10-Q 1 d338313d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the Quarterly Period Ended March 31, 2012

 

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

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)

 

 

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

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   x

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

As of May 4, 2012, 302,431,515 shares of common stock, par value $0.01 per share, of the Registrant were outstanding.

 

 

 


Table of Contents

Ambac Financial Group, Inc. and Subsidiaries

TABLE OF CONTENTS

 

     PAGE  

PART I FINANCIAL INFORMATION

  
Item 1.    Financial Statements of Ambac Financial Group, Inc. and Subsidiaries   
   Consolidated Balance Sheets – March 31, 2012 (unaudited) and December 31, 2011      3   
  

Consolidated Statements of Total Comprehensive Income (unaudited) – three months ended March  31, 2012 and 2011

     4   
   Consolidated Statements of Stockholders’ Equity (unaudited) – three months ended March 31, 2012 and 2011      5   
   Consolidated Statements of Cash Flows (unaudited) – three months ended March 31, 2012 and 2011      6   
   Notes to Unaudited Consolidated Financial Statements      8   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      63   
Item 3.    Quantitative and Qualitative Disclosures About Market Risk      101   
Item 4.    Controls and Procedures      105   

PART II OTHER INFORMATION

  
Item 1.    Legal Proceedings      107   
Item 1A.    Risk Factors      107   
Item 6.    Exhibits      108   

SIGNATURES

     109   

INDEX TO EXHIBITS

     110   


Table of Contents

Part I Financial Information

 

Item 1. Financial Statements of Ambac Financial Group, Inc. and Subsidiaries

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Balance Sheets

 

(Dollars in Thousands, Except per Share Data)    March 31,
2012
    December 31,
2011
 
     (unaudited)        

Assets:

    

Investments:

    

Fixed income securities, at fair value (amortized cost of $5,296,055 in 2012 and $5,346,897 in 2011)

   $ 5,763,133      $ 5,830,289   

Fixed income securities pledged as collateral, at fair value (amortized cost of $286,846 in 2012 and $261,958 in 2011)

     287,762        263,530   

Short-term investments (amortized cost of $893,649 in 2012 and $783,015 in 2011)

     893,822        783,071   

Other (approximates fair value)

     100        100   
  

 

 

   

 

 

 

Total investments

     6,944,817        6,876,990   

Cash

     39,931        15,999   

Restricted cash

     2,500        2,500   

Receivable for securities

     108,185        38,164   

Investment income due and accrued

     39,831        45,328   

Premium receivables

     1,917,536        2,028,479   

Reinsurance recoverable on paid and unpaid losses

     170,799        159,902   

Deferred ceded premium

     202,226        221,303   

Subrogation recoverable

     519,404        659,810   

Deferred acquisition costs

     219,001        223,510   

Loans

     19,243        18,996   

Derivative assets

     272,658        175,207   

Other assets

     58,875        104,300   

Variable interest entity assets:

    

Fixed income securities, at fair value

     2,184,665        2,199,338   

Restricted cash

     2,297        2,140   

Investment income due and accrued

     1,215        4,032   

Loans (includes $14,460,077 and $14,126,994 at fair value)

     14,661,522        14,329,515   

Other assets

     8,179        8,182   
  

 

 

   

 

 

 

Total assets

   $ 27,372,884      $ 27,113,695   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity:

    

Liabilities:

    

Liabilities subject to compromise

   $ 1,707,417      $ 1,707,421   

Unearned premiums

     3,291,152        3,457,157   

Losses and loss expense reserve

     6,924,346        7,044,070   

Ceded premiums payable

     99,643        115,555   

Obligations under investment agreements

     523,831        523,046   

Obligations under investment repurchase agreements

     23,500        23,500   

Current taxes

     97,449        95,709   

Long-term debt

     227,189        223,601   

Accrued interest payable

     196,853        170,169   

Derivative liabilities

     387,476        414,508   

Other liabilities

     97,144        107,441   

Payable for securities purchased

     37,856        1,665   

Variable interest entity liabilities:

    

Accrued interest payable

     890        3,490   

Long-term debt (includes $14,426,274 and $14,039,450 at fair value)

     14,666,921        14,288,540   

Derivative liabilities

     2,004,544        2,087,052   

Other liabilities

     315        304   
  

 

 

   

 

 

 

Total liabilities

     30,286,526        30,263,228   
  

 

 

   

 

 

 

Stockholders’ deficit:

    

Preferred stock

     —          —     

Common stock

     3,080        3,080   

Additional paid-in capital

     2,172,027        2,172,027   

Accumulated other comprehensive income

     445,797        463,259   

Accumulated deficit

     (5,786,940     (6,039,922

Common stock held in treasury at cost

     (411,081     (411,419
  

 

 

   

 

 

 

Total Ambac Financial Group, Inc. stockholders’ deficit

     (3,577,117     (3,812,975

Noncontrolling interest

     663,475        663,442   
  

 

 

   

 

 

 

Total stockholders’ deficit

     (2,913,642     (3,149,533
  

 

 

   

 

 

 

Total liabilities and stockholders’ deficit

   $ 27,372,884      $ 27,113,695   
  

 

 

   

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Statements of Total Comprehensive Income (Unaudited)

 

     Three Months Ended March 31,  
(Dollars in Thousands, Except Share Data)    2012     2011  

Revenues:

    

Net premiums earned

   $ 94,950      $ 91,799   

Net investment income

     112,117        76,468   

Other-than-temporary impairments:

    

Total other-than-temporary impairment losses

     (4,311     (1,713

Portion of loss recognized in other comprehensive income

     1,240        —     
  

 

 

   

 

 

 

Net other-than-temporary impairment losses recognized in earnings

     (3,071     (1,713

Net realized investment gains

     392        2,450   

Change in fair value of credit derivatives:

    

Realized gains (losses) and other settlements

     3,254        5,323   

Unrealized losses

     (10,476     (14,226
  

 

 

   

 

 

 

Net change in fair value of credit derivatives

     (7,222     (8,903

Derivative products

     46,957        21,004   

Other income

     64,793        28,303   

Income (loss) on variable interest entities

     15,220        (6,125
  

 

 

   

 

 

 

Total revenues before expenses and reorganization items

     324,136        203,283   
  

 

 

   

 

 

 

Expenses:

    

Losses and loss expenses

     (2,320     919,647   

Underwriting and operating expenses

     36,534        45,467   

Interest expense

     33,839        30,260   
  

 

 

   

 

 

 

Total expenses before reorganization items

     68,053        995,374   
  

 

 

   

 

 

 

Pre-tax gain (loss) from continuing operations before reorganization items

     256,083        (792,091

Reorganization items

     2,461        24,805   
  

 

 

   

 

 

 

Pre-tax gain (loss) from continuing operations

     253,622        (816,896

Provision for income taxes

     300        2,350   
  

 

 

   

 

 

 

Net income (loss)

   $ 253,322      ($ 819,246

Less: net gain attributable to the noncontrolling interest

     2        33   
  

 

 

   

 

 

 

Net income (loss) attributable to common shareholders.

   $ 253,320      ($ 819,279
  

 

 

   

 

 

 

Other comprehensive income (loss), after tax:

    

Net income (loss)

   $ 253,322      ($ 819,246
  

 

 

   

 

 

 

Unrealized (losses) gains on securities, net of deferred income taxes of $0

     (20,904     75,425   

Less: reclassification adjustment for net (loss) gain included in net income (loss)

     (4,052     1,015   

Gain on foreign currency translation, net of deferred income taxes of $0

     3,213        4,384   

Amortization of postretirement benefit, net of tax

     (3,792     711   
  

 

 

   

 

 

 

Total other comprehensive (loss) income, net of tax

     (17,431     79,505   
  

 

 

   

 

 

 

Total comprehensive income (loss)

     235,891        (739,741

Less: comprehensive income (loss) attributable to the noncontrolling interest:

    

Net income

     2        33   

Currency translation adjustments

     31        44   
  

 

 

   

 

 

 

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

     235,858        (739,818
  

 

 

   

 

 

 

Net income (loss) per share attributable to Ambac Financial Group, Inc. common shareholders

   $ 0.84      ($ 2.71
  

 

 

   

 

 

 

Net income (loss) per diluted share attributable to Ambac Financial Group, Inc. common shareholders

   $ 0.84      ($ 2.71
  

 

 

   

 

 

 

Weighted-average number of common shares outstanding:

    

Basic

     302,466,328        302,355,243   

Diluted

     302,580,597        302,355,243   

See accompanying Notes to Unaudited Consolidated Financial Statements

 

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Statements of Stockholders’ Equity (Unaudited)

 

          Ambac Financial Group, Inc.  
(Dollars in Thousands)   Total     Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income
    Preferred
Stock
    Common
Stock
    Paid-in
Capital
    Common
Stock Held
in Treasury,
at Cost
    Noncontrolling
Interest
 

Balance at January 1, 2012

  ($ 3,149,533   ($ 6,039,922   $ 463,259      $ —        $ 3,080      $ 2,172,027      ($ 411,419   $ 663,442   

Net income

    253,322        253,320                  2   

Other comprehensive loss, net of tax

    (17,431       (17,462             31   

Stock-based compensation

    (338     (338            

Shares issued under equity plans

    338                  338     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at March 31, 2012

  ($ 2,913,642   ($ 5,786,940   $ 445,797      $ —        $ 3,080      $ 2,172,027      ($ 411,081   $ 663,475   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at January 1, 2011

  $ (1,354,228   ($ 4,042,335   $ 291,774      $     $ 3,080      $ 2,187,485      ($ 448,540   $ 654,308   

Net loss

    (819,246     (819,279               33   

Other comprehensive loss, net of tax

    79,505          79,461                44   

Stock-based compensation

    (37,049     (37,157           108       

Cost of shares acquired

    (35               (35  

Shares issued under equity plans

    37,156                  37,156     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at March 31, 2011

  ($ 2,093,897   ($ 4,898,771   $ 371,325      $ —        $ 3,080      $ 2,187,593      ($ 411,419   $ 654,385   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Statements of Cash Flows (Unaudited)

 

(182,008) (182,008)
     Three Months Ended March 31,  
     2012     2011  
(Dollars in Thousands)             

Cash flows from operating activities:

    

Net income (loss) attributable to common shareholders

   $ 253,320      ($ 819,279

Noncontrolling interest in subsidiaries’ earnings

     2        33   
  

 

 

   

 

 

 

Net income (loss)

   $ 253,322      ($ 819,246

Adjustments to reconcile net income to net cash used in operating activities:

    

Depreciation and amortization

     820        780   

Amortization of bond premium and discount

     (64,542     (35,439

Reorganization items

     2,461        24,805   

Share-based compensation

     —          108   

Current income taxes

     300        2,350   

Deferred acquisition costs

     4,509        2,903   

Unearned premiums, net

     (146,928     (171,593

Losses and loss expenses, net

     9,785        921,429   

Ceded premiums payable

     (15,912     (7,202

Investment income due and accrued

     5,497        5,351   

Premium receivables

     110,943        131,676   

Accrued interest payable

     26,684        24,679   

Net mark-to-market gains

     10,476        14,226   

Net realized investment gains

     (392     (2,450

Other-than-temporary impairment charges

     3,071        1,713   

Variable interest entity activities

     (15,220     6,125   

Other, net

     (144,524     (17,400
  

 

 

   

 

 

 

Net cash provided by operating activities

     40,350        82,815   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Proceeds from sales of bonds

     35,024        93,191   

Proceeds from matured bonds

     208,133        202,806   

Purchases of bonds

     (182,008     (205,418

Change in short-term investments

     (110,751     (83,629

Loans, net

     (247     (230

Change in swap collateral receivable

     41,046        (104

Other, net

     85        787   
  

 

 

   

 

 

 

Net cash (used in) provided by investing activities

     (8,718     7,403   
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Paydown of variable interest entity secured borrowing

     (7,280     —     

Proceeds from issuance of investment and repurchase agreements

     —          24   

Payments for investment and repurchase agreement draws

     (420     (89,673

Net cash collateral received

     —          (2,440
  

 

 

   

 

 

 

Net cash used in financing activities

     (7,700     (92,089
  

 

 

   

 

 

 

Net cash flow

     23,932        (1,871

Cash at January 1

     15,999        9,497   
  

 

 

   

 

 

 

Cash at March 31

   $ 39,931      $ 7,626   

 

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(182,008) (182,008)
     Three Months Ended March 31,  
     2012      2011  
(Dollars in Thousands)              

Supplemental disclosure of cash flow information:

     

Cash paid during the year for:

     

Income taxes

   $ —         $ —     

Interest on variable interest entity secured borrowing

   $ 429       $ —     

Interest on investment agreements

   $ 3,072       $ 3,656   

Cash receipts and payments related to reorganization items:

     

Professional fees paid for services rendered in connection with the Chapter 11 proceeding

   $ 1,641       $ 5,457   

Supplemental disclosure of noncash financing activities:

In March 2011, the Segregated Account of Ambac Assurance established pursuant to Wisc. Stat. §611.24(2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities, issued surplus notes in connection with the commutation of two insurance policies with a par value of $3,000.

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Notes to Unaudited Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

1. Background and Basis of Presentation

These unaudited consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2011 Annual Report on Form 10-K.

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 (the “Petition Date”), Ambac filed a voluntary petition for relief (the “Bankruptcy Filing”) 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 Fifth Amended Plan of Reorganization on March 12, 2012 (such Fifth Amended Plan of Reorganization, as it may be amended, the “Reorganization Plan”). The Bankruptcy Court entered an order confirming the Reorganization Plan on March 14, 2012. Under the Reorganization Plan, Ambac’s debt holders and other creditors will receive all of the equity in the reorganized company. Therefore, if the 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. Additionally, the Reorganization Plan sets forth the revised capital structure of a newly reorganized Ambac and provides for corporate governance subsequent to emergence from bankruptcy.

Ambac Assurance Corporation (“Ambac Assurance”) is Ambac’s principal operating subsidiary. Ambac Assurance is a financial guarantee insurer that 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 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. Ambac Assurance is not, itself, in rehabilitation proceedings.

On October 8, 2010, the Rehabilitator filed a plan of rehabilitation for the Segregated Account (the “Segregated Account Rehabilitation Plan”) in the Circuit Court of Dane County, Wisconsin in which the Segregated Account Rehabilitation Proceedings are pending (the “Rehabilitation Court”). The Rehabilitation Court confirmed the Segregated Account Rehabilitation Plan on January 24, 2011. The confirmed Segregated Account Rehabilitation Plan also makes permanent the injunctions issued by the Rehabilitation Court on March 24, 2010.

The Segregated Account Rehabilitation Plan is not effective and is subject to modification. Pursuant to the injunctions issued by the Rehabilitation Court, claims on policies allocated to the Segregated Account have not been paid since the commencement of the Segregated Account Rehabilitation Proceedings. Net par exposure as of March 31, 2012 for policies allocated to the Segregated Account is $33,593,393. The Rehabilitator may seek to effectuate the current Segregated Account Rehabilitation Plan, modify such Plan or modify the injunctions issued by the Rehabilitation Court to allow for the payment of policy claims in such manner and at such times as the Rehabilitator determines to be in the best interest of policyholders. The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio caused downgrades, and ultimately withdrawals of Ambac Assurance’s

 

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financial strength ratings from the independent rating agencies. These losses have prevented Ambac Assurance from being able to write new business. 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 entered into on June 7, 2010 by Ambac, Ambac Assurance, Ambac Credit Products, LLC (“ACP”) and counterparties to outstanding credit default swaps with ACP (the “Settlement Agreement”). Ambac Assurance is also restricted in its ability to pay dividends pursuant to the terms of its Auction Market Preferred Shares (“AMPS”), which state that 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. Ambac Assurance has not paid dividends on AMPS since 2010. Based on the above described restrictions and circumstances, it is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future.

Chapter 11 Reorganization

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, the Segregated Account and OCI 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. In accordance with the Amended Plan Settlement, the Company shall retain ownership of Ambac Assurance, and except as otherwise approved by OCI, the Company shall use its best efforts to preserve the use of NOLs as contemplated by the Amended Plan Settlement.

Pursuant to the Amended Plan Settlement, (i) the Company, Ambac Assurance and certain affiliates entered into an amended and restated tax sharing agreement (the “Amended TSA”), (ii) the Company, Ambac Assurance and certain affiliates entered into an expense sharing and cost allocation agreement (the “Cost Allocation Agreement”) and (iii) the Company, Ambac Assurance, the Segregated Account and OCI entered into an amendment (the “Cooperation Agreement Amendment”), of that certain Cooperation Agreement, dated as of March 24, 2010, by and between the Segregated Account and Ambac Assurance (the “Cooperation Agreement”).

The Amended TSA replaces, supersedes and nullifies in its entirety the existing tax sharing agreement among the Company and its affiliates. The Amended TSA addresses certain issues including, but not limited to, the allocation and use of NOLs by the Company, Ambac Assurance and their respective subsidiaries.

The Cost Allocation Agreement provides for the allocation of costs and expenses among the Company, Ambac Assurance and certain affiliates. The Mediation Agreement also provides for sharing by the Company and Ambac Assurance of the expenses incurred since November 1, 2010 in connection with the litigation with the United States Internal Revenue Service (“IRS”) described in Note 11.

The Cooperation Agreement Amendment provides for the Rehabilitator to have certain rights with respect to (a) the tax positions taken by the Company in its consolidated tax return; (b) the acceptance by Ambac Assurance of the repayment of intercompany loans or the modification of the terms thereof; (c) changes by Ambac Assurance in the assumptions or vendors utilized in determining loss reserves determined in accordance with Statutory Accounting Principles; and (d) changes to Ambac Assurance’s investment policy and transfer of the investment management function for Ambac Assurance’s investment portfolio.

The Amended Plan Settlement, Mediation Agreement, Amended TSA, Cost Allocation Agreement and Cooperation Agreement Amendment collectively memorialize the settlement of certain claims among the Company and Ambac Assurance, OCI and the Segregated Account, and contain broad releases of the Company, Ambac

 

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Assurance, the Segregated Account, OCI, the board of directors and board committees of the Company and Ambac Assurance, all current and former individual directors, officers, or employees of the Company and Ambac Assurance, the Creditors’ Committee and the individual members thereof, and certain other released parties.

Consummation 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 11) shall have become effective; (vii) the terms of the IRS Settlement (as defined in Note 11) 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 $50,000; (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) $30,000 shall have been paid or paid into escrow by Ambac Assurance 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. Of the conditions enumerated above, the following have been satisfied: (i); (x); (xi); (xii) and (xiii). There can be no assurance about whether or when the remaining conditions will be met.

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, 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 is 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 the establishment, and subsequent rehabilitation, of the Segregated Account, the Rehabilitator retains rights to oversee and approve certain actions taken in respect of Ambac Assurance. This oversight by the Rehabilitator could impair Ambac’s ability to execute the foregoing strategy. As a result of uncertainties associated with the aforementioned factors, management has concluded that there is substantial doubt about the ability of the Company to continue as a going concern. The Company’s financial statements as of March 31, 2012 and 2011 and for the periods ended March 31, 2012 and 2011 are prepared assuming the Company continues as a going concern and do not include any adjustment that might result from its inability to continue as a going concern.

Ambac’s liquidity and solvency are largely dependent on its current cash and investments of $33,994 at March 31, 2012 (excluding $2,500 of restricted cash), consummation of the Reorganization Plan, and on the residual value of Ambac Assurance. The principal uses of liquidity are the payment of operating expenses, professional advisory fees incurred in connection with the bankruptcy and expenses related to pending litigation. Management believes that Ambac will have sufficient liquidity to satisfy its needs until it emerges from the bankruptcy proceeding; however, no assurance can be given regarding the timing or certainty of such emergence. If its cash and investments run out prior to emergence from bankruptcy, a liquidation of Ambac pursuant to Chapter 7 of the Bankruptcy Code will occur.

 

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2. Debtor in Possession Financial Information

Liabilities Subject to Compromise

As required by ASC Topic 852, Reorganizations, the amount of the Liabilities Subject to Compromise represents our estimate of known or potential pre-petition and post-petition claims to be addressed in connection with the Bankruptcy Filing. Such claims are subject to future adjustments. The Liabilities subject to compromise in the Consolidated Balance Sheet consists of the following:

 

     March 31, 2012      December 31, 2011  

Accrued interest payable

   $ 68,123       $ 68,123   

Other

     17,105         17,109   

Senior unsecured notes

     1,222,189         1,222,189   

Directly-issued Subordinated capital securities

     400,000         400,000   
  

 

 

    

 

 

 

Consolidated liabilities subject to compromise

     1,707,417         1,707,421   

Payable to non-debtor subsidiaries

     35         35   
  

 

 

    

 

 

 

Debtor’s Liabilities subject to compromise

   $ 1,707,452       $ 1,707,456   
  

 

 

    

 

 

 

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 $24,162 and $28,576 for the three months ended March 31, 2012 and 2011, respectively.

Reorganization Items, net

Professional advisory fees and other costs directly associated with our reorganization are reported separately as reorganization items pursuant to ASC Topic 852. Reorganization items also include adjustments to reflect the carrying value of certain pre-petition liabilities at their estimated allowable claim amounts. The reorganization items in the Consolidated Statements of Total Comprehensive Income for the three months ended March 31, 2012 and 2011, consisted of the following items:

 

     Three months ended
March 31, 2012
     Three months ended
March 31, 2011
 

U.S. Trustee fees

   $ 20       $ 5   

Professional fees

     2,441         10,498   

Office lease settlement

     —           14,302   
  

 

 

    

 

 

 

Total reorganization items

   $ 2,461       $ 24,805   
  

 

 

    

 

 

 

3. Net Premiums Earned

Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). For premiums received upfront, an unearned premium revenue (“UPR”) liability is established, which is initially recorded as the cash amount received. For installment premium transactions, a premium receivable asset and offsetting UPR liability is initially established in an amount equal to: (i) the present value of future contractual premiums due (the “contractual” method) or, (ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of premiums to be collected over the expected life of the transaction (the “expected” method). An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually

 

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due or expected to be collected. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in a foreign currency are discounted using the appropriate risk-free rate for the respective currency. The weighted average risk-free rate at March 31, 2012 and December 31, 2011 was 2.7% and 2.6%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at March 31, 2012, and December 31, 2011 was 10.2 years and 10.0 years, respectively.

Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities and consumer auto loans. As prepayment assumptions change for homogenous pool transactions, or if there is an actual prepayment for a “contractual” method installment transaction, the related premium receivable and UPR are adjusted in equal and offsetting amounts with no immediate effect on earnings using new premium cash flows and the then current risk free rate.

Generally, the priority for the payment of financial guarantee premiums to Ambac, as required by the bond indentures of the insured obligations, is very senior in the waterfall. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees are required under the Segregated Account Rehabilitation Plan and related court orders to continue to pay installment premiums, notwithstanding the claims moratorium. In evaluating the credit quality of the premiums receivable, management evaluates i.) the internal ratings of the transactions underlying the premiums receivable, and, as applicable, ii.) expected future premium collections for transactions for which loss reserves have been recognized. As of March 31, 2012, and December 31, 2011 approximately 44% and 43% of the premiums receivable related to transactions with non-investment grade internal ratings, comprised mainly of non-investment grade MBS and student loan transactions, which comprised 12% and 11%, respectively, of the total premiums receivable at March 31, 2012, and December 31, 2011. For the three months ended March 31, 2012, $4,417 of premium receivables relating to a non-investment obligation were deemed uncollectible and written off. At March 31, 2012, past due premiums on policies insuring non-investment grade obligations that were not written off amounted to less than $200.

For both upfront and installment premium policies, premium revenues are earned over the life of the financial guarantee contract in proportion to the insured principal amount outstanding at each reporting date (referred to as the level-yield method). For installment paying policies, the premium receivable discount, equating to the difference between the undiscounted future installment premiums and the present value of future installment premiums, is accreted as premiums earned in proportion to the premium receivable balance at each reporting date. Because the premium receivable discount and UPR are being accreted into income using different rates, the total premiums earned as a percentage of insured principal is higher in the earlier years and lower in the later years for an installment premium transaction as compared to an upfront premium transaction. Below is the premium receivable roll-forward for the periods ended March 31, 2012, and December 31, 2011:

 

     March 31,
2012
    December 31,
2011
 

Beginning premium receivable

   $ 2,028,479        2,422,596   

Premium payments received

     (40,130     (190,823

Adjustments for changes in expected life of homogeneous pools and actual changes to contractual cash flows

     (102,074     (240,547

Accretion of premium receivable discount

     13,892        62,841   

Consolidation of certain VIEs

     —          (104,736

Deconsolidation of certain VIEs

     —          87,978   

Other adjustments (including foreign exchange)

     17,369        (8,830
  

 

 

   

 

 

 

Ending premium receivable

   $ 1,917,536      $ 2,028,479   
  

 

 

   

 

 

 

 

Similar to gross premiums, premiums ceded to reinsurers are paid either upfront or in installments. For premiums paid upfront, a deferred ceded premium asset is established which is initially recorded as the cash amount paid. For installment premiums, a ceded installment premiums payable liability and offsetting deferred ceded premium asset are initially established in an amount equal to: i) the present value of future contractual premiums due or, ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the

 

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present value of expected premiums to be paid over the life of the transaction. An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually due or expected to be collected. Premiums ceded to reinsurers reduce the amount of premiums earned by Ambac from its financial guarantee insurance policies. For both up-front and installment premiums, ceded premiums written are primarily recognized in earnings in proportion to and at the same time as the related gross premium revenue is recognized. For premiums paid to reinsurers on an installment basis, Ambac records the present value of future ceding commissions as an offset to ceded premiums payable, using the same assumptions noted above for installment premiums. The ceding commission revenue associated with the ceding premiums payable is deferred (as an offset to deferred acquisition cost) and recognized in income in proportion to ceded premiums.

The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance at March 31, 2012:

 

     Future
premiums
expected
to be
collected(1)
     Future
expected
premiums to
be earned,
net of
reinsurance(1)
 

Three months ended:

     

June 30, 2012

   $ 39,030       $ 66,143   

September 30, 2012

     39,697         64,293   

December 31, 2012

     40,787         62,183   

Twelve months ended:

     

December 31, 2013

     149,704         230,902   

December 31, 2014

     149,695         212,834   

December 31, 2015

     144,199         201,025   

December 31, 2016

     138,824         190,565   

Five years ended:

     

December 31, 2021

     623,209         801,266   

December 31, 2026

     504,110         577,648   

December 31, 2031

     374,718         382,984   

December 31, 2036

     218,400         208,191   

December 31, 2041

     72,015         64,386   

December 31, 2046

     21,871         19,572   

December 31, 2051

     5,335         6,248   

December 31, 2056

     242         686   
  

 

 

    

 

 

 

Total

   $ 2,521,836       $ 3,088,926   
  

 

 

    

 

 

 

 

(1) The future premiums expected to be collected and future premiums expected to be earned, net of reinsurance disclosed in the above table relate to the discounted premium receivable asset and unearned premium liability recorded on Ambac’s balance sheet. The use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral is required in the calculation of the premium receivable as described above, which results in a higher premium receivable balance than if expected lives were considered. If installment paying policies are retired early as a result of rate step-ups or other early retirement provision incentives for the issuer, premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected in the future.

When a bond issue insured by Ambac Assurance has been retired, including those retirements due to refundings or calls, any remaining UPR is recognized at that time to the extent the financial guarantee insurance policy is legally extinguished. For installment premium paying transactions, we offset the recognition of any remaining UPR by the reduction of the related premium receivable to zero (as it will not be collected as a result of the retirement), which may cause negative accelerated premium revenue. Accelerated premium revenue for retired

 

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obligations for three months ended March 31, 2012 and 2011 was $15,790 and ($70), respectively. The table below shows premiums written on a gross and net basis for the three month periods ended March 31, 2012 and 2011:

 

     Three Months Ended
March 31,
 
     2012     2011  

Revenues:

    

Financial Guarantee:

    

Gross premiums written

   $ (92,594   ($ 160,211

Ceded premiums written

     16,854        9,218   
  

 

 

   

 

 

 

Net premiums written(1)

   $ (75,740   ($ 150,993
  

 

 

   

 

 

 

 

(1) Premiums written represent the change in the present value of future installment premiums. Such changes will not have an immediate impact on earned premium but will be earned over the life of the transaction using the level yield method discussed above. Factors that generate written premium are prepayments of the insured obligation, premium rate changes for policies that have variable premium structures, discount rate changes and early termination of an insured obligation.

4. Net Income Per Share

Basic net income per share is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding. Common shares outstanding includes common stock issued less treasury shares plus restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding plus all dilutive potential common shares outstanding during the period. All dilutive potential common shares outstanding consider common stock deliverable pursuant to stock options and nonvested restricted stock units. These dilutive shares totaled 114,269 from the assumed settlement of dilutive nonvested restricted stock units at March 31, 2012. The number of additional shares is calculated by assuming that nonvested restricted stock units were settled and that the proceeds from such exercises were used to acquire shares of common stock at the average market price during the period. There were no dilutive effects for the period ended March 31, 2011. The following table presents securities outstanding that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because they were antidilutive for the periods ended March 31, 2012 and 2011:

 

     March 31, 2012      March 31, 2011  

Stock options

     887,672         1,786,031   

Restricted stock and units

     —           469,896   

 

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5. Special Purpose Entities, Including Variable Interest Entities

Ambac has engaged in transactions with special purpose entities, including VIEs, in various capacities. Ambac most commonly has provided financial guarantees, including credit derivative contracts, for various debt obligations issued by special purpose entities, including VIEs. Ambac has also sponsored two special purpose entities that issued medium-term notes to fund the purchase of certain financial assets. Ambac is also an investor in collateralized debt obligations, mortgage-backed and other asset-backed securities issued by VIEs and its ownership interest is generally insignificant to the VIE and/or Ambac does not have rights that direct the activities that are most significant to such VIE. In 2011, Ambac entered into a secured borrowing transaction under which two VIEs were created for the purpose of resecuritizing certain invested assets and collateralizing the borrowing. These VIEs are consolidated because Ambac was involved in their design and holds a significant amount of the beneficial interests issued by the VIEs. VIE debt outstanding to third parties under this secured borrowing transaction was $28,320 and $35,600 as of March 31, 2012 and December 31, 2011, respectively. The debt represents the senior-most tranche of the securitization structure and is to be repaid from the non-insurance proceeds of certain RMBS securities which are guaranteed by Ambac Assurance. Such securities had a fair value of $179,339 and $172,880 as of March 31, 2012 and December 31, 2011, respectively. Refer to Note 8, Investments for further discussion of the restrictions on these securities.

Financial Guarantees:

Ambac has provided financial guarantees in respect of assets held or debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance or credit derivative contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms; however, the most common are over-collateralization, first loss and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the debt obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the debt obligations that have been guaranteed by Ambac Assurance. In the case of first loss, the financial guarantee insurance policy only covers a senior layer of losses on assets held or debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the asset seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the securitized assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt; such excess cash flow is applied to redeem debt, thus creating over-collateralization. Generally, upon deterioration in the performance of a transaction or upon an event of default as specified in the transaction legal documents, Ambac will obtain certain loss remediation rights. These rights may enable Ambac to direct the activities of the entity that most significantly impact the entity’s economic performance.

We determined that Ambac generally has the obligation to absorb the VIE’s expected losses given that we have issued financial guarantees supporting the liabilities (and in certain cases assets) of a VIE. We also determined for certain transactions that experienced the aforementioned performance deterioration, that we had the power, through voting rights or similar rights, to direct the activities of certain VIEs that most significantly impact the VIE’s economic performance because: a) certain triggers had been breached in these transactions resulting in Ambac having the ability to exercise certain loss remediation activities, or b) due to the passive nature of the VIEs’ activities, Ambac’s contingent loss remediation rights upon a breach of certain triggers in the future is considered to be the power to direct the activities that most significantly impact the VIEs’ economic performance. With respect to existing VIEs involving Ambac financial guarantees, Ambac is generally required to consolidate a VIE in the period that applicable triggers result in Ambac having control over the VIE’s most significant economic activities. A VIE is deconsolidated in the period that Ambac no longer has such control, which generally occurs in connection with allocation to the Segregated Account, execution of remediation activities on the transaction or amortization of insured exposure, any of which may reduce the degree of Ambac’s control over a VIE.

Ambac Sponsored VIEs:

A subsidiary of Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These special

 

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purpose entities are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve these entities. The permitted activities of these entities are limited to those outlined below. Ambac does not consolidate these entities because Ambac’s policies issued to these entities have been allocated to the Segregated Account, thereby limiting Ambac’s control over the entities’ most significant economic activities. Ambac has elected to account for its equity interest in these entities at fair value under the fair value option in accordance with ASC Topic 825, Financial Instruments. We believe that the fair value of the investments in these entities provides for greater transparency for recording profit or loss as compared to the equity method under ASC Topic 323, Investments—Equity Method in Joint Ventures. Refer to Note 7 for further information on the valuation technique and inputs used to measure the fair value of Ambac’s equity interest in these entities. At March 31, 2012 and December 31, 2011 the fair value of these entities is $16,023 and $16,779, respectively, and is reported within Other assets on the Consolidated Balance Sheets. The change in fair value of these entities is ($756) and $1,096 for the three months ended March 31, 2012 and 2011, respectively.

Since their inception, there have been 15 individual transactions with these entities, of which 5 transactions were outstanding as of March 31, 2012. Total principal amount of debt outstanding was $576,387 and $578,562 at March 31, 2012 and December 31, 2011, respectively. In each case, Ambac sold assets to these entities. The assets are composed of asset-backed securities and utility obligations with a weighted average rating of A- at March 31, 2012 and weighted average life of 8.1 years. The purchase by these entities was financed through the issuance of medium-term notes (“MTNs”), which are cross-collateralized by the purchased assets. The MTNs have the same expected weighted average life as the purchased assets. Derivative contracts (interest rate swaps) are used within the entities for economic hedging purposes only. Hedges are established at the time MTNs are issued to purchase financial assets. The activities of these entities are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. As of March 31, 2012 Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entities.

Insurance premiums paid to Ambac Assurance by these entities are earned in a manner consistent with other insurance policies, over the risk period. Additionally, any losses incurred on such insurance policies are included in Ambac’s Consolidated Statements of Total Comprehensive Income. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

There were no assets sold to these entities during the three months ended March 31, 2012 and 2011. Ambac Assurance earned premiums for issuing the financial guarantee policies on the assets, MTNs and derivative contracts of $145 and $235 for the three months ended March 31, 2012 and 2011, respectively. Ambac paid no claims to these entities under its financial guarantee policies for the three months ended March 31, 2012 and 2011. Ambac also earned fees for providing other services amounting to $11 and $11 for the three months ended March 31, 2012 and 2011, respectively.

Derivative contracts are provided by Ambac Financial Services to these entities. Consistent with other derivatives, Ambac Financial Services (“AFS”) accounts for these contracts on a trade date basis at fair value. AFS paid $138 and $131 for the three months ended March 31, 2012 and 2011, respectively, under these derivative contracts.

Consolidation of VIEs:

Upon initial consolidation of a VIE, we recognize a gain or loss in earnings for the difference between: a) the fair value of the consideration paid, the fair value of any non-controlling interests and the reported amount of any previously held interests and b) the net amount, as measured on a fair value basis, of the assets and liabilities consolidated. Upon deconsolidation of a VIE, we recognize a gain or loss for the difference between: a) the fair value of any consideration received, the fair value of any retained non-controlling investment in the VIE and the carrying amount of any non-controlling interest in the VIE and b) the carrying amount of the VIE’s assets and liabilities. Gains or losses from consolidation and deconsolidation that are reported in earnings are reported within Income (loss) on variable interest entities.

The variable interest in VIE generally involves one or more of the following: a financial guarantee policy issued to the VIE, a written credit derivative contract that references liabilities of the VIE or an investment in

 

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securities issued by the VIE. The impact of consolidating such VIEs on Ambac’s balance sheet is follows. For a financial guarantee policy issued to a consolidated VIE, Ambac does not reflect the financial guarantee insurance policy in accordance with the related insurance accounting rules under ASC Topic 944, Financial Services—Insurance. The financial guarantee policy would be eliminated upon consolidation. Consequently, Ambac eliminates insurance assets (premium receivables, reinsurance recoverable, deferred ceded premium, subrogation recoverable and deferred acquisition costs) and insurance liabilities (unearned premiums, loss and loss expense reserves and ceded premiums payable) from the Consolidated Balance Sheets. For investment securities owned by Ambac that are debt instruments issued by the VIE, the investment securities balance is eliminated upon consolidation.

Income (loss) on variable interest entities included losses of $0 and $8,422 for the three month periods ended March 31, 2012 and 2011, respectively, related to VIEs that were no longer consolidated as of the end the respective periods. Such losses for the three months ended March 31, 2011 primarily related to the impact of deconsolidating a VIE during that period.

As of March 31, 2012, consolidated VIE assets and liabilities relating to 18 consolidated entities were $16,857,878 and $16,672,670, respectively. As of December 31, 2011, consolidated VIE assets and liabilities relating to 19 consolidated entities were $16,543,207 and $16,379,386, respectively. Ambac is not primarily liable for, and does not guarantee all of the debt obligations issued by the VIEs. Ambac would only be required to make payments on the guaranteed debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of the VIEs. Ambac evaluates the net income statement effects and earnings per share effects to determine attributions between Ambac and non-controlling interests as a result of consolidating a VIE. Ambac has determined that the net changes in fair value of most consolidated VIE assets and liabilities are attributable to Ambac due to Ambac’s interest through financial guarantee premium and loss payments with the VIE.

The financial reports of certain VIEs are prepared by outside trustees and are not available within the time constraints Ambac requires to ensure the financial accuracy of the operating results. As such, the financial results of certain VIEs are consolidated on a time lag that is no longer than 90 days.

The table below provides the fair value of fixed income securities, by asset-type, held by consolidated VIEs as of March 31, 2012 and December 31, 2011:

 

     March 31, 2012      December 31, 2011  

Investments:

     

Corporate obligations

   $ 2,184,665       $ 2,199,338   
  

 

 

    

 

 

 

Total variable interest entity assets: Fixed income securities

   $ 2,184,665       $ 2,199,338   
  

 

 

    

 

 

 

The following table provides supplemental information about the loans held as assets and long-term debt associated with the VIEs for which the fair value option has been elected as of March 31, 2012 and December 31, 2011:

 

     Estimated fair value      Unpaid principal balance  

March 31, 2012:

     

Loans

   $ 14,460,077       $ 13,901,703   

Long-term debt

   $ 14,426,274       $ 15,344,542   

December 31, 2011:

     

Loans

   $ 14,126,994       $ 13,735,799   

Long-term debt

   $ 14,039,450       $ 15,134,711   

 

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Variable Interests in Non-Consolidated VIEs

The following table displays the carrying amount of the assets, liabilities and maximum exposure to loss of Ambac’s variable interests in non-consolidated VIEs resulting from financial guarantee and credit derivative contracts by major underlying asset classes, as of March 31, 2012 and December 31, 2011:

 

     Carrying Value of Assets and Liabilities  
     Maximum
Exposure To
Loss(1)
     Insurance
Assets(2)
     Insurance
Liabilities(3)
     Derivative
Liabilities(4)
 

March 31, 2012:

           

Global Structured Finance:

           

Collateralized debt obligations

   $ 13,306,646       $ 13,628       $ 22,702       $ 120,592   

Mortgage-backed—residential

     29,262,148         709,898         5,268,393         —     

Mortgage-backed—commercial

     693,627         —           —           6,793   

Other consumer asset-backed

     7,689,924         122,947         1,259,153         36,711   

Other commercial asset-backed

     12,251,503         489,489         974,307         7,366   

Other

     7,150,257         139,530         567,141         2,194   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     70,354,105         1,475,492         8,091,696         173,656   

Global Public Finance

     38,173,945         577,454         703,043         19,140   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 108,528,050       $ 2,052,946       $ 8,794,739       $ 192,796   
  

 

 

    

 

 

    

 

 

    

 

 

 
     Carrying Value of Assets and Liabilities  
     Maximum
Exposure To
Loss(1)
     Insurance
Assets(2)
     Insurance
Liabilities(3)
     Derivative
Liabilities(4)
 

December 31, 2011:

           

Global Structured Finance:

           

Collateralized debt obligations

   $ 14,093,243       $ 15,096       $ 105,219       $ 120,614   

Mortgage-backed—residential

     30,307,753         783,329         5,396,711         —     

Mortgage-backed—commercial

     685,870         —           —           6,241   

Other consumer asset-backed

     7,851,980         129,234         1,315,146         35,583   

Other commercial asset-backed

     13,363,434         559,884         1,045,477         4,541   

Other

     7,552,264         139,586         643,864         1,837   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     73,854,544         1,627,129         8,506,417         168,816   

Global Public Finance

     37,893,726         569,032         700,690         14,850   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 111,748,270       $ 2,196,161       $ 9,207,107       $ 183,666   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Maximum exposure to loss represents the gross maximum future payments of principal and interest on insured obligations and credit derivative contracts. Ambac’s maximum exposure to loss does not include the benefit of any financial instruments (such as reinsurance or hedge contracts) that Ambac may utilize to mitigate the risks associated with these variable interests.
(2) Insurance assets represent the amount recorded in “Premium receivables” and “Subrogation recoverable” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(3) Insurance liabilities represent the amount recorded in “Losses and loss expense reserve” and “Unearned premiums” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(4) Derivative liabilities represent the fair value recognized on credit derivative contracts on Ambac’s Consolidated Balance Sheets.

 

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6. Losses and Loss Expense Reserve

A loss reserve is recorded on the balance sheet on a policy-by-policy basis for the excess of: (a) the present value of expected net cash flows to be paid under an insurance contract, over (b) the UPR for that contract. Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance for the three months ended March 31, 2012 and the year ended December 31, 2011:

 

     Three months
Ended March 31,
2012
    Year Ended
December 31,
2011
 

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

     6,230,780        4,424,450   

Changes in the loss reserves due to:

    

Current year:

    

Establishment of new loss reserves, gross of subrogation and net of reinsurance

     29,610        503,697   

Claim payments, net of subrogation and reinsurance

     (2,968     (2,442

Establishment of subrogation recoveries, net of reinsurance

     (1,786     (9,761
  

 

 

   

 

 

 

Total current year

     24,856        491,494   

Prior year:

    

Change in previously established loss reserves, gross of subrogation and net of reinsurance

     (7,920     1,683,831   

Change in previously established subrogation recoveries, net of reinsurance

     (9,606     (324,151

Claim recoveries (payments), net of subrogation recoverable and reinsurance

     10,422        (179,440
  

 

 

   

 

 

 

Total prior year

     (7,104     1,180,240   

Changes in loss reserves

     17,752        1,671,734   

Net deconsolidation of certain VIEs

     —          134,596   
  

 

 

   

 

 

 

Ending loss reserves, net of subrogation recoverable and reinsurance

   $ 6,248,532      $ 6,230,780   
  

 

 

   

 

 

 

The positive development in loss reserves established in prior years for the three months ended March 31, 2012 was driven by lower estimated losses in the first-lien RMBS and student loan portfolios, offset by lower expected subrogation recoveries and an increase in loss adjustment reserves for RMBS credits.

The adverse development in loss reserves established in prior years for the year ended December 31, 2011 was primarily due to the continued deterioration of collateral supporting structured finance policies, including RMBS and student loan exposures which resulted in greater expected ultimate losses, partially offset by higher expected subrogation recoveries related to representation and warranty breaches on insured RMBS securitizations.

The net change in loss reserves of $17,752 and $1,671,734 for the period and year ended March 31, 2012 and December 31, 2011, respectively, are included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income. Loss expense reserves are also established for significant surveillance and mitigation expenses associated with adversely classified credits. Total net loss expense reserves were $145,766 and $86,171 at March 31, 2012 and December 31, 2012, respectively. Total loss expense of $(2,320) and $919,647 for the three month periods ended March 31, 2012 and 2011, respectively, are included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income. During the three month periods ended March 31, 2012 and 2011, respectively, reinsurance recoveries of losses included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income were $12,518 and $7,691, respectively.

 

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Table of Contents

The tables below summarize information related to policies currently included in Ambac’s loss reserves at March 31, 2012 and December 31, 2011:

Surveillance Categories (at March 31, 2012)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     25        7        38        125        139        1        335   

Remaining weighted-average contract period (in years)

     18        10        17        19        9        10        13   

Gross insured contractual payments outstanding:

              

Principal

     1,938,086        173,018        1,981,014        11,557,578        12,974,787        47        28,624,530   

Interest

     1,023,136        62,902        1,029,788        6,696,703        4,070,566        22        12,883,117   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     2,961,222        235,920        3,010,802        18,254,281        17,045,353        69        41,507,647   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

     46,138        6,115        52,455        4,740,571        7,768,911        69        12,614,258   

Discount, gross claim liability

     (4,752     (1,044     (4,632     (1,613,139     (812,496     (16     (2,436,078
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability before all subrogation and before reinsurance

     41,386        5,071        47,823        3,127,432        6,956,415        53        10,178,180   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —          —          —          (380,945     (2,337,818     —          (2,718,763

Discount, RMBS subrogation

     —          —          —          7,998        55,353        —          63,351   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          —          —          (372,947     (2,282,465     —          (2,655,412
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          (222     (421 )     (105,730     (691,019     —          (797,392

Discount, other subrogation

     —          80        119       11,061        37,278        —          48,538   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          (142     (302 )     (94,669     (653,741     —          (748,854
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability, net of all subrogation and discounts, before reinsurance

     41,386        4,929        47,521        2,659,816        4,020,209        53        6,773,914   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (24,012     (2,914     (21,449     (302,892     (165,202     —          (516,469

Plus: Loss adjustment expenses reserves

     —          —          —          —          147,497        —          147,497   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Claim liability reported on Balance Sheet, before reinsurance(3)

     17,374        2,015        26,072        2,356,924        4,002,504        53        6,404,942   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

     2,037        —          5,620        141,399        21,743        —          170,799   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches.

 

(2) Other subrogation represents subrogation other than subrogation as defined in (1) above.

 

(3) Claim liability reported is included in the Consolidated Balance Sheets as follows:

 

Loss and loss expense reserve (net of potential remediation subrogation of $1,966,891)

   $ 6,924,346   

Subrogation recoverable (includes gross potential remediation of $688,521)

     (519,404
  

 

 

 
   $ 6,404,942   
  

 

 

 

 

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Table of Contents

Loss reserves ceded to reinsurers at March 31, 2012 and December 31, 2011 were $156,410 and $153,480, respectively. Amounts were included in reinsurance recoverable on the Consolidated Balance Sheet.

Surveillance Categories (at December 31, 2011)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     27        10        38        125        129        1        330   

Remaining weighted-average contract period (in years)

     18        10        17        19        9        6        13   

Gross insured contractual payments outstanding:

              

Principal

   $ 2,222,493      $ 354,713      $ 2,060,102      $ 13,342,814      $ 13,092,057      $ 47      $ 31,072,226   

Interest

     1,069,538        100,448        1,088,036        8,117,496        3,587,812        29        13,963,359   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 3,292,031      $ 455,161      $ 3,148,138      $ 21,460,310      $ 16,679,869      $ 76      $ 45,035,585   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

   $ 48,573      $ 10,667      $ 52,355      $ 4,766,815      $ 7,632,709      $ 75      $ 12,511,194   

Discount, gross claim liability

     (4,208     (2,316     (3,800     (1,440,704     (828,061     (20     (2,279,109
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability before all subrogation and before reinsurance

   $ 44,365      $ 8,351      $ 48,555      $ 3,326,111      $ 6,804,648      $ 55      $ 10,232,085   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —          —          —          (461,725     (2,316,920     —          (2,778,645

Discount, RMBS subrogation

     —          —          —          12,278        46,101        —          58,379   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          —          —          (449,447     (2,270,819     —          (2,720,266
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          (256     —          (52,871     (667,744     —          (720,871

Discount, other subrogation

     —          77        —          6,550        45,912        —          52,539   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          (179     —          (46,321     (621,832     —          (668,332
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability, net of all subrogation and discounts, before reinsurance

     44,365        8,172        48,555        2,830,343        3,911,997        55        6,843,487   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (25,264     (5,126     (22,111     (335,332     (158,687     —          (546,520

Plus: Loss adjustment expenses reserves

     —          —          —          —          87,294        —          87,294   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Claim liability reported on Balance Sheet, before reinsurance(3)

     19,101        3,046        26,444        2,495,011        3,840,604        55        6,384,261   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

     1,117        9        5,714        139,499        13,563        —          159,902   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches.
(2) Other subrogation represents subrogation other than subrogation as defined in (1) above.

 

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Table of Contents
(3) Claim liability reported is included in the Consolidated Balance Sheets as follows:

 

Loss and loss expense reserve (net of potential remediation subrogation of $1,890,797)

   $ 7,044,070   

Subrogation recoverable (includes gross potential remediation of $829,469)

     (659,810
  

 

 

 
   $ 6,384,260   
  

 

 

 

Ambac records estimated subrogation recoveries for breaches of representations and warranties by sponsors of certain RMBS transactions utilizing an Adverse and Random Sample approach. Ambac has updated its estimated subrogation recoveries to $2,655,412 ($2,627,233 net of reinsurance) at March 31, 2012 from $2,720,266 ($2,692,414 net of reinsurance) at December 31, 2011. The balance of subrogation recoveries and the related claim liabilities, by estimation approach, at March 31, 2012 and December 31, 2011, are as follows:

 

     March 31, 2012  

Approach

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

Adverse samples

     29 (2)    $ 2,699,417       $ (1,493,416   $ 1,206,001   

Random samples

     16 (2)      1,184,921         (1,161,996     22,925   
  

 

 

   

 

 

    

 

 

   

 

 

 

Totals

     45      $ 3,884,338       $ (2,655,412   $ 1,228,926   
  

 

 

   

 

 

    

 

 

   

 

 

 
     December 31, 2011  

Approach

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

Adverse samples

     30 (2)    $ 2,637,479       $ (1,457,472   $ 1,180,006   

Random samples

     16 (2)      1,140,102         (1,262,794     (122,691
  

 

 

   

 

 

    

 

 

   

 

 

 

Totals

     46      $ 3,777,581       $ (2,720,266   $ 1,057,315   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

(1) The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus the present value of projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of subrogation recoveries may exceed the expected future claims for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than expected future claims, the net cash outflow for these policies is recorded as a “Loss and loss expense reserve” liability. Of the $2,655,412 of subrogation recoveries recorded at March 31, 2012, $688,521 was included in “Subrogation recoverable” and $1,966,891 was included in “Loss and loss expense reserves.” Of the $2,720,266 of subrogation recoveries recorded at December 31, 2011, $829,469 was included in “Subrogation recoverable” and $1,890,797 was included in “Loss and loss expense reserves.”

 

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Table of Contents
(2) The sponsor’s repurchase obligation may differ depending on the terms of the particular transaction and the status of the specific loan, such as whether it is performing or has been liquidated or charged off. The estimated subrogation recovery for these transactions is based primarily on loan level data provided through trustee reports received in the normal course of our surveillance activities or provided by the sponsor. While this data may not include all the components of the sponsor’s contractual repurchase obligation we believe it is the best information available to estimate the subrogation recovery.

Below is the rollforward of RMBS subrogation, by estimation approach, for the period December 31, 2011 through March 31, 2012:

 

     Random
sample
    Number of
transactions
     Adverse
sample
     Number of
transactions
    Total  

Rollforward:

            

Discounted RMBS subrogation (gross of reinsurance) at December 31, 2011

   $ 1,262,794        16       $ 1,457,472         30        2,720,266   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Changes recognized in 2012:

            

Additional transactions reviewed

     —          n/a         —           n/a        n/a   

Additional adverse sample loans reviewed

     —          n/a         —           n/a        n/a   

Adverse loans repurchased by the sponsor

     —          n/a         —           n/a        n/a   

All other changes(1)

     (100,798     n/a         35,944         (1     (64,854
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Discounted RMBS subrogation (gross of reinsurance) at March 31, 2012

   $ 1,161,996        16       $ 1,493,416         29        2,655,412   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) Other changes which may impact subrogation recoveries include changes in actual or projected collateral performance and/or the projected timing of recoveries. For the three months ended March 31, 2012, one transaction was removed from the Adverse Sample subrogation population; however, the impacts on RMBS subrogation disclosed in the Adverse Sample column relate to multiple transactions.

 

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Table of Contents

7. Fair Value Measurements

ASC Topic 820, Fair Value Measurements and Disclosures establishes a framework for measuring fair value and disclosures about fair value measurements.

Fair value Hierarchy:

ASC Topic 820 specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company-based market assumptions. In accordance with ASC Topic 820, the fair value hierarchy prioritizes model inputs into three broad levels as follows:

 

•    Level 1

    Quoted prices for identical instruments in active markets. Assets and liabilities classified as Level 1 include US Treasury securities, exchange traded futures contracts, variable rate demand obligations, money market funds and mutual funds.

•    Level 2

    Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Assets and liabilities classified as Level 2 generally include direct investments in fixed income securities representing municipal, asset-backed and corporate obligations, financial services derivatives (including certain interest rate and currency swap derivatives), certain credit derivative contracts and most long-term debt of variable interest entities consolidated under ASC Topic 810.

•    Level 3

    Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. This hierarchy requires the use of observable market data when available. Assets and liabilities classified as Level 3 include most credit derivative contracts written as part of the financial guarantee business, certain financial services interest rate swap contracts which are not referenced to commonly quoted interest rates, call options on long-term debt, equity interests in Ambac sponsored special purpose entities and certain investments in fixed income securities. Additionally, Level 3 assets and liabilities generally include fixed income securities and loan receivables, as well as certain long-term debt of variable interest entities consolidated under ASC Topic 810.

The following table sets forth the carrying amount and fair value of Ambac’s financial assets and liabilities as of March 31, 2012 and December 31, 2011, including the level within the fair value hierarchy at which fair value measurements are categorized. As required by ASC Topic 820, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

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Table of Contents
                 Fair Value Measurements Categorized as:  
     Carrying
Amount
    Total Fair
Value
    Level 1      Level 2     Level 3  

March 31, 2012

           

Financial assets:

           

Fixed income securities:

           

Municipal obligations

   $ 1,971,283      $ 1,971,283      $ —         $ 1,971,283      $ —     

Corporate obligations

     1,148,198        1,148,198        —           1,134,831        13,367   

Foreign obligations

     70,563        70,563        —           70,563        —     

U.S. government obligations

     129,196        129,196        129,196         —          —     

U.S. agency obligations

     86,161        86,161        —           84,943        1,218   

Residential mortgage-backed securities

     1,426,657        1,426,657        —           1,426,657        —     

Collateralized debt obligations

     43,419        43,419        —           33,580        9,839   

Other asset-backed securities

     887,656        887,656        —           750,630        137,026   

Short term investments

     893,822        893,822        869,126         24,696        —     

Other investments

     100        100        —           —         100  

Fixed income securities, pledged as collateral:

           

U.S. government obligations

     284,744        284,744        284,744         —          —     

Residential mortgage-backed securities

     3,018        3,018        —           3,018        —     

Cash

     39,931        39,931        39,931         —          —     

Restricted cash

     2,500        2,500        2,500         —          —     

Loans

     19,243        17,616        —           —          17,616  

Derivative assets:

           

Interest rate swaps—asset position

     385,509        385,509        —           248,131        137,378   

Interest rate swaps—liability position

     (185,150     (185,150     —           (26     (185,124

Future contracts

     4,564        4,564        4,564        —          —     

Call options on long-term debt

     67,735        67,735        —           —          67,735   

Other assets

     16,023        16,023        —           —          16,023   

Variable interest entity assets:

           

Fixed income securities:

           

Corporate obligations

     2,184,665        2,184,665        —           —          2,184,665   

Restricted cash

     2,297        2,297        2,297         —          —     

Loans

     14,661,522        14,649,776        —           189,699        14,460,077   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial assets

   $ 24,143,656      $ 24,130,283      $ 1,332,358       $ 5,938,005      $ 16,859,920   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Financial liabilities:

           

Obligations under investment and repurchase agreements

   $ 547,331      $ 547,397      $ —         $ —        $ 547,397   

Liabilities subject to compromise

     1,622,189        195,689        —           195,689       —     

Long Term Debt

     227,189        833,248        —           —          833,248   

Derivative liabilities:

           

Credit derivatives

     201,129        201,129      $ —         $ —        $ 201,129   

Interest rate swaps—asset position

     (949     (949     —           —          (949

Interest rate swaps—liability position

     185,593        185,593        —           10,168        175,425   

Currency swaps

     1,574        1,574        —           1,574        —     

Other contracts

     129        129        —           129        —     

Liabilities for net financial guarantees written

     7,505,108        2,858,224        —           —          2,858,224   

Variable interest entity liabilities:

           

Long-term debt

     14,666,921        14,642,515        —           11,855,871        2,786,644   

Derivative liabilities:

           

Interest rate swaps—liability position

     1,930,259        1,930,259        —           1,930,259        —     

Currency swaps—asset position

     (15,634     (15,634     —           (15,634     —     

Currency swaps—liability position

     89,919        89,919        —           89,919        —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial liabilities

   $ 26,960,758      $ 21,469,093      $ —         $ 14,067,975      $ 7,401,118   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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                 Fair Value Measurements Categorized as:  
     Carrying
Amount
    Total Fair
Value
    Level 1      Level 2     Level 3  

December 31, 2011

           

Financial assets:

           

Fixed income securities:

           

Municipal obligations

   $ 2,002,999      $ 2,002,999      $ —         $ 2,002,999      $ —     

Corporate obligations

     1,127,500        1,127,500        —           1,119,570        7,930   

Foreign obligations

     94,795        94,795        —           94,795        —     

U.S. government obligations

     111,562        111,562        111,562         —          —     

U.S. agency obligations

     86,871        86,871        —           85,647        1,224   

Residential mortgage-backed securities

     1,412,517        1,412,517        —           1,412,517        —     

Collateralized debt obligations

     46,237        46,237        —           33,755        12,482   

Other asset-backed securities

     947,808        947,808        —           871,922        75,886   

Short term investments

     783,071        783,071        769,204         13,867        —     

Other investments

     100        100        —           —          100   

Fixed income securities, pledged as collateral:

           

U.S. government obligations

     260,802        260,802        260,802         —          —     

Residential mortgage-backed securities

     2,728        2,728        —           2,728        —     

Cash

     15,999        15,999        15,999         —          —     

Restricted cash

     2,500        2,500        2,500         —          —     

Loans

     18,996        16,934        —           —          16,934   

Derivative assets:

           

Interest rate swaps—asset position

     411,652        411,652        —           260,851        150,801   

Interest rate swaps—liability position

     (242,500     (242,500     —           (53     (242,447

Future contracts

     —          —          —           —          —     

Call options on long-term debt

     6,055        6,055        —           —          6,055   

Other assets

     16,779        16,779        —           —          16,779   

Variable interest entity assets:

           

Fixed income securities:

           

Corporate obligations

     2,199,338        2,199,338        —           —          2,199,338   

Restricted cash

     2,140        2,140        2,140         —          —     

Loans

     14,329,515        14,309,134        —           182,140        14,126,994   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial assets

   $ 23,637,464      $ 23,615,021      $ 1,162,207       $ 6,080,738      $ 16,372,076   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Financial liabilities:

           

Obligations under investment and repurchase agreements

   $ 546,546      $ 549,043      $ —         $ —        $ 549,043   

Liabilities subject to compromise

     1,622,189        112,233        —           112,233        —     

Long Term Debt

     223,601        562,043        —           —          562,043   

Derivative liabilities:

           

Credit derivatives

     190,653        190,653        —           —          190,653   

Interest rate swaps—asset position

     (30,859     (30,859     —           —          (30,859

Interest rate swaps—liability position

     251,303        251,303        —           9,913        241,390   

Futures contracts

     627        627        627         —          —     

Currency swaps

     2,423        2,423        —           2,423        —     

Other contracts

     361        361        —           361        —     

Liabilities for net financial guarantees written

     7,547,288        2,642,795        —           —          2,642,795   

Variable interest entity liabilities:

           

Long-term debt

     14,288,540        14,255,452        —           12,320,810        1,934,642   

Derivative liabilities:

           

Interest rate swaps—liability position

     2,023,974        2,023,974        —           2,023,974        —     

Currency swaps—asset position

     (27,779     (27,779     —           (27,779     —     

Currency swaps—liability position

     90,857        90,857        —           90,857        —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial liabilities

   $ 26,729,724      $ 20,623,126      $ 627       $ 14,532,792      $ 6,089,707   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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Determination of Fair Value:

When available, the Company generally uses quoted market prices to determine fair value, and classifies such items within Level 1. Because many fixed income securities do not trade on a daily basis, pricing sources apply available information through processes such as matrix pricing to calculate fair value. In those cases the items are classified within Level 2. If quoted market prices are not available, fair value is based upon models that use, where possible, current market-based or independently-sourced market parameters. Items valued using valuation models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be significant inputs that are readily observable.

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. Market disruptions make valuation even more difficult and subjective. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. We believe the potential for differences in third-party pricing levels is particularly significant with respect to residential mortgage-backed and certain other asset-backed securities held in our investment portfolio and referenced in our credit derivative portfolio, due to the low levels of recent trading activity for such securities. In addition, the use of internal valuation models may require assumptions about hypothetical or inactive markets. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position by Ambac, may be significantly different from its recorded fair value.

Ambac’s financial instruments carried at fair value are mainly comprised of investments in fixed income securities, derivative instruments, call options on certain long-term debt, most variable interest entity assets and liabilities and equity interests in Ambac sponsored special purpose entities. Valuation of financial instruments is performed by Ambac’s Finance group using methods approved by senior financial management with consultation from risk management and portfolio managers as appropriate. Preliminary valuation results are discussed with portfolio managers quarterly to assess consistency with market transactions and trends as applicable. Market transactions such as trades or negotiated settlements of similar positions, if any, are reviewed quarterly to validate fair value model results. However many of the financial instruments valued using significant unobservable inputs have very little or no observable market activity. Methods and significant inputs and assumptions used to determine fair values across portfolios are reviewed quarterly by senior financial management. Additionally, changes to fair value methods and assumptions are reviewed with the CEO and audit committee when such changes may be material to the company’s financial position or results. Other valuation control procedures specific to particular portfolios are described further below.

We reflect Ambac’s own creditworthiness in the fair value of financial liability by including a credit valuation adjustment (“CVA”) in the determination of fair value. A decline (increase) in Ambac’s creditworthiness as perceived by market participants will generally result in a higher (lower) CVA, thereby lowering (increasing) the fair value of Ambac’s financial liabilities as reported.

Fixed Income Securities:

The fair values of fixed income investment securities held by Ambac and its operating subsidiaries are based primarily on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and yield curves for asset-type and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. Longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value. Generally, lower credit ratings or longer expected maturities will be accompanied by higher yields used to value a security. At March 31, 2012, approximately 7%, 91%, and 2% of the investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively.

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

 

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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 that the pricing source cannot provide a reasonable value for a security or cannot adequately support a quote, in which case Ambac would resort to using either other quotes or internal models. Results of price challenges are reviewed and approved by senior traders and finance managers.

Third party quotes represent the only input to the reported fair value of Level 2 fixed income securities. Fixed income securities are classified as Level 3 when the fair value is internally modeled. Information about the valuation inputs for fixed income securities classified as Level 3 is included below:

Corporate obligations: These securities represent interest only strips of investment grade corporate obligations, and at March 31, 2012, one fixed rate investment grade corporate obligation. The fair value of such securities classified as Level 3 was $13,367 and $7,930 at March 31, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with the discount rate determined from the yields of corporate bonds from the same issuers. Significant inputs for the fixed rate corporate security valuation at March 31, 2012 were a coupon rate, maturity, and yield of 5.94%, 3.54 years and 2.72%, respectively. Significant inputs for the interest only strips valuation at March 31, 2012 and December 31, 2011 include the following weighted averages:

March 31, 2012

 

  a. Coupon rate: 0.60%

 

  b. Maturity: 21.20 years

 

  c. Yield: 6.81%

December 31, 2011

 

  a. Coupon rate: 0.60%

 

  b. Maturity: 21.44 years

 

  c. Yield: 7.20%

U.S. agency obligations: These notes are secured by separate lease rental agreements with the U.S. Government acting through the General Services Administration. The fair value of such securities classified as Level 3 was $1,218 and $1,224 at March 31, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with the yield based on comparable U.S. agency securities. Significant inputs for the valuation at March 31, 2012 and December 31, 2011 include the following weighted averages:

March 31, 2012

 

  a. Coupon rate: 6.91%

 

  b. Maturity: 1.24 years

 

  c. Yield: 2.18%

December 31, 2011

 

  a. Coupon rate: 6.91%

 

  b. Maturity: 1.33 years

 

  c. Yield: 2.13%

 

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Collateralized debt obligations (“CDO”): Securities are floating rate senior notes with the underlying securities of the CDO consist of subordinated bank perpetual preferred securities. The fair value of such securities classified as Level 3 was $9,839 and $12,482 at March 31, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at March 31, 2012 and December 31, 2011 include the following weighted averages:

March 31, 2012

 

  a. Coupon rate: 1.12%

 

  b. Maturity: 1.50 years

 

  c. Yield: 11.46%

December 31, 2011

 

  a. Coupon rate: 0.86%

 

  b. Maturity: 1.55 years

 

  c. Yield: 11.79%

Other asset-backed securities: These securities are floating rate investment grade notes collateralized by various asset types. The fair value of such securities classified as Level 3 was $137,026 and $75,886 at March 31, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at March 31, 2012 and December 31, 2011 include the following weighted averages:

March 31, 2012

 

  a. Coupon rate: 1.14%

 

  b. Maturity: 4.18 years

 

  c. Yield: 5.99%

December 31, 2011

 

  a. Coupon rate: 1.41%

 

  b. Maturity: 3.00 years

 

  c. Yield: 4.50%

Derivative Instruments:

Ambac’s derivative instruments primarily comprise interest rate and credit default swaps, exchange traded futures contracts and call options to repurchase Ambac Assurance surplus notes. Fair value is determined based upon market quotes from independent sources, when available. When independent quotes are not available, fair value is determined using valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads and ratings on underlying referenced obligations, yield curves and tax-exempt interest ratios. 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. Under ASC Topic 820, Ambac is required to consider its own credit risk when measuring the fair value of derivative and other liabilities. The fair value of net credit derivative liabilities was reduced by $469,692 at March 31, 2012 and $572,523 at December 31, 2011, as a result of incorporating a CVA on Ambac Assurance into the valuation model for these transactions. Interest rate swaps and other derivative liabilities may also require an adjustment to fair value to reflect Ambac Assurance’s credit risk. Factors considered in estimating the amount of any Ambac CVA on such contracts include collateral posting provisions, right of set-off with the counterparty, the period of time remaining on the derivatives and the pricing of recent terminations and amendments. Derivative liabilities were reduced by $131,600 at March 31, 2012 and $166,868 at December 31, 2011, as a result of Ambac CVA adjustments to derivative contracts other than credit derivatives.

 

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As described further below, certain valuation models require other inputs that are not readily observable in the market. The selection of a model to value a derivative depends on the contractual terms of, and specific risks inherent in the instrument as well as the availability of pricing information in the market.

For derivatives that are less complex and trade in liquid markets or may be valued primarily by reference to interest rates and yield curves that are observable and regularly quoted, such as interest rate and currency swaps, we utilize vendor-developed models. These models provide the net present value of the derivatives based on contractual terms and observable market data. Downgrades of Ambac Assurance, as guarantor of the financial services derivatives, beginning 2008 have increased collateral requirements and triggered termination provisions in certain interest rate and currency swaps. Increased termination activity since the initial rating downgrades of Ambac Assurance has provided additional information about the current replacement and/or exit value of our financial services derivatives, which may not be fully reflected in our vendor-models but has been incorporated into the fair value of these derivatives at March 31, 2012 and December 31, 2011. These fair value adjustments are applied to individual groups of derivatives based on common attributes such as counterparty type and credit condition, term to maturity, derivative type and net present value. Generally, the need for counterparty (or Ambac) CVAs is mitigated by the existence of collateral posting agreements under which adequate collateral has been posted. Derivative contracts entered into with financial guarantee customers are not typically subject to collateral posting agreements. Counterparty credit risk related to such customer derivative assets is included in our fair value adjustments.

For derivatives that do not trade, or trade in less liquid markets such as credit derivatives, a proprietary model is used because such instruments tend to be unique, contain complex or heavily modified and negotiated terms, and pricing information is not readily available in the market. Derivative fair value models and the related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in modeling techniques. Ambac has not made any significant changes to its modeling techniques or related model inputs for the periods presented.

Credit Derivatives (“CDS”):

Fair value of Ambac’s CDS is determined using internal valuation models and represents the net present value of the difference between the fees Ambac originally charged for the credit protection and our estimate of what a financial guarantor of comparable credit worthiness would hypothetically charge to provide the same protection at the balance sheet date. Ambac competed in the financial guarantee market, which differs from the credit markets where Ambac-insured obligations may trade. As a financial guarantor, Ambac assumes only credit risk; we do not assume other risks and costs inherent in direct ownership of the underlying reference securities. Additionally, as a result of having the ability to influence our CDS counterparty in certain investor decisions, financial guarantors generally have the ability to actively remediate the credit, potentially reducing the loss given a default. Financial guarantee contracts, including CDS, issued by Ambac and its competitors are typically priced to capture some portion of the spread that would be observed in the capital markets for the underlying (insured) obligation, with minimum pricing constrained by objective estimates of expected loss and financial guarantor required rates of return. Such pricing was well established by historical financial guarantee fees relative to capital market spreads as observed and executed in competitive markets, including in financial guarantee reinsurance and secondary market transactions. Because of this relationship and in the absence of severe credit deterioration, changes in the fair value of our credit default swaps will generally be less than changes in the fair value of the underlying reference obligations.

Key variables used in our valuation of substantially all of our credit derivatives include the balance of unpaid notional, expected term, fair values of the underlying reference obligations, reference obligation credit ratings, assumptions about current financial guarantee CDS fee levels relative to reference obligation spreads and the CVA applied against Ambac Assurance liabilities by market participants. Notional balances, expected remaining term and reference obligation credit ratings are monitored and determined by Ambac’s Risk Group. Fair values of the underlying reference obligations are obtained from broker quotes when available, or are derived from other market indications such as new issuance spreads and quoted values for similar transactions. Implicit in the fair values we obtain on the underlying reference obligations are the market’s assumptions about default probabilities, default timing, correlation, recovery rates and collateral values.

Broker quotes on the reference obligations named in our CDS contracts represent an input to determine the estimated fair value of the CDS contract. Broker quotes are indicative values for the reference obligation and

 

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generally do not represent a bid or doing-business quote for the reference instrument. Such quotes follow methodologies that are generally consistent with those used to value similar assets on the quote providers’ own books. Methodologies may differ among brokers but are understood to reflect observable trading activity (when available) and modeling that relies on empirical data and reasonable assumptions. For certain CDS contracts referencing unsecuritized pools of assets, we will obtain counterparty quotes on the credit derivative itself. Such quotes are adjusted to reflect Ambac’s own credit risk when determining the fair value of credit derivative liabilities. Third party reference obligation values or specific credit derivative quotes were used in the determination of CDS fair values related to transactions representing 83% of CDS gross par outstanding and 85% of the CDS derivative liability as of March 31, 2012.

When broker quotes for reference obligations are not available, reference obligation prices used in the valuation model are estimated internally based on averages of the quoted prices for other transactions of the same bond type and Ambac rating as well as changes in published credit spreads for securities with similar collateral and ratings characteristics. When price quotes of a similar bond type vary significantly or the number of similar transactions is small, management will consider additional factors, such as specific collateral composition and performance and contractual subordination, to identify similar transactions. Reference obligation prices derived internally as described above were used in the determination of CDS fair values related to transactions representing 17% of CDS gross par outstanding and 15% of the CDS derivative liability as of March 31, 2012.

Ambac’s CDS fair value calculations are adjusted for increases in our estimates of expected loss on the reference obligations and observable changes in financial guarantee market pricing. If no adjustment is considered necessary, Ambac maintains the same percentage of the credit spread (over LIBOR) demanded in the market for the reference obligation as existed at the inception of the CDS. Therefore, absent changes in expected loss on the reference obligations or financial guarantee CDS market pricing, the financial guarantee CDS fee used for a particular contract in Ambac’s fair value calculations represent a consistent percentage, period to period, of the credit spread determinable from the reference obligation value at the balance sheet date. This results in a CDS fair value balance that fluctuates in proportion with the reference obligation value.

The amount of expected loss on a reference obligation is a function of the probability that the obligation will default and severity of loss in the event of default. Ambac’s CDS transactions were all originally underwritten with extremely low expected losses. Both the reference obligation spreads and Ambac’s CDS fees at the inception of these transactions reflect these low expected losses. When reference obligations experience credit deterioration, there is an increase in the probability of default on the obligation and, therefore, an increase in expected loss. Ambac reflects the effects of changes in expected loss on the fair value of its CDS contracts by increasing the percentage of the reference obligation spread (over LIBOR) which would be captured as a CDS fee (“relative change ratio”) at the valuation date, resulting in a higher mark-to-market loss on our CDS relative to any price decline on the reference obligation. The fundamental assumption is that financial guarantee CDS fees will increase relative to reference obligation spreads as the underlying credit quality of the reference obligation deteriorates and approaches payment default. For example, if the credit spread of an underlying reference obligation was 80 basis points at the inception of a transaction and Ambac received a 20 basis point fee for issuing a CDS on that obligation, the relative change ratio, which represents the CDS fee to cash market spread Ambac would utilize in its valuation calculation, would be 25%. If the reference obligation spread increased to 100 basis points in the current reporting period, absent any observable changes in financial guarantee CDS market pricing or credit deterioration, Ambac’s current period CDS fee would be computed by multiplying the current reference obligation spread of 100 basis points by the relative change ratio of 25%, resulting in a 25 basis point fee. Thus, the model indicates we would need to receive an additional 5 basis points (25 basis points currently less the 20 basis points contractually received) for issuing a CDS in the current reporting period for this reference obligation. We would then discount the product of the notional amount of the CDS and the 5 basis point hypothetical CDS fee increase, over the weighted average life of the reference obligation to compute the current period mark-to-market loss. Using the same example, if the reference obligation spread increased to 100 basis points and there was credit deterioration as evidenced by an internal rating downgrade which increased the relative change ratio from 25% to 35%, we would estimate a 15 basis point hypothetical CDS fee increase in our model (35% of 100 basis points reference obligation spread, or 35 basis points currently, less the 20 basis points contractually received). Therefore, we would record a higher mark-to-market loss based on the computations described above absent any observable changes in financial guarantee CDS market pricing.

 

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We do not adjust the relative change ratio until an actual internal rating downgrade has occurred unless we observe new pricing on financial guarantee CDS contracts. However, because we have active surveillance procedures in place for our entire CDS portfolio, particularly for transactions at or near a below investment grade threshold, we believe it is unlikely that an internal downgrade would lag the actual credit deterioration of a transaction for any meaningful time period. The factors used to increase the relative change ratio are based on rating agency probability of default percentages determined by management to be appropriate for the relevant bond type. That is, the probability of default associated with the respective tenor and internal rating of each CDS transaction is utilized in the computation of the relative change ratio in our CDS valuation model. The new relative change ratio in the event of an internal downgrade of the reference obligation is calculated as the weighted average of: (i) a given transaction’s inception relative change ratio and (ii) a ratio of 100%. The weight given to the inception relative change ratio is 100% minus the current probability of default (i.e. the probability of non-default) and the weight given to using a 100% relative change ratio is the probability of default. For example, assume a transaction having an inception relative change ratio of 33% is downgraded to B- during the period, at which time it has an estimated remaining life of 8 years. If the estimated probability of default for an 8 year, B- rated credit of this type is 60% then the revised relative change ratio will be 73.2%. The revised relative change ratio can be calculated as 33% x (100%-60%) + 100% x 60% = 73.2%.

As noted above, reference obligation spreads incorporate market perceptions of default probability and loss severity, as well as liquidity risk and other factors. Loss severities are generally correlated to default probabilities during periods of economic stress. By increasing the relative change ratio in our calculations proportionally to default probabilities, Ambac incorporates into its CDS fair value the higher expected loss on the reference obligation (probability of default x loss severity), by increasing the portion of reference obligation spread that should be paid to the CDS provider.

Ambac incorporates its own credit risk into the valuation of its CDS liabilities by applying a CVA to the calculations described above. Under our methodology, determination of the CDS fair value requires estimating hypothetical financial guarantee CDS fees for a given credit at the valuation date and estimating the present value of those fees. Our approach begins with pricing in the risk of default of the reference obligation using that obligation’s credit spread. The widening of the reference obligation spread results in a mark-to-market loss to Ambac, as the credit protection seller, and a gain to the credit protection buyer because the cost of credit protection on the reference obligation (ignoring CDS counterparty credit risk) will be greater than the amount of the actual contractual CDS fees. The Ambac CVA is a percentage applied to the estimated CDS liability fair value otherwise calculated as described above. The Ambac CVA is estimated using relevant data points, including quoted prices of securities guaranteed by Ambac Assurance which indicate the value placed by market participants on Ambac Assurance’s insurance obligations and the fair value of Ambac Assurance surplus notes. The resulting Ambac CVA percentage used in the valuation of CDS liabilities was 70% and 75% as of March 31, 2012 and December 31, 2011, respectively. In instances where narrower reference obligation spreads result in a CDS asset to Ambac, those hypothetical future CDS fees are discounted at a rate which incorporates our counterparty’s credit spread (i.e. the discount rate used is LIBOR plus the current credit spread of the counterparty).

In addition, when there are sufficient numbers of new observable transactions, negotiated settlements or other market indications of a general change in market pricing trends for CDS on a given bond type, management will adjust its assumptions about the percentage of reference obligation spreads captured as CDS fees to match the current market. No such adjustments were made during the periods presented. Ambac is not transacting CDS business currently and other guarantors have stated they have exited this product. Additionally, there have been no negotiated settlements of CDS contracts during the periods presented.

Key variables which impact the “Realized gains and losses and other settlements” component of “Net change in fair value of credit derivatives” in the Consolidated Statements of Total Comprehensive Income are the most readily observable variables since they are based solely on the CDS contractual terms and cash settlements. Those variables include premiums received and accrued and losses paid and payable on written credit derivative contracts for the appropriate accounting period. Losses paid and payable reported in “Realized gains and losses and other settlements” include those arising after a credit event that requires a payment under the contract terms has occurred or in connection with a negotiated termination of a contract. The remaining key variables described above impact the “Unrealized gains (losses)” component of “Net change in fair value of credit derivatives.” The net notional outstanding of Ambac’s CDS contracts were $13,643,364 and $14,166,612 at March 31, 2012 and December 31, 2011, respectively.

 

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Credit derivative liabilities at March 31, 2012 and December 31, 2011 had a combined fair value of $201,129 and $190,653, respectively, and related to underlying reference obligations that are classified as either CLOs or Other. Information about the above described model inputs used to determine the fair value of each class of credit derivatives as of March 31, 2012 and December 31, 2011is summarized below:

 

As of March 31, 2012

 

    
     CLOs     Other(1)  

Notional outstanding

   $ 8,049,334      $ 3,826,188   

Weighted average reference obligation price

     94.0        84.5   

Weighted average life (WAL) in years

     2.5        4.7   

Weighted average credit rating

     AA-        A   

Weighted average relative change ratio

     34.4     38.3

CVA percentage

     70     70

Fair value of derivative liabilities

   $ (51,688   $ (93,043

 

As of December 31, 2011

 

    
     CLOs     Other(1)  

Notional outstanding

   $ 8,228,577      $ 4,099,766   

Weighted average reference obligation price

     92.5        84.3   

Weighted average life (WAL) in years

     2.7        4.7   

Weighted average credit rating

     AA-        A   

Weighted average relative change ratio

     34.4     38.5

CVA percentage

     75     75

Fair value of derivative liabilities

   $ (54,320   $ (86,526

 

(1) Excludes contracts for which fair values are based on credit derivative quotes rather than reference obligation quotes. Such contracts have a combined notional outstanding of $1,767,842, WAL of 9.0 years and liability fair value of ($56,398) as of March 31, 2012. Other inputs to the valuation of these transactions at March 31, 2012 include weighted average quotes of 13% of notional, weighted average rating of A and Ambac CVA percentage of 70%. As of December 31, 2011, these contracts had a combined notional outstanding of $1,838,269, WAL of 9.0 years and liability fair value of ($49,807). Other inputs to the valuation of these transactions at December 31, 2011 include weighted average quotes of 11% of notional, weighted average rating of A+ and Ambac CVA percentage of 75%.

Significant unobservable inputs for credit derivatives include WAL, credit rating, relative change ratio and CVA percentage. A longer (shorter) WAL, lower (higher) reference obligation credit rating, higher (lower) relative change ratio or lower (higher) CVA percentage, in isolation, would result in an increase (decrease) in the fair value liability measurement. A change in credit rating of a reference obligation in our model will generally result in a directionally opposite change in the relative change ratio. Also, a shorter (longer) WAL will generally correspond with a lower (higher) CVA percentage.

Call options on long-term debt:

The fair value of Ambac Assurance’s options to repurchase Ambac Assurance surplus notes at a discount to par is estimated based on a combination of internal discounted cash flow analysis and market observations. The discounted cash flow analysis uses multiple discount rate scenarios to determine the present value of the surplus notes assuming exercise and non-exercise of the options, with the difference representing the option value under that scenario. The results are probability weighted to determine the recorded option value. The weighted average discount rates used were 24.91% at March 31, 2012 and 36.57% at December 31, 2011. The board of directors of Ambac Assurance has approved the exercise of all options to purchase surplus notes issued by Ambac Assurance. The exercise of such options also requires the approval of OCI and the Rehabilitator of the Segregated Account. Ambac Assurance is seeking such approvals. There can be no assurance that such approvals will be obtained.

 

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Table of Contents

Financial Guarantees:

Fair value of net financial guarantees written represents our estimate of the cost to Ambac to completely transfer its insurance obligation to another financial guarantor of comparable credit worthiness. In theory, this amount should be the same amount that another financial guarantor of comparable credit worthiness would hypothetically charge in the market place, on a present value basis, to provide the same protection as of the balance sheet date.

This fair value estimate of financial guarantees is presented on a net basis and includes direct and assumed contracts written, which represent our liability, net of ceded reinsurance contracts, which represent our asset. The fair value estimate of direct and assumed contracts written is based on the sum of the present values of (i) unearned premium reserves; and (ii) loss and loss expense reserves, including claims presented and not paid as a result of the claim moratorium imposed by the Rehabilitation Court on March 24, 2010. The fair value estimate of ceded reinsurance contracts is based on the sum of the present values of (i) deferred ceded premiums net of ceding commissions; and (ii) reinsurance recoverables on paid and unpaid losses.

Key variables are par amounts outstanding (including future periods for the calculation of future installment premiums), expected term, discount rate, and expected net loss and loss expense payments. Net par outstanding is monitored by Ambac’s Risk Group. With respect to the discount rate, ASC Topic 820 requires that the nonperformance risk of a financial liability be included in the estimation of fair value. This nonperformance risk would include considering Ambac Assurance’s own credit risk in the fair value of financial guarantees we have issued, thus the estimated fair value for direct contracts written included an Ambac CVA to reflect Ambac’s credit risk. The Ambac CVA was 70% and 75% as of March 31, 2012 and December 31, 2011, respectively. Refer to “Credit Derivatives” above for additional information on the determination of the CVA. Refer to Note 6 for additional information on factors which influence our estimate of loss and loss expenses. The estimated fair value of ceded reinsurance contracts factors in any adjustments related to the counterparty credit risk we have with reinsurers.

There are a number of factors that limit our ability to accurately estimate the fair value of our financial guarantees. The first limitation is the lack of observable pricing data points as a result of Ambac no longer writing new financial guarantee business. Additionally, although the fair value accounting guidance for liabilities requires a company to consider the cost to completely transfer its obligation to another party of comparable credit worthiness, our primary insurance obligation is irrevocable and thus there is no established active market for transferring such obligations. Variables which are not incorporated in our current fair value estimate of financial guarantees include the credit spreads of the underlying insured obligations, the underlying ratings of those insured obligations and assumptions about current financial guarantee premium levels relative to the underlying insured obligations’ credit spreads.

Liabilities Subject to Compromise:

The fair value of Ambac’s debt included in Liabilities Subject to Compromise is based on quoted market prices.

Long-term Debt:

The fair value of surplus notes issued by Ambac Assurance and classified as long-term debt is internally estimated considering market transactions when available and internally developed discounted cash flow models. Surplus notes were initially recorded at fair value at the date of issuance. In subsequent periods, surplus notes are carried at their face value less unamortized discount.

Other Financial Assets and Liabilities:

The fair values of Ambac’s equity interest in Ambac sponsored special purpose entities (included in Other assets), Loans, and Obligations under investment and repurchase agreements are estimated based upon internal valuation models that discount expected cash flows using discount rates consistent with the credit quality of the obligor after considering collateralization.

 

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Variable Interest Entity Assets and Liabilities:

The financial assets and liabilities of VIEs consolidated under ASC Topic 810 consist primarily of fixed income securities, loans receivable, derivative instruments and debt instruments and are generally carried at fair value. These consolidated VIEs are securitization entities which have liabilities and/or assets guaranteed by Ambac Assurance. 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 debt fair value is based on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes are considered Level 2 and generally consider a variety of factors, including recent trades of the same and similar securities. For those VIE debt instruments where quotes were not available, the debt instrument fair values are considered Level 3 and are based on internal discounted cash flow models. Comparable to the sensitivities of investments in fixed income securities described above, longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value liability measurement for VIE debt. VIE debt instruments considered Level 3 include fixed rate, floating rate and zero coupon notes secured by various asset types, primarily European ABS. Information about the valuation inputs for the various VIE debt categories classified as Level 3 is as follows:

European ABS transactions: The fair value of such obligations classified as Level 3 was $2,786,644 and $1,934,642 at March 31, 2012 and December 31, 2011, respectively. Fair values were calculated by using a discounted cash flow approach. The discount rates used were based on the rates implied from the third party quoted values (Level 2) for comparable notes from the same securitization. Significant inputs for the valuation at March 31, 2012 and December 31, 2011 include the following weighted averages:

March 31, 2012

 

  a. Coupon rate: 1.64%

 

  b. Maturity: 13.24 years

 

  c. Yield: 4.10%

December 31, 2011

 

  a. Coupon rate: 1.56%

 

  b. Maturity: 11.99 years

 

  c. Yield: 3.90%

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, foreign 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. VIE derivative fair value balances at March 31, 2012 and December 31, 2011 were developed using vendor-developed models and do not use significant unobservable inputs.

The fair value of VIE assets are obtained from market quotes when available. Typically the asset fair values are not readily available from market quotes and are estimated internally. The consolidated VIEs are securitization entities in which net cash flows from assets and derivatives (after adjusting for financial guarantor cash flows and other expenses) will be paid out to note holders or equity interests. Our valuation of VIE assets (fixed income securities or loans), therefore, are derived from the fair value of notes and derivatives, as described above, adjusted for the fair value of cash flows from Ambac’s financial guarantee. The fair value of financial guarantee cash flows include: (i) estimated future premiums discounted at a rate consistent with that implicit in the fair value of the VIE’s liabilities and (ii) internal estimates of future loss payments by Ambac discounted at a rate that includes Ambac’s own credit risk. Excluding changes in estimated financial guarantee cash flows, changes in the fair value of VIE assets will be accompanied by corresponding and offsetting changes in the fair value of VIE liabilities plus VIE derivatives. Higher (lower) estimated future premiums or lower (higher) estimated loss payments on financial guarantee policies in isolation will result in increases (decreases) in the fair value measurement of VIE assets. Changes in financial guarantee estimated premiums and loss payments are generally independent. A higher CVA will reduce the fair value of expected claim payments and therefore increase VIE asset measures. The amount of CVA is generally independent of other significant inputs to the calculation of VIE assets. Estimated future premium payments to be paid by the VIEs were discounted at a weighted average rate of 7.2% and 8.4% at March 31, 2012 and December 31, 2011, respectively. The value of future loss payments to be paid by Ambac to the VIEs was adjusted to include an Ambac CVA appropriate for the term of expected Ambac claim payments.

 

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The following tables present the changes in the Level 3 fair value category for the three months ended March 31, 2012 and 2011. Ambac classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs.

Level-3 financial assets and liabilities accounted for at fair value

 

                      VIE Assets and Liabilities        

Three months ended

March 31, 2012

  Investments     Other
assets
    Derivatives     Investments     Loans     Derivatives     Long-term
debt
    Total  

Balance, beginning of period

  $ 97,522      $ 16,779      $ (486,775   $ 2,199,338      $ 14,126,994        —        $ (1,934,642   $ 14,019,216   

Additions of VIEs consolidated

    —          —          —          —          —          —          —          —     

Total gains/(losses) realized and unrealized:

              —         

Included in earnings

    (49     (756     122,327        (82,816     166,665        —          (136,563     68,808   

Included in other comprehensive income

    7,814        —          —          68,143        415,857        —          (63,205     428,609   

Purchases

    —          —          —          —          —          —          —          —     

Issuances

    —          —          —          —          —          —          —          —     

Sales

    —          —          —          —          —          —          —          —     

Settlements

    (2,742     —          8,832        —          (249,439     —          13,030        (230,319

Transfers in Level 3

    58,905        —          —          —          —          —          (665,264     (606,359

Transfers out of Level 3

    —          —          —          —          —          —          —          —     

Deconsolidation of VIEs

    —          —          —          —          —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

  $ 161,450      $ 16,023      $ (355,616   $ 2,184,665      $ 14,460,077      $ —        $ (2,786,644   $ 13,679,955   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

  $ —        $ (756   $ 107,245      $ (82,816   $ 167,146      $ —        $ (136,563   $ 54,256   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents
                      VIE Assets and Liabilities        

Three months ended

March 31, 2011

  Investments     Other
Assets
    Derivatives     Investments     Loans     Derivatives     Long-term
debt
    Total  

Balance, beginning of period

  $ 199,172      $ 17,909      $ (195,933   $ 1,904,361      $ 15,800,918      $ 4,511      $ (1,856,366   $ 15,874,572   

Total gains/(losses) realized and unrealized:

               

Included in earnings

    (50     1,096        17,645        (28,844     (49,464     (4,511     29,749        (34,739

Included in other comprehensive income

    3,223        —          —          54,174        435,170        —          (52,185     440,382   

Purchases

    —          —          —          —          —          —          —          —     

Issuances

    —          —          —          —          —          —          —          —     

Sales

    —          —          —          —          —          —          —          —     

Settlements

    (2,269     —          (11,325     —          (262,311     —          (873     (276,778

Transfers in Level 3

    —          —          —          —          —          —          (50,125     (50,125

Transfers out of Level 3

    —          —          —          —          —          —          57,106        57,106   

Deconsolidation of VIEs

    —          —          —          —          (1,894,967     —          —          (1,894,967
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

  $ 200,076      $ 19,005      $ (189,613   $ 1,929,691      $ 14,029,346      $ —        $ (1,872,694   $ 14,115,811   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

  $ —        $ 1,096      $ 13,342      $ (28,844   $ (49,464   $ (4,511   $ 29,749      $ (38,632
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The tables below provide roll-forward information by class of investments and derivatives measured using significant unobservable inputs. This information is provided for the three months ended March 31, 2012 and 2011, as required by ASC Topic 820.

 

Three months ended March 31, 2012

   Collateralized
Debt
Obligations
    Other Asset
Backed
Securities
     Corporate
Obligations
    U.S.  Agency
Obligations
    Total
Investments
 

Balance, beginning of period

   $ 12,482      $ 75,886       $ 7,930      $ 1,224      $ 97,522   

Total gains/(losses) realized and unrealized:

           

Included in earnings

     (2     —           (46     (1     (49

Included in other comprehensive income

     101        8,072         (354     (5     7,814   

Purchases

     —          —           —          —          —     

Issuances

     —          —           —          —          —     

Sales

     —          —           —          —          —     

Settlements

     (2,742     —           —          —          (2,742

Transfers in Level 3

     —          53,068         5,837       —          58,905  

Transfers out of Level 3

     —          —           —          —          —     
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 9,839      $ 137,026       $ 13,367      $ 1,218      $ 161,450   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

   $ —        $ —         $ —        $ —        $ —     
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

 

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Table of Contents

Level 3 – Investments by class

 

Three months ended March 31, 2011

   Collateralized
Debt
Obligations
    Other Asset
Backed
Securities
    Corporate
Obligations
    U.S.  Agency
Obligations
    Total
Investments
 

Balance, beginning of period

   $ 30,433      $ 159,473      $ 8,069      $ 1,197      $ 199,172   

Additions of VIEs for ASC 2009-17

          

Total gains/(losses) realized and unrealized:

          

Included in earnings

     (6     —          (43     (1     (50

Included in other comprehensive income

     1,133        2,190        (90     (10     3,223   

Purchases

     —          —          —          —          —     

Issuances

     —          —          —          —          —     

Sales

     —          —          —          —          —     

Settlements

     (1,533     (736     —          —          (2,269

Transfers in Level 3

     —          —          —          —          —     

Transfers out of Level 3

     —          —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 30,027      $ 160,927      $ 7,936      $ 1,186      $ 200,076   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

   $ —        $ —        $ —        $ —        $ —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Level 3 – Derivatives by class

 

Three months ended March 31, 2012

   Interest  Rate
Swaps
    Credit
Derivatives
    Currency
Swaps
     Call Options
on  Long-term
debt
     Total
Derivatives
 

Balance, beginning of period

   $ (302,177   $ (190,653   $ —         $ 6,055       $ (486,775

Additions of VIEs for ASC 2009-17

            

Total gains/(losses) realized and unrealized:

            

Included in earnings

     67,869        (7,222     —           61,680         122,327   

Included in other comprehensive income

     —          —          —           —           —     

Purchases

     —          —          —           —           —     

Issuances

     —          —          —           —           —     

Sales

     —          —          —           —           —     

Settlements

     12,086        (3,254     —           —           8,832   

Transfers in Level 3

     —          —          —           —