper issued by corporates throughout the Euro zone, one is a CMBS transaction and one is a structured insurance transaction. The following table sets forth these exposures by country of risk:

 

Country

   Number of
Exposures
     Net par
outstanding

($ in millions)
 

Austria

     1       $ 943   

France

     3         1,326   

Ireland

     1         360   

Italy

     6         3,346   

Spain & Portugal

     1         63   

Germany

     2         619   

Euro—cross border

     2         93   

Total

     16       $ 6,750   

Given the current uncertainty in the debt capital markets in the EU, it is possible that some of Ambac’s exposures will have difficulties refinancing their debts. This short term refinancing risk in the next twelve months is limited to one policy, with debt due to be refinanced of approximately Euro 500 million. Discussions with the obligor are ongoing and we do not currently anticipate that this refinancing will result in a claim.

Additional Insured Portfolio Statistics:

Ambac Assurance underwrote and priced financial guarantees based on the assumption that the guarantees would remain in force until the expected maturity of the underlying bonds. Ambac Assurance estimates that the average life of its guarantees on par in force at December 31, 2011 is approximately 13 years. The 13 year average life is determined by applying a weighted average calculation, using the remaining years to expected maturity of each guaranteed bond, and weighting them on the basis of the remaining net par guaranteed. Except for RMBS policies, no assumptions are made for future refundings or terminations of insured issues. RMBS policies incorporate assumption on expected prepayments over the remaining life of the insured obligation.

 

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Ratings Distribution

The following tables provide a rating distribution of guaranteed total net par outstanding based upon internal Ambac Assurance credit ratings at December 31, 2011 and December 31, 2010 and a distribution by bond type of Ambac Assurance’s below investment grade exposures at December 31, 2011 and December 31, 2010. Below investment grade is defined as those exposures with a credit rating below BBB-:

Percentage of Guaranteed Portfolio(1)

 

     December  31,
2011
    December  31,
2010
 

AAA

     1     1

AA

     24        23   

A

     43        43   

BBB

     17        19   

BIG

     15        14   
  

 

 

   

 

 

 

Total

     100     100
  

 

 

   

 

 

 

 

(1) Internal 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 Assurance 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 Assurance 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 Assurance may have received premiums or fees.

Summary of Below Investment Grade Exposure

 

Bond Type

   December 31,
2011
     December 31,
2010
 
($ in millions)              

Public Finance:

     

Transportation

   $ 776       $ 1,175   

Health care

     79         259   

General obligation

     492         234   

Tax-backed

     764         531   

Housing

     795         741   

Other

     1,137         604   
  

 

 

    

 

 

 

Total Public Finance

     4,043         3,544   
  

 

 

    

 

 

 

Structured Finance:

     

Residential mortgage-backed and home equity—first lien

     11,673         12,836   

Residential mortgage-backed and home equity—second lien

     8,784         10,121   

Structured Insurance

     1,657         1,037   

Auto Rentals

     820         1,270   

Student loans

     7,690         11,044   

Enhanced equipment trust certificates

     401         430   

Mortgage-backed and home equity—other

     586         369   

Other CDOs

     6,061         100   

Other

     578         625   
  

 

 

    

 

 

 

Total Structured Finance

     32,250         37,832   
  

 

 

    

 

 

 

International Finance:

     

Airports

     1,580         1,505   

Other

     957         922   
  

 

 

    

 

 

 

Total International Finance

     2,537         2,427   
  

 

 

    

 

 

 

Total

   $ 38,830       $ 43,803   
  

 

 

    

 

 

 

 

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The decrease in below investment grade exposures are primarily due to (i) commutations of insurance policies during 2011, and (ii) reductions to Residential Mortgage-backed Securities during the year as result of prepayments by issuers and claims presented to Ambac Assurance. The sections that follow will discuss below investment grade exposures with residential mortgage backed, student loans and tax-backed municipal exposures.

U.S. residential mortgage-backed securities exposure

RMBS portfolio exposures included in financial guarantee insurance portfolio

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

 

     Total Gross Par Outstanding
At December 31, 2011 ($ in millions)
 

Year of Issue

   Second Lien     Sub-prime     Mid-prime(1)     Other(4)  

1998-2001

   $ 93.6      $ 647.1      $ 5.7      $ 542.0   

2002

     44.5        582.2        64.6        18.8   

2003

     31.5        887.1        450.3        179.2   

2004

     1,219.0        472.5        756.1        42.6   

2005

     1,260.4        1,127.8        2,479.5        64.1   

2006

     3,101.2        801.7        1,681.7        209.9   

2007

     3,398.7        527.4        2,468.3        295.9   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 9,148.9      $ 5,045.8      $ 7,906.2      $ 1,352.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

% of Total RMBS Portfolio

     39.0     21.5     33.7     5.8

 

     Gross claim liability, before Subrogation Recoveries
At December 31, 2011 ($ in millions)
 

Year of Issue

   Second Lien      Sub-prime      Mid-prime(1)      Other(4)  

1998-2001

   $ —         $ 72.4       $ —         $ 7.9  

2002

     3.5         47.6         0.1        —     

2003

     0.1         15.1         4.2        3.5  

2004

     153.6         28.3         34.1         —     

2005

     289.9         395.1         917.6         77.3   

2006

     1,469.8         403.3         1,098.3         149.1   

2007

     435.5         275.5         1,383.5         108.6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,352.4       $ 1,237.3       $ 3,437.8       $ 346.4   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     Gross Subrogation Recoveries
At December 31, 2011 ($ in millions)
 

Year of Issue

   Second Lien     Sub-prime     Mid-prime(1)     Other(4)  

1998-2001

   $ —        $ —        $ —        $ —     

2002

     —          —          —          —     

2003

     —          —          —          —     

2004

     (55.1     —          —          —     

2005

     (145.1     (188.7 )     (236.3     —     

2006

     (818.1     (189.9 )     (169.9     —     

2007

     (612.3     (72.9     (231.8     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ (1,630.6   $ (451.5   $ (638.0   $ —     
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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     Percent of Related RMBS Transactions’
Gross Par At December 31, 2011
 

Internal Ambac Credit Rating(2)

   Second Lien     Sub-prime     Mid-prime(1)     Other(4)  

AAA

     0     3     1     10

AA

     <0.1     3     4     24

A

     1     5     1     14

BBB(3)

     2     1     1     5

Below investment grade(3)

     97     88     93     47

 

(1) Mid-prime includes Alt-A transactions and affordability product transactions, which includes interest only or option adjustable rate features.
(2) Ambac Assurance ratings set forth above reflect internal credit ratings as of December 31, 2011, and may be changed at any time based on our internal credit review. Ambac Assurance undertakes no obligation to update such ratings. This does 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 Assurance may have received premiums or fees.
(3) Ambac’s BBB internal rating reflects bonds which are of medium grade credit quality with adequate capacity to pay interest and repay principal. Certain protective elements and margins may weaken under adverse economic condition and changing circumstances. These bonds are more likely than higher rated bonds to exhibit unreliable protection levels over all cycles. Ambac’s below investment grade internal ratings reflect bonds which are of speculative grade credit quality with the adequacy of future margin levels for payment of interest and repayment of principal potentially adversely affected by major ongoing uncertainties or exposure to adverse conditions. Ambac Assurance’s below investment grade category includes transactions on which claims have been submitted.
(4) Other includes primarily manufactured housing and lot loan exposures.

RMBS exposure in collateralized debt obligations

Ambac’s outstanding CDO exposures are comprised of the following asset type and credit ratings as of December 31, 2011 and December 31, 2010:

 

Business Mix by Net Par

   December 31, 2011     December 31, 2010  
   Net Par      Percentage     Net Par      Percentage  
($ in billions)                           

High yield corporate (CLO)

   $ 10.1         81   $ 14.7         80

Market value CDOs

     0.5         4        1.5         8   

CDO of ABS < 25% MBS

     0.5         4        0.5         3   

Other

     1.3         11        1.5         9   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 12.4         100   $ 18.2         100
  

 

 

    

 

 

   

 

 

    

 

 

 

 

Ambac Ratings by Net Par(1)

   December 31, 2011     December 31, 2010  
   Net Par      Percentage     Net Par      Percentage  
($ in billions)                           

AAA

   $ 1.0         8   $ 2.1         12

AA

     6.8         55        9.9         54   

A

     4.2         34        5.7         31   

BBB

     0.1         1        0.2         1   

Below investment grade

     0.3         2        0.3         2   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 12.4         100   $ 18.2         100
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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(1) Internal Ambac Assurance credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. Ambac Assurance ratings set forth above reflect the internal Ambac Assurance ratings as of December 31, 2011, and may be changed at any time based on our internal credit review. This does not constitute investment advice. Ambac Assurance or one of its affiliates has guaranteed the obligations included above and may also provide other products or services to the issuers of these obligations for which Ambac Assurance may have received premiums or fees.

Student Loans

Our student loan portfolio consists of credits collateralized by (i) federally guaranteed loans under the Federal Family Education Loan Program (“FFELP”) and (ii) private student loans. Whereas FFELP loans are guaranteed for a minimum of 97% of defaulted principal and interest, private loans have no government guarantee and, therefore, are subject to credit risk as with other types of unguaranteed credits. Private student loans are outside the purview of recent government programs designed to assist borrowers. Recent default data has shown a significant deterioration in the performance of private student loans underlying our transactions. Additionally, due to the failure of the auction rate and variable rate markets as noted below in Auction Rate and Variable Rate Demand Obligation, the interest rates on student loan securities has increased significantly to punitive levels pursuant to the transaction terms. Such increases have caused the collateralization ratio in these transactions to deteriorate on an accelerated basis due to negative excess spread and/or the use of principal receipts to pay current interest. Effective July 1, 2010, lenders were unable to originate federal guaranteed loans, due to the termination of the FFELP program. The resulting reduction in new revenues may adversely affect a number of smaller issuers, whose ability to remain a going concern may be at risk.

Student loan net par outstanding, excluding debt service reserve funds on Ambac insured obligations:

 

Issuer Type ($ in millions)

   Net Par         

For-Profit Issuers

   $ 3,288.5         43

Not-For-Profit Issuers

     4,391.1         57
  

 

 

    

 

 

 

Total

   $ 7,679.6         100
  

 

 

    

 

 

 

Collateral for the For-Profit Issuers consists of private loans which are uninsured and do not have any federal guarantee as to defaulted principal and interest. Collateral for the Not-For-Profit Issuers consists of both FFELP and private loans. For the total student loan portfolio, approximately 63% of the collateral backing student loan trusts consists of private loans while the remaining 37% consists of FFELP loans. Private loan defaults have been on the rise since the credit crisis in 2008 began. Elevated unemployment rates, combined with high student loan debt levels will continue to put pressure on borrower’s ability to pay their loans.

The following table represents the student loan net par outstanding by underlying debt type, excluding debt service reserve funds on Ambac insured obligations:

 

Debit Type ($ in millions)

   Net Par         

Auction Rate

   $ 4,644.6         61

Fixed Rate

     414.9         5

VRDOs

     204.6         3

Floating Rate Notes

     2,415.5         31
  

 

 

    

 

 

 

Total

   $ 7,679.6         100
  

 

 

    

 

 

 

 

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All of the Auction Rate and VRDO debt is paying interest at the maximum auction rate or the “penalty rate” pursuant to the transaction documents. These rates are putting negative pressure on excess spread and credit enhancement in transactions which is causing an erosion of equity. Additionally, most floating rate securities have the bond interest rate tied to the credit rating of the deal. As such, most Floating Rate Notes that we insure are also paying interest at the maximum rate pursuant to the deal documents which has the same adverse consequence on excess spread and credit enhancement.

The current capital markets and rating agency assumptions for new private loan transactions requires a significant amount of equity which makes refinancing of Ambac insured transactions backed by private loans uneconomical for issuers. As such, we do not expect that our private loan exposure will be reduced via refinancing in the near term. Deals collateralized by FFLEP loans are more likely to be refinanced if issuers raise enough equity through action rate redemptions or otherwise to meet the overcollateralization required from the rating agencies.

Auction Rate Securities and Variable Rate Demand Obligations:

Debt securities issued in the US bond market include fixed and variable rate bonds. Included within the variable rate bond category are Auction Rate Securities (“ARS”) and Variable Rate Demand Obligations (“VRDO”). The following table sets forth Ambac Assurance’s financial guarantee net par exposure outstanding, by bond type, relating to such variable rate securities at December 31, 2011 and December 31, 2010:

 

     December 31,  2011
Total
     December 31,  2010
Total
 
($ in millions)              

Student Loans

   $ 4,849       $ 7,331   

Investor-owned utilities

     3,512         3,906   

Transportation

     1,983         2,179   

Lease and Tax-backed

     1,830         2,246   

Healthcare

     1,474         1,603   

General Obligation

     828         978   

Utility

     307         534   

Other

     930         1,796   
  

 

 

    

 

 

 

Total

   $ 15,713       $ 20,573   
  

 

 

    

 

 

 

ARS are sold through a Dutch auction, which is a competitive bidding process used to determine rates on each auction date. VRDOs are long-term bonds that bear a floating interest rate and that provide investors the option to tender or put securities back to the issuer or the liquidity provider at any time with appropriate notice. Additionally, there are certain mandatory events that require all bondholders to tender their VRDOs to the issuer or liquidity provider. The interest rate resets daily or weekly, depending upon the security.

VRDOs are typically supported by a liquidity facility in the form of a standby bond purchase agreement (“Standby Bond Purchase Agreement”), usually provided by a commercial bank (“Liquidity Provider”). If the remarketing agent is unable to remarket all tendered VRDO, the Liquidity Provider is required to purchase such VRDO at the purchase price, subject to limited conditions precedent, thus providing liquidity to investors. While held by the Liquidity Provider, VRDOs bear interest at a rate determined under the Standby Bond Purchase Agreement, often based on the Prime Rate or LIBOR plus a spread (the “Bank Rate”). During such time, the remarketing agent remains obligated to continue to try to remarket the VRDO held by the Liquidity Provider. Many Standby Bond Purchase Agreements provide that, after the Liquidity Provider has held the VRDO for a specified time period, the issuer or other obligor is required to cause such VRDO to be redeemed prior to maturity, either: in periodic installments over a predetermined number of years, typically from three to five (the

 

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“Term-Out”); or with available funds as defined in the transaction documents; or in a single lump sum at the end of three to five years. Other Standby Bond Purchase Agreements do not contain a Term-Out. For VRDO insured by Ambac Assurance, Ambac Assurance has typically endorsed its insurance policy to cover interest at the Bank Rate. For VRDOs insured by Ambac Assurance that contain a Term-Out, Ambac has often endorsed its insurance policy to cover the required redemptions in accordance with the Term-Out schedule (though not any acceleration of the VRDO maturity ahead of the Term-Out schedule).

For student loan VRDO transactions, Ambac Assurance is required to purchase any outstanding VRDOs from the Liquidity Providers at the end of the Term-Out period for the par amount of the bonds. All student loan VRDOs transactions insured by Ambac Assurance have been purchased by the Liquidity Providers and, as such, at December 31, 2011 Ambac Assurance had obligations to purchase outstanding VRDOs at par coming due in 2013 and 2015 in the amounts of $166.0 million and $175.0 million, respectively.

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

For Ambac Assurance insured ARS and VRDO transactions that have been unable to refinance, the higher debt service costs have resulted in decreased debt service coverage ratios and/or the erosion of first loss and/or other credit enhancements that are subordinate to Ambac Assurance’s risk position (such as excess spread). The decrease in student loan ARS/VRDO net par during 2011 was primarily driven by the commutation of certain insured transactions. Ambac has established gross loss reserves of approximately $1,325 million for ARS and VRDO exposures. Ambac continues to actively review the credit implications of this additional issuer stress and its impact to our internal credit ratings and loss reserves as necessary.

Tax Allocation Bonds

Ambac Assurance has $6,433 million net exposure to California redevelopment agencies (“RDAs”) in its public finance portfolio, including $484 million that is below investment grade. RDAs were established by certain municipalities to fund redevelopment projects. RDAs issued debt, in some cases insured by Ambac Assurance, that was secured by property tax revenues above a designated assessed valuation (“AV”) level. Declines in AV levels in California have reduced the revenues available to cover RDAs’ debt service, in some cases causing shortfalls. Most of our exposures have adequate cash flow coverage to service our insured debt. Our Adversely Classified RDA exposures comprise those with low or inadequate debt service coverage ratios. We anticipate additional stress in these and potentially other RDA exposures arising from a December 2011 California Supreme Court ruling that upheld a recently enacted state law abolishing RDAs but confirming their obligation to service existing debt from their pledged revenues. Municipalities’ previous willingness to cover revenue shortfalls in stressed RDAs is unlikely to continue because the new legislation requires that RDA revenues in excess of debt service be segregated from the municipalities, essentially prohibiting the recovery of advances. Conversely, this change in law may be viewed as helpful to some existing RDA credits insofar as it would preclude further leveraging of RDA revenues. We are exposed to liquidity claims or ultimate losses arising from inadequate tax revenue due to low AVs, timing mismatches between tax receipts and debt service payments and potential consequences from municipalities not adequately segregating revenues pledged to pay debt service. While we believe these risks will be contained, there can be no certainty these or other risks will not increase as the new law is enacted and its guidelines promulgated.

 

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Issue Size

Ambac Assurance’s financial guarantee exposure in the U.S. public finance market reflects the historical participation across the whole range of deal sizes including those with an original par amount of less than $50 million. U.S. Structured Finance and International Finance transactions generally involved larger transaction sizes. The following table sets forth the distribution of Ambac Assurance’s guaranteed portfolio as of December 31, 2011 with respect to the original size of each guaranteed issue:

 

Original Par Amount

   Number  of
Issues
     % of Total
Number of Issues
    Par Amount
as of December 31, 2011
 
        Amount
Outstanding
     % of Total  

Less than $10 million

     5,809         53   $ 20,583         8

$10-less than 50 million

     3,371         31        51,271         19   

$50-250 million

     1,353         12        84,986         31   

Greater than $250 million

     500         4        115,664         42   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

     11,033         100   $ 272,504         100
  

 

 

    

 

 

   

 

 

    

 

 

 

Geographic Area

The following table sets forth the geographic distribution of Ambac Assurance’s insured exposure as of December 31, 2011:

 

Geographic Area

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

Domestic:

     

California

   $ 36,133         13.3

New York

     18,267         6.7

Florida

     13,906         5.1

Texas

     12,983         4.8

New Jersey

     9,650         3.5

Illinois

     8,524         3.1

Massachusetts

     5,799         2.1

Pennsylvania

     5,301         2.0

Colorado

     5,010         1.8

Washington

     4,772         1.8

Mortgage and asset-backed(1)

     27,896         10.2

Other states

     83,721         30.7
  

 

 

    

 

 

 

Total Domestic

     231,962         85.1
  

 

 

    

 

 

 

International:

     

United Kingdom

     22,317         8.2

Australia

     5,176         1.9

Italy

     3,346         1.2

Austria

     956         0.4

Germany

     619         0.2

Internationally diversified(2)

     5,318         2.0

Other international

     2,810         1.0
  

 

 

    

 

 

 

Total International

     40,542         14.9
  

 

 

    

 

 

 

Grand Total

   $ 272,504         100
  

 

 

    

 

 

 

 

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

Exposure Currency:

The table below shows the distribution by currency of Ambac Assurance’s insured exposure as of December 31, 2011:

 

Currency

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

U.S. Dollars

     236,093       $ 236,093   

British Pounds

     13,976         21,675   

Euros

     7,025         9,091   

Australian Dollars

     4,865         4,972   

Other

     1,223         673   
     

 

 

 

Total

      $ 272,504   
     

 

 

 

Ceded Reinsurance

Ambac Assurance has reinsurance in place pursuant to treaty and facultative reinsurance agreements. For exposures reinsured, Ambac Assurance withholds a ceding commission to defray its underwriting and operating expenses. The following table shows the distribution, by bond type, of Ambac Assurance’s ceded guaranteed portfolio at December 31, 2011:

 

Bond Type

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

Public Finance:

     

Lease and tax-backed revenue.

   $ 5,712         9

General obligation

     4,450         9   

Utility revenue

     2,555         10   

Transportation revenue

     2,747         13   

Higher education

     1,565         10   

Housing revenue

     1,115         11   

Health care revenue

     754         9   

Other

     152         6   
  

 

 

    

 

 

 

Total Public Finance

     19,050         10   
  

 

 

    

 

 

 

Structured Finance:

     

Mortgage-backed and home equity

     290         1   

Investor-owned utilities

     794         8   

Other CDOs

     11         <1   

Student loan

     1,430         15   

Asset-backed

     576         11   

Other

     282         11   
  

 

 

    

 

 

 

Total Structured Finance

     3,383         6   
  

 

 

    

 

 

 

Total Domestic

     22,433         9   
  

 

 

    

 

 

 

International Finance:

     

Investor-owned and public utilities

     964         8   

Asset-backed

     275         3   

Sovereign/sub-sovereign

     36         <1   

Transportation

     199         3   

Other CDOs

     42         1   

Mortgage-backed and home equity

     10         1   
  

 

 

    

 

 

 

Total International Finance

     1,526         4   
  

 

 

    

 

 

 

Grand Total

   $ 23,959         8
  

 

 

    

 

 

 

 

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As a primary financial guarantor, Ambac Assurance is required to honor its obligations to its policyholders whether or not its reinsurers perform their obligations under the various reinsurance agreements. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance is entitled to receive collateral from its reinsurance counterparties in certain reinsurance contracts and has certain cancellation rights that can be exercised by Ambac Assurance in the event of rating agency downgrades of a reinsurer. At the inception of each reinsurance contract, Ambac Assurance required collateral from certain reinsurers primarily to (i) receive statutory credit for the reinsurance to foreign reinsurers, (ii) provide liquidity to Ambac Assurance in the event of claims on the reinsured exposures, and (iii) enhance rating agency credit for the reinsurance. Ambac Assurance held letters of credit and collateral amounting to approximately $337.6 million from its reinsurers at December 31, 2011. Refer to Item 7A – Qualitative and Quantitative Disclosures About Market Risk, Risk Management for further discussion on the credit ratings of our reinsurance counterparties and unsecured reinsurance balances.

Assumed Reinsurance:

At December 31, 2011, assumed par outstanding was $257.5 million. On March 24, 2010, all assumed reinsurance agreements with third parties were allocated to the Segregated Account, which will not allow for cancellations without the approval of the Rehabilitator.

Rating Agencies

Ambac Assurance’s financial strength ratings had been downgraded several times since 2008. In 2011 and 2010 Ambac Assurance requested that Moody’s and S&P, respectively, withdraw its ratings. Ambac Assurance’s requests were predicated by a review of the value of such ratings relative to the cost.

Insurance Regulatory Matters

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

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

 

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Wisconsin Insurance Laws require regulated insurance companies to maintain minimum standards of business conduct, minimum surplus to policyholders and solvency, meet certain financial tests, and file certain reports, including information concerning their capital structure, ownership and financial condition. As the principal, or domiciliary, regulator of Ambac Assurance and Everspan, OCI has primary regulatory authority, including with respect to the initiation and administration of rehabilitation or liquidation proceedings with respect to Ambac Assurance and Everspan. Additionally, the accounts and operations of Ambac Assurance and Everspan are subject to a comprehensive examination by the OCI every three to five years. Wisconsin Insurance Laws also require prior approval by OCI of certain transactions between Ambac Assurance and Everspan and their respective affiliates. As described in “2010, 2011 and Recent Events” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, the Rehabilitator of the Segregated Account has imposed certain constraints upon Ambac Assurance through the covenants made for the benefit of the Segregated Account and has assumed the authority to control the management of the Segregated Account.

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

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

The FSA has exercised significant oversight of Ambac UK since 2008, when Ambac Financial Group, and Ambac Assurance (Ambac UK’s sole reinsurer and principal financial support provider prior to the AUK Commutation Agreement) began experiencing financial stress. As more fully discussed in “2010, 2011 and Recent Events” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K, Ambac Assurance entered into the AUK Commutation Agreement with Ambac UK and the Special Deputy Commissioner of OCI, on September 28, 2010, pursuant to which the AUK Reinsurance Agreement was commuted and the Net Worth Maintenance Agreement between Ambac UK and Ambac Assurance was terminated in exchange for, among other things, certain mutual releases, including, without limitation, any right of Ambac Assurance or the Segregated Account to reinsurance premiums from Ambac UK. Ambac Assurance paid a nominal termination amount of one U.S. dollar to Ambac UK in connection with the commutation.

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

 

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and submit to the FSA a solvency margin calculation return in respect of its ultimate parent. All of these solvency requirements may be amended in order to implement the European Union’s proposed “Solvency II” directive on risk-based capital, but that is not expected to be implemented until 2013 at the earliest. The impact of such proposals on Ambac UK remains unclear.

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

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

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

Dividend Restrictions, Including Contractual Restrictions

Pursuant to the Wisconsin Insurance Laws, Ambac Assurance and Everspan may declare dividends, subject to restrictions in their respective articles of incorporation, provided that, after giving effect to the distribution, such dividends would not violate certain statutory equity, solvency, income and asset tests. Board action authorizing a shareholder distribution by Ambac Assurance or Everspan (other than stock dividends) must be reported to the OCI at least 30 days prior to payment. Additionally, no quarterly dividend may exceed the dividend paid in the corresponding quarter of the preceding year by more than 15% without notifying the OCI 30 days in advance of payment. Extraordinary dividends must be reported prior to payment and are subject to disapproval by the OCI. An extraordinary dividend is defined as a dividend or distribution, the fair market value of which, together with all dividends from the preceding 12 months, exceeds the lesser of: (a) 10% of policyholders’ surplus as of the preceding December 31 or (b) the greater of: (i) statutory net income for the calendar year preceding the date of the dividend or distribution, minus realized capital gains for that calendar year; or (ii) the aggregate of statutory net income for the three calendar years preceding the date of the dividend or distribution, minus realized capital gains for those calendar years and minus dividends paid or credited and distributions made within the first two of the preceding three calendar years. Additionally, in connection with the termination of reinsurance contracts, OCI requires adjustments to the dividend calculations for any surplus or net income gains recognized. Due to losses experienced by Ambac Assurance, Ambac Assurance was unable to pay common dividends to Ambac in 2010 and 2011 and will be unable to pay common dividends in 2012, without the prior consent of the OCI. See Note 7 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K for further information on dividends. During 2010, Ambac Assurance paid cash dividends on its preferred shares of $0.8 million.

 

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Ambac Assurance’s ability to pay dividends is further restricted by certain covenants made for the benefit of the Segregated Account and by the Settlement Agreement. See “2010, 2011 and Recent Events” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K for further information.

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

Pursuant to the Settlement Agreement, as discussed in the “2010, 2011 and Recent Events Overview” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K, Ambac Assurance may not make any “Restricted Payment” (which includes dividends from Ambac Assurance to Ambac) in excess of $5 million in the aggregate per annum, other than Restricted Payments from Ambac Assurance to Ambac in an amount (i) up to $52 million per annum solely to pay interest on indebtedness of Ambac outstanding as of March 15, 2010, or any indebtedness issued as a result of a restructuring or refinancing thereof and (ii) up to $7.5 million per annum solely to pay operating expenses of Ambac. Concurrent with making any such Restricted Payment, a pro rata amount of the Surplus Notes issued by Ambac Assurance under the Settlement Agreement would also need to be redeemed at par.

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

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

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

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

 

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Financial Services Segment

Ambac’s Financial Services segment historically provided financial and investment products, including investment agreements, derivative products (interest rate and currency swaps) and funding conduits, principally to clients of the financial guarantee business. In 2008, Ambac discontinued writing new investment agreements and derivative products. Ambac also discontinued executing derivative transactions except those entered into with professional counterparties to hedge corporate exposure to changes in interest-rates. Its existing investment agreement and derivative product portfolios are in active runoff, which in addition to natural attrition, may include transaction terminations, settlements, restructurings, hedges, and transfers. The portfolios of the Financial Services segment during 2010 and 2011 included interest rate and currency swaps and investment agreements, including the associated invested asset portfolio. While the derivative products business generally seeks to remain neutral to interest rate and currency fluctuations, the portfolio could experience gains or losses related to certain aspects of portfolio positioning. The derivative products portfolio has been positioned to benefit from rising interest rates in order to mitigate exposure to floating rate obligations in the Financial Guarantee segment.

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

Investment Agreements

Ambac currently has remaining investment agreements, including repurchase agreements to asset-backed, structured finance and municipal issuers through its wholly-owned subsidiary, Ambac Capital Funding. In general, investment agreements were customized for each investor to provide a guaranteed interest coupon and ultimate return of principal in accordance with their requirements. Each investment agreement was insured by Ambac Assurance in the form of a financial guaranty insurance policy.

Liquidity risk exists in the portfolio of investment agreements due to contract provisions which require collateral posting or allow early termination of contracts. As of December 31, 2011, 97% of investment agreement principal and accrued interest outstanding was collateralized. Funding for early terminations was supported in part through loans between Ambac Capital Funding and Ambac Assurance. At December 31, 2011, Ambac Capital Funding was indebted to Ambac Assurance in the amount of $500.6 million in cash loans.

See “Liquidity and Capital Resources” of the Management Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 and Note 13 of this Form 10-K to the Consolidated Financial Statements located in Part II, Item 8 for further information on investment agreements.

Derivative Products

The primary activities in the derivative products business were intermediation of interest rate and currency swap transactions through Ambac Financial Services (“AFS”). The derivative products portfolio is positioned to benefit from rising rates as an economic hedge against interest rate exposure in the financial guarantee portfolio. This portfolio position may have a significant impact on the results of the Financial Services segment as reported under GAAP. Additionally, certain municipal interest rate swaps are not hedged for the basis difference between

 

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issue specific and general tax-exempt index rates. The derivative portfolio also includes an unhedged Sterling-denominated exposure to consumer price inflation in the United Kingdom. In addition, the derivative products business uses exchange traded U.S. Treasury futures contracts to hedge interest rate exposures.

Interest rate and currency swaps used for hedging purposes are generally subject to master agreements. These agreements generally require a counterparty in a net mark-to-market liability position to post increasing amounts of collateral if that counterparty’s credit rating declines and/or the net mark-to-market liability increases. Some contracts also contain additional termination provisions linked to downgrades of Ambac Assurance, as guarantor of the swaps. As a result of ratings downgrades to Ambac Assurance, AFS must fully collateralize its mark-to-market liability and generally must post additional collateral in excess of its mark-to-market liabilities under these agreements. In addition, AFS experienced termination events across all its professional counterparties. Such termination events resulted in losses to AFS due to the higher cost of replacing hedge positions, and may result in additional losses in future periods. AFS has borrowed cash and securities from Ambac Assurance, to help support its incremental collateral posting requirements, termination payments and other cash needs. At December 31, 2011, AFS was indebted to Ambac Assurance in the amounts of $468.3 million in cash loans and $270.8 million in borrowed securities.

AFS manages a variety of risks inherent in its businesses, including credit, market, liquidity, operational and legal. These risks are identified, measured, and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. See “Quantitative and Qualitative Disclosures About Market Risk” located in Part II, Item 7A of this Form 10-K for further information.

Funding Conduits

Ambac previously transferred financial assets to two special purpose entities. The business purpose of these entities was to provide certain financial guarantee clients with funding for their debt obligations. The activities of the special purpose entities are contractually limited to purchasing assets from a subsidiary of Ambac, issuing medium-term notes (“MTNs”) to fund such purchases, executing derivative hedges and related administrative services. As of December 31, 2011, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the special purpose entities. Ambac does not consolidate these special purpose entities under the relevant accounting guidance for consolidation of variable interest entities. See Notes 2 and 3 to the Consolidated Financial Statements located in Part II, Item  8 of this Form 10-K for further information.

INVESTMENTS AND INVESTMENT POLICY

As of December 31, 2011, the consolidated investments of Ambac had an aggregate fair value of approximately $6.9 billion and an aggregate amortized cost of approximately $6.4 billion. The majority of these investments are primarily managed internally by officers of Ambac, who are experienced investment managers. A portion of the portfolio is managed by external investment managers. All investments are made in accordance with the general objectives and guidelines for investments reviewed or overseen by Ambac Assurance and Ambac UK’s respective Boards of Directors. These guidelines include liquidity, credit quality, diversification and duration objectives, and are periodically reviewed and revised as appropriate.

As of December 31, 2011, the Ambac Assurance investment portfolio had an aggregate fair value of approximately $5.5 billion and an aggregate amortized cost of approximately $5.1 billion. Ambac Assurance’s investment objectives are to achieve the highest after-tax yield on a diversified portfolio of fixed income investments while employing active asset/liability management practices to satisfy all operating and strategic liquidity needs. Ambac Assurance’s investment portfolio is subject to internal investment guidelines and is subject to limits on types and quality of investments imposed by the insurance laws and regulations of the States

 

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of Wisconsin and New York. Ambac Assurance purchases Ambac Assurance insured securities given their relative risk/reward characteristics in order to mitigate the effect of potential future adverse development in the insured portfolio. Ambac Assurance financial guarantee policies related to these securities have been allocated to the Segregated Account. As described in “2010, 2011 and Recent Events” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, Ambac Assurance’s investment policies are subject to certain covenants made for the benefit of the Segregated Account. Further, Ambac Assurance’s investment policies are subject to oversight by the rehabilitator pursuant to contracts entered into between Ambac Assurance and the Segregated Account and, therefore, such policies may change. Any such changes could adversely impact the performance of the investment portfolio.

As of December 31, 2011, the Ambac UK investment portfolio had an aggregate fair value of approximately $0.3 billion and an aggregate amortized cost of approximately $0.3 billion. Ambac UK’s investment policy is designed with the primary objective of ensuring that Ambac UK is able to meet its financial obligations as they fall due, in particular with respect to policy holders and meeting their claims. Ambac UK’s investment portfolio is subject to internal investment guidelines and may be subject to limits on types and quality of investments imposed by the FSA as regulator of Ambac UK. The Board of Directors of Ambac UK approves any changes or exceptions to Ambac UK’s investment policy.

As of December 31, 2011, the Financial Services investment portfolio had an aggregate fair value of approximately $0.8 billion and an aggregate amortized cost of approximately $0.8 billion. The investment objectives are to invest primarily in high-grade securities that produce sufficient cash flow to satisfy all investment agreement liabilities and intercompany obligations. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

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

 

     Summary of Investments as of December 31,  
     2011     2010  

Investment Category

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

Long-term investments:

          

Taxable bonds

   $ 4,611,370         7.24   $ 4,385,551         6.09

Tax-exempt bonds

     1,482,449         4.84     1,476,093         4.88
  

 

 

      

 

 

    

Total long-term investments

     6,093,819         6.65     5,861,644         5.77

Short-term investments(2)

     783,071         0.19     991,567         0.20

Other

     100         —          100         —     
  

 

 

      

 

 

    

Total

   $ 6,876,990         5.86   $ 6,853,311         4.93
  

 

 

      

 

 

    

 

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

 

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     Investments by Security Type as of December 31,  
     2011     2010  

Investment Category

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

Municipal obligations(2)

   $ 2,002,999         5.17   $ 1,921,336         5.19

Corporate securities

     1,127,500         4.15     917,908         4.31

Foreign obligations

     94,795         4.13     118,455         3.80

U.S. government obligations

     372,364         1.26     272,275         1.89

U.S. agency obligations

     86,871         4.34     88,294         4.35

Residential mortgage-backed securities.

     1,415,245         16.12     1,506,809         10.83

Asset-backed securities

     994,045         3.87     1,036,567         3.40
  

 

 

      

 

 

    

Total long-term investments

     6,093,819         6.65     5,861,644         5.77

Short-term investments(2)

     783,071         0.19     991,567         0.20

Other

     100         —          100         —     
  

 

 

      

 

 

    

Total

   $ 6,876,990         5.86   $ 6,853,311         4.93
  

 

 

      

 

 

    

 

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

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

EMPLOYEES

As of December 31, 2011, Ambac and its subsidiaries had 227 employees. Ambac considers its employee relations to be satisfactory.

CORPORATE GOVERNANCE

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

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

 

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References in the risk factors to “Ambac” are to Ambac Financial Group, Inc. References to “we,” “our,” “us” and “Company” are to Ambac, Ambac Assurance Corporation, Everspan Financial Guarantee Corp., and Ambac Credit Products LLC as the context requires. Capitalized terms used but not defined in this section shall have the meanings ascribed thereto in Part I, Item 1 of this Form 10-K or in Note (1) to the Consolidated Financial Statements contained in Part II, Item 8 of this Form 10-K unless otherwise indicated.

The Reorganization Plan may not be consummated if certain conditions are not met which would result in delay and significant expense to us, adversely impacting our operations during this period.

Consummation and effectiveness of the Reorganization Plan is subject to the satisfaction or waiver of the following conditions: (i) the Bankruptcy Court shall have entered an order confirming the Reorganization Plan and such order shall have become final in accordance with the Reorganization Plan; (ii) the Bankruptcy Court shall have approved any supplement filed with respect to the Reorganization Plan; (iii) new organizational documents of the Company shall have been effected; (iv) the Company shall have executed and delivered all documents necessary to effectuate the issuance of the common stock and warrants (if applicable) pursuant to the Reorganization Plan; (v) all authorizations, consents and regulatory approvals required, if any, in connection with the consummation of the Reorganization Plan shall have been obtained; (vi) the Stipulation (as defined in Note 17 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) shall have become effective; (vii) the terms of the IRS Settlement (as defined in Note 17 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) shall have been approved by OCI, the United States, the Rehabilitation Court, and the Creditors’ Committee, and all conditions to the effectiveness of the IRS Settlement shall have been satisfied; (viii) the IRS Settlement and all transaction documents relating thereto shall have been executed by the parties thereto; (ix) the Bankruptcy Court shall have entered an order pursuant to Bankruptcy Rule 9019 approving the IRS Settlement; (x) the aggregate face amount of allowed and disputed general unsecured claims shall be less than $50 million; (xi) the Rehabilitation Court shall have approved the transactions contemplated by the Mediation Agreement, the Amended TSA, the Cost Allocation Agreement, and the Cooperation Agreement Amendment; (xii) the Cash Grant shall have been paid or paid into escrow as provided in the Mediation Agreement; (xiii) the Amended TSA, the Cooperation Agreement Amendment and the Cost Allocation Agreement shall have been executed; and (xiv) all other actions, documents, certificates and agreements necessary to implement the Reorganization Plan shall have been effected or executed and delivered to the required parties and, to the extent required, filed with applicable governmental units in accordance with applicable laws.

As noted above, the conditions to the consummation of the Reorganization Plan included the finalization of the IRS Settlement. Finalization of such settlement requires (i) the acceptance of the terms set forth in the Offer Letter (as defined in Note 14 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) by the United States; (ii) the satisfaction of all conditions set forth in the Offer Letter; (iii) the approvals of OCI, the Rehabilitation Court, the Creditors’ Committee, and the Bankruptcy Court; (iv) the execution by all parties thereto of all transaction documents related to the IRS Settlement; and (v) agreement by the IRS that no “ownership change” with respect to Ambac Assurance for purposes of Section 382 of the Internal Revenue Code of 1986, as amended (the “Tax Code”) or Deconsolidation Event occurred during the 2010 taxable year as a result of certain events described in the Offer Letter.

Furthermore, as noted above, the Reorganization Plan may not be consummated unless the Rehabilitation Court has approved the transactions contemplated in the Mediation Agreement. The Rehabilitation Court entered an order approving such transactions on November 10, 2011; however, such order has been appealed and may be overturned or stayed. There can be no assurance that the order entered by the Rehabilitation Court will remain in effect.

As noted above, consummation of the Reorganization Plan also requires that the Stipulation has become effective. The Stipulation will not become effective until certain conditions are met, including, without limitation, the following:

 

  (i)

The judgment of the United States District Court for the Southern District of New York (“USDC SDNY”) approving the settlement of the Securities Class Actions (as defined in Note 17 to the

 

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  Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) shall have become “Final,” meaning that the time to appeal such judgment shall have expired without an appeal having been taking or, if an appeal has been taken, that (a) the appeal has been decided by all appellate courts without causing a material change in the judgment or (b) the judgment has been upheld on appeal and is no longer subject to appellate review. The judgment of the USDC SDNY has not yet become “Final” as a result of the filing of an appeal.

 

  (ii) The order of the Bankruptcy Court approving the Stipulation and approving Ambac’s entry into the Stipulation shall have become Final. The order of the Bankruptcy Court has not yet become Final as a result of the filing of an appeal.

 

  (iii) The Derivative Actions (as defined in Note 17 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) filed in the Southern District of New York, the Delaware Court of Chancery, and the New York Supreme shall have been dismissed. The order of the Delaware Court of Chancery dismissing the Delaware derivative action has been appealed to the Delaware Supreme Court, and one of the New York Supreme Court Derivative Actions remains listed on the Court’s docket as “stayed” instead of disposed of.

There can be no assurance that these conditions will be met and that the Stipulation will become effective; nor can there be any assurance as to the timing of the satisfaction of such conditions.

Given the number and complexity of the conditions to consummation and effectiveness of the Reorganization Plan, there can be no assurance that such conditions will be met. Nor can the Company estimate when consummation and effectiveness of the Reorganization Plan will occur, even assuming that such conditions will be satisfied. The failure to satisfy or obtain the necessary waivers with respect to such conditions in a timely manner could result in the Company seeking to modify the Reorganization Plan, pursuing an alternative Chapter 11 plan of reorganization or electing to convert the Chapter 11 case to a Chapter 7 liquidation. Modification of the Reorganization Plan or development of an alternative Chapter 11 plan would result in delay and significant expense, thus imperiling the Company’s ability to successfully reorganize. Furthermore, there can be no assurance that any alternative Chapter 11 plan would be as favorable to holders of Ambac securities and claims as those proposed in the Reorganization Plan. Conversion to Chapter 7 liquidation would, in the view of the Company, produce a less favorable outcome for holders of Ambac securities and claims than would the Reorganization Plan.

Trading in our securities prior to our emergence from bankruptcy is highly speculative and poses substantial risks as our Reorganization Plan reflects that our common stock will be cancelled and accordingly holders of such common stock will not receive any distribution with respect to, or be able to recover any portion of, such investment.

If our Reorganization Plan is consummated, our existing common stock will be cancelled and extinguished and the holders thereof would not be entitled to receive, and would not receive or retain, any property or interest in property on account of such equity interests. Amounts invested by such holders in our outstanding equity securities will not be recoverable. As such, our currently outstanding equity securities likely have no value.

The IRS Settlement may not be finalized, which would negatively impact the ability of the Company to consummate the Reorganization Plan and expose the Company to risks of litigation.

As stated above, failure to finalize the IRS Settlement could imperil the ability of the Company to consummate its Reorganization Plan. Moreover, a prolonged timetable in consummating the settlement could result in significant expense, threatening the Company’s ability to successfully reorganize. In the absence of a settlement, the IRS Dispute will proceed to trial. Should the IRS prevail in litigation, allowance of its claim as filed in the Bankruptcy Court would seriously jeopardize the Company’s ability to reorganize and may result in conversion to a Chapter 7 case.

 

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Disputes between Ambac and Ambac Assurance may result from the failure to consummate a Plan, which could reduce the overall value of the Company.

If the Reorganization Plan is not consummated, the Company may lose the benefits of the Amended Plan Settlement. In the absence of an agreement among the Company, the Creditors’ Committee, Ambac Assurance, the Segregated Account and OCI with respect to the allocation of potential sources of value (principally NOLs) and expense sharing between the Company and Ambac Assurance, the Company or its creditors could take actions which would adversely affect Ambac Assurance and/or the Segregated Account. For example, the Company or its creditors could seek to impose a constructive trust with respect to cash payments received by Ambac Assurance and/or seek to re-organize Ambac’s ownership interest in Ambac Assurance in order to achieve a deconsolidation of Ambac and Ambac Assurance for tax purposes, with the result that Ambac would become entitled to the use of all NOLs in existence on the date of such deconsolidation. Such disputes and/or litigation between Ambac and Ambac Assurance could prolong the Chapter 11 proceeding, with resultant increases in the expenses of the Chapter 11 proceeding, and could threaten Ambac’s ability to successfully reorganize. Additionally, such disputes and/or litigation could prompt OCI to initiate rehabilitation proceedings with respect to Ambac Assurance, either preemptively or in response to any such action; initiation of a rehabilitation proceeding with respect to Ambac Assurance could decrease the residual value, if any, of Ambac Assurance.

A long and protracted Chapter 11 proceeding could disrupt our operations and divert the attention of our management from our operations and the implementation of our post-bankruptcy plan.

So long as the Chapter 11 proceeding continues, our senior management will be required to spend a significant amount of time and effort working on the reorganization, distracting focus from our business operations. A prolonged period of operating under Chapter 11 protection may also make it more difficult to attract and retain management and other key personnel necessary to effect a successful reorganization.

The Rehabilitator is considering substantial amendments to the Segregated Account Rehabilitation Plan and/or the initiation of rehabilitation proceedings against Ambac Assurance which would likely have adverse consequences to holders of Ambac securities and may have adverse consequences to holders of securities insured by Ambac Assurance.

As described elsewhere herein, the issuance of Surplus Notes by both Ambac Assurance and the Segregated Account as contemplated by the current Segregated Account Rehabilitation Plan could subject Ambac Assurance to the risk of deconsolidation from Ambac for tax purposes, which may also result in a Section 382 limitation with respect to Ambac Assurance’s NOLs or an attribution of such NOLs to Ambac, or could subject Ambac Assurance to the risk of recognizing significant cancellation of indebtedness income. As a result, the Rehabilitator is considering substantial amendments to the Segregated Account Rehabilitation Plan and/or the initiation of rehabilitation proceedings with respect to Ambac Assurance. Such amendments to the Segregated Account Rehabilitation Plan (and, presumably, any rehabilitation plan with respect to Ambac Assurance) could include the elimination of the issuance of Surplus Notes by the Segregated Account and/or the imposition of transfer restrictions on any Surplus Notes issued by the Segregated Account.

Any such amendments to the Segregated Account Rehabilitation Plan could adversely affect the interests of Ambac security holders and holders of securities insured by Ambac Assurance. Notwithstanding that amendments to the Segregated Account Rehabilitation Plan and/or the initiation of rehabilitation proceedings would be designed to preserve tax attributes for the ultimate benefit of policyholders, such amendments might have other adverse impacts on holders of securities insured by Ambac Assurance, including, without limitation, delays in receipt of cash in respect of claims, absence of Surplus Notes in respect of claims and/or the imposition of trading restrictions on Surplus Notes received in respect of claims. Additionally, the initiation of rehabilitation proceedings with respect to Ambac Assurance would result in the assumption of control by the Rehabilitator of all of Ambac Assurance’s assets and management of Ambac Assurance. In exercising control, the Rehabilitator

 

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will act for the benefit of policyholders, and will not take into account the interests of security holders of Ambac; such actions may result in material adverse consequences for Ambac’s security holders. In addition, the initiation of delinquency proceedings against Ambac Assurance would further decrease the likelihood that OCI will permit Ambac Assurance to make future dividend payments to Ambac.

Since our consolidated financial statements will reflect fresh start accounting adjustments upon emergence from bankruptcy, and because of the effects of the transactions that will become effective pursuant to the Reorganization Plan, our financial information in the post-emergence financial statements will not be comparable to our financial information from prior periods.

Upon our emergence from bankruptcy, we will adopt fresh start accounting pursuant to which the carrying value of the Company’s assets and liabilities will be adjusted as of the date of its emergence from bankruptcy. Thus, our future consolidated financial statements will not be comparable in many respects to our consolidated financial statements for periods prior to our adoption of fresh-start accounting and prior to accounting for the effects of the reorganization proceedings.

We might not be able to accomplish the objectives of our business strategy even after we have reorganized our capital structure and financial obligations through the consummation of the Reorganization Plan.

The value of Ambac is dependent upon the residual value of Ambac Assurance, the receipt of payments to be made by Ambac Assurance pursuant to the Mediation Agreement, the Amended TSA and the Cost Allocation Agreement, and Ambac’s ability to generate new business. There can be no assurance that Ambac will be able to realize residual value in Ambac Assurance. Ambac Assurance is in run-off and the Segregated Account is subject to rehabilitation proceedings. It is uncertain whether Ambac Assurance will be able to satisfy all of its obligations and make dividend payments to Ambac. Furthermore, the payments to be made to Ambac under the Mediation Agreement, the Amended TSA and the Cost Allocation Agreement are subject to contingencies that are difficult to predict, making the amount and timing of such payments uncertain. Ambac’s ability to generate new business is also uncertain, given the condition and circumstances of Ambac Assurance and the difficulty of leveraging or monetizing its other assets.

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

Holders of claims that were allocated to the Segregated Account have challenged the establishment of the Segregated Account. If such challenges are successful, Ambac Assurance and/or the Segregated Account may be exposed to the risk of greater losses. Similarly, if the Amended Plan Settlement is lost due to a failure to consummate the Reorganization Plan, Ambac (or its creditors) could take actions which would adversely affect Ambac Assurance and/or the Segregated Account. In response to these or other events, such as increased loss development in the General Account of Ambac Assurance, OCI may determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to Ambac Assurance, either preemptively or in response to any such event.

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

 

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

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

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

As of December 31, 2011, we have estimated subrogation recoveries of $2,692.4 million (net of reinsurance), which is included in our loss reserves. These recoveries are based principally on contractual claims arising from RMBS transactions that we have insured, and represent our estimate of the amounts we will ultimately recover. However, our ability to recover these amounts is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties and/or their respective parents and affiliates, timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take the actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. The amount of these subrogation recoveries is significant and if we were unable to recover any amounts our stockholders’ deficit as of December 31, 2011 would increase from $3,149.5 million to $5,841.9 million.

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

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

In addition, the Rehabilitator may propose amendments to the Segregated Account Rehabilitation Plan that could have a significant impact on our financial statements as such amendments could have the effect of minimizing NOL usage payments to Ambac pursuant to the Amended TSA.

In addition, as a result of the Segregated Account Rehabilitation Proceedings, certain key personnel have chosen to leave Ambac, and additional people may decide to leave. The loss of such personnel could adversely impact Ambac’s financial results.

 

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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 are established when management has observed credit deterioration, in most cases, when the underlying credit is considered below investment grade. Loss reserves established with respect to our non-derivative financial guarantee insurance business are based upon estimates and judgments by management, including estimates and judgments with respect to the probability of default, the severity of loss upon default, management’s ability to execute commutation transactions, and estimated remediation recoveries for, among other things, breaches by RMBS issuers of representations and warranties. Furthermore, the objective of establishing loss reserve estimates is not to reflect the worst possible outcome. As a result of the inherent uncertainties in the estimates and judgments made to determine loss reserves, there can be no assurance that the actual losses in our financial guarantee insurance portfolio will not exceed such reserves.

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

We also rely on internally and externally developed complex financial models, including licensed models related to RMBS to project performance of our insured obligations. Differences in the models that we employ, and/or flaws in these financial models and/or faulty assumptions inherent in these financial models and those determined by management, could lead to increased losses and loss reserves. Uncertainty with respect to the ultimate performance of certain of our insured exposures may result in substantial changes in loss reserves and/or actual losses. Moreover, modeled estimates of transaction performance depend in part on our interpretations of contracts and other bases of our legal rights. Such interpretations may prove to be incorrect or different interpretations may be employed by bond trustees and other transaction participants, which could lead to increased losses and loss reserves.

Some of the state and local governments and finance authorities that issue public finance obligations we insure are experiencing fiscal stress that could result in increased credit losses or impairments on those obligations or increased liquidity claims.

We have historically experienced low levels of defaults in our U.S. public finance insured portfolio, including during the financial crisis that began in mid-2007. However, recently many state and local governments that issue obligations we insure have reported unprecedented budget shortfalls that will require them to significantly raise taxes and/or cut spending in order to satisfy their obligations. Government entities may also take other actions that may impact their own creditworthiness or the creditworthiness of directly or indirectly related issuers. For example, the State of California recently abolished redevelopment agencies in the State, and while the agencies’ existing debt is required to be repaid, there can be no certainty that the agencies have the ability or willingness to pay their debts when due. In addition, some issuers of obligations we insure have either defaulted or filed for bankruptcy, raising concerns about their ultimate ability to service the debt we insure or recover claims paid in the future. While there has been some support provided by the U.S. federal government designed to provide aid to state and local governments, certain state and local governments remain under extreme financial stress. If the issuers of the obligations in our U.S. public finance portfolio are unable to raise taxes, cut spending, or receive federal assistance, we may experience liquidity claims and/or ultimate losses or impairments on those obligations, which could adversely affect our business, financial condition and results of operations.

 

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We are exposed to operational risks with respect to the payment of claim liabilities of the Segregated Account.

Ambac Assurance, as the management services provider to the Segregated Account, handles certain administrative and management services for the Segregated Account. Under the Segregated Account Rehabilitation Plan that has been confirmed by the Rehabilitation Court but is not yet effective and is subject to change, it is contemplated that the Segregated Account will partially satisfy its claim liabilities through the issuance of Surplus Notes. In connection with the distribution of Surplus Notes, or the implementation of any alternative processes designed to handle policy claims against the Segregated Account, Ambac Assurance is exposed to operational risks related to the settlement or proper accounting for such claims.

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

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

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

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

Risks that impact assets in our investment portfolio could adversely affect our ability to pay our liabilities and accordingly have a negative effect on our operations.

Our investment portfolio may be adversely affected by events and developments in the capital markets including interest rate movements, credit rating downgrades, ABS and RMBS prepayment speeds (which are impacted by the claims moratorium in effect at Ambac Assurance) and foreign exchange movements.

To the extent we need 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 could be sold at prices less than fair value as of December 31, 2011.

The change in composition of the securities in our investment portfolio exposes us to greater risk.

Prior to the rating agency actions on Ambac Assurance, Ambac Assurance managed its investment portfolio in accordance with rating agency standards for a AAA-rated insurance company. As a result of the significant

 

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declines in, and ultimate withdrawal of, Ambac Assurance’s financial strength ratings, it is no longer necessary to comply with the strict investment portfolio guidelines for a AAA-rated company. Therefore, Ambac Assurance has decided to maintain a portion of its investment portfolio in lower-rated securities in order to increase the investment return on its portfolio. Investments in lower-rated securities and “alternative assets” could expose Ambac to increased losses on its investment portfolio in addition to risks described above and/or decrease the liquidity of the investment portfolio. Ambac Assurance’s investment policies are also subject to certain covenants enforceable by OCI. Any changes as a result of such covenants could adversely impact the performance of the investment portfolio.

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

The determination of the amount of impairments on our investments vary by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in impairments as such evaluations are revised. There can be no assurance that our management has accurately assessed the level of impairments taken in our financial statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. We use externally developed financial models to project impairments with respect to RMBS held in our investment portfolio. Differences in the models we employ and/or flaws in these models and/or faulty assumptions inherent in these models and those determined by management, could lead to increased impairments with respect to RMBS in our investment portfolio.

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

Ambac’s Investment Agreement business has issued investment agreements to investors that may allow for early withdrawal (i.e. deviate from a defined or expected withdrawal schedule). The provisions that allow for early withdrawal vary by transaction but include events such as credit events, early call provisions, loss events, construction project development variance and changes in tax laws. 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.

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

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

 

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

Ambac, and certain of its present and former officers and directors, have been named in lawsuits that allege violations of the federal securities laws and/or state law. Ambac also has been named in lawsuits relating to transactions entered into by its financial guarantee subsidiary, Ambac Assurance, and its financial services businesses. In addition, Ambac has received various regulatory inquiries and requests for information. Please see Note 17 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for information on these various proceedings.

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

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

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

While further deterioration in the performance of consumer assets, including mortgage-related assets, credit cards, student loans and auto loans and leases, may occur, the extent and duration of any future deterioration of the credit markets is unknown, as is the impact, if any, on potential claim payments and ultimate losses of the securities within Ambac Assurance’s portfolio. In addition, there can be no assurance that any of the governmental or private sector initiatives designed to address such credit deterioration in the markets will be successful or inure to the benefit of the transactions insured by Ambac. Servicer settlements with governmental authorities regarding foreclosure irregularities are generally designed to protect homeowners and may increase losses on securities insured by Ambac.

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

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

We are exposed to the risk that issuers of debt which we have insured (or with respect to which we have written credit derivatives), issuers of debt which we hold in our investment portfolio, reinsurers and other contract counterparties (including derivative counterparties) may default in their financial obligations, whether as

 

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

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

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

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

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

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

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

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

 

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

Our principal subsidiary, Ambac Assurance, is subject to the insurance laws and regulations of each jurisdiction in which it is licensed. Ambac Assurance UK Limited (“Ambac UK”), the subsidiary through which we wrote financial guarantee insurance in the United Kingdom and in the European Union, is regulated by the UK’s Financial Services Authority (“FSA”). Failure to comply with applicable insurance laws and regulations (including, without limitation, minimum surplus requirements, aggregate risk limits and single risk limits) could expose us to fines, the loss or suspension of insurance licenses in certain jurisdictions, the imposition of orders by regulators with respect to the conduct of business by our insurance company subsidiaries 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.

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

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

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

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

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

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

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

Ambac Assurance’s CDS portfolio experienced significant losses. The majority of these CDS contracts are on a “pay as you go” basis, and we believe that they are properly characterized as notional principal contracts for

 

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U.S. federal income tax purposes. Generally, losses on notional principal contracts are ordinary losses. However, the federal income tax treatment of credit default swaps is an unsettled area of the tax law. As part of the ongoing audit of Ambac’s 2007-2009 consolidated federal income tax returns and refund claims, the IRS has proposed to disallow Ambac’s (as the consolidated tax filer) deductions of CDS losses as ordinary losses, effectively taking the position that they were more properly characterized as capital losses. On May 4, 2011 the IRS filed a proof of claim in the Bankruptcy Court in the amount of approximately $800 million relating to the tax treatment of the CDS contracts, which Ambac opposed. As of December 31, 2011, Ambac had NOLs amounting to approximately $7,862 million, which is comprised of $7,151 million in ordinary, $364 million in capital federal income tax losses, and $347 million in international losses. Although Ambac believes these contracts are properly characterized as notional principal contracts, if the IRS were to successfully assert the proposed disallowance resulting from its examination and its claim in the bankruptcy case, Ambac would be subject to both a substantial reduction in its NOLs and would suffer a material assessment for U.S. federal income taxes. Such assessments and reductions in NOLs would have a material adverse impact on our financial condition and would seriously jeopardize the Company’s ability to reorganize and may result in conversion to a Chapter 7 case. Such assessments related to the tentative refunds, which amount to approximately $700 million, may be made by the Internal Revenue Service at any time and, without prior notice to Ambac, pursuant to section 6213(b) of the Tax Code. Subject to applicable law, existing court orders and the terms of a stipulation requiring the IRS to provide notice to Ambac five business days before taking any enforcement action, the IRS may then file a lien that attaches to Ambac’s property interests, including the property interests of any member of the consolidated tax group, and commence collection efforts. If these events occur, the Segregated Account Rehabilitation Plan may be materially impacted and Ambac’s ability to effectively reorganize may be seriously jeopardized. While these issues would be resolved upon finalization of the IRS Settlement, there can be no assurance that the IRS Settlement will be consummated.

Issuance of Surplus Notes may cause Ambac Assurance to recognize CODI, which could significantly reduce the Ambac Assurance NOLs.

If either the Surplus Notes issued by Ambac Assurance or by the Segregated Account or the claims for which the Surplus Notes are exchanged are “publicly traded” for purposes of section 1273 of the Tax Code and applicable Treasury Regulations thereunder, Ambac Assurance will be treated as having satisfied the policyholders’ claims against Ambac Assurance for an amount equal to the fair market value of the Surplus Notes (plus any other consideration transferred). Although the analysis related to whether the Surplus Notes or claims are “publicly traded” is not clear and there is little authority addressing this issue, determining that either the Surplus Notes or claims are “publicly traded” could cause Ambac Assurance to recognize a potentially significant amount of cancellation of debt income (“CODI”), which would reduce the Ambac Assurance NOLs by the amount of such CODI. The reduction in the Ambac Assurance NOL could impair Ambac Assurance’s ability to satisfy claims asserted against the Segregated Account or Ambac Assurance. In addition, holders of the Surplus Notes may recognize interest income pursuant to the original issue discount rules prior to receipt of interest payments on the Surplus Notes.

Surplus Notes issued by either Ambac Assurance or the Segregated Account may be characterized as equity of Ambac Assurance and as a result, Ambac Assurance may no longer be a member of the U.S. federal income tax consolidated group of which the Company is the common parent.

It is possible the Surplus Notes issued by either Ambac Assurance or the Segregated Account may be characterized as equity of Ambac Assurance for U.S. federal income tax purposes. If the Surplus Notes are characterized as equity of Ambac Assurance and it is determined the Surplus Notes represented more than twenty (20) percent of the total value of the stock of Ambac Assurance, Ambac Assurance may no longer be characterized as an includable corporation that is affiliated with the Company. As a result, Ambac Assurance may no longer be characterized as a member of the U.S. federal income tax consolidated group of which the

 

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Company is the common parent (the “Ambac Consolidated Group”) and Ambac Assurance would be required to file a separate consolidated tax return as the common parent of a new U.S. federal income tax consolidated group including Ambac Assurance as the new common parent and Ambac Assurance’s affiliated subsidiaries (the “Ambac Assurance Consolidated Tax Group”).

To the extent Ambac Assurance is no longer a member of the Ambac Consolidated Group, Ambac Assurance’s NOLs (and certain other available tax attributes of Ambac Assurance and the other members of the Ambac Assurance Consolidated Tax Group) may no longer be available for use by the Ambac Assurance Consolidated Tax Group or any of the remaining members of the Ambac Assurance Consolidated Tax Group to reduce the U.S. federal income tax liabilities of the Ambac Assurance Consolidated Tax Group. Pursuant to the Mediation Agreement, the Company and Ambac Assurance, among other parties, agreed to enter into a tax sharing agreement that would require the Company to make certain tax elections that could mitigate the loss of NOLs and other tax attributes resulting from a deconsolidation of Ambac Assurance from the Ambac Consolidated Group. However, in the event of a deconsolidation, certain other benefits resulting from U.S. federal income tax consolidation may no longer be available to the Ambac Consolidated Group including certain favorable rules relating to transactions occurring between members of the Ambac Consolidated Group and members of the Ambac Assurance Consolidated Tax Group.

If the Surplus Notes are characterized as equity of Ambac Assurance, the Ambac Assurance NOLs (and certain other tax attributes or tax benefits of the Ambac Consolidated Group) may be subject to limitation under Section 382 of the Tax Code.

It is possible the Surplus Notes may be characterized as equity of Ambac Assurance for U.S. federal income tax purposes. As a result, transfers of the Surplus Notes by holders or to holders of more than 5 percent of the Surplus Notes may result in an “ownership change” of Ambac Assurance for purposes of Section 382 of the Tax Code. If such an ownership change were to occur, the value and amount of the Ambac Assurance NOLs would be substantially impaired, increasing the U.S. federal income tax liability of Ambac Assurance and materially reducing cash available to dividend to the reorganized company, as well as reducing the value of Ambac Assurance’s stock owned by the reorganized company.

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

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

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

Under Section 382 of the Tax Code, if a “loss corporation” (generally, a corporation with NOLs and/or built-in losses) undergoes an “ownership change,” the amount of such corporation’s pre-ownership change NOLs that may be utilized to offset future taxable income generally is subject to an annual limitation (the “Annual Section 382 Limitation”). In general, the amount of the Annual Section 382 Limitation is equal to the product of

 

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(1) the fair market value of the stock of the corporation (or, in the case of a consolidated group, generally the stock of the common parent) immediately before the ownership change (with certain adjustments) and (2) the “long-term tax-exempt rate” in effect for the month in which the ownership change occurs. In general, an “ownership change” occurs if shareholders owning 5 percent or more of the corporation’s stock increase their ownership by greater than 50 percentage points over a three-year testing period.

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

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

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

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

The U.S. federal income tax consequences resulting from the creation of the Segregated Account are uncertain. For example, to the extent the Segregated Account were treated as a separate taxable entity, depending upon the terms of the Segregated Account Rehabilitation Plan, gain or loss could be realized by Ambac or the new taxable entity (i.e., the Segregated Account) materially increasing the U.S. federal income tax liability of the relevant party and materially reduce cash available to be pay third party obligations or dividends.

Continued uncertainty regarding the European debt crisis may have prolonged adverse consequences on the capital markets which in turn may impact Ambac’s investment results and have negative consequences for certain insured transactions.

The uncertainties related to European sovereign and bank default risk have resulted in greater levels of volatility within the capital markets and a “flight to quality” that has helped suppress US interest rates. As a result, reinvestment opportunities have been limited by the overall low level of nominal rates and liquidity for other than the highest quality investments has been constrained. If such market conditions continue for a prolonged period of time they could have a material adverse impact on Ambac’s operating results and financial condition. In addition, stress in the European markets may have an adverse impact on certain obligations insured by Ambac Assurance and Ambac UK that are sensitive to economic conditions in Europe and that are reliant on the European capital markets for financing.

 

Item 1B. Unresolved Staff Comments

None.

 

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Item 2. Properties.

The executive office of Ambac is located at One State Street Plaza, New York, New York 10004, which consists of approximately 103,500 square feet of office space, under an agreement with an initial term that expires in December 2015. This office houses operations for all reportable business segments.

Ambac UK also maintains offices in the United Kingdom (London), which consist of approximately 3,500 square feet of office space, under an agreement that expires in October 2020, with an earlier term option at Ambac’s discretion; and in Italy (Milan).

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

 

Item 3. Legal Proceedings.

Please refer to Note 17 “Commitments and Contingencies” of the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K for a discussion on Legal Proceedings against Ambac and its subsidiaries.

 

Item 4. Mine Safety Disclosures.

Not applicable.

Part II

 

Item 5. Market for Registrant’s Common Equity, and Related Stockholder Matters and Issuer Purchases of Equity Securities.

(a) Market Information

Our common stock currently trades on OTCQB, the middle tier of the OTC marketplace reserved for fully reporting issuers, under the symbol “ABKFQ.” On November 9, 2010, our common stock ceased trading on the New York Stock Exchange (“NYSE”) and began trading on the OTCQB. The following table sets forth the high and low sales prices for the common stock for the periods indicated through November 8, 2010 as reported by the NYSE and on or after November 9, 2010, the high and low bid quotations as reported by Bloomberg Financial Services, Inc. Such Over-the-counter market quotations reflect interdealer prices without retail mark-up, markdown or commission and may not represent actual transactions.

 

     High      Low      Dividends  

2011:

        

Fourth Quarter

   $ 0.078       $ 0.021       $ 0   

Third Quarter

   $ 0.120       $ 0.040       $ 0   

Second Quarter

   $ 0.160       $ 0.079       $ 0   

First Quarter

   $ 0.275       $ 0.108       $ 0   

2010:

        

Fourth Quarter

   $ 1.150       $ 0.021       $ 0   

Third Quarter

   $ 1.050       $ 0.400       $ 0   

Second Quarter

   $ 3.390       $ 0.540       $ 0   

First Quarter

   $ 0.880       $ 0.515       $ 0   

(b) Holders

On March 9, 2012, there were 90 stockholders of record of Ambac’s Common Stock.

 

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Item 5. Market for Registrant’s Common Equity, and Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

(c) Dividends

Information concerning payments and restrictions on the payment of dividends is set forth in Item 1 above under the caption “Insurance Regulatory Matters—Dividend Restrictions, Including Contractual Restrictions” and in Note 7 to the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K.

 

Item 6. Selected Financial Data.

Not applicable.

 

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

OVERVIEW

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. On November 8, 2010, Ambac filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). Ambac has continued to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court. The Company, as debtor and debtor-in-possession, filed a Plan of Reorganization on July 6, 2011, a First Amended Plan of Reorganization on September 21, 2011, a Second Amended Plan of Reorganization on September 30, 2011, a Third Amended Plan of Reorganization on February 24, 2012, a Fourth Amended Plan of Reorganization on March 9, 2012, and a Fifth Amended Plan of Reorganization on March 12, 2012 (such Fifth Amended Plan of Reorganization, as it may be further amended, the “Reorganization Plan”). The Reorganization Plan reflects a resolution of certain issues (the “Amended Plan Settlement”) among the Company, the statutory committee of creditors appointed by the United States Trustee on November 17, 2010 (the “Creditors’ Committee”), Ambac Assurance Corporation (“Ambac Assurance”), the Segregated Account (as defined below) and OCI (as defined below) (as regulator of Ambac Assurance and as Rehabilitator (as defined below) of the Segregated Account) related to (i) the net operating loss carryforwards (“NOLs”) of the consolidated tax group of which the Company is the parent and Ambac Assurance is a member (the “Ambac Consolidated Group”), (ii) certain tax refunds received in respect thereof (the “Tax Refunds”) and (iii) the sharing of expenses between the Company and Ambac Assurance. The terms of the Amended Plan Settlement are memorialized in that certain Mediation Agreement dated September 21, 2011 (the “Mediation Agreement”) among such parties. Refer to Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for further discussion of the Amended Plan Settlement.

Ambac Assurance is Ambac’s principal operating subsidiary. Ambac Assurance is a financial guarantee insurer which provided financial guarantees and financial services to clients in both the public and private sectors around the world. In March 2010, Ambac Assurance established a segregated account pursuant to Wisc. Stat. §611.24(2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities. The Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) commenced rehabilitation proceedings with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit the OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. The Rehabilitator is Theodore Nickel, the Commissioner of Insurance of the State of Wisconsin.

The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio caused downgrades of Ambac Assurance’s financial strength ratings from the independent rating agencies. These losses have prevented Ambac Assurance from being able to write new business. On April 7, 2011, at Ambac Assurance’s request, Moody’s Investors Service, Inc. withdrew its ratings of Ambac Assurance and each of its affiliates. As a result, as of April 7, 2011, Ambac Assurance is no longer rated by any of the independent rating agencies. An inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends, and as a result Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition, by the rehabilitation of the Segregated Account and by the terms of the Settlement Agreement (with certain CDO of ABS counterparties). It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future. Refer to “2010, 2011 and Recent Events” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of Ambac’s bankruptcy, the creation and rehabilitation of the Segregated Account and the Settlement Agreement with the counterparties of CDO of ABS transactions. Ambac Assurance is also restricted in its ability to pay dividends pursuant to the terms

 

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

 

of its Auction Market Preferred Shares (“AMPS”). Refer to Part I, Item 1, “Business—Dividend Restrictions, Including Contractual Restrictions” of this Form 10-K for discussion of Ambac Assurance’s AMPS.

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

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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

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

Losses and Loss Expenses of Non-derivative Financial Guarantees:

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

ASC Topic 944, Financial Services—Insurance clarifies how existing guidance applies to financial guarantee insurance contracts issued by insurance contracts issued by insurance enterprises, including the recognition and measurement of claim liabilities (i.e. loss reserves). Under ASC Topic 944, a loss reserve is recorded on the balance sheet for the excess of (a) the present value of expected losses, over (b) the unearned premium reserve (“UPR”) for that contract. Expected losses represent projected net cash flows and are defined as the expected future claims to be paid under an insurance contract plus the impact of potential settlement outcomes upon future installment premiums, less potential recoveries. To the extent (a) is less than (b), no loss reserve is recorded. Changes to the loss reserve estimate in subsequent periods are recorded as a loss and loss expense on the income statement. For those policies where the potential recovery is less than the expected future claims, the resulting net cash outflow is recorded as a “Loss and loss expense reserve” liability. For those policies where significant losses have been paid, but not yet recovered, the potential recovery may be greater than the expected future claims and the resulting net cash inflow is recorded as a “Subrogation recoverable” asset.

 

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

 

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

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

The second approach entails the use of more precise estimates of expected losses (future claim payments, net of potential recoveries, expected to be paid to the holder of the insured financial obligation). Ambac’s surveillance group will consider the likelihood of all possible outcomes and develop appropriate cash flow scenarios. This approach can include the utilization of internal or external models to project future claim payment estimates. We have utilized such tools for residential mortgage-backed and student loan exposures. In general, these tools use historical performance of the collateral pools in order to then assume or derive future performance characteristics, such as default and voluntary prepayment rates, which in turn determine projected future claim payments. In this approach a probability-weighted expected loss estimate is developed based on assigning probabilities to multiple claim payment scenarios and applying an appropriate discount factor. Additionally, we assign a probability to the issuer’s ability to refinance an insured issue and/or Ambac’s ability to execute a potential settlement (i.e. commutation) of the insurance policy, inclusive of the impact on future installment premiums. The methodology used to estimate the most substantial amount of the potential recovery component of expected losses is further described in the “RMBS Representation and Warranty Subrogation Recovery” section below and in Note 2 to the Consolidated Financial Statements, located in Part II, Section 8 of this Form 10-K.

 

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The discount factor applied to both of the above described approaches is based on a risk-free discount rate corresponding to the remaining expected weighted-average life of the exposure and the exposure currency. The discount factor is updated for the current risk-free rate each reporting period.

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

As the probability of default for an individual credit increases and/or the severity of loss given a default increases, our loss reserve for that insured obligation will also increase. Political, economic, credit or other unforeseen events could have an adverse impact on default probabilities and loss severities. The performance and loss reserves for many transactions (such as many public finance exposures) are derived from the issuer’s obligation to pay. The performance and reserves of other transactions such as most structured finance exposures including RMBS have no direct issuer support and therefore are derived from the default activity and loss given default of collateral supporting the transactions. Many transactions have a combination of issuer/entity and collateral support. Loss reserves reflect our assessment of the transaction’s overall structure, support and expected performance. Loss reserve volatility will be a direct result of the credit performance of our insured portfolio, including the number, size, bond types and quality of credits included in our loss reserves as well as our ability to execute commutations. The number and severity of credits included in our loss reserves depend to a large extent on transaction specific attributes, but will generally increase during periods of economic stress and decline during periods of economic stability. Reinsurance recoveries do not have a significant effect on loss reserve volatility because Ambac has little exposure ceded to reinsurers and has received collateral from the majority of its reinsurers.

Ambac has exposure to various bond types issued in the debt capital markets. Our experience has shown that, for the majority of bond types, we have not experienced significant claims. We have observed that, with respect to certain bond types, it is reasonably possible that a material change in actual loss severities and defaults could occur over time. In the future, our experience may differ with respect to the types of guaranteed bonds affected or the magnitude of the effect. The bond types that have experienced significant claims are residential mortgage-backed securities (“RMBS”), student loan securities and collateralized debt obligations (“CDOs”). These three bond types represent 91% of our ever-to-date insurance claims presented with RMBS comprising 88% of our ever-to-date claims payments.

The table below indicates the number of credits, gross par outstanding and gross loss reserves (including loss adjustment expenses) related to policies in Ambac’s loss reserves on credits at December 31, 2011:

 

($ in millions)

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

RMBS

     166       $ 17,881       $ 4,455   

Student Loans

     79         6,749         1,155   

All other credits

     85         6,442         687   

Loss adjustment expenses

     —           —           87   
  

 

 

    

 

 

    

 

 

 

Totals

     330       $ 31,072       $ 6,384 (1) 
  

 

 

    

 

 

    

 

 

 

 

(1) Ceded Par Outstanding and ceded loss reserves are $1,913 and $151, respectively. Ceded loss reserves are included in Reinsurance Recoverable on paid and unpaid losses.
(2) Loss reserves of $6,384 are included in the balance sheet in the following line items: Loss and loss expense reserve—$7,044; Subrogation recoverable—$660.

 

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RMBS:

Ambac insures RMBS transactions that contain first-lien mortgages. Ambac classifies its insured first-lien RMBS exposure principally into two broad credit risk classes: Alt-A (including mid-prime, interest only, and negative amortization) and sub-prime. Alt-A loans were typically made to borrowers who had stronger credit profiles relative to sub-prime loans, but weaker than prime loans. Compared with Alt-A loans, sub-prime loans typically had higher loan-to-value ratios, reflecting the greater difficulty that sub-prime borrowers have in making down payments and the propensity of these borrowers to extract equity during refinancing. The Alt-A category includes:

 

   

Loans with specific payment features that afforded borrowers the option to have lower payments in the early years with resets after several years. For example, so-called interest only loans have monthly payments comprised of interest but no principal. So called negative amortization loans permit borrowers to defer interest and principal in the early years and then make higher payments in the period after the reset. Both types may also have lower interest rates in the early years. Future increases in monthly payments, commonly called payment shock, raise the probability of delinquencies and defaults given the decline in house prices over the past few years.

 

   

Loans backed by borrowers who typically did not meet standard agency guidelines for documentation requirement, property type or loan-to-value ratio. These are typically higher-balance loans made to individuals who might have past credit problems that were not severe enough to warrant “sub-prime” classification, or borrowers who chose not to obtain a prime mortgage due to documentation requirements.

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

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

Methodology for Projecting Expected Losses in our RMBS Portfolio

Prior to January 1, 2011, we utilized an internal roll-rate model to project losses for our second-lien transactions and a licensed third-party multi-scenario stochastic (Monte Carlo) cash flow model (“stochastic model”) to project losses for our first-lien transactions. Effective January 1, 2011, we started using a licensed statistical regression model (“regression model”) to develop estimates of projected losses for both our second and first-lien transactions. For the first three quarters of 2011, we developed reserves using all three models. As of the quarter ending December 31, 2011, we discontinued the use of both the stochastic model and the internal roll rate model and commenced the development of reserves using only the regression model.

 

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Our reserving methodology in the first three quarters of 2011 reflected a blending of the results of the two approaches used for each transaction, with 50% probability assigned to the regression model and 50% assigned to either our internal roll-rate model in the case of second-lien transactions or to the stochastic model in the case of our first-lien transactions. In the months leading up to the transition to one model, we worked extensively with the vendor for the regression model to ensure the model was adequately projecting the performance of our transactions, and to provide additional information and data to improve the precision of the model’s projections. Prior to solely utilizing the results of the regression model, our internal RMBS credit and quantitative professionals evaluated and analyzed the results of the regression model versus loss estimates generated utilizing our internal roll-rate model for second-lien transactions and our stochastic model for first-lien transactions. This cross disciplined team compared the specific drivers and methodology of the regression model with our existing approaches, and analyzed deal performance and model outputs across the portfolio. For example, the team considered the general reasonableness of the models’ projected defaults of borrowers not currently in seriously delinquent or worse payment status and also conducted selective collateral analyses. The team also assessed the models’ cumulative loss estimates and compared such estimates by asset type and vintage with rating agency and other published loss projections. Based upon this analysis, we believe the exclusive use of the regression model to project RMBS losses is reasonable at this time. Although RMBS loss projections can be widely disparate and there can be no certainty with regard to projecting such losses, we believe our current reserving approach, including the regression model itself and the assumptions utilized, is sound and reasonable.

The regression model considers historical and recent market performance to perform statistical analyses, the results of which are used to model the timing of prepayment and default events. Depending upon the availability of underlying data, the model utilizes either of two approaches: a loan-level approach or a deal-level approach. A loan-level approach is most often applied to first lien-transaction while a deal-level approach is more often applied to second-lien transactions, as home loan data is not available from recognized market sources for second-lien mortgage loans. Both the regression model and the stochastic model include home price appreciation (“HPA”) among their primary drivers. We rely upon recognized sources for HPA and interest rate projections and we use a recognized source for transaction waterfall structuring.

The regression model differentiates among servicers and their impact on loan performance, and also acknowledges the extension of liquidation timelines that has exacerbated loss severities. The regression model also takes into account payment shock (the increased likelihood of borrower defaults when adjustable payment mortgages reset to higher monthly payments). These aspects of the regression model represent enhancements from our previously utilized approaches. The regression model itself is subject to ongoing refinements resulting from industry research and performance that better inform model assumptions, enhanced model capabilities and other factors. For example, we anticipate a new release of this model scheduled for the first quarter of 2012, will include, among other enhancements, improved treatment of borrowers’ payment history, to better reflect our belief that borrowers with strong payment history will experience lower default rates than borrowers with poor payment history.

In our experience, market performance and model characteristics change and are updated through time and a regular review of models and the overall approach to loss estimation is beneficial. Our ability to drive change in the models we license is limited and subject to the expertise and views of the independent developer/vendor. On the other hand, our ability to estimate losses without such models is difficult and challenging for a large portfolio across multiple RMBS exposure types.

Summarized below is our approach to projecting claims and ultimate losses in our RMBS portfolio.

Second-Lien

In evaluating our portfolio of insured second-lien transactions we use the regression model, having discontinued the use of our internal roll-rate model for the fourth quarter of 2011.

 

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The regression model estimates mortgage loan collateral performance, the effect of such collateral cash flows within the transaction waterfall and the liability structure we insure. Collateral performance is modeled primarily at the deal level given the paucity of mortgage loan level data for second-lien transactions. Without the specific loan-level information, the deal-level approach processes a loan pool as if it were a single loan, selecting certain aggregated deal-level characteristics to then perform a statistical analysis using a multinomial logistic regression model. We use three HPA projection scenarios to develop a base case as well as stress and upside cases. The highest probability is assigned to the base case, with significantly lower probabilities to the stress and upside cases. This deal-level approach of the regression model takes a relatively complicated monthly cash flow and simplifies it into two parts: a borrower-behavior-dependent stage and a servicer-behavior-dependent stage. The borrower stage is designed to forecast the probability of a loan’s present delinquency status to any of eight future statuses. Through the borrower-behavior-dependent stage, at any given monthly period, a loan can take on one of the following eight statuses: current, 30, 60, 90, 120, 150, 180+ delinquent or prepaid. The deal-level approach calculates defaults using a roll-rate that evaluates the possible future state of a set of loans based on its current status and three variables: average FICO, average current CLTV, and an overall quality indicator. The servicer-behavior-dependent stage of the regression model governs a loan’s life cycle after it reaches 180 or more days delinquent. This stage evaluates the servicer’s propensity to foreclose or pursue a short sale, the speed of the foreclosure process, and the speed of the post-foreclosure distressed property liquidation. The transition probabilities between advanced delinquency and foreclosure, foreclosure and REO, and finally REO and ultimate liquidation are assumed by the model to depend upon how long a loan has already been in a particular status, as well as by the servicer and state-specific liquidation timeline factors.

The internal roll-rate model used in prior periods observes trends in delinquencies, defaults, loss severities and prepayments and extrapolates ultimate performance from this data on an individual transaction basis (and their component pools where they exist). As more information (performance and other) accumulates for each underperforming transaction we were able to update assumptions in this model to reflect these changes. By employing the roll-rate methodology, we examined the historical rate at which delinquent loans in each transaction rolled into later delinquency categories (i.e. 30-59 days, 60-89 days, 90+ days). This historical rate was adjusted each period to reflect current performance. The key inputs for this model were prepayment rates and loss severity. Voluntary prepayments have declined, driven by negative HPA, an impaired mortgage market, and borrowers’ inability to prepay balances. In our opinion, these factors will not improve in the foreseeable future and thus we generally projected recent trends into the future. This results in projected prepayment rates in the 2% to 5% range. We estimated loss severities between 100% and 105% as we expected complete write-offs of mortgage loans exacerbated by carrying costs. We determined a pool specific current-to-30-to-59 day delinquency curve and applied a statistical regression technique to historical roll rates. We carried forward the non-performing mortgages through the delinquency pipeline through the 60-89 and 90+ day delinquency categories all the way through to charge-off. We used this data in the internal roll-rate model to project a default curve for the life of the transaction.

First-Lien

In evaluating our portfolio of insured first-lien transactions we use the regression model, having discontinued the use of the stochastic model for the fourth quarter of 2011.

For most first-lien transactions, the regression model utilizes home mortgage loan level data from recognized market sources to calculate each loan’s probability of default and prepayment based on the characteristics of the loan. The loan-level approach of the regression model uses the results of a regression analysis to project prepayment and default vectors on a monthly basis based on its embedded risks. For first-lien transactions that do not have loan-level data available, we use the deal-level approach of the regression model that is described in the Second-Lien section above.

 

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There are three transitional stages with the loan-level approach of the regression model: current, prepayment or default. The model then looks beyond the stages to assess a set of loans based on a number of individual characteristics that are distinct to that set of loans. These individual characteristics are property type, occupancy status, loan purpose, documentation type, cumulative loan-to-value ratio, originator quality rating, servicer quality rating, FICO score, original loan balance, interest rate margin, and regional unemployment rate. The model then estimates the rate at which a loan will prepay or default reducing the balance of each loan monthly during the projection period based on the borrower’s given probability of defaulting or prepaying for that month. Servicer behavior is a unique variable in the loan-level approach of the regression model and is used to calculate the impact of servicer performance on expected prepayments and defaults. Consistent with the second-lien modeling, we consider three HPA scenarios in the regression model to develop a base case as well as stress and upside cases. The highest probability is assigned to the base case, with significantly lower probabilities to the stress and upside cases.

The stochastic model used in prior periods projected multiple scenarios at the individual mortgage loan level using various inputs, including:

 

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

 

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

 

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

 

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

 

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

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

Additional RMBS factors for first and second-lien transactions

Additional factors that may impact ultimate RMBS losses include, but may not be limited to, mortgage insurance, government programs and servicer intervention. These factors, and the impact on our loss reserve estimate, are further discussed below:

Mortgage insurance: Six of our mortgage-backed transactions have pool-level mortgage insurance remaining. Pool mortgage insurance is a master policy issued to the mortgage securitization trust, which indemnifies the trust either on a first loss or mezzanine basis in the event that covered mortgage loans in the trust default. The mortgage insurance master policy specifies the particular characteristics and conditions of each individual loan within the mortgage trust that is subject to coverage. The policy also includes various conditions including exclusions, conditions for notification of loans in default and claims settlement. We have noted with regard to these transactions that payment by mortgage insurers of claims presented by the mortgage trusts has been inconsistent, resulting in higher claims presented under Ambac Assurance’s financial guarantee policies. As a result, the impact of mortgage insurance on our loss reserve estimate is negligible.

Government programs: In May of 2009, the Federal Government initiated the Home Affordable Modification Plan (HAMP) which allows servicers to modify loans. After determining a borrower’s eligibility, a

 

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servicer can take a series of steps to reduce the monthly mortgage payment. HAMP is applicable to the Ambac-wrapped transactions serviced by the servicers that have signed servicer participation agreements to modify loans under HAMP. Based on the activity HAMP offers and indications from government published sources that suggest this program is unlikely to have a material impact on Ambac-wrapped transactions, beginning in the third quarter of 2011 we no longer assumed any impact for HAMP on our first-lien portfolio. At December 31, 2010, Ambac’s first-lien stochastic model assumed that 0.5% of HAMP-eligible loans will be modified monthly for 24 months for Ambac portfolios serviced by HAMP participating servicers. During 2010 and the first half of 2011 we reduced the impact of HAMP modifications to reflect the reported performance of HAMP. We have not given credit to any other government programs, most of which are targeted to home mortgages that are bank owned, and not in RMBS securitizations.

Servicer Intervention: With the exception of the internal second-lien roll-rate model used until the fourth quarter of 2011, we are able to include in our modeling the steps which Ambac is taking to address shortcomings in servicing performance including transfers of servicing where the legal right exists to do so. Ambac has initiated, with the cooperation of the Rehabilitator of the Segregated Account, programs with special servicers that we believe will mitigate losses on such transactions through intervention strategies such as loan modifications, improved liquidation timelines, and short sales. Ambac believes these are the principal factors that will result in reduced losses over time. Given the uncertainty in initiating additional programs of this nature, we are projecting that only exposures that have already transferred servicing or entered into special servicing agreements will benefit from the effects of servicer intervention strategies.

RMBS Representation and Warranty Subrogation Recoveries:

In an effort to better understand the unprecedented levels of delinquencies, Ambac or its counsel engaged consultants with significant mortgage underwriting experience to review the underwriting documentation for mortgage loans underlying certain insured RMBS transactions. Transactions which exhibited exceptionally poor performance were chosen for further examination of the underwriting documentation supporting the underlying loans. Factors which Ambac believes to be indicative of poor performance include (i) increased levels of early payment defaults, (ii) significant number of loan liquidations or charge-offs and resulting high levels of losses, and (iii) rapid elimination of credit protections inherent in the transactions’ structures. Item (ii), “loan liquidations” refers to loans for which the servicer has liquidated the related collateral and the securitization has realized losses on the loan; “charge-offs” refers to loans which have been written off as uncollectible by the servicer, thereby generating no recoveries to the securitization, and may also refer to the unrecovered balance of liquidated loans. In either case, the servicer has taken actions to recover against the collateral, and the securitization has incurred losses to the extent such actions did not result in full repayment of the borrower’s obligations. Generally, the sponsor of the transaction provided representations and warranties with respect to the securitized loans, including representations with respect to the loan characteristics, the absence of fraud or other misconduct in the origination process, and attesting to the compliance of loans with the prevailing underwriting policies. In such cases, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations and warranties. Refer to Note 2 and Note 4 of the Consolidated Financial Statements included in Part II, Item 8 of the Form 10-K for more information regarding representation and warranty subrogation recoveries.

 

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The table below distinguishes between RMBS credits for which we have not established a representation and warranty subrogation recovery and those for which we have, providing in both cases the number of credits, gross par outstanding, gross loss reserves before subrogation recoveries, subrogation recoveries, and gross loss reserves net of subrogation for all RMBS exposures for which Ambac established reserves at December 31, 2011:

 

($ in millions)

   Number of
policies
     Gross
par
outstanding
     Gross loss
reserve
before
subrogation
recoveries
     Subrogation
recoveries
    Gross loss
reserve net  of
subrogation
recoveries
 

Second-lien

     24       $ 3,572       $ 673         —        $ 673   

First-lien-Mid-prime

     50         4,151         2,165         —          2,165   

First-lien-Sub-prime

     33         1,449         223         —          223   

Other

     13         610         337         —          337   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Credits Without Subrogation

     120         9,782         3,398         —          3,398   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Second-lien

     23         3,786         1,605         (1,631     (26

First-lien Mid-prime

     18         2,025         1,217         (638     579   

First-lien Sub-prime

     5         2,288         956         (451     505   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Credits With Subrogation

     46         8,099         3,778         (2,720     1,058   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total

     166       $ 17,881       $ 7,176       $ (2,720   $ 4,456   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

STUDENT LOANS:

Our student loan portfolio consists of credits collateralized by (i) federally guaranteed loans under the Federal Family Education Loan Program (“FFELP”) and (ii) private student loans. Whereas FFELP loans are guaranteed for a minimum of 97% of defaulted principal and interest, private loans have no government guarantee and therefore are subject to credit risk as with other types of unguaranteed credits. Private student loans are outside the purview of recent government programs designed to assist borrowers. Recent default data has shown a significant deterioration in the performance of private student loans underlying our transactions. Additionally, due to the failure of the auction rate and variable rate markets, the interest rates on these securities increased significantly to punitive levels pursuant to the terms of the transaction. Such increases have caused the collateralization ratio in these transactions to deteriorate on an accelerated basis due to negative excess spread and/or the use of principal receipts to pay current interest.

Methodology for Projecting Expected Losses in our Student Loan Portfolio

The calculation of loss reserves for our student loan portfolio involves evaluating numerous factors that can impact ultimate losses. The factor which contributes to the greatest degree of uncertainty in ascertaining appropriate loss reserves is the long time horizon associated with the final legal maturity date of the bonds. Most of the student loan bonds which we insure were issued with original terms of 20 to 40 years until final maturity. Since our policy covers timely interest and ultimate principal payment, our loss projections must make assumptions for many factors covering a long time horizon. Key assumptions that will impact ultimate losses include but are not limited to the following: collateral performance which is highly correlated to the economic environment, interest rates, issuers ability to refinance bonds with a failed debt structure such as Auction Rate Securities and Variable Rate Demand Obligations, willingness of investors to tender their Auction Rate Securities at a discount; and, as applicable, Ambac’s ability to commute policies at a discount and servicer’s ability to stay a going concern after the termination of the FFELP program.

 

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In evaluating our Student Loan portfolio, losses were projected using either a cash flow or statistical expected loss approach. As more fully described in Note 4 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K, the statistical methodology uses probability of default and loss given default (LGD) under various scenarios to derive at a weighted average loss expectation. The scenarios used under the statistical expected loss approach evaluate each transaction under base case and stress case scenarios. The main drivers in assigning appropriate probabilities to LGDs for each policy includes an analysis of the collateral mix; debt type and interest rates; parity level; enhancement levels and remediation opportunities. We believe the statistical expected loss approach is a more efficient methodology for certain deals in our student loan portfolio, such as (i) deals where collateral loan level data is unavailable (and thus the cash flow model, as more fully discussed below could not be used), and (ii) deals where we do not expect to experience meaningful losses.

We use a third party deterministic cash flow model to develop loss projections for a portion of our portfolio. The model allows us to capture each transaction’s particular structure (i.e. the waterfall structure, triggers, redemption priority). For collateral performance, the model uses loan level detail that allows us to make specific default and recovery assumptions for each type of loan. We contract with a separate third party to run the model at our direction. We provide the third party with the material deal level assumptions such as default, recovery and interest rate assumptions.

We develop multiple cash flow scenarios and assign probabilities to each cash flow scenario based on each transaction’s unique situation. Probabilities assigned are based on available data related to the credit, any contact with the issuer, and any economic or market information that may impact the outcomes of the various scenarios being evaluated. Our base case usually projects the deal out to maturity using expected loss assumptions and interest rates adhering to the projected forward interest rate curve at the reporting date. We also develop stress cases that incorporate various stresses to the transaction, including but not limited to defaults, recoveries and interest rates. In estimating loss reserves, we also incorporate scenarios which represent remediation strategies. Remediation scenarios may include the following; (i) a potential refinancing of the transactions by the issuer; (ii) the issuer’s ability to redeem outstanding auction rate securities at a discount, thereby increasing the structure’s ability to absorb future losses; and (iii) our ability to terminate the policy in whole or in part (e.g. commutation). The remediation scenarios and the related probabilities of occurrence vary by policy depending on on-going discussions and negotiations that are underway with issuers and/or investors. In addition to commutation negotiations that are underway with various counterparties in various forms, our reserve estimates may also include scenarios which incorporate our ability to commute additional exposure with other counterparties.

REASONABLY POSSIBLE ADDITIONAL LOSSES:

RMBS:

It is possible that our loss estimate assumptions for the RMBS insurance policies discussed above could be materially under-estimated as a result of continued deterioration in housing prices, poor servicing, the effects of a weakened economy marked by growing unemployment and wage pressures, inability to execute commutation transactions with insurers and/or investors and/or continued illiquidity of the mortgage market. Additionally, our actual subrogation recoveries of $2,720.2 million could be lower than our current estimates if the sponsors of these transactions: (i) fail to honor their obligations to repurchase the mortgage loans, (ii) successfully dispute our breach findings, or (iii) no longer have the financial means to fully satisfy their obligations under the transaction documents.

We have attempted to identify the reasonably possible additional losses using more stressful assumptions. Different methodologies, assumptions and models could produce different base and reasonably possible additional losses and actual results may differ materially from any of these various modeled results.

 

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In the case of both first and second-lien exposures, the regression model’s reasonably possible stress case assumes a significantly harsher HPA projection, which in turn drives higher defaults and severities. Using this approach, the reasonably possible increase in loss reserves for RMBS credits for which we have an estimate of expected loss at December 31, 2011 could be approximately $603 million. The reasonably possible scenario considers the highest stress scenario that was utilized in the development of our probability-weighted expected loss at December 31, 2011 and assumes an inability to execute commutation transactions with issuers and/or investors.

Student Loans:

It is possible that our loss estimate assumptions for student loan credits could be materially under-estimated as a result of various uncertainties including but not limited to, the interest rate environment, an increase in default rates and loss severities on the collateral due to economic factors, inability to execute commutation transactions with issuers and/or investors, as well as a failure of issuers to refinance insured bonds which have a failed debt structure, such as auction rate securities and variable rate debt obligations. Refer to Auction Rate Securities and Variable Rate Demand Obligations in Part 1, Item 1 of this Form 10-K for further information on our exposures to such failed debt structures. For student loan credits for which we have an estimate of expected loss at December 31, 2011, the reasonably possible increase in loss reserves from loss reserves at December 31, 2011 could be approximately $1,324 million. The reasonably possible scenario considers the highest stress scenario that was utilized in the development of our probability-weighted expected loss at December 31, 2011 and assumes an ability to execute commutation transactions with issuers and/or investors.

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

Valuation of Financial Instruments:

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

The fair market values of financial instruments held are determined by using independent market quotes when available and valuation models when market quotes are not available. ASC Topic 820, Fair Value Measurements and Disclosures requires the categorization of these assets and liabilities according to a fair value valuation hierarchy. Approximately 82% of our assets and approximately 55% of our liabilities are carried at fair value and categorized in either Level 2 of the valuation hierarchy (meaning that their fair value was determined by reference to quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in inactive markets and other observable inputs) or Level 3 (meaning that their fair value was determined by reference to significant inputs that are unobservable in the market and therefore require a greater degree of management judgment). The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. In addition, the use of internal valuation models for certain highly structured instruments, such as credit default swaps, require assumptions about markets in which there has been a negligible amount of trading activity for several years. As a result of these factors, the actual trade value of a financial

 

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instrument in the market, or exit value of a financial instrument position owned by Ambac, may be significantly different from its recorded fair value. Refer to Note 8 to the Consolidated Financial Statements in Item 8 of this Form 10-K for discussion related to the transfers in and/or out of Level 1, 2 and 3 fair value categories.

Investment in Fixed Income Securities:

Investments in fixed income securities are accounted for in accordance with ASC Topic 320, Investments—Debt and Equity Securities. ASC Topic 320 requires that all debt instruments and certain equity instruments be classified in Ambac’s Consolidated Balance Sheets according to their purpose and, depending on that classification, be carried at either cost or fair market value. The fair values of fixed income investments held in the investment portfolios of Ambac and its operating subsidiaries are based primarily on quoted market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Refer to Note 8 to the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of the valuation methods, inputs and assumptions for fixed income securities. Ambac performs various review and validation procedures to quoted and modeled prices for fixed income securities, including price variance analyses, missing and static price reviews, overall valuation analyses by senior traders and finance managers and reviews associated with our ongoing impairment analysis. Unusual prices identified through these procedures will be evaluated further against separate broker quotes (if available) or internally modeled prices, and the pricing source values will be challenged as necessary. Price challenges generally result in the use of the pricing source’s quote as originally provided or as revised by the source following their internal diligence process. A price challenge may result in a determination by the pricing source that they cannot provide a reasonable value for a security, in which case Ambac would resort to using either other quotes or internal models. Valuation results, particularly those derived from valuation models and quotes on certain mortgage and asset-backed securities, could differ materially from amounts that would actually be realized in the market.

Ambac’s investments in fixed income securities (excluding VIE investments) classified as “available-for-sale” are carried at fair value, with the after-tax difference from amortized cost reflected in stockholders’ equity as a component of Accumulated Other Comprehensive Income (“AOCI”). One of the significant estimates related to available-for-sale securities is the evaluation of investments for other-than-temporary impairments. Under GAAP, if management assesses that it either (i) has the intent to sell its investment in a debt security or (ii) more likely than not will be required to sell the debt security before the anticipated recovery of its amortized cost basis less any current period credit loss, then an other-than-temporary impairment charge must be recognized in earnings, with the amortized cost of the security being written-down to fair value. If these conditions are not met, but it is determined that a credit loss exists, the impairment is separated into the amount related to the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income. To determine whether a credit loss has occurred, management considers certain factors, including the length of time and extent to which the fair value of the security has been less than its amortized cost and downgrades of the security’s credit rating. If such factors indicate that a potential credit loss exists, management will compare the present value of estimated cash flows from the security to the amortized cost basis to assess whether the entire amortized cost basis will be recovered. When it is determined that all or a portion of the amortized cost basis will not be recovered, a credit impairment charge is recorded in earnings in the amount of the difference between the present value of cash flows and the amortized cost at the balance sheet date, with the amortized cost basis of the impaired security written-down to the present value of cash flows. Ambac estimates expected future cash flows from residential mortgage-backed securities using models and assumptions consistent with those used to project losses in the financial guarantee RMBS portfolio described above under “Critical Accounting Policies—Losses and Loss Expenses of Non-derivative Financial Guarantees.” Estimated cash flows are discounted at the effective interest rate implicit in the security at the date of acquisition or, for debt securities that are beneficial interests in securitized financial assets, at a rate equal to the current yield used to accrete the beneficial interest. For floating rate securities,

 

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estimated cash flows are projected using the relevant index rate forward curve and the discount rate is adjusted for changes in that curve. For debt securities for which other-than-temporary impairments were recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected are accreted as interest income over the expected remaining life of the security.

Ambac’s investment portfolio includes certain securities that are guaranteed by Ambac Assurance. As described further in Note 9 to the Consolidated Financial Statements in Item 8 of this Form 10-K, future cash flows used to measure credit impairment of Ambac-wrapped bonds represents the sum of (i) the bond’s intrinsic cash flows and (ii) the estimated fair value of Ambac claim payments. Under the Segregated Account Rehabilitation Plan, which has been confirmed but is not effective and is subject to change, future claim payments made by Ambac Assurance on these securities would be satisfied 25% in cash and 75% in surplus notes. However, it is uncertain whether the actual form and amount of claim payments will conform to that set forth in the Segregated Account Rehabilitation Plan. The date that claim payments will resume under a final Segregated Account Rehabilitation Plan is also uncertain. As a result, estimation of the fair value of future claim payments is highly subjective.

The evaluation of securities for impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer’s or guarantor’s financial condition and/or future prospects, the effects of changes in interest rates or credit spreads and the expected recovery period. There is also significant judgment in determining whether Ambac intends to sell securities or will continue to have the ability to hold temporarily impaired securities until recovery. Future events could occur that were not reasonably foreseen at the time management rendered its judgment on the Company’s intent to retain such securities until recovery. Examples of such events include, but are not limited to, the deterioration in the issuer’s or guarantor’s creditworthiness, a change in regulatory requirements or a major business combination or major disposition.

VIE Assets and Liabilities:

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

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

The fair value of VIE assets are obtained from market quotes when available. Typically the asset fair values are not readily available from market quotes and are estimated internally. The consolidated VIEs are securitization entities in which net cash flows from assets and derivatives (after adjusting for financial guarantor cash flows and other expenses) will be paid out to note holders or equity interests. Therefore, when market quotes are not available, our valuation of VIE assets (fixed income securities or loans) are derived from the fair value of debt and derivatives, as described above, adjusted for the fair value of cash flows related to the financial guarantee. The fair value of financial guarantee cash flows include: (i) estimated future premiums discounted at a

 

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rate consistent with that implicit in the fair value of the VIE’s liabilities and (ii) internal estimates of future loss payments by Ambac Assurance or Ambac UK discounted to consider the guarantor’s credit risk.

Derivatives:

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

The fair values of credit derivatives are sensitive to changes in credit ratings on the underlying reference obligations, particularly when such changes reach below investment grade levels. Ratings changes are reflected in Ambac’s valuation model as changes to the “relative change ratio,” which represents the ratio of the estimated cost of credit protection relative to the cash market spread on the reference obligation. Such adjustments to the relative change ratio have primarily impacted the fair value of CDO of ABS transactions containing over 25% MBS exposure which suffered significant credit downgrades. All remaining CDO of ABS transactions were settled in 2010. See Note 1 to the Consolidated Financial Statements for more information on the commutation of all such transactions under the Settlement Agreement. Within the remaining credit derivative (“CDS”) portfolio as of December 31, 2011, transactions comprising approximately 91% of par outstanding have experienced some degree of credit rating downgrade since inception, including four structured finance transactions that are internally rated below investment grade. The relative change ratio on these transactions averaged 82% at December 31, 2011. The average rating for all other transactions that have been downgraded was A+ as of December 31, 2011 and, therefore, changes to the relative change ratio have not been significant. The fair values of credit derivatives are also sensitive to the credit valuation adjustment (“CVA”) included in the valuation to reflect Ambac’s own credit risk. As of December 31, 2011, the CVA reduces the fair value liability of the credit derivative portfolio to approximately 25% of the amount that would be reported excluding any CVA.

Ambac’s credit derivative valuation model, like any financial model, has certain strengths and weaknesses. We believe our model’s primary strength is that it maximizes the use of market-driven inputs. Most importantly, the model uses market-based discount rates and fair values of the underlying reference obligations. Ambac employs a three-level hierarchy for obtaining reference obligation fair values used in the model as follows: (i) broker quotes on the reference obligation, (ii) prices and spreads from other transactions in the portfolio with similar asset, structure and credit attributes, and (iii) internal models comparable to those used for invested assets when quotes are unavailable. We believe using this type of approach is preferable to other models, which may emphasize modeled expected losses or which rely more heavily on the use of market indices that may not be reflective of the underlying reference obligation. Another strength is that our model is relatively easy to understand, which increases its transparency.

A potential weakness of our valuation model is our reliance on broker quotes obtained from dealers which originated the underlying transactions, who in certain cases may also be the counterparty to our CDS transaction. All of the transactions falling into this category are illiquid and it is usually difficult to obtain alternative quotes.

 

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Ambac employs various procedures to corroborate the reasonableness of quotes received; including comparing to other quotes received on similarly structured transactions, observed spreads on structured products with comparable underlying assets and, on a selective basis when possible, values derived through internal estimates of discounted future cash flows. Each quarter, the portfolio of CDS transactions is reviewed to ensure every reference obligation price has been updated. Period to period valuations are compared for each CDS and by underlying bond type. For each CDS, this analysis includes comparisons of key valuation inputs to the prior period and against other CDS within the bond type. No adjustments were made to the broker quotes we received when determining fair value of CDS contracts as of December 31, 2011. Another potential weakness of our valuation model is the lack of new CDS transactions executed by financial guarantors, which makes it difficult to validate the percentage of the reference obligation spread which would be captured as a CDS fee at the valuation date (i.e. the relative change ratio). Changes to the relative change ratio based on internal ratings assigned are another potential weakness as internal ratings could differ from actual ratings provided by rating agencies. However, we believe our internal ratings are updated at least as frequently as the external ratings. We believe the approach we have developed to increase the relative change ratio as the underlying reference obligation experiences credit deterioration is consistent with a market-based approach to valuation. Ultimately, our approach exhibits the same weakness as other modeling approaches, as it is unclear if we could execute at these values.

Valuation of Deferred Tax Assets:

Our provision for taxes is based on our income, statutory tax rates and tax planning opportunities available to us in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions. We review our tax positions quarterly and adjust the balances as new information becomes available. Deferred tax assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carry forwards. More specifically, deferred tax assets represent a future tax benefit (or receivable) that results from losses recorded under U.S. GAAP in a current period which are only deductible for tax purposes in future periods and net operating loss carry forwards. In accordance with ASC Topic 740, Income Taxes, we evaluate our deferred income taxes quarterly to determine if valuation allowances are required. ASC Topic 740 requires that companies assess whether valuation allowances should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. All available evidence, both positive and negative, needs to be identified and considered in making the determination with significant weight given to evidence that can be objectively verified. The level of deferred tax asset recognition is influenced by management’s assessment of future expected taxable income, which depends on the existence of sufficient taxable income of the appropriate character (ordinary vs. capital) within the carry back or carry forward periods available under the tax law. In the event that we determine that we would not be able to realize all or a portion of our deferred tax assets, we would record a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable in the period in which that determination is made.

RESULTS OF OPERATIONS

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

We follow the accounting prescribed by ASC Topic 852, “Reorganizations”. Entities operating in bankruptcy and expecting to reorganize under Chapter 11 of the Bankruptcy Code are subject to the additional

 

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accounting and financial reporting guidance in ASC Topic 852. While ASC Topic 852 provides specific guidance for certain matters, other portions of US GAAP continue to apply so long as the guidance does not conflict with ASC Topic 852. This accounting literature provides guidance for periods subsequent to a Chapter 11 filing for, among other things, the presentation of liabilities that are and are not subject to compromise by the Bankruptcy Court proceedings, as well as the treatment of interest expense and presentation of costs associated with the proceedings. Accordingly, the financial results in the prior periods or filed in future filings may not be comparable.

On January 1, 2010, Ambac adopted new consolidation accounting guidance related to VIEs. Among other changes, the new guidance eliminated the concept of qualifying special-purpose entity (“QSPE”) that were previously exempt from consolidation, and introduced a new framework for consolidation of VIEs. Under the new guidance, the primary beneficiary of a VIE is the party that has both the following characteristics: a) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and b) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. As a result, a cumulative effect adjustment of $705.0 million was recorded as a net increase to total equity at January 1, 2010. Refer to Note 3 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of the cumulative effect of adopting the standard.

Ambac’s loss was ($1,960.4) million or ($6.48) per share in 2011, compared to ($753.2) million or ($2.56) per share in 2010. The year ended December 31, 2011 financial results compared to 2010 were primarily negatively impacted by (i) a higher provision for loss and loss expenses; (ii) higher losses in derivative product revenues; (iii) lower net premiums earned; (iv) lower realized gains; (v) lower other income; (v) a higher provision for income taxes; and (vi) higher interest expense on surplus notes, partially offset by (i) no corporate interest expense as a result of our bankruptcy filing; (ii) lower losses related to consolidated variable interest entities; and (iii) lower underwriting and operating expenses.

The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for 2011 and 2010 and its financial condition as of December 31, 2011 and 2010.

Commutations, Terminations and Settlements of Financial Guarantee Contracts. A key business strategy for Ambac is to increase the residual value of its financial guarantee business by mitigating losses on poorly performing transactions via the pursuit of commutations and terminations of financial guarantee insurance contracts, including insurance policies and credit derivative contracts. For both 2011 and 2010, Ambac executed a number of such transactions as follows:

During 2011, the Segregated Account of Ambac Assurance completed the commutation of insurance policies or portions of insurance policies on several student loan transactions, two multiple-assets securities programs, and a transportation bond issuance. Total par commuted, was $4.0 billion, including $513 million through a bond tender, with an aggregate cash payment of $256 million ($247 million in losses paid and $9 million in loss adjustment expenses) and the issuance of Segregated Account Surplus Notes with a par value of $3.0 million. In addition to the above, there have been various early terminations and expirations of financial guarantee and credit derivative contracts with no cash or other consideration.

As more fully discussed in “2010, 2011 and Recent Events” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, Ambac Assurance entered into a Settlement Agreement with respect to its CDO of ABS and certain other CDO-related obligations on June 7, 2010. Pursuant to the Settlement Agreement, in exchange for the termination of all credit default swaps written by ACP with respect to certain CDO of ABS obligations, and the related financial guarantee insurance policies written by Ambac Assurance with respect to ACP’s obligations thereunder, Ambac Assurance paid to ACP’s counterparties in the aggregate (i) $2,600 million in cash and (ii) $2,000 million in principal amount of newly issued surplus notes of Ambac Assurance. The par amount of the commuted CDO of ABS obligations was $16,543 million. In addition to the

 

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CDO of ABS obligations, Ambac Assurance also commuted for $96.5 million of cash certain additional obligations, including certain non-CDO of ABS obligations to ACP’s counterparties with par amounting to $1,407 million. Ambac Assurance commuted another CDO of ABS transaction in an amount equal to its remaining par value of $90 million. Also in 2010, Ambac Assurance settled all its remaining hedge contracts on exposures commuted as part of the Settlement Agreement and received $205 million. In addition to these commutations, during 2010 Ambac Assurance commuted certain additional obligations with a par of $4,516 million, receiving net settlement fees of approximately $7 million. These settlements are recognized within Net realized losses on credit derivatives on the Consolidated Statement of Operations.

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

Net Premiums Earned. Net premiums earned during 2011 were $406.0 million, a decrease of 26% from $546.0 million in 2010. Net premiums earned include accelerated premiums, which result from refunding, calls and other accelerations. Ambac had accelerated earnings of $60.3 million during 2011 versus $105.2 million in 2010. The net decrease in accelerated earnings was driven by (i) a decrease in overall volume of calls of Ambac insured debt within the public finance market, and (ii) negative accelerations on certain structured finance installment premium paying transactions; partially offset by accelerated earned premiums of $15.8 million in 2011 resulting from the expiration of forward commitments issued during 2008 on certain public finance transactions. Normal net premiums earned excludes accelerated premiums. Normal net premiums earned for 2011 has been negatively impacted by the runoff of the insured portfolio either via transaction terminations, refundings or scheduled maturities. As a result of the consolidation of VIEs, $40.1 million and $43.9 million of net premiums earned were not recognized in the years ended December 31, 2011 and 2010, respectively; rather, the total income statement results of such VIEs were recorded in Loss on variable interest entities. Normal net premiums earned and accelerated premiums are reconciled to total net premiums earned in the table below and are included in the Financial Guarantee segment. The following table provides a breakdown of net premiums earned by market sector:

 

($ in millions)

   2011      2010  

Public Finance

   $ 165.1       $ 178.4   

Structured Finance

     97.3         164.8   

International Finance

     83.3         97.6   
  

 

 

    

 

 

 

Total normal premiums earned

     345.7         440.8   

Accelerated earnings

     60.3         105.2   
  

 

 

    

 

 

 

Total net premiums earned

   $ 406.0       $ 546.0   
  

 

 

    

 

 

 

 

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

 

($ in millions)

   2011     2010  

Public Finance

   $ 66.8      $ 61.6   

Structured Finance

     (8.9     4.6   

International Finance

     2.4        39.0   
  

 

 

   

 

 

 

Total accelerated earnings

   $ 60.3      $ 105.2   
  

 

 

   

 

 

 

Net Investment Income. Net investment income in 2011 was $354.8 million, a 1% decrease from $358.6 million in 2010. The following table provides details by segment for the years ended December 31, 2011 and 2010:

 

($ in millions)

   2011      2010  

Financial Guarantee

   $ 326.2       $ 324.1   

Financial Services

     28.3         34.1   

Corporate

     0.3         0.4   
  

 

 

    

 

 

 

Total net investment income

   $ 354.8       $ 358.6   
  

 

 

    

 

 

 

The increase in Financial Guarantee net investment income in 2011 reflects the benefit of higher yielding assets in the portfolio compared to 2010, partially offset by a lower average long-term invested asset base. During the first half of 2010, long-term assets were sold and matured with proceeds used to fund the commutation of certain CDO-related obligations in June 2010 for approximately $2.8 billion. The negative effect of the commutation on the average asset base has been partially countered by continuing receipt of installment premiums and investment coupon payments while under the moratorium on segregated account claim payments. Higher average yields on the portfolio for 2011 compared to 2010 resulted from the shift in the portfolio mix away from tax-exempt municipals toward taxable securities, primarily corporate bonds and taxable municipals. Additionally, the portfolio held a larger position in Ambac-insured securities during 2011 than 2010 which contributed to higher yields. The par value of Ambac-wrapped securities as of December 31, 2011 was $1,263 million compared to $982 million at December 31, 2010. The overall size of the Financial Guarantee long-term asset portfolio has grown by approximately $372 million since December 31, 2010, benefiting from the moratorium on claim payments and continuing collection of installment paying financial guarantee premiums and coupon receipts on invested assets.

The Financial Services decrease in investment income for the year ended December 31, 2011 was driven primarily by a smaller portfolio of investments in the investment agreement business. The portfolio decreased primarily as a result of sales of securities to fund repayment of investment agreements as Ambac’s investment agreement obligations were reduced from $805.6 million at December 31, 2010 to $546.5 million at December 31, 2011.

Corporate investment income relates to the investments from Ambac’s investment portfolio.

Net Other-Than-Temporary Impairment Losses. Net other-than-temporary impairment losses recorded in the statement of operations include only the credit related impairment amounts to the extent management does not intend to sell and it is not more likely than not that the company will be required to sell before recovery of the amortized cost basis less any current period credit impairment. Non-credit related impairment amounts are recorded in accumulated other comprehensive income on the balance sheet. Alternatively, the non-credit related impairment would be recorded in net other-than-temporary impairment losses in the statement of operations if management intends to sell the securities or it is more likely than not the company will be required to sell before recovery of amortized cost less any current period credit impairment. Charges for net other-than-temporary

 

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impairment losses were $63.8 million and $59.8 million for 2011 and 2010, respectively. As further described in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K, on March 24, 2010, the OCI commenced the Segregated Account Rehabilitation Proceedings in order to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account. As a result of actions taken by the OCI, financial guarantee payments on securities guaranteed by Ambac Assurance which have been allocated to the Segregated Account were suspended in March 2010 and are no longer under the control of Ambac management. The form and timing of future financial guarantee payments will be determined by the Segregated Account Rehabilitation Plan once it or a new rehabilitation plan becomes effective. Claim payments under Segregated Account policies have remained suspended throughout 2011. Changes in the estimated effective date of the Segregated Account Rehabilitation Plan and resumption of claim payments thereunder have resulted in adverse changes in projected cash flows on certain impaired Ambac-wrapped securities during 2011 and the latter half of 2010. For cash flow modeling purposes, management has assumed that the Segregated Account moratorium will be lifted in June 2011. If the Segregated Account does not begin paying claims until a later period additional impairments are likely. Net other-than-temporary impairments for the year ended December 31, 2011 resulted primarily from adverse changes to projected cash flows on Ambac-wrapped securities stemming from the continued suspension of claim payments as described above and from credit impairments on certain other non-agency RMBS securities. Net other-than-temporary impairments for year ended December 31, 2010 reflect credit losses on securities guaranteed by Ambac Assurance arising from the impact of the Segregated Account Rehabilitation Plan as well as charges to write-down structured finance securities to fair value as a result of management’s intent to sell securities to meet liquidity needs. As of December 31, 2011, management has not asserted an intent to sell any securities from its portfolio that are in an unrealized loss position. Future changes in our estimated liquidity needs could result in a determination that Ambac no longer has the ability to hold such securities, which could result in additional other-than-temporary impairment charges.

Net Realized Investment Gains. The following table provides a breakdown of net realized gains for the years ended December 31, 2011 and 2010:

 

($ in millions)

   Financial
Guarantee
     Financial
Services
    Corporate     Total  

December 31, 2011:

         

Net gains on securities sold or called

   $ 13.1       $ 2.9      $ —        $ 16.0   

Gains on terminations of investment agreements

     —           3.1        —          3.1   

Foreign exchange gains

     1.4         —          —          1.4   
  

 

 

    

 

 

   

 

 

   

 

 

 

Total net realized gains

     14.5       $ 6.0        —          20.5   
  

 

 

    

 

 

   

 

 

   

 

 

 

December 31, 2010:

         

Net gains (losses) on securities sold or called

   $ 74.3       $ (1.7 )   $ —        $ 72.6   

Gains on terminations of investment agreements

     —           74.6        —          74.6   

Extinguishment of corporate debentures

     —           —          10.7       10.7   

Loss on sale of subsidiary

     —           —          (0.5     (0.5

Foreign exchange gains

     2.1         —          —          2.1   
  

 

 

    

 

 

   

 

 

   

 

 

 

Total net realized gains

   $ 76.4       $ 72.9      $ 10.2     $ 159.5   
  

 

 

    

 

 

   

 

 

   

 

 

 

Included in the year ended December 31, 2010 are gains of $10.7 million from the extinguishment of $20.3 million of Ambac’s 9.375% debentures and a $0.5 million loss from the sale of RangeMark. These Ambac debentures were acquired when Ambac entered into a series of debt for equity exchanges with certain holders of Ambac’s common stock. Ambac recognized a gain on the extinguishment of these debentures, which was the difference between the fair value of the new shares issued less than the net carrying value of the debentures. The net realized gains on investment agreements resulted from the termination of certain investment agreement contracts at a discount from their carrying value.

 

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Change in Fair Value of Credit Derivatives. The net change in fair value of credit derivatives was $48.0 million and $60.2 million for the years ended December 31, 2011 and 2010, respectively. The net gain for 2011 resulted from improvement in average reference obligation prices, the reversal of unrealized losses associated with terminations and amortization of fair value liabilities due to natural runoff of the portfolio, and fees earned, partially offset by a decrease of the AAC credit valuation adjustment (“CVA”). The CVA was lowered in the first quarter of 2011, reflecting observed increases in the market value of Ambac Assurance’s direct and guaranteed obligations during the period. The net gain in 2010 included an increase in the CVA increases in reference obligation pricing and exposure amortization in asset classes other than CDO of ABS, partially offset by the recognition of losses related to transactions included in the CDO Settlement Agreement and the impact of internal credit downgrades to below investment grade (“BIG”) on certain structured finance transactions within the portfolio. Our fair value methodology for credit derivatives reflects larger mark-to-market losses when a transaction is downgraded, with the greatest impact occurring upon a downgrade to BIG. See Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for a further description of the Settlement Agreement and Note 8 for a further description of Ambac’s methodology for determining the fair value of credit derivatives.

Realized gains (losses) and other settlements on credit derivative contracts were $17.0 million and ($2,757.6) million for the years ended December 31, 2011 and 2010, respectively. These amounts represent premiums received and accrued on written contracts, premiums paid and accrued on purchased contracts and net losses and settlements paid and payable where a formal notification of shortfall has occurred. Net realized gains for the years ended December 31, 2011 and 2010 included $17.0 million and $31.4 million of net fees earned. There were no losses and settlements included in net realized gains (losses) for the year ended December 31, 2011. Net losses and settlement payments included in net realized gains (losses) for the year ended December 31, 2010 were ($2,789.0) million, primarily related to the settlement of CDO of ABS and certain other CDO-related obligations under the Settlement Agreement.

Unrealized gains (losses) on credit derivative contracts were $31.0 million and $2,817.8 million for 2011 and 2010, respectively. The net unrealized gains in fair value of credit derivatives reflect the same factors as the overall change in fair value of credit derivatives as noted above, adjusted for the reclassification of losses from unrealized to realized losses.

Derivative Product Revenues. The losses in derivative product revenues for the years ended December 31, 2011 and 2010 resulted primarily from mark-to-market losses arising from declining interest rates, partially offset by increases to the valuation adjustment related to Ambac credit risk. Additionally, 2010 results were negatively impacted by losses on the termination of certain interest rate swaps. The derivative products portfolio is positioned to benefit from rising rates as an economic hedge against interest rate exposure in the financial guarantee portfolio. Excluding the offsetting effects of Ambac’s credit valuation adjustments, this additional interest rate sensitivity contributed losses of $393.5 million and $121.8 million for the years ended December 31, 2011 and 2010, respectively.

The fair value of derivatives includes a valuation adjustment to reflect Ambac’s own credit risk when appropriate (Ambac “CVA”). Within the financial services derivatives portfolio, an Ambac CVA is generally applicable for uncollateralized derivative liabilities that may not be offset by derivative assets under a master netting agreement. Changes to the Ambac CVA reduced losses within derivative products revenues by $106.4 million and $68.8 million for the years ended December 31, 2011 and 2010, respectively.

Derivative product revenues include termination fees and fair value adjustments to reflect estimated swap replacement costs on positions remaining in the portfolio. Termination fees generally reflect the counterparties’ cost to replace Ambac on their swaps. These fees are realized upon the swap counterparties’ exercise of termination rights allowed by Ambac Assurance’s rating downgrades or upon negotiated settlements. The fair value of derivatives remaining in the portfolio include a provision for the estimated value of these termination

 

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rights. Many derivative counterparties retain the right to terminate contracts. Termination losses, including related changes in fair value adjustments, were ($7.9) million and ($45.5) million for the years ended December 31, 2011 and 2010, respectively. The value of future terminations cannot be determined with certainty until such terminations occur. Accordingly, further termination losses may occur in the future.

Other Income. Other income in 2011 was $25.5 million, as compared to $107.3 million in 2010. Included within other income are non-investment related foreign exchange gains and losses, deal structuring fees, commitment fees and reinsurance settlement gains (losses), from the Financial Guarantee segment. Other income for the year ended December 31, 2011 primarily resulted from: mark-to-market gains of $6.1 million related to Ambac’s option to call certain Ambac Assurance surplus notes and income relating to structuring fees, amendment fees, waiver and consent fees of $14.3 million. Other income for the year ended December 31, 2010 primarily resulted from the consolidated effect of terminating the reinsurance agreement between Ambac UK and Ambac Assurance for a gain of $157.8 million. Additionally, other income for the year ended December 31, 2010 included (i) the impact of the movement in the British Pound and Euro to US Dollar exchange rate upon premium receivables, resulting in a loss of approximately $48.7 million, and (ii) revenues of $1.3 million from RangeMark investment advisory, consulting and research services fees (prior to the sale in July 2010).

Loss on variable interest entities. Loss on variable interest entities for the year ended December 31, 2011 was $214.4 million, compared to $616.7 million for the year ended December 31, 2010. Included within Loss on variable interest entities are income statement amounts relating to VIEs consolidated under ASC Topic 810, including gains or losses attributable to consolidating or deconsolidating VIEs during the period reported. Generally, the Company’s consolidated VIEs are entities for which Ambac has provided financial guarantees on its assets or liabilities. In consolidation, most assets and liabilities of the VIEs are reported at fair value and the related insurance assets and liabilities are eliminated. Differences between the net carrying value of the insurance accounts under ASC Topic 944 and the carrying value of the consolidated VIE’s net assets are recorded through income at the time of consolidation or deconsolidation.

The net loss for 2011 primarily related to a VIE consolidated effective April 1, 2011 and deconsolidated in December 2011 which contributed losses of $224.3 million reported during the year. These losses were partially offset by income from the operations of other consolidated VIEs during the year, primarily reflecting accretion of the present value discount on net VIE assets into income. For financial guarantee transactions a loss upon deconsolidation typically arises from re-establishment of the carrying value of insurance loss reserves and other insurance accounts which have an aggregate net liability balance greater than the aggregate net liabilities of the VIEs in consolidation. The VIE that was both consolidated and deconsolidated within 2011 involved an adversely classified credit for which Ambac temporarily had control rights requiring consolidation. During the period that the VIE was consolidated, credit deterioration of the transaction occurred such that the loss from deconsolidation was greater than the gain from consolidation.

Ambac adopted new consolidation accounting guidance related to VIEs effective January 1, 2010, with the adoption gain of $705.0 million recorded as an adjustment to beginning retained earnings. Under the new guidance, Ambac consolidated significantly more VIEs beginning January 1, 2010 than were previously consolidated. Further, as a result of the Rehabilitation of the Segregated Account of Ambac Assurance, effective March 24, 2010 Ambac no longer had the unilateral power to direct the activities that most significantly impact the economic performance of most of the newly consolidated VIEs. Accordingly, Ambac deconsolidated a significant number of VIEs, mostly RMBS transactions, on March 24, 2010. Additionally, the financial guarantee policies on certain student loan securitization transactions were allocated to the Segregated Account in October 2010 causing Ambac to deconsolidate the related VIEs. The net loss related to these deconsolidated VIEs for 2010 was $630.3 million. Refer to Note 3 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for further information on the accounting for VIEs.

 

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Losses and Loss Expenses. Losses and loss expenses are based upon estimates of the aggregate losses inherent in the non-derivative financial guarantee portfolio for insurance policies issued to beneficiaries, including unconsolidated VIEs. Loss and loss expenses were $1,859.4 million and $719.4 million in 2011 and 2010, respectively. Loss and loss expenses in 2011 were primarily driven by higher estimated losses in the first-lien RMBS, student loan and structured insurance portfolios, offset by a decrease in estimated losses for the second-lien RMBS portfolio and higher estimated recoveries under representation and warranty breaches for certain RMBS transactions.

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

Please refer to the “Critical Accounting Estimates—Financial Guarantee Insurance Losses and Loss Expenses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to the Loss Reserves section located in Note 4 of the Consolidated Financial Statements located in Item 8 of this Form 10-K for further background information on loss reserves.

The following table summarizes the changes in the total net loss reserves for 2011 and 2010:

 

($ in millions)

   Year Ended
December 31, 2011
    Year Ended
December 31, 2010
 

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

   $ 4,424.5      $ 3,777.3   

Impact of adopting the new consolidation accounting guidance related to VIEs

     —          (503.8
  

 

 

   

 

 

 

Beginning balance of net loss reserves

     4,424.5        3,273.5   

Provision for losses and loss expenses

     1,859.5        719.4   

Losses paid

     (308.6     (368.1

Recoveries of losses paid from reinsurers

     21.0        14.6   

Other recoveries, net of reinsurance

     105.7        107.9   

Other adjustments (including foreign exchange)

     (5.9     0.5   

Net deconsolidation of certain VIEs

     134.6        676.7   
  

 

 

   

 

 

 

Ending balance of net loss reserves

   $ 6,230.8      $ 4,424.5   
  

 

 

   

 

 

 

Refer to Note 3 to the Consolidated Financial Statements in Part II, Item 8 of the Form 10-K for further information on the basis for consolidations and deconsolidations of VIEs.

The losses and loss expense reserves as of December 31, 2011 and December 31, 2010 are net of estimated recoveries under representation and warranty breaches for certain RMBS transactions in the amount of $2,720.2 million and $2,391.3 million, respectively. Please refer to the “Critical Accounting Estimates” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to Notes 2 and 4 of the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further background information on the change in estimated recoveries.

 

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The following tables provide details of net claims presented, net of recoveries received for the years ended December 31, 2011 and 2010:

 

($ in millions)

   2011(1)      2010  

Net claims presented:

     

Public Finance

   $ 132.2       $ 36.2   

Structured Finance(2)

     1,372.7         1,597.0   

International Finance

     —           23.7   
  

 

 

    

 

 

 

Total

   $ 1,504.9       $ 1,656.9   
  

 

 

    

 

 

 

 

(1) As a result of the claim moratorium on the Segregated Account of Ambac Assurance by the Rehabilitator on March 24, 2010, $2,768.6 million ($1,357.2 and $1,411.4 in 2011 and 2010, respectively) of claims were presented and not paid as of December 31, 2011.
(2) Includes commutation payments in 2011of $246.9 million.

Refer to table of Contractual Obligations by Year in the “Liquidity and Capital Reserves” section below for expected future claims to be presented or paid.

Please refer to the “Critical Accounting Estimates—Financial Guarantee Insurance Losses and Loss Expenses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to the Loss Reserves section located in Notes 2 and 4 of the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K for further background information on loss reserves.

Underwriting and Operating Expenses. Underwriting and operating expenses of $141.3 million in 2011 decreased by 44% from $254.5 million in 2010. Underwriting and operating expenses consist of gross underwriting and operating expenses plus the amortization of previously deferred expenses (included in Financial Guarantee segment). The following table provides details of underwriting and operating expenses by segment for the years ended December 31, 2011 and 2010:

 

($ in millions)

   2011      2010  

Underwriting and operating:

     

Financial Guarantee

   $ 125.8       $ 198.4   

Financial Services

     10.5         13.8   

Corporate

     5.0         42.3   
  

 

 

    

 

 

 

Total

   $ 141.3       $ 254.5   
  

 

 

    

 

 

 

The decrease in Financial Guarantee underwriting and operating expenses for year ended December 31, 2011 were primarily due to lower compensation, premises, consulting and legal expenses. Compensation costs declined primarily as a result of (i) increase in forfeitures of previous stock option and RSU awards and (ii) lower headcount. As a result of the termination of Ambac’s corporate office lease in May 2011 all existing assets (leasehold improvements) and liabilities (deferred rent) relating to this lease were reduced to zero. Deferred rent was caused by the free rent periods during the life of the lease, whereas the expense of the lease was recognized on a straight-line basis (see Note 1 to the Consolidated Financial Statements for a description of the lease termination and related settlement). Declines in legal and consulting costs as compared to 2010 primarily related to the CDO of ABS commutation costs in 2010.

As a consequence of the Segregated Account Rehabilitation Proceedings, the Rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including the hiring of advisors. During 2011 and 2010, expenses incurred in connection with legal and

 

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consulting services provided for the benefit of OCI amounted to $17.1 million and $20.8 million. Accordingly, future expenses may include a significant amount of advisory costs for the benefit of OCI that are outside the control of Ambac’s management.

Corporate expenses include the operating expenses of Ambac, and, for 2010, RangeMark Financial Services. The decrease is primarily due to (i) lower legal and consulting costs as such professional fees are reflected in reorganization items for the full year 2011 and (ii) RangeMark expenses of $8.6 million for the year ended December 31, 2010, respectively, compared to none in 2011. Included within the $8.6 million is $4.0 million of goodwill impairment charges that were recognized prior to the sale of RangeMark Financial Services, Inc. (“RangeMark”) to the management of RangeMark.

Interest Expense. Interest expense includes accrued interest and accretion of the discount on surplus notes issued by Ambac Assurance and the Segregated Account, the interest expense relating to investment agreements, the interest expense related to a secured borrowing transaction closed in December 2011 and the interest expense related to Ambac’s corporate debentures. The following table provides details for the years ended December 31, 2011 and 2010:

 

($ in millions)

   2011      2010  

Interest expense:

     

Surplus notes

   $ 119.9       $ 62.2   

Investment agreements

     8.1         16.8   

Secured borrowing

     0.1         —     

Corporate debt (thru November 8, 2010)

     —           102.3   
  

 

 

    

 

 

 

Total

   $ 128.1       $ 181.3   
  

 

 

    

 

 

 

The increase in interest expense on surplus notes resulted from the higher average face amount of surplus notes outstanding during the 2011 periods compared to 2010 and to the impact of applying the level yield method as the discount to the face value of the surplus notes accretes over time. Surplus note interest payments require the approval of OCI. On June 1, 2011 OCI issued its disapproval of the requests of Ambac Assurance and the Rehabilitator of the Segregated Account, acting for and on behalf of the Segregated Account, to pay interest on all outstanding Surplus Notes issued by Ambac and the Segregated Account on the first scheduled interest payment date of June 7, 2011. Such interest was capitalized and the Company is accruing interest on these additional amounts.

The decline in interest expense related to investment agreements stemmed primarily from reductions on outstanding investment agreements as the portfolio declined to $546.5 million at December 31, 2011 from $805.6 million at December 31, 2011.

Interest expense in 2011 includes interest on a $35.6 million 6.65% note issued on December 16, 2011. The note is secured by certain Ambac Assurance-wrapped RMBS securities that were deposited into a bankruptcy remote trust. The trusts used to effectuate this transaction qualify as VIEs and are consolidated by Ambac.

Interest was no longer accrued on Ambac’s debt obligations included in Liabilities Subject to Compromise on the Consolidated Balance Sheets after Ambac filed for bankruptcy protection on November 8, 2010. If Ambac had continued to accrue interest on its debt obligations, contractual interest expense would have been $110.1 million and $113.6 million for the year ended December 31, 2011 and 2010, respectively.

Reorganization Items. Reorganization items are primarily expenses directly attributed to our Chapter 11 reorganization process. Reorganization items in 2011 and 2010 were $49.9 million and $32.0 million, respectively, including professional advisory fees of approximately $35.8 million and $5.5 million in 2011 and

 

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2010, respectively, and debt valuation adjustments on pre-petition liabilities of $26.4 million in 2010. On March 1, 2011, Ambac, Ambac Assurance, the Segregated Account and One State Street, LLC (“OSS”) entered into a settlement agreement (the “OSS Settlement Agreement”) to terminate the Company’s office lease with OSS and to settle all claims among the parties. The OSS Settlement Agreement provides that OSS will have an allowed general unsecured claim in Ambac’s bankruptcy case for approximately $14.1 million. See Note 2 to the Consolidated Financial Statements in Item 8 of this Form 10-K for a summary of these costs.

Provision for Income Taxes. Income tax expense was $77.4 million and $0.1 million for the years ended December 31, 2011 and 2010, respectively. The income tax for 2011 related predominantly to the accrual of additional federal income tax expense to bring the overall reserve for income taxes in line with Ambac’s intent to pay the IRS to settle the IRS Dispute, inclusive of amounts contributed by both the Company and Ambac Assurance as contemplated by the Mediation Agreement. Please refer to Note 1 to the Consolidated Financial Statements located in Item 8 of this Form 10-K for additional information on the Mediation Agreement.

Ambac Assurance Statutory Basis Financial Results

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

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

Ambac Assurance reported statutory capital and surplus of $495.3 million and $1,026.9 million as of December 31, 2011 and December 31, 2010, respectively. Ambac Assurance, combined with Everspan, reported contingency reserves of $192.7 million and $512.6 million as of December 31, 2011 and December 31, 2010, respectively. Ambac Assurance and Everspan received approval to release contingency reserves of $444.6 million in 2011. Ambac Assurance reported a statutory net loss of $835.8 million for the year ended December 31, 2011. The primary drivers of the statutory net loss were increases in statutory loss and loss expenses related primarily to: (i) RMBS financial guarantee contracts that defaulted during 2011, as well as adverse development on insurance policies that defaulted in prior years, and (ii) the execution of commutations for certain financial guarantee contracts that had not previously defaulted during 2011, and (iii) impairment losses on its loans to subsidiaries.

Statutory surplus is sensitive to: (i) further credit deterioration on the defaulted credits in the insured portfolio, (ii) deterioration in the financial position of Ambac Assurance subsidiaries that have their obligations guaranteed by Ambac Assurance, (iii) first time payment defaults of insured obligations, which increases statutory loss reserves, (iv) commutations of insurance policies or credit derivative contracts at amounts that differ from the amount of liabilities recorded, (v) reinsurance contract terminations at amounts that differ from net assets recorded, (vi) reductions in the fair value of previously impaired investments or additional downgrades

 

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of the ratings on investment securities to below investment grade by the independent rating agencies, (vii) settlements of representation and warranty breach claims at amounts that differ from amounts recorded, including failures to collect such amounts, (viii) issuance of surplus notes, and (ix) intercompany loan impairments based on changes to interest rates and/or early terminations of investment agreements at amounts that differ from the amount of liabilities recorded.

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

 

   

Loss reserves are only established for losses on guaranteed obligations that have defaulted in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default, less estimated recoveries under subrogation rights (currently discounted at 5.1% as prescribed by OCI). Under U.S. GAAP, in addition to the establishment of loss reserves for defaulted obligations, loss reserves are established (net of U.S GAAP basis unearned premium reserves) for obligations that have experienced credit deterioration, but have not yet defaulted using a weighted-average risk-free discount rate, currently at 1.5%.

 

   

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

 

   

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

 

   

Wholly owned subsidiaries are not consolidated; rather, the equity basis of accounting is utilized and the carrying values of these investments are subject to an admissibility test. When Ambac Assurance’s share of the subsidiaries’ losses exceeds the related carrying amounts of the wholly owned subsidiary, Ambac Assurance discontinues applying the equity method and the investment is reduced to zero. For those subsidiaries that have insufficient claims paying resources and whose obligations are guaranteed by Ambac Assurance, Ambac Assurance records an estimated impairment for probable losses which are in excess of the subsidiaries’ claims paying resources. Such impairments were recorded for our credit derivative subsidiary for periods prior to June 2010. Under U.S. GAAP, credit derivatives are recorded at fair value, which is impacted by market valuations of the exposures and includes the effect of Ambac Assurance’s own credit in the measurement. This mark-to-market valuation often differs significantly from the statutory measure of impairment discussed above.

 

   

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

 

   

As a result of prescribed practices by OCI, all issued surplus notes are included in Surplus at an amount equal to par regardless of the amounts received in consideration for issuance of the notes. Under U.S. GAAP, surplus notes are included in long-term debt obligations recorded at their estimated fair value and accrete up to face value via the effective interest method. The OCI has extended the preceding prescribed practice related to surplus notes to the evaluation of other-than-temporary impairments for Ambac Assurance guaranteed securities held in the investment portfolio. Under both U.S. GAAP and the NAIC SAP, the present value of cash flows expected to be collected will be equal the sum of the present value of (i) the bond’s intrinsic cash flows and (ii) the estimated fair value of Ambac claim

 

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payments. Under the Segregated Account Rehabilitation Plan, which has been confirmed but is not effective and is subject to change, future claim payments made by Ambac Assurance on these securities would be satisfied 25% in cash and 75% in surplus notes. The Wisconsin Insurance Commissioner has directed Ambac Assurance to utilize par value rather than fair value of these surplus notes in this computation.

 

   

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

 

   

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

 

   

Deferred tax assets are reduced by a statutory valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized; any remaining net deferred tax asset is then subject to an admissibility test; whereas US GAAP only requires a valuation allowance if it is more likely than not that the deferred tax asset will not be realized.

LIQUIDITY AND CAPITAL RESOURCES

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

Ambac’s liquidity and solvency are largely dependent on its current cash and investments of $35.4 million at December 31, 2011 (excluding $2.5 million of restricted cash), consummation of the Reorganization Plan and on the residual value of Ambac Assurance. Pursuant to the Mediation Agreement, Amended TSA and Cost Allocation Agreement (as each such term is defined in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K), Ambac Assurance is required, under certain circumstances, to make payments to the Company with respect to the utilization of NOLs and to reimburse certain costs and expenses. See Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for descriptions of the Mediation Agreement, the Amended TSA and the Cost Allocation Agreement. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future and therefore the aforementioned payments and reimbursements will be Ambac’s principal source of funds in the near term. The principal uses of liquidity are the payment of operating expenses, professional advisory fees incurred in connection with the bankruptcy and expenses and settlements related to pending litigation. Ambac’s liquidity requirements are being funded by cash on hand and reimbursements of a portion of IRS litigation expenses from Ambac Assurance, and any contingencies could cause material additional liquidity strains.

 

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

 

     Contractual Obligations by Year  

($ in millions)

   2012      2013      2014      2015      2016      Thereafter  

Surplus note obligations(1)

   $ 214.3       $ 104.7       $ 104.7       $ 104.7       $ 104.7       $ 2,528.4   

Investment and repurchase agreement obligations(2)

     319.2         21.0         100.7         1.5         1.5         177.9   

Operating lease obligations(3)

     4.9         5.0         5.1         5.2         0.4         0.8   

Purchase obligations(4)

     18.3         169.1         0.4         177.1         —           —     

Post retirement benefits(5)

     0.4         0.5         0.5         0.6         0.6         3.8   

Loss and loss expense reserves(6)

     4,174.3         1,029.6         1,026.4         423.6         234.1         4,630.0   

Federal Taxes(7)

     101.9         —           —           —           —           97.0   

Secured borrowing(8)

     20.7         13.0         4.2         —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 4,854.0       $ 1,342.9       $ 1,242.0       $ 712.7       $ 341.3       $ 7,437.9   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Includes principal of and interest on surplus notes, issued as of December 31, 2010, when due. All payments of principal and interest on Surplus Notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the surplus notes, such interest will accrue and compound annually until paid. Amounts in the table consider approval by OCI for all principal and investment payments in the future.
(2) Includes principal of and interest on obligations using current rates for floating rate obligations. Certain investment agreements have contractual provisions that allow our counterparty the flexibility to withdraw funds prior to legal maturity date. Amounts included in the table are based on the earliest optional draw date.
(3) Amount represents future lease payments on lease agreements existing as of December 31, 2011.
(4) Purchase obligations represent future expenditures for contractually scheduled fixed terms and amounts due for various technology-related maintenance agreements and other outside services. Purchase obligations also include the purchase of insured student loan obligations by Ambac Assurance, primarily variable rate demand obligations from liquidity providers as required by the terms of our insurance agreements. Amounts reflected in this table are the current outstanding par at December 31, 2011. 
(5) Amount represents future benefit payments on the postretirement benefit plans for the next 10 years.
(6)

The timing of expected claim payments is based on deal specific cash flow payments, excluding expected recoveries and those student loan obligations as noted in Purchase obligations. These deal specific cash flow payments are based on the expected cash flows of the underlying transactions (e.g. for RMBS credits we model estimated future claim payments). The timing of expected claim payments for credits with reserves that were established using our statistical loss reserve method is determined based on the weighted average expected life of the exposure. Refer to the Loss Reserves section located in Note 2 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of our statistical loss reserve method. The timing of these payments may vary significantly from the amounts shown above, especially for credits that are based on our statistical loss reserve method. Claims on Segregated Account Policies remain subject to a payment moratorium until the Segregated Account Rehabilitation Plan becomes effective. Insurance claims presented during the moratorium of $2,768 million for policies allocated to the Segregated Account have not yet been paid. Although the Rehabilitator has not established an effective date for the Rehabilitation Plan, we have

 

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  included such unpaid amounts as obligations due in 2012 in the table above based on management’s internal cash flow projections. Under the Segregated Account Rehabilitation Plan, which has been confirmed but is not effective and remains subject to change, holders of permitted policy claims will receive 25% of their permitted claims in cash and 75% in Segregated Account Surplus Notes. Refer to 2010, 2011 and Recent Events section in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for discussion of insurance policies and other liabilities and interests allocated to the Segregated Account on March 24, 2010 and the settlement with respect to certain CDO-related obligations.
(7) Includes a Federal tax settlement in 2012 and $97.0 million of unrecognized tax benefits that is not possible to make a reliable estimate about the period in which the payment may occur.
(8) Includes estimated interest and principal payments on the secured borrowing. These estimates are based on modeled expected future cash flows from the underlying RMBS securities which collateralize and fund repayment of the secured borrowing. Refer to Notes 12 and 9 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of the secured borrowing and of our cash flow estimation process for RMBS securities, respectively.

Ambac Assurance Liquidity. Ambac Assurance’s liquidity is dependent on the balance of liquid investments and, over time, the net impact of sources and uses of funds. The principal sources of Ambac Assurance’s liquidity are gross installment premiums on insurance and credit default swap contracts, investment coupon receipts, scheduled investment maturities, sales of investment securities, proceeds from repayment of affiliate loans, claim and reinsurance recoveries and RMBS subrogation recoveries. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claim and commutation payments on both insurance and credit derivative contracts, ceded reinsurance premiums, surplus notes principal and interest payments and additional loans to affiliates. As a result of the Segregated Account Rehabilitation Plan, claim payments on policies allocated to the Segregated Account will not be paid until the Segregated Account Rehabilitation Plan is declared effective. Surplus note interest payments require the approval of OCI. On June 1, 2011 OCI issued its disapproval of the requests of Ambac Assurance and the Rehabilitator of the Segregated Account, acting for and on behalf of the Segregated Account, to pay interest on all outstanding Surplus Notes issued by Ambac and the Segregated Account on the first scheduled interest payment date of June 7, 2011.

Our ability to recover RMBS subrogation recoveries is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties (and/or their respective parents and affiliates), timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. Our current estimate considers that we will receive subrogation recoveries of $2,778.6 million, beginning in 2013. The amount of these subrogation recoveries is significant and if we are unable to recover any amounts our future available liquidity to pay claims would be reduced materially. Similarly, our right to receive installment premium as well as the amount is impacted by the contractual terms of each policy and period in which the insured obligation remains outstanding. Termination of installment premium policies on an accelerated basis may adversely impact Ambac Assurance’s liquidity. A subsidiary of Ambac Assurance provides a $360 million liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility, which is guaranteed by Ambac Assurance, provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurer is required to repay all amounts drawn under the liquidity facility. At December 31, 2011 and December 31, 2010, $8.8 million was drawn on this liquidity facility.

Ambac and its affiliates participate in leveraged lease transactions with municipalities, utilities and quasi-governmental agencies (collectively “lessees”), either directly or through various affiliated companies. Assets underlying these leveraged lease transactions involve equipment and facilities used by the lessees to provide basic public services such as mass transit and utilities. Ambac and its affiliates provided one or more of the following financial products in these transactions: (i) credit default swaps, (ii) guarantees of the lessees’

 

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termination payment obligations, (iii) loans, (iv) sureties and (v) investment agreements and payment agreements, both of which serve as collateral to economically defease portions of the lessees’ payment obligations in respect of termination payments.

These transactions expose Ambac to the following risks, primarily as a result of Ambac Assurance’s rating downgrades:

 

   

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

 

   

Lease events, of default and the requirement for a lessee to make a termination payment upon a demand by the lessor. Portions of any termination payments may be funded from the liquidation of the related defeasance collateral (i.e. payment agreements, investment agreements and/or other securities). To the extent a lessee fails to make a required termination payment, Ambac may be required to make a surety bond payment, or a swap settlement, under its guarantee policy or credit default swap, as applicable. The payment required under the Ambac credit enhancement will be based on the difference between the termination amount and the value derived from the defeasance collateral. Following a payment, Ambac would then be entitled to settle a credit default swap with the lessee or exercise its reimbursement rights against the lessee. In such circumstances Ambac, through subrogation or ownership in the leased assets, would have the right, along with other remedies, to liquidate the leased assets.

Ambac Assurance’s aggregate financial guarantee exposure to termination payments related to leveraged lease transactions that contain Ambac Assurance rating downgrade triggers at December 31, 2011 and 2010 was $844.3 million and $889.1 million, respectively. Ambac Assurance’s financial guarantee exposure to these termination payments, net of defeasance collateral was $699.9 million, at December 31, 2011, and $749.1 million, at December 31, 2010. However, the court supervising the rehabilitation of the Segregated Account has issued an injunction barring the early termination of contracts based on the occurrence of events or the existence of circumstances like those described above. As a result, Ambac Assurance does not expect to make early termination payments in respect of leveraged lease transactions where such amounts are claimed based on the occurrence of events, or the existence of circumstances, relating to the financial condition of Ambac Assurance.

A wholly-owned subsidiary of Ambac Assurance is a party to credit default swaps (“CDS”) with various commercial counterparties. Ambac Assurance guarantees its subsidiary’s payment obligations under such CDS. The terms of such CDS include events of default or termination events based on the occurrence of certain events, or the existence of certain circumstances, relating to the financial condition of Ambac Assurance, including the commencement of an insolvency, rehabilitation or like proceeding. If such an event of default or termination event were to occur, the CDS counterparties could claim the contractual right to terminate the CDS and require Ambac Assurance, as financial guarantor, to make termination payments. Ambac Assurance estimates that such potential termination payments amounted to $1,454.2 million as of December 31, 2011. However, the court supervising the rehabilitation of the Segregated Account has issued an injunction barring the early termination of contracts based on the occurrence of events or the existence of circumstances like those described above. As a result, Ambac Assurance does not expect to make early termination payments in respect of CDSs where such amounts are claimed based on the occurrence of events, or the existence of circumstances, relating to the financial condition of Ambac Assurance.

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

 

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

Investment agreements subject Ambac to liquidity risk associated with unanticipated withdrawals of principal as allowed by the terms of certain contingent withdrawal investment agreements, including those issued to entities that provide credit protection with respect to collateralized debt obligations. These entities issue credit linked-notes, invest a portion of the proceeds in the contingent withdrawal investment agreements and typically sell credit protection by issuing a credit default swap referencing specified asset-backed or corporate securities. Upon a credit event of one of the underlying reference obligations, the issuer may need to draw on the investment agreement to pay under the terms of the credit default swap. Accordingly, these investment agreements may be drawn prior to our original expectations, resulting in an unanticipated withdrawal. As of December 31, 2011, $361.6 million of contingent withdrawal investment agreements issued to CDOs remained outstanding. To manage the liquidity risk of unscheduled withdrawals, Ambac utilizes several tools, including regular surveillance of the related transactions. This surveillance process is customized for each investment agreement transaction and includes a review of past activity, recently issued trustee reports, reference name performance characteristics and third party tools to analyze early withdrawal risk.

Credit Ratings and Collateral. The significant rating downgrades of Ambac Assurance by Moody’s and S&P resulted in the triggering of required cure provisions in nearly all of the investment agreements issued. In many cases, Ambac chose to terminate investment agreements, particularly when it was able to do so at levels that resulted in meaningful discounts to book value. In addition, Ambac has posted collateral of $564.0 million in connection with its outstanding investment agreements, including accrued interest, at December 31, 2011.

Ambac Financial Services (“AFS”) provided interest rate and currency swaps for states, municipalities, asset-backed issuers and other entities in connection with their financings. AFS hedges most of the related risks of these instruments with standardized derivative contracts, which include collateral support agreements. Under these agreements, AFS is required to post collateral to a swap dealer to cover unrealized losses. In addition, AFS is often required to post independent amounts of collateral in excess of the amounts needed to cover unrealized losses. Additionally, AFS hedges part of its interest rate risk with financial futures contracts which require it to post margin with its futures clearing merchant. All AFS derivative contracts possessing rating-based downgrade triggers that could result in collateral posting or a termination have been triggered. If additional terminations were to occur, it would generally result in a return of collateral to AFS in the form of cash, U.S. Treasury or U.S. government agency obligations with market values approximately equal to or in excess of market values of the swaps. In most cases, AFS will look to re-establish the hedge positions that are terminated early. This may result in additional collateral posting obligations or the use of futures contracts or other derivative instruments which could require AFS to post margin amounts. The amount of additional collateral required or margin posted on futures contracts will depend on several variables including the degree to which counterparties exercise their termination rights and the ability to replace these contracts with existing counterparties under existing documents and credit support arrangements. All contracts that require collateral posting are currently collateralized. Collateral and margin posted by AFS totaled a net amount of $302.8 million, including independent amounts, under these contracts at December 31, 2011.

Ambac Credit Products (“ACP”) entered into credit derivative contracts. ACP is not required to post collateral under any of its contracts.

 

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BALANCE SHEET

In 2011, total assets decreased by approximately $1.9 million to $27.11 billion at December 31, 2011, driven by the net decline in assets of consolidated variable interest entities, partially offset by (i) installment premium receipts on insurance and credit derivative transactions; and (ii) coupon payments on investment securities. As of December 31, 2011, total stockholders’ deficit was $3.15 billion, as compared to $1.35 billion deficit at December 31, 2010. This change was primarily caused by the net loss for the period, partially offset by improvements in fair value of investment securities during the period.

Investment Portfolio. Ambac Assurance’s investment objective for the Financial Guarantee portfolio is to achieve the highest after-tax yield on a diversified portfolio of fixed income investments while employing asset/liability management practices to satisfy all operating and strategic liquidity needs. Ambac Assurance’s investment portfolio is subject to internal investment guidelines and is subject to limits on types and quality of investments imposed by the insurance laws and regulations of the States of Wisconsin and New York. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits. Within these guidelines, Ambac Assurance opportunistically purchases Ambac Assurance insured securities in the open market given their relative risk/reward characteristics and to mitigate the effect of potential future adverse development in the insured portfolio. Further, Ambac Assurance’s investment policies are subject to oversight by the Rehabilitator of the Segregated Account pursuant to contracts entered into between Ambac Assurance and the Segregated Account.

Ambac UK’s investment policy is designed with the primary objective of ensuring that Ambac UK is able to meet its financial obligations as they fall due, in particular with respect to policy holders and meeting their claims. Ambac UK’s investment portfolio is subject to internal investment guidelines and may be subject to limits on types and quality of investments imposed by the FSA as regulator of Ambac UK. Ambac UK’s investment policy sets forth minimum credit rating requirements and concentration limits, among other restrictions. The Board of Directors of Ambac UK approves any changes or exceptions to Ambac UK’s investment policy.

The Financial Services investment portfolio consists primarily of assets funded with proceeds from the issuance of investment agreement liabilities. The investment objectives are to invest in primarily high-grade securities that produce sufficient cash flow to satisfy all investment agreement liabilities and intercompany loans, and which will satisfy investment agreement collateral requirements. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

 

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The following table summarizes the composition of Ambac’s investment portfolio at fair value by segment at December 31, 2011 and 2010:

 

($ in millions)

   Financial
Guarantee
    Financial
Services
    Corporate     Total  

December 31, 2011:

        

Fixed income securities:

        

Municipal obligations(1)

   $ 2,003.0      $ —        $ —        $ 2,003.0   

Corporate obligations

     1,015.6        111.9        —          1,127.5   

Foreign obligations

     94.8        —          —          94.8   

U.S. government obligations

     86.2        25.4        —          111.6   

U.S. agency obligations

     82.6        4.3        —          86.9   

Residential mortgage-backed securities(2)

     1,054.5        358.0        —          1,412.5   

Collateralized debt obligations

     31.7        14.5        —          46.2   

Other asset-backed securities

     669.6        278.2        —          947.8   
  

 

 

   

 

 

   

 

 

   

 

 

 
     5,038.0        792.3        —          5,830.3   

Short-term(1)

     729.5        18.7        34.9        783.1   

Other

     0.1        —          —          0.1   
  

 

 

   

 

 

   

 

 

   

 

 

 
     5,767.6        811.0        34.9        6,613.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Fixed income securities pledged as collateral:

        

U.S. government obligations

     260.8        —          —          260.8   

Residential mortgage-backed securities

     2.7        —          —          2.7   
  

 

 

   

 

 

   

 

 

   

 

 

 
     263.5        —          —          263.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

   $ 6,031.1      $ 811.0      $ 34.9      $ 6,877.0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Percent total

     87.7     11.8     0.5     100

December 31, 2010:

        

Fixed income securities:

        

Municipal obligations(1)

   $ 1,921.3      $ —        $ —        $ 1,921.3   

Corporate obligations

     811.0        106.9        —          917.9   

Foreign obligations

     118.4        —          —          118.4   

U.S. government obligations

     121.1        35.8        —          156.9   

U.S. agency obligations

     83.9        4.4        —          88.3   

Residential mortgage-backed securities

     944.2        554.5        —          1,498.7   

Collateralized debt obligations

     32.3        —          —          32.3   

Other asset-backed securities

     604.4        399.9        —          1,004.3   
  

 

 

   

 

 

   

 

 

   

 

 

 
     4,636.6        1,101.5        —          5,738.1   

Short-term(1)

     921.3        6.9        63.4        991.6   

Other

     0.1        —          —          0.1   
  

 

 

   

 

 

   

 

 

   

 

 

 
     5,558.0        1,108.4        63.4        6,729.8   
  

 

 

   

 

 

   

 

 

   

 

 

 

Fixed income securities pledged as collateral:

        

U.S. government obligations

     115.4        —          —          115.4   

Residential mortgage-backed securities

     8.1        —          —          8.1   
  

 

 

   

 

 

   

 

 

   

 

 

 
     123.5        —          —          123.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

   $ 5,681.5      $ 1,108.4      $ 63.4      $ 6,853.3   
  

 

 

   

 

 

   

 

 

   

 

 

 

Percent total

     82.9     16.2     0.9     100

 

(1) Includes taxable and tax exempt securities.
(2) Includes RMBS insured by Ambac Assurance.

 

79


Table of Contents
Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations

 

The following table represents the fair value of mortgage and asset-backed securities at December 31, 2011 and 2010 by classification:

 

($ in millions)

   Financial
Guarantee
     Financial
Services
     Corporate      Total  

December 31, 2011: