10-K 1 d449863d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

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

For the fiscal year ended December 31, 2012

 

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

For the transition period from                      to                     

Commission file number 1-10777

 

 

Ambac Financial Group, Inc.

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

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   13-3621676
(State of incorporation)  

(I.R.S. employer

identification no.)

One State Street Plaza

New York, New York

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

(212) 668-0340

(Registrant’s telephone number, including area code)

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

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

 

 

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

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

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

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

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

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

 

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

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

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

The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2012 was $8,336,718. As of March 8, 2013, 302,436,610 shares of Common Stock, par value $0.01 per share, were outstanding.

 

 

Documents Incorporated By Reference

None.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  
  

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

     3   

PART I

  

Item 1.

  

Business

  
  

Introduction

     4   
  

Business Segments

     5   
  

Investments and Investment Policy

     28   
  

Employees

     30   
  

Corporate Governance

     30   

Item 1A.

  

Risk Factors

     31   

Item 1B.

  

Unresolved Staff Comments

     42   

Item 2.

  

Properties

     43   

Item 3.

  

Legal Proceedings

     43   

Item 4.

  

Mine Safety Disclosures

     43   

PART II

  

Item 5.

  

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

     43   

Item 6.

  

Selected Financial Data

     44   

Item 7.

  

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

     45   
  

Overview

     45   
  

Critical Accounting Policies and Estimates

     46   
  

Results of Operations

     59   
  

Liquidity and Capital Resources

     70   
  

Balance Sheet

     74   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     85   

Item 8.

  

Financial Statements and Supplementary Data

     90   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     186   

Item 9A.

  

Controls and Procedures

     186   

Item 9B.

  

Other Information

     187   

PART III

  

Item 10.

  

Directors, Executive Officers and Corporate Governance

     188   

Item 11.

  

Executive Compensation

     201   

Item 12.

  

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

     207   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     208   

Item 14.

  

Principal Accountant Fees and Services

     208   

PART IV

  

Item 15.

  

Exhibits, Financial Statement Schedules

     209   

FINANCIAL STATEMENT SCHEDULES

  
  

Schedule I—Summary of Investments Other Than Investments in Related Parties

     215   
  

Schedule II—Condensed Financial Information of Registrant (Parent Company Only)

     216   
  

Schedule IV—Reinsurance

     224   

SIGNATURES

     225   

 

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

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

Any or all of management’s forward-looking statements here or in other publications may turn out to be incorrect and are based on Ambac Financial Group, Inc. (“Ambac” or the “Company”) management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) failure to consummate a plan of reorganization under Chapter 11, which may lead to the commencement of liquidation proceedings pursuant to Chapter 7; (2) the impact of the bankruptcy proceeding on the holders of Ambac securities; (3) failure to satisfactorily resolve our dispute with the United States Internal Revenue Service; (4) the failure of Ambac Assurance Corporation (“Ambac Assurance”) to pay dividends to Ambac; (5) adverse events arising from the rehabilitation proceedings for the Segregated Account of Ambac Assurance Corporation (the “Segregated Account”), including the failure of the injunctions issued by the Wisconsin rehabilitation court to protect the Segregated Account and Ambac Assurance from certain adverse actions; (6) litigation arising from the Segregated Account rehabilitation proceedings; (7) decisions made by the rehabilitator of the Segregated Account for the benefit of policyholders may result in material adverse consequences for Ambac’s security holders; (8) intercompany disputes or disputes with the rehabilitator of the Segregated Account; (9) uncertainty concerning our ability to achieve value for holders of Ambac securities after the Company’s emergence from bankruptcy; (10) potential of a full rehabilitation proceeding against Ambac Assurance or material changes to the Segregated Account rehabilitation plan, with resulting adverse impacts; (11) inadequacy of reserves established for losses and loss expenses, including our inability to realize the recoveries or future commutations included in our reserves; (12) market risks impacting assets in our investment portfolio or the value of our assets posted as collateral in respect of investment agreements and interest rate swap transactions; (13) risks relating to determination of amount of impairments taken on investments; (14) credit and liquidity risks due to unscheduled and unanticipated withdrawals on investment agreements; (15) market spreads and pricing on insured collateralized loan obligations (“CLOs”) and other derivative products insured or issued by Ambac or its subsidiaries; (16) Ambac’s financial position and the Segregated Account rehabilitation proceedings may prompt departures of key employees and may impact our ability to attract qualified executives and employees; (17) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on our business, operations, financial position, profitability or cash flows; (18) credit risk throughout our business, including but not limited to credit risk related to residential mortgage-backed securities, student loan and other asset securitizations, CLOs, public finance obligations and exposures to reinsurers; (19) default by one or more of Ambac Assurance’s portfolio investments, insured issuers, counterparties or reinsurers; (20) the risk that our risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss as a result of unforeseen risks; (21) factors that may influence the amount of installment premiums paid to Ambac, including the Segregated Account rehabilitation proceedings; (22) changes in prevailing interest rates; (23) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting, required under the relevant derivative accounting guidance; (24) changes in accounting principles or practices that may impact Ambac’s reported financial results; (25) legislative and regulatory developments; (26) operational risks, including with respect to internal processes, risk models, systems and employees; (27) changes in tax laws, tax disputes and other tax-related risks; and (28) other risks and uncertainties that have not been identified at this time.

 

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Part I

 

Item 1. Business

INTRODUCTION

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a holding company whose sole material asset is Ambac Assurance Corporation (“Ambac Assurance”). Ambac was incorporated in the state of Delaware on April 29, 1991. On November 8, 2010, Ambac filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). Ambac has continued to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court. As debtor and debtor-in-possession, Ambac 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.

The Reorganization Plan sets forth the revised capital structure of a newly reorganized Ambac and provides for corporate governance subsequent to emergence from bankruptcy. 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 value on account of such equity interests. As noted below, we are exploring new business opportunities for Ambac. It is not possible at this time to predict the industry, operating results, revenues, future prospects or other characteristics of any future business, or the terms of any future acquisition. Our efforts to pursue a new business opportunity may be unsuccessful or require significant financial or other resources. No assurance can be given that we will be able to locate or complete the acquisition or development of any business or, if acquired or developed, generate any revenues or be able to successfully integrate such business into our current operating structure. Due to these factors, as well as uncertainties relating to Ambac Assurance as described below, the value of our securities is highly speculative and investors could lose the entirety of any such investment. Amounts reflected in our Consolidated Financial Statements relative to these securities are not intended to represent redemption values that will be realized by the holders thereof pursuant to the bankruptcy proceedings or otherwise. For additional risks and uncertainties concerning Ambac, please refer to Part I, Item 1A of this Form 10-K.

The Bankruptcy Court has entered an order (the “Trading Order”) that generally restricts (i) investors from acquiring Ambac stock if after any such acquisition a holder would beneficially own at least 13,500,000 shares of Ambac stock and (ii) investors from transferring or acquiring claims (including debt securities) if after any such transfer or acquisition a holder would beneficially own claims that could result in such holder receiving stock in reorganized Ambac pursuant to the terms of the Reorganization Plan with a value equal to or greater than 4.5% of the value of the stock of reorganized Ambac. Refer to Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for further discussion of the Trading Order.

The Reorganization Plan reflects a resolution of certain issues (the “Amended Plan Settlement”) among the Company, the statutory committee of creditors appointed by the United States Trustee on November 17, 2010 (the “Creditors’ Committee”), Ambac Assurance Corporation (“Ambac Assurance”), the Segregated Account (as defined below) and 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 as well as to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) 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 and contributed to Ambac Assurance, and (iii) the sharing of expenses between the Company and Ambac Assurance. The terms of the Amended Plan Settlement are memorialized in that certain Mediation Agreement dated September 21, 2011 (the “Mediation Agreement”) among such parties. Refer to Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for further discussion of the Amended Plan Settlement and Ambac’s bankruptcy.

The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio caused downgrades and ultimately rating withdrawals of Ambac Assurance’s financial strength ratings from the independent rating agencies. These losses have prevented Ambac Assurance from being able to write new business. An inability to write new business has and will continue to negatively impact Ambac Assurance’s future operations and financial results. Ambac Assurance is unable to pay dividends, and as a result Ambac’s liquidity has been restricted. Refer to Dividend Restrictions, Including Contractual Restrictions below for further discussion.

 

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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. OCI commenced rehabilitation proceedings in the Dane County, Wisconsin Circuit Court (the “Rehabilitation Court”) with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit 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. Refer to Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of the creation and rehabilitation of the Segregated Account.

Ambac’s principal business objective is to reorganize its capital structure and financial obligations through the bankruptcy process and to increase the residual value of its financial guarantee business. Ambac’s financial guarantee business was executed through its primary operating subsidiary, Ambac Assurance. Ambac is also exploring entering into new businesses, apart from Ambac Assurance and Everspan Financial Guarantee Corp., as it prepares to emerge from bankruptcy. As part of its efforts to increase the residual value of its financial guarantee business, Ambac Assurance has pursued certain loss mitigation strategies, including seeking recovery of paid claims, commencing litigation to recover losses or mitigate future losses, entering into commutations of policies at discounts to their expected losses and purchasing Ambac-insured securities (collectively “de-risking”). Ambac Assurance considers the cash payment, if any, as well as the potential for lost future premium receipts in its review of the economic impact of executing such de-risking transactions. In 2012, Ambac Assurance commuted $2.0 billion of gross par exposure for aggregate payments of $56 million primarily relating to student loan credits. Additionally, Ambac Assurance purchased securities guaranteed by it for an aggregate purchase price of $328 million, inclusive of the intrinsic cash flows from the issuer of the securities. Refer to “BUSINESS SEGMENTS—Risk Management” below for further discussion of such activities. Opportunities for de-risking transactions depend on market conditions, including the perception of Ambac Assurance’s creditworthiness by interested parties, the structure of the underlying risk and associated policy, as well as other factors. Ambac Assurance’s ability to further commute policies or purchase securities may be limited by available liquidity. Execution of de-risking transactions with respect to liabilities allocated to the Segregated Account is subject to the authority of the Rehabilitator. In exercising such authority, the Rehabilitator will act for the benefit of policyholders, and will not take into account the interests of 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 enter into de-risking transactions

BUSINESS SEGMENTS

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

Ambac provided financial guarantee insurance for public and structured finance obligations through its primary operating subsidiary, Ambac Assurance. Ambac Assurance’s principal business consists of mitigating losses on poorly performing transactions (including through the pursuit of recoveries in respect of paid claims, litigation to recover losses or mitigate future losses, commutations of policies, purchases of Ambac-insured obligations and repurchases of surplus notes issued by Ambac Assurance or the Segregated Account) and maximizing the return on its investment portfolio. Refer to Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for additional discussion of the establishment of the Segregated Account and the subsequent Segregated Account Rehabilitation Proceedings.

Through its financial services subsidiaries, Ambac provided financial and investment products, including investment agreements, funding conduits and interest rate swaps, principally to the clients of its financial guarantee business. Ambac Assurance insured all of the obligations of its financial services subsidiaries. The interest rate swap and investment agreement

 

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businesses are in active runoff, which is being effectuated by means of transaction terminations, settlements, assignments and scheduled amortization of contracts.

Ambac’s Asset Liability Management Committee (“ALCO”) is a multidisciplinary committee that was established in late 2011. ALCO’s objective is to implement and foster an enterprise wide culture and approach to liquidity management, asset valuation, hedging, and risk remediation. Members of ALCO include the Chief Executive Officer (“CEO”), Chief Financial Officer (“CFO”) and senior managers from investment management, capital markets and risk management. ALCO has scheduled monthly meetings and will also meet on an ad hoc basis to consider, for example, the commutation of distressed financial guarantee exposures.

Financial information concerning our business segments for each of 2012 and 2011 is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures About Market Risk,” and the Consolidated Financial Statements and the Notes thereto, included elsewhere in this Form 10-K. Our Internet address is www.ambac.com. We make available free of charge, on or through the investor relations section of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission. Our Investor Relations Department can be contacted at Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, Attn: Investor Relations, telephone: 212-208-3222. The reference to our website address does not constitute inclusion or incorporation by reference of the information contained on our website in this Form 10-K or other filings with the SEC, and the information contained on our website is not part of this document.

Financial Guarantee Segment

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

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

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

Risk Management

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

 

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Furthermore, by virtue of the contracts executed between Ambac Assurance and the Segregated Account, the Rehabilitator retains the discretion to oversee and approve certain actions taken by Ambac Assurance in respect of assets and liabilities, which have not been allocated to the Segregated Account. As such, the following discussion of Ambac’s risk management practices is qualified by reference to the Rehabilitator’s exercise of its discretion to alter or eliminate any of these risk management practices.

Ambac’s risk management function for the insured portfolio has an organizational structure designed around the two major areas of focus: Portfolio Risk Management and Analysis (“PRM”) and Credit Risk Management (“CRM”). As a result of the current credit and economic environment, Ambac heightened its surveillance efforts on all exposures, focusing on the identification of credits and asset types across the portfolio that were likely to experience increased stress or potential for losses. The senior managers within the risk management groups report directly to the Chief Executive Officer (“CEO”) and regularly inform and update the Audit Committee of the Board of Directors of Ambac and Ambac Assurance with respect to risk-related topics in the insured portfolio.

Portfolio Risk Management and Analysis

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

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

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

 

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

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

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

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

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

A team of professionals has also been established to focus on recoveries from sponsors where Ambac Assurance believes that a material breach of representations and warranties has occurred with respect to certain RMBS policies. The team monitors monthly performance of the RMBS insured portfolio and uses criteria to determine which transactions to pursue with regard to such recoveries. The team engages experienced consultants to perform the re-underwriting of loan files and consult with internal and external legal counsel with regard to loan putbacks as well as settlement and litigation strategies (refer to Note 2 to the Consolidated Financial Statements included in Part II, Section 8 of this Form 10–K for further discussion on this topic).

 

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The risk restructuring group focuses on the analysis, implementation and execution of commutation and related claims reduction or defeasance strategies primarily for policies allocated to the Segregated Account. Analysts evaluate the estimated timing and severity of projected policy claims as well as the potential impact of other loss mitigation strategies in order to target and prioritize policies, or portions thereof, for commutation, refinancing, bond purchase (of securities guaranteed by Ambac Assurance), or other claims reduction or defeasance strategies. For targeted policies, analysts will engage with bondholders, issuers and other economic stakeholders to negotiate, structure, and execute such strategies.

Credit Risk Management

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

Adversely Classified Credit Review

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

The insured portfolio contains exposures that are correlated and/or concentrated. Ambac’s surveillance includes identifying these types of exposures and identifying the risks that would or could trigger credit deterioration across the related exposures. When such risks occur, adverse credit classification may be warranted across many of the correlated and/or concentrated exposures. This is the case with student loans and RMBS for example. In the past, our not for profit healthcare and our leveraged lease exposures experienced periods of stress arising from their concentrated and/or correlated risks. In the future, Ambac’s portfolio may be subject to similar credit deterioration arising from concentrated and/or correlated risks. Examples of other such risks that could impact our portfolio, and that our surveillance is designed to monitor include for example, the impact of large scale domestic military cutbacks on our military housing portfolio or event risk such as natural disasters or other regional stresses. Most such risks cannot be predicted, and may materialize unexpectedly or develop rapidly, however our surveillance allows us to connect the event and stress to the related exposures and assign an adverse credit classification and estimate losses across the affected credits when necessary.

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

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

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

 

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Financial Guarantees in Force

Financial guarantee products were sold in three principal markets: the U.S. public finance market, the U.S. structured finance and asset-backed market and the international finance market. The following table provides a breakdown of guaranteed net par outstanding by market sector at December 31, 2012 and December 31, 2011. Guaranteed net par outstanding includes the exposures of policies that insure variable interest entities (“VIEs”) consolidated in accordance with ASC Topic 810, Consolidation. Guaranteed net par outstanding excludes the exposures of policies that insure bonds which have been refunded or pre-refunded:

 

($ in millions)

   December 31,
2012
     December 31,
2011
 

Public Finance

   $ 143,018       $ 176,817   

Structured Finance

     42,359         55,145   

International Finance

     38,256         40,542   
  

 

 

    

 

 

 

Total net par outstanding

   $ 223,633       $ 272,504   
  

 

 

    

 

 

 

Included in the above net par exposures at December 31, 2012 and 2011 are $11,282 and $14,167, respectively, of exposures that were executed in the form of credit derivatives, primarily collateralized loan exposures. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data” for further discussion of credit derivative exposures.

U. S. Public Finance Insured Portfolio

Ambac’s portfolio of U.S. public finance exposures is $143,018 million, representing 64% of Ambac’s net par outstanding as of December 31, 2012. While Ambac’s U.S. Public Finance portfolio consists predominately of municipal issuances such as general and revenue obligations, lease and tax-backed obligations of state and local government entities (including tax allocation bonds as described further below), the portfolio also comprises a wide array of non-municipal types of issuances, including financings for not-for-profit entities and transactions with public and private elements, which generally finance infrastructure, housing and other public interests.

Municipal issuance is generally supported directly or indirectly by the issuer’s taxing authority or by public sector fees and assessments which may or may not be specifically pledged. Risk factors in these transactions derive from the health of the municipal issuer, including its fiscal management, politics, economic position, stability and trends, as well as issuers’ ability and willingness to continue to pay their debt service while undergoing severe stress. Municipal bankruptcy, while still uncommon, has increased, exposing Ambac to the risk of liquidity claims and ultimate losses if issuers cannot successfully reorganize without impairing debt creditors.

Not-for-profit transactions are generally supported by the not-for-profit entities’ net revenues and may also include specific pledges, liens and/or mortgages. The entity typically serves a well-defined market and promulgates a public purpose mission. These transactions may afford Ambac contractual protections such as financial covenants and control rights in the event of issuer breaches and defaults. Risk factors in these transactions derive from the creditworthiness of the issuer, including but not limited to its financial condition, leverage, management, business mix, competitive position, industry and socioeconomic trends, government programs, etc. Examples of these types of transactions include not-for-profit hospitals and universities, charities, associations and museums.

Public/private transactions are generally structured to achieve their targeted public interest objective without direct support from the public sector. Some examples of this type of financing include affordable housing, private education, and privatized military and student housing. Protections these financings offer to Ambac usually include the strength of the financed asset’s essentiality and public purpose, financial covenants, security, and control rights. Risk factors include financial underperformance, event risk and a shift in the asset’s mission or essentiality. One example of this type of financing is U.S. military housing. Ambac insures approximately $6.8 billion of privatized military housing debt. The debt was issued to finance the construction and / or renovation of housing units for military personnel and their families on domestic U.S. military bases. Debt service is not directly paid or guaranteed by the U.S. Government. Rather, the bonds are serviced from the cash flow generated by rental payments deposited by the military directly into lockbox accounts as part of each service personnel’s Basic Allowance for Housing (BAH). Security for these transactions includes the BAH payments as well as an interest in the ground lease. Risk factors affecting these transactions include the ongoing base essentiality, military deployments, the U.S. government’s commitment to fund 100% of the BAH, the marketability/attractiveness of the on-base housing units versus off base housing, construction completion, environmental remediation, utility and other operating costs and housing management.

 

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Certain issuers in our public finance portfolio have issued floating rate debt, which may introduce interest rate risk to Ambac Assurance. Refer to Auction Rate Securities and Variable Rate Demand Obligation Exposures below for further discussion. See Note 4 to the Consolidated Financial Statements, located in Part II, Item 8 of this Form 10-K for exposures by bond type.

The table below shows Ambac’s ten largest U. S. public finance exposures, by repayment source, as a percentage of total financial guarantee net par outstanding at December 31, 2012:

 

($ in millions)

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

California State—GO

  A   $ 2,800        1.3

New Jersey Transportation Trust Fund Authority—Transportation System

  A+     2,053        0.9

Bay Area Toll Authority, CA Toll Bridge Revenue

  AA-     1,581        0.7

NYS Thruway Authority, Highway & Bridge Revenue

  AA-     1,414        0.6

Massachusetts School Building Authority, MA, Sales Tax Revenue

  AA     1,248        0.6

Massachusetts Commonwealth—GO

  AA     1,216        0.5

Washington State—GO

  AA     1,154        0.5

Los Angeles Unified School District, CA—GO

  AA-     944        0.4

Sales Tax Asset Receivable Corporation, NY, Revenue

  A     846        0.4

Golden State Tobacco Securitization Corp., CA Enhanced Tobacco Settlement

  A     833        0.4
   

 

 

   

 

 

 

Total

    $ 14,089        6.3
   

 

 

   

 

 

 

 

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

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

Ambac’s portfolio of U.S. structured finance exposures is $42,359 million, representing 19% of Ambac’s net par outstanding as of December 31, 2012. Insured exposures include securitizations of mortgage loans, home equity loans, student loans, leases, operating assets, collateralized debt obligations (“CDO”), collateralized loan obligations (“CLO”), and other asset-backed financings, in each case where the majority of the underlying collateral risk is situated in the United States. Additionally, Ambac’s structured finance insured portfolio encompasses both secured and unsecured debt issued by investor-owned utilities. Included within the operating asset sector are securitizations of aircraft, shipping containers and rail car fleets. See Note 4 to the Consolidated Financial Statements, located in Part II, Item 8 in this Form 10-K for exposures by bond type as of December 31, 2012.

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

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

 

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held by the senior note holders, or guarantor in insured transactions, will determine the extent to which underlying asset performance can be influenced upon non-performance to improve the revenues available to cover debt service.

The following table presents the top five servicers by net par outstanding at December 31, 2012 for U.S. structured finance exposures:

 

Servicer

   Bond Type    Net Par
Outstanding
 
($ in millions)            

Bank of America N.A.

   Mortgage-backed    $ 5,641   

Ally Bank

   Mortgage-backed    $ 2,754   

Pennsylvania Higher Education Assistance Agency

   Student Loan    $ 2,734   

Specialized Loan Servicing, LLC

   Mortgage-backed    $ 2,170   

Wells Fargo Bank

   Mortgage-backed    $ 2,159   

The table below shows Ambac’s ten largest structured finance transactions, as a percentage of total financial guarantee net par outstanding at December 31, 2012:

 

($ in millions)

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

CDO of ABS < 25% RMBS

  A   $ 1,278        0.6     CDO of ABS   

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

  BIG     1,166        0.5     Home Equity Loan   

Ballantyne Re Plc (3)

  BIG     900        0.4     Structured Insurance   

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

  BIG     802        0.4     Home Equity Loan   

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

  BIG     790        0.4     Student Loan   

Spirit Master Funding

  BBB     760        0.3     Asset Securitizations   

Timberlake Financial, LLC

  BIG     620        0.3     Structured Insurance   

Michigan Higher Education Student Loan Authority (2)

  BIG     591        0.3     Student Loan   

Progress Energy Carolinas, Inc

  A-     558        0.2     Investor Owned Utility   

Ares XI CLO, Ltd

  AA+     508        0.2     High Yield Corp. CLO   
   

 

 

   

 

 

   

Total

    $ 7,973        3.6  
   

 

 

   

 

 

   

 

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

 

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CDO and CLO transactions involve the securitization of a portfolio of corporate bonds, corporate loan obligations and/or asset-backed securities. The majority of these exposures are executed through credit derivatives. Ambac’s outstanding CDO and CLO exposures are comprised of the following types as of December 31, 2012 and December 31, 2011:

 

Business Mix by Net Par

   December 31, 2012     December 31, 2011  
   Net Par      Percentage     Net Par      Percentage  
($ in billions)                           

High yield corporate

   $ 6,426         70   $ 8,758         70

CDO of ABS < 25% MBS

     1,742         19        2,177         18   

Market value CDOs

     525         6        851         7   

Other

     439         5        649         5   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 9,132         100   $ 12,435         100
  

 

 

    

 

 

   

 

 

    

 

 

 

International Finance Insured Portfolio

Ambac’s portfolio of international finance insured exposures is $38,256 million, representing 17% of Ambac’s net par outstanding as of December 31, 2012. Ambac’s international finance insured exposures include a wide array of obligations in the international markets, including infrastructure financings, asset-securitizations, CDOs, utility obligations, and whole business securitizations (e.g. securitizations of substantially all of the operating assets of a corporation). In emerging markets, Ambac focused on future cash flow transactions from top tier issuers (structured transactions secured by U.S. Dollar and Euro cash flows generated from exports or payment remittances) and, to a more limited extent, on domestic securitizations. See Note 4 to the Consolidated Financial Statements, located in Part II, Item 8 in this Form 10-K for exposures by bond type as of December 31, 2012.

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

Ambac UK, which is regulated in the United Kingdom, had been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the United Kingdom (“UK”) and the European Union with $26,671 million of par outstanding at December 31, 2012. Geographically, Ambac UK’s exposures are principally in the United Kingdom and continental Europe. In 2009, Ambac UK’s license to issue new business was curtailed by the FSA, Ambac UK’s regulator. The portfolio of insured exposures underwritten by Ambac UK is financially supported exclusively by the assets of Ambac UK and no capital support arrangements are in place with any other Ambac affiliate.

 

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The table below shows our ten largest international finance transactions as a percentage of total financial guarantee net par outstanding at December 31, 2012. Except where noted, all international finance transactions included in the table below are insured by Ambac UK:

 

($ in millions)

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

Mitchells & Butlers Finance plc-UK Pub Securitisation

  A+   $ 2,055        0.9     UK-Asset Securitizations   

Romulus Finance s.r.l

  BIG     1,504        0.7     Italy-Airports   

Channel Link Enterprises

  BBB-     1,262        0.6     UK-Infrastructure   

Telereal Securitisation plc

  AA     1,248        0.6     UK-Asset Securitizations   

Punch Taverns Finance plc-UK Pub Securitisation

  BIG     1,235        0.6     UK-Asset Securitizations   

National Grid Electricity Transmission

  A-     1,215        0.5     UK-Utility   

Aspire Defense Finance plc

  BBB+     1,189        0.5     UK-Infrastructure   

Regione Campania

  BBB     1,028        0.5     Italy-Sub-Sovereign   

Capital Hospitals plc (2)

  BBB-     1,015        0.4     UK-Infrastructure   

Ostregion Investmentgesellschaft NR 1 SA (2)

  BIG     943        0.4     Austria-Infrastructure   
   

 

 

   

 

 

   

Total

    $ 12,694        5.7  
   

 

 

   

 

 

   

 

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

Economic uncertainty in the European Union (EU), particularly Euro based countries, continues. Widespread austerity measures are taking place throughout the region as countries look to take action to address fiscal deficits and implement balanced budgets. The prospects of economic growth in the region in the short to medium term may prove challenging due to these actions although this will differ from country to country.

Ambac UK, on behalf of Ambac Assurance and Ambac UK, manages exposures to fourteen issuers based in EU member countries (not including the UK). Two exposures, with net par outstanding of $1,071 million, are classified as sub sovereign/municipal exposures that may be impacted should there be continued adverse financial developments in the relevant countries. Eight exposures, with net par outstanding of $4,452 million, are classified as infrastructure/operating asset backed deals that are concession based where the underlying assets independently generate cashflow without operational reliance on the sovereign. Of the remaining four deals with net par outstanding of $877 million, two are CLOs that consist of various paper issued by corporates throughout the Euro zone, one is a CMBS transaction and one is a structured insurance transaction. Given the current uncertainty in the debt capital markets in the EU, it is possible that some of Ambac’s exposures will have difficulties refinancing their debts. This short term refinancing risk in the next twelve months is limited to one policy, with debt due to be refinanced of approximately Euro 386 million. The debt was refinanced in February 2013, without a claim payment by Ambac UK.

Additional Insured Portfolio Statistics

Ambac Assurance underwrote and priced financial guarantees based on the assumption that the guarantees would remain in force until the expected maturity of the underlying bonds. Ambac Assurance estimates that the average life of its guarantees on par in force at December 31, 2012 is approximately 12 years. The 12 year average life is determined by applying a weighted average calculation, using the remaining years to expected maturity of each guaranteed bond, and weighting them on the basis of the remaining net par guaranteed. Except for RMBS policies, no assumptions are made for future refundings or terminations of insured issues. RMBS policies incorporate assumptions on expected voluntary and involuntary prepayments over the remaining life of the insured obligation.

 

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Issue Size

Ambac Assurance’s financial guarantee exposure in the U.S. public finance market reflects the historical participation across the whole range of deal sizes including those with an original par amount of less than $50 million. U.S. structured finance and international finance transactions generally involved larger transaction sizes. The following table sets forth the distribution of Ambac Assurance’s guaranteed portfolio as of December 31, 2012 with respect to the original size of each guaranteed issue:

 

Original Par Amount

   Number  of
Issues
     % of Total
Number of Issues
    Par Amount
as of December 31, 2012
 
        Amount
Outstanding
     % of Total  
($ in millions)                           

Less than $10 million

     4,900         53   $ 16,835         8

$10-less than 50 million

     2,796         30        40,452         18   

$50-250 million

     1,132         12        65,749         29   

Greater than $250 million

     458         5        100,597         45   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

     9,286         100   $ 223,633         100
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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Geographic Area

The following table sets forth the geographic distribution of Ambac Assurance’s insured exposure as of December 31, 2012:

 

Geographic Area

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

Domestic:

     

California

   $ 32,105         14.4

New York

     14,389         6.4

Florida

     11,110         5.0

Texas

     10,016         4.5

New Jersey

     7,906         3.5

Illinois

     6,878         3.1

Massachusetts

     5,373         2.4

Colorado

     4,376         2.0

Pennsylvania

     4,304         1.9

Washington

     3,480         1.6

Mortgage and asset-backed (1)

     22,022         9.9

Other domestic (2)

     63,418         28.2
  

 

 

    

 

 

 

Total Domestic

     185,377         82.9
  

 

 

    

 

 

 

International:

     

United Kingdom

     22,585         10.1

Australia

     4,820         2.2

Italy

     3,068         1.4

Austria

     943         0.4

Germany

     598         0.3

Internationally diversified (3)

     3,968         1.8

Other international

     2,274         0.9
  

 

 

    

 

 

 

Total International

     38,256         17.1
  

 

 

    

 

 

 

Grand Total

   $ 223,633         100
  

 

 

    

 

 

 

 

(1) Mortgage and asset-backed obligations includes guarantees with multiple locations of risk within the United States and is primarily comprised of residential mortgage and other asset-backed securitizations.
(2) Other domestic includes exposures to Puerto Rico of $2,531 at December 31, 2012.
(3) Internationally diversified is primarily made up of CDOs which include significant components of U.S. exposure.

 

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Exposure Currency

The table below shows the distribution by currency of Ambac Assurance’s insured exposure as of December 31, 2012:

 

Currency

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

U.S. Dollars

     188,474       $ 188,474   

British Pounds

     13,529         21,980   

Euros

     5,976         7,889   

Australian Dollars

     4,440         4,618   

Other

     1,147         672   
     

 

 

 

Total

      $ 223,633   
     

 

 

 

Ratings Distribution

The following tables provide a rating distribution of guaranteed total net par outstanding based upon internal Ambac Assurance credit ratings at December 31, 2012 and December 31, 2011 and a distribution by bond type of Ambac Assurance’s below investment grade net par exposures at December 31, 2012 and December 31, 2011. Below investment grade is defined as those exposures with a credit rating below BBB-:

Percentage of Guaranteed Portfolio

 

Ambac Rating (1)

   December 31,
2012
    December 31,
2011
 

AAA

     1     1

AA

     22        24   

A

     44        43   

BBB

     18        17   

Below investment grade

     15        15   
  

 

 

   

 

 

 

Total

     100     100
  

 

 

   

 

 

 

 

(1) Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance, and for Ambac UK related transactions, based on the view of Ambac UK. In cases where Ambac Assurance or Ambac UK has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac Assurance and Ambac UK credit ratings are subject to revision at any time and do not constitute investment advice.

 

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Summary of Below Investment Grade Exposure

 

Bond Type

   December 31,
2012
     December 31,
2011
 
($ in millions)              

Public Finance:

     

Housing (1)

   $ 775       $ 790   

Tax-backed

     741         764   

Transportation

     533         669   

General obligation

     392         492   

Health care

     11         79   

Other

     1,436         1,137   
  

 

 

    

 

 

 

Total Public Finance

     3,888         3,931   
  

 

 

    

 

 

 

Structured Finance:

     

Residential mortgage-backed and home equity—first lien

     9,592         11,673   

Residential mortgage-backed and home equity—second lien

     7,533         8,784   

Student loans

     5,331         7,728   

Structured Insurance

     1,657         1,657   

Mortgage-backed and home equity—other

     403         586   

Auto Rentals

     —          820   

Enhanced equipment trust certificates

     —          401   

Other

     554         639   
  

 

 

    

 

 

 

Total Structured Finance

     25,070         32,288   
  

 

 

    

 

 

 

International Finance:

     

Airports

     1,504         1,466   

Other

     3,452         3,399   
  

 

 

    

 

 

 

Total International Finance

     4,956         4,865   
  

 

 

    

 

 

 

Total

   $ 33,914       $ 41,084   
  

 

 

    

 

 

 

 

(1) Includes $488 and $490 of military housing net par at December 31, 2012 and 2011, respectively.

The decrease in below investment grade exposures are primarily due to (i) reductions to residential mortgage-backed securities during the year as a result of both voluntary prepayments by issuers and claims presented to Ambac Assurance; (ii) commutations and refinancings of certain student loan obligations during 2012; (iii) early prepayments in full of auto rental policies; and (iv) an improvement in the credit quality of the enhanced equipment trust certificate policies resulting in their upgrade from below investment grade.

U.S. residential mortgage-backed securities exposure

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

 

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    Total Gross Par Outstanding
At December 31, 2012 ($ in millions)
 

Year of Issue

  Second Lien     First-lien
Sub-prime
    First-lien
Mid-prime  (1)
    Other  (2)  

1998-2001

  $ 67      $ 581      $ 4      $ 457   

2002

    34        516        56        15   

2003

    25        779        362        166   

2004

    1,048        427        653        33   

2005

    1,043        993        1,956        59   

2006

    2,666        693        1,085        99   

2007

    2,874        478        1,968        228   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 7,757      $ 4,467      $ 6,084      $ 1,057   
 

 

 

   

 

 

   

 

 

   

 

 

 

% of Total RMBS Portfolio

    40.1     23.1     31.4     5.4

% of Related Par Outstanding rated below investment grade (3)

    98.2     89.1     93.7     41.8

 

    Gross Loss Reserves before Subrogation Recoveries
At December 31, 2012 ($ in millions)
 

Year of Issue

  Second Lien     First-lien
Sub-prime
    First-lien
Mid-prime  (1)
    Other  (2)  

1998-2001

  $ —       $ 72      $ —       $ —    

2002

    —         66        2        —    

2003

    —         31        3        —    

2004

    83        43        40        1   

2005

    262        438        853        15   

2006

    1,280        431        728        115   

2007

    305        224        1,029        62   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 1,930      $ 1,305      $ 2,655      $ 193   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

    Gross Subrogation Recoveries
At December 31, 2012 ($ in millions)
 

Year of Issue

  Second Lien     First-lien
Sub-prime
    First-lien
Mid-prime  (1)
    Other  (2)  

1998-2001

  $ —       $ —       $ —       $ —    

2002

    —         —         —         —    

2003

    —         —         —         —    

2004

    (30     —         —         —    

2005

    (136     (215     (247     —    

2006

    (788     (214     (124     —    

2007

    (561     (51     (157     —    
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ (1,515   $ (480   $ (528   $ —    
 

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Mid-prime includes Alt-A transactions and affordability product transactions, which includes interest only or option adjustable rate features.
(2) Other includes primarily manufactured housing and lot loan exposures.
(3) Ambac’s below investment grade internal ratings reflect bonds which are of speculative grade credit quality with the adequacy of future margin levels for payment of interest and repayment of principal potentially adversely affected by major ongoing uncertainties or exposure to adverse conditions. Ambac Assurance’s below investment grade category includes transactions on which claims have been submitted.

 

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Student Loans

Ambac Assurance’s student loan portfolio consists of credits collateralized by (i) federally guaranteed loans under the Federal Family Education Loan Program (“FFELP”) and (ii) private student loans. Whereas FFELP loans are guaranteed for a minimum of 97% of defaulted principal and interest, private loans have no government guarantee and, therefore, are subject to credit risk as with other types of unguaranteed credits. Due to the failure of the auction rate markets, the interest rates on some student loan securities have increased significantly to punitive levels pursuant to the transaction terms. Such increases have caused the collateralization ratio in these transactions to deteriorate on an accelerated basis due to negative excess spread and/or the use of principal receipts to pay current interest. Effective July 1, 2010, lenders were unable to originate federal guaranteed loans, due to the termination of the FFELP program. The resulting reduction in new revenues may adversely affect a number of smaller issuers, whose ability to remain a going concern may be at risk.

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

 

Issuer Type ($ in millions)

   December 31,
2012
Net Par
     % of Net
Par
    December 31,
2011
Net Par
     % of Net
Par
 

For-Profit Issuers

   $ 2,870         54   $ 3,289         43

Not-For-Profit Issuers

     2,402         46     4,391         57
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 5,272         100   $ 7,680         100
  

 

 

    

 

 

   

 

 

    

 

 

 

Collateral for the For-Profit Issuers consists of private loans which do not have any federal guarantee as to defaulted principal and interest. Collateral for the Not-For-Profit Issuers consists of both FFELP and private student loans. For the total student loan portfolio, approximately 82% of the collateral backing student loan trusts consists of private loans while the remaining 18% consists of FFELP loans. Private loan defaults have been on the rise since the credit crisis in 2008 began. Elevated unemployment rates, combined with high student loan debt levels will continue to put pressure on borrower’s ability to pay their loans.

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

 

Debit Type ($ in millions)

   December 31,
2012
Net Par
     % of net
Par
    December 31,
2011
Net Par
     % of net
Par
 

Auction Rate

   $ 2,713         51   $ 4,645         61

Fixed Rate

     260         5     415         5

VRDO

     —          —       205         3

Floating Rate Notes

     2,299         44     2,415         31
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 5,272         100   $ 7,680         100
  

 

 

    

 

 

   

 

 

    

 

 

 

All of the Auction Rate debt is paying interest at the maximum auction rate or the “penalty rate” pursuant to the transaction documents, reflecting both the failure of the auction rate market as well as the deteriorating credit ratings of the deals. These rates are putting negative pressure on excess spread and credit enhancement in transactions and this, in many cases, is causing an erosion of equity. This impact has been offset modestly by the current low interest rate environment.

The current capital markets and rating agency assumptions for new private loan transactions require a significant amount of equity which makes refinancing of Ambac insured transactions backed by private loans difficult for issuers. As such, we do not expect that our private loan exposure, particularly For-Profit Issuers, will be significantly reduced via refinancing in the near term. Transactions collateralized by FFELP loans are increasingly more likely to be refinanced if issuers raise enough equity through auction rate redemptions or otherwise to meet the overcollateralization required from the rating agencies.

 

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Auction Rate Securities (“ARS”) and Variable Rate Demand Obligations (“VRDO”):

Debt securities issued in the bond market include fixed and variable rate bonds. Included within the variable rate bond category are ARS and VRDO issued in the United States. The following table sets forth Ambac Assurance’s financial guarantee net par exposure outstanding, by bond type, relating to such variable rate securities at December 31, 2012 and December 31, 2011:

 

     December 31,  2012
Total
     December 31,  2011
Total
 
($ in millions)              

Investor-owned utilities

   $ 3,249       $ 3,512   

Student Loans

     2,713         4,849   

Transportation

     1,922         1,983   

Lease and Tax-backed

     1,390         1,830   

Healthcare

     1,369         1,474   

General Obligation

     322         828   

Utility

     306         307   

Other

     636         930   
  

 

 

    

 

 

 

Total

   $ 11,907       $ 15,713   
  

 

 

    

 

 

 

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

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

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

 

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For Ambac Assurance insured ARS and VRDO transactions that have been unable to refinance, the higher debt service costs have resulted in decreased debt service coverage ratios and/or the erosion of first loss and/or other credit enhancements that are subordinate to Ambac Assurance’s risk position (such as excess spread). The decrease in student loan ARS and VRDO net par during 2012 was primarily driven by the commutation or refinancing of certain insured transactions. In 2012, Ambac Assurance commuted its last remaining student loan VRDO exposure. Ambac has established gross loss reserves of approximately $994 million for the remaining ARS and VRDO exposures. Ambac continues to actively review the credit implications of this additional issuer stress and its impact to our internal credit ratings and loss reserves as necessary.

Tax Allocation Bonds

Ambac Assurance has $6,172 million net exposure to debt issued by California redevelopment agencies (“RDAs”) in its public finance portfolio, including $471 million that is below investment grade. Certain municipalities established RDAs to fund redevelopment projects. Debt issued by RDAs is principally secured by incremental property tax revenues above a designated assessed valuation (“AV”) level. The credit deterioration in our underperforming exposures arises from AV declines, and in some cases, from disputes arising among some or all of the RDA’s successor agency, and the municipality, county and State regarding entitlement to revenues and properties following the State’s dissolution of RDAs in December 2011. Additionally, although the RDA successor agencies continue to be entitled to the pledged revenues and assets and remain obligated to service RDA debt, we may be subject to liquidity claims due to timing mismatches between tax receipts and debt service payments. While we believe the above credit and liquidity risks will be contained, there can be no certainty these or other risks, and therefore our risk of loss, will not increase as the new law is enacted and its guidelines promulgated and AVs remain stressed. Ambac has established gross loss reserves of approximately $10 million for these California RDAs.

 

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Ceded Reinsurance

Ambac Assurance has reinsurance in place pursuant to treaty and facultative reinsurance agreements. For exposures reinsured, Ambac Assurance withholds a ceding commission to defray its underwriting and operating expenses. The following table shows the distribution, by bond type, of Ambac Assurance’s ceded guaranteed portfolio at December 31, 2012:

 

Bond Type

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

Public Finance:

     

Lease and tax-backed revenue

   $ 5,217         9

General obligation

     3,960         10   

Utility revenue

     2,427         12   

Transportation revenue

     2,426         15   

Higher education

     1,438         12   

Housing revenue (1)

     1,101         12   

Health care revenue

     598         10   

Other

     111         11   
  

 

 

    

 

 

 

Total Public Finance

     17,278         11   
  

 

 

    

 

 

 

Structured Finance:

     

Mortgage-backed and home equity

     247         1   

Investor-owned utilities

     721         9   

Other CDOs

     5         <1   

Student loan

     1,100         17   

Asset-backed

     371         11   

Other

     264         13   
  

 

 

    

 

 

 

Total Structured Finance

     2,708         6   
  

 

 

    

 

 

 

Total Domestic

     19,986         10   
  

 

 

    

 

 

 

International Finance:

     

Investor-owned and public utilities

     919         8   

Asset-backed

     206         2   

Sovereign/sub-sovereign

     38         <1   

Transportation

     198         3   

Other CDOs

     41         1   

Mortgage-backed and home equity

     9         1   
  

 

 

    

 

 

 

Total International Finance

     1,411         4   
  

 

 

    

 

 

 

Grand Total

   $ 21,397         9
  

 

 

    

 

 

 

 

(1) Includes $1,007 of military housing ceded par.

As a primary financial guarantor, Ambac Assurance is required to honor its obligations to its policyholders whether or not its reinsurers perform their obligations under the various reinsurance agreements. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance is entitled to receive collateral from its reinsurance counterparties in certain reinsurance contracts and has certain cancellation rights that can be exercised by Ambac Assurance in the event of rating agency downgrades of a reinsurer. Ambac Assurance held letters of credit and collateral amounting to approximately $302.7 million from its reinsurers at December 31, 2012. Refer to Item 7A—Quantitative and Qualitative Disclosures About Market Risk, Risk Management for further discussion on the credit ratings of our reinsurance counterparties and unsecured reinsurance balances.

Assumed Reinsurance:

At December 31, 2012, assumed par outstanding was $235.5 million. On March 24, 2010, all assumed reinsurance agreements with third parties were allocated to the Segregated Account, which will not allow for cancellations without the approval of the Rehabilitator.

 

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Rating Agencies

Ambac Assurance’s financial strength ratings had been downgraded and subsequently withdrawn by Moody’s and S&P. Ambac Assurance requested such withdrawals upon a review of the value of such ratings relative to the cost.

Insurance Regulatory Matters

United States

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

Insurance laws and regulations applicable to financial guarantee insurers vary by jurisdiction. The laws and regulations generally require financial guarantors to maintain minimum standards of business conduct and solvency; to meet certain financial tests; and to file policy forms, premium rate schedules and certain reports with regulatory authorities, including information concerning capital structure, ownership and financial condition. Regulated insurance companies are also required to file quarterly and annual statutory financial statements with the National Association of Insurance Commissioners (“NAIC”), and in each jurisdiction in which they are licensed. The level of supervisory authority that may be exercised by non-domiciliary insurance regulators varies by jurisdiction. Generally, however, non-domiciliary regulators are authorized to suspend or revoke insurance licenses and to impose license restrictions in the event that laws or regulations are breached by a regulated insurance company or in the event that continued or unrestricted licensure of the regulated insurance company constitutes a “hazardous condition” in the opinion of the regulator. As a result of losses from its insured portfolio, Ambac Assurance is no longer able to write new business. In addition, Ambac Assurance’s authority to write new business in Alabama, Connecticut, Louisiana, Mississippi, North Carolina, North Dakota, Ohio, Tennessee and Virginia has been restricted by regulatory action or by agreement with the relevant insurance department.

Wisconsin Insurance Laws require regulated insurance companies to maintain minimum standards of business conduct, maintain minimum surplus to policyholders meet certain financial tests, and file certain reports, including information concerning their capital structure, ownership and financial condition. Ambac Assurance, Everspan and the Segregated Account are not subject to risk-based capital requirements, since they are financial guarantee insurers. Ambac Assurance and Everspan are in compliance with minimum surplus levels. The Segregated Account, in rehabilitation, is not in compliance with minimum surplus levels. As the principal, or domiciliary, regulator of Ambac Assurance and Everspan, OCI has primary regulatory authority, including with respect to the initiation and administration of rehabilitation or liquidation proceedings. Additionally, the accounts and operations of Ambac Assurance and Everspan are subject to periodic comprehensive examinations by the OCI. OCI is currently performing its examination for the five year period ending December 31, 2011 for Ambac Assurance and Everspan. Wisconsin Insurance Laws also require prior approval by OCI of certain transactions between Ambac Assurance or Everspan and their respective affiliates. As described in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, the Rehabilitator of the Segregated Account has imposed certain constraints upon Ambac Assurance through the covenants made for the benefit of the Segregated Account and has assumed the authority to control the management of the Segregated Account.

In addition, pursuant to the terms of the Settlement Agreement, dated as of June 7, 2010, by and among Ambac Assurance, Ambac Credit Products LLC (“ACP”), Ambac and counterparties to credit default swaps with ACP that were guaranteed by Ambac Assurance (the “Settlement Agreement”), Ambac Assurance must seek prior approval by OCI of certain corporate actions. The Settlement Agreement includes covenants which generally restrict the operations of Ambac Assurance and remain in force until the surplus notes that were issued to the Counterparties by Ambac Assurance have been redeemed, repurchased or repaid in full. Certain of these restrictions may be waived with the approval of a majority of Unaffiliated Qualified Directors (described below) and/or the OCI. Pursuant to the Settlement Agreement, Ambac Assurance filed an amendment to its articles of incorporation which requires that at least one-third (and, in any event, not less than three members) of the board of directors of Ambac Assurance must be Unaffiliated Qualified Directors (as defined in the Settlement Agreement). If at any time Ambac Assurance does not have the requisite number of Unaffiliated Qualified Directors to authorize an action that is otherwise restricted by the Settlement Agreement, it will need to seek the approval of OCI to take such action.

 

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United Kingdom

The FSA has exercised significant oversight of Ambac UK since 2008, when Ambac Financial Group and Ambac Assurance began experiencing financial stress. In 2009, Ambac UK’s license to do new business was curtailed by the FSA and the insurance license was limited to undertaking only run-off related activity. As such, Ambac UK is authorized to run-off its credit, suretyship and financial guarantee insurance portfolio in the United Kingdom, and to do the same through a branch in Milan, Italy, and a number of other European Union (“EU”) countries. EU legislation has allowed Ambac UK to conduct business in EU states other than the United Kingdom through a “passporting” arrangement, which eliminates the necessity of additional licensing or authorization in those other EU jurisdictions.

Ambac UK remains subject to regulation by the FSA in the conduct of its business. The FSA is the single statutory regulator responsible for regulating the financial services industry in the United Kingdom, with the purpose of maintaining confidence in the U.K. financial system, providing public understanding of the system, securing the proper degree of protection for consumers and helping to reduce financial crime. In addition, the regulatory regime in the United Kingdom must comply with certain EU legislation binding on all EU member states. From April 1, 2013, the FSA is being reorganized into the Financial Conduct Authority (“FCA”) and the Prudential Regulatory Authority (“PRA”). Ambac UK will be subject to dual regulation by both the FCA and PRA. No material impact is anticipated with respect to Ambac UK since it is being closely supervised as a run-off entity.

The FSA requires that non-life insurance companies such as Ambac UK maintain a margin of solvency at all times in respect of the liabilities of the insurance company, the calculation of which depends on the type and amount of insurance business a company writes. In addition, the FSA had established a capital monitoring level for Ambac UK related to its insured portfolio. Breach of the monitoring level required that Ambac UK inform the FSA and enter into discussions as to the reasons for the breach, and ultimately with a view to a remedy that could include additional capital being required. The monitoring level is normally an interim arrangement, while the FSA reflects on alternative methodologies for a permanent basis for calculating regulatory capital in respect of Ambac UK and other financial guarantors regulated by the FSA. In addition, an insurer is required to perform and submit to the FSA a solvency margin calculation return in respect of its ultimate parent. All of these solvency requirements may be amended in order to implement the European Union’s proposed “Solvency II” directive on risk-based capital, but that is not expected to be implemented until 2016 at the earliest. The impact of such proposals on Ambac UK remains unclear.

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

Regulations over change in control

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

 

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Dividend Restrictions, Including Contractual Restrictions

Due to losses experienced by Ambac Assurance, Ambac Assurance was unable to pay common dividends to Ambac since 2008 and will be unable to pay common dividends in 2013, without the prior consent of the OCI, which is unlikely. See Note 6 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K for further information on dividends.

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

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

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

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

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

 

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Item 1. Business

 

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

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

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

Financial Services Segment

Ambac’s Financial Services segment historically provided financial and investment products, including investment agreements, derivative products (interest rate and currency swaps) and funding conduits, principally to clients of the financial guarantee business. In 2008, Ambac discontinued writing new investment agreements. Ambac also discontinued executing new derivative transactions except those entered into with professional counterparties to risk manage the derivatives portfolio and provide a hedge to Financial Guarantee interest rate exposure. The existing investment agreement and derivative product portfolios are in active runoff, which in addition to natural attrition may include early terminations, restructurings, hedges, and transfers. The derivative products portfolio has been positioned to benefit from rising interest rates in order to mitigate exposure to floating rate insured obligations in the Financial Guarantee segment.

The principal factors that may affect the Financial Services Segment results include: (1) availability of counterparties for hedging transactions; (2) investment returns; (3) the value of future contract terminations, settlements or transfers which may differ from carrying value of the those contracts; (4) collateral posting requirements; (5) the availability of liquidity from Ambac Assurance; (6) changes in the fair value of the derivatives portfolio resulting from interest rate fluctuations; (7) timing of investment agreement withdrawals; and (8) restrictions imposed upon Ambac Assurance by the contracts executed with the Segregated Account and the Settlement Agreement, and, to the extent that Segregated Account Policies are implicated, the authority of the Rehabilitator of the Segregated Account to control the management of the Segregated Account.

Investment Agreements

Ambac’s remaining investment agreements and repurchase agreements (collectively, “investment agreements”) issued to asset-backed, structured finance and municipal issuers were issued through its wholly-owned subsidiary, Ambac Capital Funding. Investment agreements were customized for each investor to provide guaranteed interest and ultimate return of principal in accordance with their requirements. Each investment agreement was insured by Ambac Assurance through a financial guaranty insurance policy.

Liquidity risk exists in the business due to contract provisions which require collateral posting and allow for early termination of investment agreements. As of December 31, 2012, 96% of investment agreement principal and accrued interest outstanding was collateralized. Funding for early terminations was supported in part through loans between Ambac Capital Funding and Ambac Assurance. At December 31, 2012, Ambac Capital Funding was indebted to Ambac Assurance in the amount of $234.3 million.

See “Liquidity and Capital Resources” of the Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 and Note 12 of this Form 10-K to the Consolidated Financial Statements located in Part II, Item 8 for further information on investment agreements.

 

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Item 1. Business

 

Derivative Products

The primary activity in the derivative products business was the intermediation of interest rate and currency swap transactions through Ambac Financial Services (“AFS”), a wholly-owned subsidiary of Ambac Assurance. As of year-end 2012, there is no foreign currency exposure in the derivative products portfolio. The derivative products portfolio is positioned, via swaps and exchange traded U.S. treasury futures, to benefit from rising rates as an economic hedge against interest rate exposure in the financial guarantee insurance portfolio. This hedge position may have a significant impact on the results of the Financial Services segment as reported under GAAP. Interest rate swaps used for hedging purposes are generally subject to master agreements. These agreements generally require a counterparty in a net mark-to-market liability position to post increasing amounts of collateral if that counterparty’s credit rating declines and/or the net mark-to-market liability increases. Some contracts also contain additional termination provisions linked to downgrades of Ambac Assurance, as guarantor of the swaps. As a result, AFS must fully collateralize its mark-to-market liability and must post additional collateral in excess of its mark-to-market liabilities under these agreements. AFS experienced termination events across all its swaps with professional counterparties in connection with Ambac’s ratings downgrades. Such termination events resulted in losses to AFS due to the counterparties’ cost of replacing hedge positions, and may result in additional losses in future periods. AFS has borrowed cash and securities from Ambac Assurance, to help support its incremental collateral posting requirements, termination payments and other cash needs. At December 31, 2012, AFS was indebted to Ambac Assurance in the amounts of $415.0 million in cash loans and $258.4 million in borrowed securities.

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

Funding Conduits

A subsidiary of Ambac has previously transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. The activities of the special purpose entities are contractually limited to purchasing assets from Ambac, issuing medium-term notes (“MTNs”) to fund such purchases, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. As of December 31, 2012, Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entities. Ambac does not consolidate these entities under the relevant accounting guidance for consolidation of variable interest entities. See Notes 2 and 3 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K for further information.

INVESTMENTS AND INVESTMENT POLICY

As of December 31, 2012, the consolidated non-VIE investments of Ambac had an aggregate fair value of approximately $6.3 billion and an aggregate amortized cost of approximately $5.7 billion. The majority of these investments are managed internally by officers of Ambac, who are experienced investment managers. A portion of the portfolio is managed by external investment managers. All investments are made in accordance with the general objectives and guidelines for investments reviewed or overseen by Ambac Assurance and Ambac UK’s respective Boards of Directors. These guidelines include liquidity, credit quality, diversification and duration objectives, and are periodically reviewed and revised as appropriate.

As of December 31, 2012, the Ambac Assurance non-VIE investment portfolio had an aggregate fair value of approximately $5.1 billion and an aggregate amortized cost of approximately $4.5 billion. Ambac Assurance’s investment objectives are to achieve the highest after-tax yield on a diversified portfolio of fixed income investments while employing active asset/liability management practices to satisfy all operating and strategic liquidity needs. Ambac Assurance’s investment portfolio is subject to internal investment guidelines and is subject to limits on types and quality of investments imposed by the insurance laws and regulations of the States of Wisconsin and New York. Ambac Assurance purchases Ambac Assurance insured securities given their relative risk/reward characteristics in order to mitigate the effect of potential future adverse development in the insured portfolio. Ambac Assurance financial guarantee policies related to most of these securities have been allocated to the Segregated Account. As described in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, Ambac Assurance’s investment policies are subject to certain covenants made for the benefit of the Segregated Account and, therefore, such policies may be subject to restrictions outside the control of management. Such covenants could adversely impact the performance of the investment portfolio.

 

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Item 1. Business

 

As of December 31, 2012, the non-VIE Ambac UK investment portfolio had an aggregate fair value of approximately $0.4 billion and an aggregate amortized cost of approximately $0.4 billion. Ambac UK’s investment policy is designed with the primary objective of ensuring that Ambac UK is able to meet its financial obligations as they fall due, in particular with respect to policy holders and meeting their claims. Ambac UK’s investment portfolio is subject to internal investment guidelines and may be subject to limits on types and quality of investments imposed by the FSA as regulator of Ambac UK. The Board of Directors of Ambac UK approves any changes or exceptions to Ambac UK’s investment policy.

As of December 31, 2012, the non-VIE Financial Services investment portfolio had an aggregate fair value of approximately $0.4 billion and an aggregate amortized cost of approximately $0.4 billion. The primary investment objective is to invest in a diversified portfolio of high-grade securities that produce sufficient cash flow to satisfy all investment agreement liabilities while meeting the related collateral requirements. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

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

 

     Summary of Investments as of December 31,  
     2012     2011  

Investment Category

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

Long-term investments:

          

Taxable bonds

   $ 4,409,491         7.32   $ 4,611,370         7.24

Tax-exempt bonds

     1,258,683         4.76     1,482,449         4.84
  

 

 

      

 

 

    

Total long-term investments

     5,668,174         6.74     6,093,819         6.65

Short-term investments (2)

     661,658         0.10     783,071         0.19

Other

     100         —          100         —     
  

 

 

      

 

 

    

Total

   $ 6,329,932         5.96   $ 6,876,990         5.86
  

 

 

      

 

 

    

 

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

 

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Item 1. Business

 

     Investments by Security Type as of December 31,  
     2012     2011  

Investment Category

   Carrying
Value (3)
     Weighted
Average
Yield (1)
    Carrying
Value (3)
     Weighted
Average
Yield (1)
 
($ in thousands)                           

Municipal obligations (2)

   $ 1,814,730         5.11   $ 2,002,999         5.17

Corporate securities

     1,112,174         3.88     1,127,500         4.15

Foreign obligations

     70,112         3.75     94,795         4.13

U.S. government obligations

     393,062         0.69     372,364         1.26

U.S. agency obligations

     82,535         4.34     86,871         4.34

Residential mortgage-backed securities

     1,455,582         15.79     1,415,245         16.12

Asset-backed securities

     739,979         4.54     994,045         3.87
  

 

 

      

 

 

    

Total long-term investments

     5,668,174         6.74     6,093,819         6.65

Short-term investments (2)

     661,658         0.10     783,071         0.19

Other

     100         —         100         —    
  

 

 

      

 

 

    

Total

   $ 6,329,932         5.96   $ 6,876,990         5.86
  

 

 

      

 

 

    

 

(1) Yields are stated on a pre-tax basis, based on average amortized cost.
(2) Includes taxable and tax-exempt investments.
(3) Includes investments guaranteed by Ambac Assurance and Ambac Assurance UK. Refer to Note 8 of the Consolidated Financial Statements located in Part II Item 8 of this Form 10-K for further discussion of Ambac insured securities held in the investment portfolio.

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

EMPLOYEES

As of December 31, 2012, Ambac and its subsidiaries had 226 employees. Ambac considers its employee relations to be satisfactory.

CORPORATE GOVERNANCE

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

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

 

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Item 1A. Risk Factors

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

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

Consummation and effectiveness of the Reorganization Plan is subject to the satisfaction or waiver of the following outstanding conditions: (i) the Bankruptcy Court shall have approved any supplement filed with respect to the Reorganization Plan; (ii) new organizational documents of Ambac shall have been effected; (iii) Ambac shall have executed and delivered all documents necessary to effectuate the issuance of the common stock and warrants pursuant to the Reorganization Plan; (iv) all authorizations, consents and regulatory approvals required, if any, in connection with the consummation of the Reorganization Plan shall have been obtained; (v) the terms of the IRS Settlement (as defined in Note 15 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) shall have been approved by the United States, and all conditions to the effectiveness of the IRS Settlement shall have been satisfied; (vi) the IRS Settlement and all transaction documents relating thereto shall have been executed by the parties thereto; (vii) the Bankruptcy Court shall have entered an order pursuant to Bankruptcy Rule 9019 approving the IRS Settlement; and (viii) all other actions, documents, certificates and agreements necessary to implement the Reorganization Plan shall have been effected or executed and delivered to the required parties and, to the extent required, filed with applicable governmental units in accordance with applicable laws.

As noted above, the conditions to the consummation of the Reorganization Plan include the finalization of the IRS Settlement. Finalization of such settlement requires the issuance by the Congressional Joint Committee on Taxation (the “Joint Committee”) of a “no adverse criticism” response, which is expected to be issued after the following conditions have been satisfied: (a) closing documents acceptable to the United States, Ambac and the other parties to the IRS Settlement have been executed, (b) the IRS Settlement has been approved by the Bankruptcy Court and (c) Ambac will have made payment of $1.9 million and Ambac Assurance and/or the Segregated Account will have made payment of $100 million to the United States.

Furthermore, the Reorganization Plan may not be consummated unless the Rehabilitation Court has approved the transactions contemplated in the Mediation Agreement. The Rehabilitation Court entered an order approving such transactions on November 10, 2011; however, such order has been appealed and may be overturned or stayed. On March 1, 2013, the Wisconsin Court of Appeals entered an order dismissing this appeal for lack of standing; however, appellants may appeal that order to the Wisconsin Supreme Court. Moreover, the Mediation Agreement provides that the $30 million transferred by Ambac Assurance to an escrow account on March 15, 2012 may not be released from escrow to Ambac, and the $350 million junior surplus note to be issued to Ambac by the Segregated Account pursuant to the Mediation Agreement may not be issued, until such order becomes final and non-appealable. There can be no assurance that the order entered by the Rehabilitation Court will remain in effect. If such order is vacated or overturned, Ambac may not receive the above-described cash grant or junior surplus note from Ambac Assurance or the Segregated Account, respectively.

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

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

Although the Joint Committee has reviewed the Offer Letter and has indicated that it has no objection to the offer, there can be no assurance that the required closing documentation will be negotiated successfully in order for the Joint Committee

 

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to issue a “no adverse criticism” response as required for the effectiveness of the IRS Settlement. As stated above, failure to finalize the IRS Settlement could imperil the ability of Ambac to consummate its Reorganization Plan. Moreover, a prolonged timetable in consummating the settlement could result in significant expense, threatening Ambac’s ability to successfully reorganize. In the absence of a settlement, the IRS Dispute will proceed to trial. Should the IRS prevail in litigation, allowance of its claim as filed in the Bankruptcy Court would seriously jeopardize Ambac’s ability to reorganize and may result in conversion to a Chapter 7 case.

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

Ambac Assurance’s portfolio of CDS related to CDOs of ABS experienced significant losses. The majority of these CDS contracts were on a “pay as you go” basis, and we believe that they were properly characterized as notional principal contracts for U.S. federal income tax purposes. Generally, losses on notional principal contracts are ordinary losses. However, the federal income tax treatment of credit default swaps is an unsettled area of the tax law. As part of the ongoing audit of Ambac’s 2007-2009 consolidated federal income tax returns and refund claims, the IRS has proposed to disallow Ambac’s (as the consolidated tax filer) deductions of CDS losses as ordinary losses, effectively taking the position that they were more properly characterized as capital losses. On May 4, 2011 the IRS filed a proof of claim in the Bankruptcy Court in the amount of approximately $800 million relating to the tax treatment of the CDS contracts, which Ambac opposed. As of December 31, 2012, Ambac had NOLs amounting to approximately $8,165.6 million, which is comprised of $7,287.1 million in ordinary, $486.9 million in capital federal income tax losses, and $391.7 million in international losses. Although the Company believes its CDS contracts are properly characterized as notional principal contracts, if the IRS were to successfully assert the proposed disallowance resulting from its examination and its claim in the bankruptcy case, Ambac would be subject to both a substantial reduction in its NOLs and would suffer a material assessment for U.S. federal income taxes. Such assessments and reductions in NOLs would have a material adverse impact on our financial condition and would seriously jeopardize Ambac’s ability to reorganize and may result in conversion to a Chapter 7 case. Such assessments related to the tentative refunds, which amount to approximately $700 million, may be made by the Internal Revenue Service at any time and, without prior notice to Ambac, pursuant to section 6213(b) of the Tax Code. Subject to applicable law, existing court orders and the terms of a stipulation requiring the IRS to provide notice to Ambac five business days before taking any enforcement action, the IRS may then file a lien that attaches to Ambac’s property interests, including the property interests of any member of the consolidated tax group, and commence collection efforts. If these events occur, the Segregated Account Rehabilitation Plan may be materially impacted and Ambac’s ability to effectively reorganize may be seriously jeopardized. While these issues would be resolved upon finalization of the IRS Settlement, there can be no assurance that the IRS Settlement will be consummated.

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

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

The investment value of our securities is highly speculative; furthermore, if and when we emerge from bankruptcy through the consummation of the Reorganization Plan, we might not be successful in pursuing our new business strategy or achieving any value for holders of such securities.

The value of Ambac is dependent upon the residual value of Ambac Assurance, the receipt of payments to be made by Ambac Assurance pursuant to the Mediation Agreement, the Amended TSA and the Cost Allocation Agreement, and Ambac’s ability to generate new business. There can be no assurance that Ambac will be able to realize residual value in Ambac Assurance, which is in run-off. In addition, the Segregated Account is subject to rehabilitation proceedings and under the control of the Rehabilitator. It is presently unclear whether Ambac Assurance will be able to satisfy all of its obligations to policyholders or holders of its securities, making it highly unlikely that Ambac Assurance will pay dividends to Ambac. Furthermore, the payments to be made to Ambac under the Mediation Agreement, the Amended TSA and the Cost Allocation Agreement are subject to contingencies that are difficult to predict, making the amount and timing of such payments uncertain. Payments to be made under the Amended TSA, in particular, depend on the generation of taxable income by Ambac Assurance and the amount of NOLs that can be utilized by Ambac Assurance prior to the utilization of NOLs that require payment to Ambac. Ambac Assurance’s ability to generate taxable income is uncertain. Moreover, losses incurred by Ambac Assurance since the Amended TSA was executed have increased the amount of NOLs that can be utilized by Ambac Assurance without payment to Ambac. Due to these factors, there can be no assurance as to the amounts, if any, that Ambac will receive from Ambac Assurance under the Amended TSA.

 

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We are exploring new business opportunities for Ambac, which may involve the acquisition of assets or existing businesses or the development of businesses through new or existing subsidiaries. It is not possible at this time to predict the industry, revenues (including the amount of dividends that would be paid to Ambac), future prospects or other characteristics of a future business, or the terms of a future acquisition. We are not limiting our search for business opportunities to any particular industry; therefore, our management may not be experienced in matters relating to the business of any such target and will rely upon its own reasonable efforts in accomplishing our business objectives. Our efforts to pursue a new business opportunity may be unsuccessful or require significant financial or other resources, which could have a negative impact on our financial results. No assurance can be given that we will be able to locate or complete the acquisition or development of any business or, if acquired or developed, generate any revenues or be able to successfully integrate such business into our current operating structure. Moreover, Ambac’s ability to generate new business, including entering into new business apart from Ambac Assurance and Everspan Financial Guarantee Corp., is also subject to significant doubt, given the condition and circumstances of Ambac Assurance, the difficulty of leveraging or monetizing its other assets, and the uncertainty of its ability to raise capital. Due to these factors, as well as those relating to Ambac Assurance as described above, the value of our securities is highly speculative.

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

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

Intercompany disputes or disputes with OCI may arise, which may have material adverse effects on the Company.

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

The Segregated Account, Ambac Assurance, Ambac and other affiliates have entered into agreements that govern certain activities of such entities. OCI has certain enforcement rights with respect to such agreements and, as regulator of Ambac Assurance and as Rehabilitator of the Segregated Account, has further authority over the activities of Ambac Assurance and the Segregated Account. Disputes may arise over the interpretation of such agreements, the exercise or purported exercise of rights thereunder, or the performance of or failure or purported failure to perform obligations thereunder. Disputes may also arise over certain actions taken or proposed to be taken by OCI in reliance on its contractual or legal rights. Any such dispute could have material adverse effects on the Company, whether through litigation, failure to execute transactions sought by management, interference with corporate strategies, objectives or prerogatives, inefficient decision-making or execution, forced realignment of resources, increased costs, distractions to management, strained working relationships or otherwise. Such effects would also increase the risk that OCI would seek to initiate rehabilitation proceedings against Ambac Assurance.

The Rehabilitator is considering substantial amendments to the Segregated Account Rehabilitation Plan and/or the initiation of rehabilitation proceedings against Ambac Assurance, both of which would likely have adverse consequences to holders of Ambac securities and may have adverse consequences to holders of securities insured by Ambac Assurance and could have material impact on our financial condition and results of operation.

As described elsewhere herein, the issuance of Surplus Notes by Ambac Assurance or by the Segregated Account as contemplated by the current Segregated Account Rehabilitation Plan, or the issuance of other securities, instruments or obligations by the Segregated Account to satisfy claims under a revised Segregated Account Rehabilitation Plan (“Other

 

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

Any such amendments to the Segregated Account Rehabilitation Plan could adversely affect the interests of Ambac security holders and holders of securities insured by Ambac Assurance. Notwithstanding that amendments to the Segregated Account Rehabilitation Plan and/or the initiation of rehabilitation proceedings with respect to Ambac Assurance would be designed to preserve tax attributes for the ultimate benefit of policyholders, such amendments (or any rehabilitation plan with respect to Ambac Assurance) might have other adverse impacts on holders of securities insured by Ambac Assurance, including, without limitation, delays in receipt of cash in respect of claims, absence of Surplus Notes (or Other Instruments) in respect of claims and/or the imposition of trading restrictions on Surplus Notes or Other Instruments received in respect of claims. If Surplus Notes were eliminated from the Segregated Account Rehabilitation Plan (and Other Instruments were not issued in their place), then the portion of permitted claims on policies allocated to the Segregated Account that have not been paid in cash would remain unsatisfied obligations of the Segregated Account. Such obligations may or may not accrue interest according to the terms of a modified Segregated Account Rehabilitation Plan (or any rehabilitation plan for Ambac Assurance). If the portion of permitted claims on policies allocated to the Segregated Account that have not been paid in cash was left unsatisfied pending further cash payments, then Ambac Assurance could lose its entitlement to certain reimbursements that would have been payable to it had such claims been (or been deemed to be) fully satisfied by the issuance of Surplus Notes (or Other Instruments). Furthermore, certain insured securities would accrue additional interest inasmuch as the outstanding balance of such securities would not be reduced by the amount of unpaid claims. As a result of the aforementioned, allowing the portion of permitted claims on policies allocated to the Segregated Account that have not been paid in cash to remain unsatisfied could result in a material change in our financial results.

The initiation of rehabilitation proceedings with respect to Ambac Assurance would result in the assumption of control by the Rehabilitator of all of Ambac Assurance’s assets and management of Ambac Assurance. In exercising control, the Rehabilitator would act for the benefit of policyholders, and would not take into account the interests of security holders of Ambac; such actions may result in material adverse consequences for Ambac’s security holders.

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

Holders of claims that were allocated to the Segregated Account have challenged the establishment of the Segregated Account. If such challenges are successful, Ambac Assurance and/or the Segregated Account may be exposed to the risk of greater losses. Similarly, if the Amended Plan Settlement is not executed due to a failure to consummate the Reorganization Plan, Ambac (or its creditors) could take actions which would adversely affect Ambac Assurance and/or the Segregated Account. In response to these or other events, such as failure to consummate the IRS Settlement or increased loss development in the General Account of Ambac Assurance, OCI may determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to Ambac Assurance, either preemptively or in response to any such event.

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

Our inability to realize the expected recoveries included in our loss reserves could adversely impact our liquidity and financial condition.

As of December 31, 2012, we have estimated subrogation recoveries of $2,523.2 million (net of reinsurance), which is included in our loss reserves. These recoveries are based principally on contractual claims arising from RMBS transactions that we have insured, and represent our estimate of the amounts we will ultimately recover. However, our ability to recover these amounts is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties and/or their respective parents and affiliates, timing of receipt of any such recoveries, regulatory intervention

 

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which could impede our ability to take the actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. The amount of these subrogation recoveries is significant and if we were unable to recover any amounts our stockholders’ deficit as of December 31, 2012 would increase from $3,247.0 million to $5,771.6 million.

We expect to recover material amounts of claims payments through remediation measures other than the litigation described above as well as through cash flows in the securitization structures of transactions that we insure. Realization of such expected recoveries is subject to various risks and uncertainties, including the rights and defenses of other parties with interests that conflict with our interests, the performance of the collateral and assets backing the obligations that we insure, the performance of servicers involved in securitizations in which we participate as insurer, and the effect on our rights of features of the Segregated Account Rehabilitation Plan and orders of the Rehabilitation Court. Additionally, the Segregated Account Rehabilitation Proceedings may result in the loss of future recoveries in insured transactions. Adverse developments with respect to such variables may cause our recoveries to fall below expectations.

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

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

We are subject to credit risk and other risks related to RMBS and securities backed by student loans.

We have insured RMBS transactions (including transactions comprised of second lien mortgage products, home equity line of credit (“HELOCs”) and closed end second mortgage loans, and Alt-A or mid-prime loans), as well as securities backed by student loans, and are thus exposed to credit risk associated with those asset classes. Performance of these transactions can be adversely affected by general economic conditions, including recession, rising unemployment rates, underemployment, home prices which decline or which do not increase in the patterns assumed in our models, increasing foreclosure rates and unavailability of consumer credit; mortgage product attributes, such as interest rate adjustments and balloon payment obligations; borrower and/or originator fraud; mortgage and student loan servicer activities, including underperformance and financial difficulty.

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

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

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

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

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

Increases in prevailing interest rate levels can adversely affect the value of our investment portfolio and, therefore, our financial strength. In the event that investments must be sold in order to pay claims or to meet Financial Services liquidity needs due to contract terminations or collateral posting requirements, such investments would likely be sold at discounted

 

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prices. Additionally, increasing interest rates would have an adverse impact on our insured portfolio. For example, increasing interest rates could result in higher claim payments in respect of defaulted obligations which bear interest at floating rates of interest. Higher interest rates can also lead to increased credit stress on consumer asset-backed transactions in our insured portfolio (as the securitized assets supporting a portion of these exposures are floating rate consumer obligations); slower prepayment speeds and resulting “extension risk” relative to such consumer asset-backed transactions in our insured portfolio and in our investment portfolio; decreased volume of capital markets activity and, correspondingly, decreased volume of insured transactions.

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

In an attempt to bolster the economic recovery, the Federal Reserve has set the Federal Funds Target Rate at low levels in recent years while conducting open market operations intended to lower interest rates across the yield curve. The success and/or continuation of these efforts could have a material adverse effect on Ambac’s operating results as many of the obligations guaranteed by Ambac are tied to interest rates while the entities responsible for servicing these obligations could be negatively impacted by increases in interest rates or further economic distress.

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

As a consequence of the Segregated Account Rehabilitation Proceedings, the Rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including surveillance, remediation, loss mitigation and efforts to recover losses in the Segregated Account, including recovery efforts in respect of breaches of representations and warranties by sponsors of Ambac-insured RMBS. Similarly, by virtue of the contracts executed between Ambac Assurance and the Segregated Account in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the Rehabilitator retains the discretion to oversee and approve certain actions taken by Ambac Assurance in respect of assets and liabilities that remain in Ambac Assurance. As a result, certain efforts to remediate losses, and certain other actions taken by Ambac Assurance, are subject to the approval of the Rehabilitator. In exercising such authority, the Rehabilitator will act for the benefit of policyholders, and will not take into account the interests of securityholders of Ambac. Decisions made by the Rehabilitator for the benefit of policyholders may result in material adverse consequences for Ambac’s securityholders. In addition, we are not able to predict the impact such oversight will have on the remediation of losses, and, in particular, on our efforts to recover losses attributable to breaches of representations and warranties by sponsors of Ambac-insured RMBS and our ability to commute outstanding policies and repurchase Surplus Notes, and how vigorously the Rehabilitator will pursue such remediation.

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

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

Issuance of Surplus Notes or other securities, instruments or obligations issued to satisfy claims under a revised Segregated  Account Rehabilitation Plan may cause Ambac Assurance to recognize CODI, which could significantly reduce the Ambac  Assurance NOLs.

If the Surplus Notes issued by Ambac Assurance or by the Segregated Account, or other securities, instruments or obligations issued by the Segregated Account to satisfy claims under a revised Segregated Account Rehabilitation Plan (“Other Instruments”), or the claims for which the Surplus Notes or Other Instruments are exchanged, are “publicly traded” for purposes of section 1273 of the Tax Code and applicable Treasury Regulations thereunder, Ambac Assurance will be treated as having satisfied the policyholders’ claims against Ambac Assurance for an amount equal to the fair market value of such Surplus Notes or Other Instruments (plus any other consideration transferred). Determining that the Surplus Notes, Other Instruments or claims are “publicly traded” could cause Ambac Assurance to recognize a potentially significant amount of cancellation of debt income (“CODI”), which would reduce the Ambac Assurance NOLs by the amount of such CODI. The reduction in the Ambac Assurance NOL could impair Ambac Assurance’s ability to satisfy claims asserted against the Segregated Account or Ambac Assurance. In addition, holders of the Surplus Notes or Other Instruments may recognize interest income pursuant to the original issue discount rules prior to receipt of interest payments on the Surplus Notes or Other Instruments.

 

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

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

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

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

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

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

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

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

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

These collateral-posting obligations could have a material adverse effect on our liquidity. At present, these collateral-posting requirements are being partially satisfied by Ambac Assurance and by loans from Ambac Assurance to the Financial

 

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

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

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

Our investment portfolio may be adversely affected by events and developments in the capital markets including interest rate movements, credit rating downgrades, ABS and RMBS prepayment speeds and foreign exchange movements, spread volatility, and credit losses. To the extent we need to liquidate large blocks of investment assets in order to pay claims under financial guarantee insurance policies, to make payments under investment agreements and/or to collateralize our obligations under investment agreements and interest rate swaps, such investment assets could be sold at prices less than fair value as of December 31, 2012.

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

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

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

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

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

We have historically experienced low levels of defaults in our U.S. public finance insured portfolio, including during the financial crisis that began in mid-2007. However, many state and local governments that issue obligations we insure have reported budget shortfalls that will require them to significantly raise taxes and/or cut spending in order to satisfy their obligations. Government entities may also take other actions that may impact their own creditworthiness or the creditworthiness of related issuers. For example, in 2011, the State of California abolished redevelopment agencies in the State, and while the agencies’ existing debt is required to be repaid, there can be no certainty that the agencies have the ability or willingness to pay their debts when due. In addition, some issuers of obligations we insure have either defaulted or filed for bankruptcy, raising concerns about their ultimate ability to service the debt we insure or recover claims paid in the future. If the issuers of the obligations in our U.S. public finance portfolio are unable to raise taxes, cut spending, or receive

 

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federal assistance, we may experience liquidity claims and/or ultimate losses on those obligations, which could adversely affect our business, financial condition and results of operations.

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

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

As described elsewhere herein, any changes to the Segregated Account Rehabilitation Plan in respect of the treatment of the portion of claims that is not paid in cash on an as-presented basis could cause Ambac Assurance to lose its entitlement to certain reimbursements or to incur additional interest payment obligations, which could result in a material change in our loss reserves.

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

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

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

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

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

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

 

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

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

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

The U.S. federal income tax consequences resulting from the creation of the Segregated Account are uncertain. For example, to the extent the Segregated Account were treated as a separate taxable entity, depending upon the terms of the Segregated Account Rehabilitation Plan, gains or losses could be realized by Ambac or the Segregated Account, materially increasing the U.S. federal income tax liability of the relevant party and materially reducing cash available to pay obligations.

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

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

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

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

Ambac, and certain of its present and former officers and directors, have been named in lawsuits that allege violations of the federal securities laws and/or state law. Ambac also has been named in lawsuits relating to transactions entered into by its financial guarantee subsidiary, Ambac Assurance, and its financial services businesses. Ambac Assurance is also defending various lawsuits relating to its financial guarantee business as well as securities that it has issued. In addition, the Company has received various regulatory inquiries and requests for information. Please see Note 15 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for information on these various proceedings.

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

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

Our subsidiary, Ambac Assurance, is a Wisconsin corporation and is subject to the insurance and regulatory laws of the State of Wisconsin. Under Wisconsin insurance holding company laws, there is a presumption that a holder of 10% or more of Ambac’s voting stock controls Ambac Assurance and any such acquisition of control requires the prior approval of the

 

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OCI. In addition, as a result of Ambac being the holding company of Ambac UK, the prior consent of the FSA is required for any individual, group or institution who proposes to take a step that would result in becoming a controller, or increasing control, over Ambac UK. Among other things, any shareholder must receive the prior consent of the FSA prior to holding 10 percent or more of Ambac’s shares.

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

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

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

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

Financial Markets have recently been affected by concerns over U.S. fiscal policy.

Financial markets have recently been affected by concerns over U.S. fiscal policy, including uncertainty regarding automatic spending cuts that will become effective in March 2013 and the need to again raise the U.S. federal government’s debt ceiling by May 2013 and reduce the federal deficit. These issues could, on their own, or combined with the slowing of the global economy generally, send the United States into a new recession, have severe repercussions to the United States and global credit and financial markets, further exacerbate concerns over sovereign debt of other countries and disrupt economic activity in the United States and elsewhere. In addition, a recession in the United States could negatively impact earnings, adversely affect the performance of Ambac’s investments or result in impairments and could have a material adverse effect on Ambac’s business, results of operations and financial condition. Moreover, recent tax increases and future fiscal policies may have adverse effects on the economy and on consumers, which could increase the risk of default on collateral backing securities that we insure.

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

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

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

Our ability to mitigate losses in Ambac Assurance’s insured portfolio and with respect to liabilities allocated to the Segregated Account, and to effectively implement a reorganization under Chapter 11, depend on the retention and recruitment of qualified executives and other professionals. We rely substantially upon the services of our current executive team. In addition to these officers, we require key staff with risk mitigation, structured finance, insurance, credit, investment, accounting, finance, legal and technical skills. As a result of Ambac’s bankruptcy filing and the rehabilitation proceedings for the Segregated Account, there is an increased risk that executive officers and other key staff will leave the Company and

 

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replacements may not be incented to join the Company. The loss of the services of members of our senior management team or our inability to hire and retain other talented personnel could delay or prevent us from fully implementing our remediation and reorganization strategies, which could further negatively impact our business.

 

Item 1B. Unresolved Staff Comments

None.

 

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Item 2. Properties

The executive office of Ambac is located at One State Street Plaza, New York, New York 10004, which consists of approximately 103,500 square feet of office space, under an agreement with an initial term that expires in December 2015. This office houses operations for all reportable business segments. Additionally, Ambac maintains a disaster recovery site as part of its Disaster Recovery Plan, which is located approximately 100 miles from One State Street Plaza under a lease that also expires in December, 2015.

Ambac UK also maintains offices in the United Kingdom (London), which consist of approximately 3,500 square feet of office space, under an agreement that expires in October 2020, with an earlier term option at Ambac’s discretion; and in Italy (Milan), under an agreement that expires in December 2013.

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

 

Item 3. Legal Proceedings

Please refer to Note 15 “Commitments and Contingencies” of the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K for a discussion on Legal Proceedings against Ambac and its subsidiaries.

 

Item 4. Mine Safety Disclosures

Not applicable.

Part II

 

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

(a) Market Information

Our common stock currently trades on OTCQB, the middle tier of the OTC marketplace reserved for fully reporting issuers, under the symbol “ABKFQ.” On November 9, 2010, our common stock ceased trading on the New York Stock Exchange (“NYSE”). If the Reorganization Plan is consummated, our existing common stock will be cancelled and extinguished and the holders thereof will not be entitled to receive any value for their securities upon such cancellation. The following table sets forth the high and low bid quotations as reported by Bloomberg Financial Services, Inc. Such over-the-counter market quotations reflect interdealer prices without retail mark-up, markdown or commission and may not represent actual transactions.

 

     High      Low      Dividends  

2012:

        

Fourth Quarter

   $ 0.026       $ 0.014       $ 0   

Third Quarter

   $ 0.031       $ 0.016       $ 0   

Second Quarter

   $ 0.046       $ 0.026       $ 0   

First Quarter

   $ 0.084       $ 0.025       $ 0   

2011:

        

Fourth Quarter

   $ 0.078       $ 0.021       $ 0   

Third Quarter

   $ 0.120       $ 0.040       $ 0   

Second Quarter

   $ 0.160       $ 0.079       $ 0   

First Quarter

   $ 0.275       $ 0.108       $ 0   

(b) Holders

On March 13, 2013, there were 93 stockholders of record of Ambac’s common stock.

 

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

(c) Dividends

Information concerning payments and restrictions on the payment of dividends is set forth in Item 1 above under the caption “Insurance Regulatory Matters—Dividend Restrictions, Including Contractual Restrictions” and in Note 6 to the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K.

 

Item 6. Selected Financial Data

Not applicable.

 

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

OVERVIEW

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. On November 8, 2010, Ambac filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). Ambac has continued to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court. Refer to Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of Ambac’s bankruptcy. Ambac has two reportable business segments: Financial Guarantee and Financial Services.

Ambac Assurance Corporation (“Ambac Assurance”) is Ambac’s principal operating subsidiary. Ambac Assurance is a financial guarantee insurer which provided financial guarantees and financial services to clients in both the public and private sectors around the world. In March 2010, Ambac Assurance established a segregated account pursuant to Wisc. Stat. §611.24(2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities. As of December 31, 2012, insurance liabilities for policies allocated to the Segregated Account were $6,245.5 million. These insurance liabilities consist of loss reserves and loss expense reserves, gross of remediation and reinsurance recoveries, established in accordance with SAP as defined in Ambac Assurance’s Statutory Basis Financial Results. Refer to Note 1 to the Consolidated Financial Statements located in Item 8 of this Form 10-K for information on Ambac Assurance’s liabilities that were allocated to the Segregated Account. The Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) commenced rehabilitation proceedings with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit the OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. The Rehabilitator is Theodore Nickel, the Commissioner of Insurance of the State of Wisconsin. Refer to Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of the creation and rehabilitation of the Segregated Account.

The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio caused downgrades and ultimately ratings withdrawals of Ambac Assurance’s financial strength ratings from the independent rating agencies. These losses have prevented Ambac Assurance from being able to write new business. An inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance has been unable to pay common dividends to Ambac since 2008 and it is highly unlikely that it will be able to make dividend payments to Ambac for the foreseeable future. Refer to Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of Ambac’s bankruptcy and the creation and rehabilitation of the Segregated Account. Ambac Assurance is also restricted in its ability to pay dividends pursuant to the terms of its Auction Market Preferred Shares (“AMPS”). Refer to Part I, Item 1, “Business—Dividend Restrictions, Including Contractual Restrictions” of this Form 10-K for discussion of the dividend restrictions applicable pursuant to the terms of Ambac Assurance’s AMPS.

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

 

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

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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

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

Losses and Loss Expenses of Non-derivative Financial Guarantees:

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

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

 

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

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

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

 

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

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

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

Ambac has exposure to various bond types issued in the debt capital markets. Our experience has shown that, for the majority of bond types, we have not experienced significant claims. We have observed that, with respect to certain bond types, it is reasonably possible that a material change in actual loss severities and defaults could occur over time. In the future, our experience may differ with respect to the types of guaranteed bonds affected or the magnitude of the effect. The bond types that have experienced significant claims are residential mortgage-backed securities (“RMBS”), student loan securities, healthcare obligations and collateralized debt obligations (“CDOs”). These four bond types represent 93% of our ever-to-date insurance claims recorded with RMBS comprising 90% of our ever-to-date claims payments.

The table below indicates the number of credits, gross par outstanding and gross loss reserves (including loss adjustment expenses) related to policies in Ambac’s loss reserves on credits at December 31, 2012:

 

($ in millions)

   Number of
credits
     Gross  par
outstanding (1)
     Gross Loss
Reserves  (1) (2) (3)
 

RMBS

     177       $ 14,127       $ 3,560   

Student Loans

     48         4,224         1,041   

All other credits

     91         5,709         1,383   

Loss adjustment expenses

     —          —          138   
  

 

 

    

 

 

    

 

 

 

Totals

     316       $ 24,060       $ 6,122   
  

 

 

    

 

 

    

 

 

 

 

(1) Ceded Par Outstanding and ceded loss and loss expense reserves are $1,017 and $147, respectively. Ceded loss reserves are included in Reinsurance Recoverable on paid and unpaid losses.
(2) Loss reserves of $6,122 are included in the balance sheet in the following line items: Loss and loss expense reserve—$6,619 and Subrogation recoverable—$497.
(3) Included in Gross Loss Reserves are unpaid claims of $3,388 million related to policies allocated to the Segregated Account.

 

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RMBS

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

 

   

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

 

   

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

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

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

Methodology for Projecting Expected Losses in our RMBS Portfolio

For the first three quarters of 2011, we utilized an equal blending of the results of the following approaches to determine expected losses for each transaction: (i) an internal roll-rate model to project losses for our second-lien transactions and a licensed third-party multi-scenario stochastic (Monte Carlo) cash flow model (“stochastic model”) to project losses for our first-lien transactions; and (ii) a licensed statistical regression model (“regression model”) to develop estimates of projected losses for both our second and first-lien transactions. As of December 31, 2011, we discontinued the use of both the stochastic model and the internal roll rate model and utilized only the regression model to develop estimates of projected losses.

 

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

The regression model projects losses utilizing: (i) the RMBS transaction’s collateral, characteristics and status, (ii) the RMBS transaction’s payment waterfall structure, including the application of interest and principal payments and recoveries, (iii) projected home price appreciation (“HPA”), and (iv) projected interest rates. We provide the regression model vendor with both HPA projections from a recognized source and interest rate projections we develop from market sources. We generally utilize waterfall structures from a market accepted vendor of securitization deal structures. In some cases, we may utilize an internally developed waterfall structure when our legal and commercial analysis of the transaction’s payment structure differs from the vendor’s waterfall structure. We compare monthly claims submitted against the trustees’ reports, third-party provided waterfall models and our understanding of the transactions’ structures to identify and resolve discrepancies. We also review the vendor’s published waterfall revisions to further identify material discrepancies. Resolving discrepancies is challenging and may take place over an extended period of time. Moreover, transaction documents are subject to interpretation, and our interpretation or that of the vendor and as reflected in our loss reserves may prove to be incorrect and/or not executed by the trustees directing cash flows in the future.

The regression model is subject to ongoing refinements resulting from industry research and performance that may better inform model assumptions, enhance model capabilities and other factors. For example, enhancements were made to the model in 2012 to better reflect the potential impact of borrowers’ payment histories on default rates and to normalize HPA seasonality.

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

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

Second-Lien

The regression model estimates mortgage loan collateral performance, the effect of such collateral cash flows within the transaction waterfall and the liability structure we insure. Collateral performance is frequently modeled at the deal level given the paucity of mortgage loan level data for second-lien transactions. Without specific loan-level information, the deal-level approach processes a loan pool as if it were a single loan, selecting certain aggregated deal-level characteristics to then perform a statistical analysis using a multinomial logistic regression model. We use three home price appreciation (“HPA”) projection scenarios to develop a base case as well as stress and upside cases. The highest probability is assigned to the base case, with lower probabilities to the stress and upside cases. This deal-level approach of the regression model takes a relatively complicated monthly cash flow and simplifies it into two parts: a borrower-behavior-dependent stage and a servicer-behavior-dependent stage. The borrower stage is designed to forecast the probability of a loan’s present delinquency status transitioning to any of eight future statuses. The deal-level approach calculates defaults using a roll-rate that evaluates

 

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the possible future state of a set of loans based on its current status and three variables: average FICO (credit score), average current consolidated loan to value ratio (“CLTV”), and an overall quality indicator. The servicer-behavior-dependent stage governs a loan’s life cycle after it reaches 180 or more days delinquent. This stage evaluates the servicer’s propensity to foreclose or pursue a short sale, the speed of the foreclosure process, and the speed of the post-foreclosure distressed property liquidation. The transition probabilities between advanced delinquency and foreclosure, foreclosure and REO, and finally REO and ultimate liquidation are assumed by the model to depend upon how long a loan has already been in a particular status, as well as on the servicer and on state-specific liquidation timeline factors.

First-Lien

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

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

 Additional RMBS factors for first and second-lien transactions

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

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

Government programs: In May of 2009, the Federal Government initiated the Home Affordable Modification Plan (HAMP) which allows servicers to modify loans. Under HAMP, after determining a borrower’s eligibility, a servicer can take a series of steps to reduce the borrower’s monthly mortgage payment. HAMP is applicable to the Ambac-wrapped transactions serviced by firms that have signed servicer participation agreements to modify loans under the program. Based on the observed activity reflected in data from government published sources, we believe this program is unlikely to have any additional material impact on Ambac-wrapped transactions beyond that already incorporated into our projections. Beginning in the third quarter of 2011 we no longer assumed any additional impact for HAMP on our first-lien portfolio. We have not given credit to any other government programs, most of which are targeted to home mortgages that are bank-owned, included in RMBS securitizations.

 

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

RMBS Representation and Warranty Subrogation Recoveries

In an effort to better understand the unprecedented levels of delinquencies, Ambac or its counsel engaged consultants with significant mortgage underwriting experience to review the underwriting documentation for mortgage loans underlying certain insured RMBS transactions. Transactions which exhibited exceptionally poor performance were chosen for further examination of the underwriting documentation supporting the underlying loans. Factors which Ambac believes to be indicative of poor performance include (i) high levels of early payment defaults, (ii) significant number of loan liquidations or charge-offs and resulting high levels of losses, and (iii) rapid elimination of credit protections inherent in the transactions’ structures. Clause (ii), “loan liquidations,” refers to loans for which the servicer has liquidated the related collateral and the securitization has realized losses on the loan; “charge-offs” refers to loans which have been written off as uncollectible by the servicer, thereby generating no recoveries to the securitization, and may also refer to the unrecovered balance of liquidated loans. In either case, the servicer has taken actions to recover against the collateral, and the securitization has incurred losses to the extent such actions did not result in full repayment of the borrower’s obligations. Generally, the sponsor of the transaction provided representations and warranties with respect to the securitized loans, including representations with respect to the loan characteristics, the absence of fraud or other misconduct in the origination process, and attesting to the compliance of loans with the prevailing underwriting policies. In such cases, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations and warranties. Refer to Note 2 and Note 5 of the Consolidated Financial Statements included in Part II, Item 8 of the Form 10-K for more information regarding representation and warranty subrogation recoveries.

The table below distinguishes between RMBS credits for which we have not established a representation and warranty subrogation recovery and those for which we have, providing in both cases the number of policies, gross par outstanding, gross loss reserves before subrogation recoveries, subrogation recoveries, and gross loss reserves net of subrogation for all RMBS exposures for which Ambac established reserves at December 31, 2012:

 

($ in millions)

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

Second-lien

     20       $ 2,215       $ 597         —       $ 597   

First-lien-Mid-prime

     57         3,432         1,511         —         1,511   

First-lien-Sub-prime

     39         1,476         219         —         219   

Other

     12         304         193         —         193   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Credits Without Subrogation

     128         7,427         2,520         —         2,520   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Second-lien

     22         3,200         1,333         (1,515     (182

First-lien Mid-prime

     22         1,498         1,144         (528     616   

First-lien Sub-prime

     5         2,002         1,086         (480     606   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Credits With Subrogation

     49         6,700         3,563         (2,523     1,040   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total

     177       $ 14,127       $ 6,083       $ (2,523   $ 3,560   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

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

 

STUDENT LOANS

Our student loan portfolio consists of credits collateralized by (i) federally guaranteed loans under the Federal Family Education Loan Program (“FFELP”) and (ii) private student loans. Whereas FFELP loans are guaranteed for a minimum of 97% of defaulted principal and interest, private loans have no government guarantee and therefore are subject to credit risk as with other types of unguaranteed credits. Default data has shown a significant deterioration in the performance of private student loans underlying some of our transactions. Additionally, due to the failure of the auction rate markets, the interest rates on some of student loan securities have increased significantly to punitive levels pursuant to the transaction terms. Such increases have caused the collateralization ratio in these transactions to deteriorate on an accelerated basis due to negative excess spread and/or the use of principal receipts to pay current interest. Rating agency downgrades of outstanding auction rate notes have resulted in step-ups of the interest rate payable on such securities which, in certain cases, has further accelerated the erosion of the trust estate.

Methodology for Projecting Expected Losses in our Student Loan Portfolio

The calculation of loss reserves for our student loan portfolio involves evaluating numerous factors that can impact ultimate losses. The factor which contributes to the greatest degree of uncertainty in ascertaining appropriate loss reserves is the long time horizon associated with the final legal maturity date of the bonds. Most of the student loan bonds which we insure were issued with original terms of 20 to 40 years until final maturity. Since our policy covers timely interest and ultimate principal payment, our loss projections must make assumptions for many factors covering a long time horizon. Key assumptions that will impact ultimate losses include but are not limited to the following: collateral performance which is highly correlated to the economic environment, interest rates, operating risks associated with the issuer, servicers, administrators, issuers willingness and ability to refinance, investor appetitive for tendering auction rate securities at a discount and, as applicable, Ambac’s ability and willingness to commute policies.

In evaluating our student loan portfolio, losses were projected using either a cash flow or statistical expected loss approach. As more fully described in Note 2 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K, the statistical methodology uses probability of default and loss given default (“LGD”) metrics under various scenarios to derive a weighted average loss expectation. The scenarios used under the statistical expected loss approach evaluate each transaction under base case and stress case scenarios. The main drivers in assigning appropriate probabilities to LGDs for each policy includes an analysis of the collateral mix; debt type and interest rates; parity level; enhancement levels and remediation opportunities. We believe the statistical expected loss approach is a more efficient methodology for certain deals in our student loan portfolio, such as (i) deals where collateral loan level data is unavailable (and thus the cash flow model, as more fully discussed below could not be used), and (ii) deals where we do not expect to experience meaningful losses.

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

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

 

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REASONABLY POSSIBLE ADDITIONAL LOSSES

RMBS

It is possible that our loss estimate assumptions for the RMBS insurance policies discussed above could be materially under-estimated as a result of continued deterioration in housing prices, poor servicing, the effects of a weakened economy marked by growing unemployment and wage pressures, inability to execute commutation transactions with insurers and/or investors and/or continued illiquidity of the mortgage market. Additionally, our actual subrogation recoveries could be significantly lower than our current estimates of $2,523 million if the sponsors of these transactions: (i) fail to honor their obligations to repurchase the mortgage loans, (ii) successfully dispute our breach findings, or (iii) no longer have the financial means to fully satisfy their obligations under the transaction documents.

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

In the case of both first and second-lien exposures, the regression model’s reasonably possible stress case assumes a significantly harsher HPA projection, which in turn drives higher defaults and severities. Using this approach, the reasonably possible increase in loss reserves for RMBS credits for which we have an estimate of expected loss at December 31, 2012 could be approximately $1,088 million. The reasonably possible scenario considers the highest stress scenario that was utilized in the development of our probability-weighted expected loss at December 31, 2012 and assumes an inability to execute commutation transactions with issuers and/or investors.

Student Loans

It is possible that our loss estimate assumptions for student loan credits could be materially under-estimated as a result of various uncertainties including but not limited to, the interest rate environment, an increase in default rates and loss severities on the collateral due to economic factors, as well as a failure of issuers to refinance insured bonds which have a failed debt structure, such as auction rate securities. Refer to Auction Rate Securities and Variable Rate Demand Obligations in Part 1, Item 1 of this Form 10-K for further information on our exposures to such failed debt structures. For student loan credits for which we have an estimate of expected loss at December 31, 2012, the reasonably possible increase in loss reserves from loss reserves at December 31, 2012 could be approximately $692 million. The reasonably possible scenario considers the highest stress scenario that was utilized in the development of our probability-weighted expected loss at December 31, 2012 and assumes an inability to execute commutation transactions with issuers and/or investors.

Other Credits

It is possible our loss reserves on other types of credits may be materially under-estimated because most credits have possible outcomes more adverse than the recorded probability weighted loss reserve. Although we do not believe it is reasonably possible to have worst case outcomes in all cases, it is reasonably possible we could have worst case outcomes in some or even many cases. Similarly, it is also reasonably possible we will achieve better outcomes than our recorded probability weighted loss reserve. For all credits with loss reserves at December 31, 2012, the sum of all the highest stress case loss scenarios is $1,123 million greater than the current loss reserve. The reasonably possible scenario assumes an inability to execute commutation transactions.

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

 

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

 

Valuation of Financial Instruments:

Ambac’s financial instruments that are reported on the Consolidated Balance Sheets at fair value and subject to valuation estimates include investments in fixed income securities, VIE assets and liabilities and derivatives comprising credit default and interest rate swap transactions. Surplus notes issued by Ambac Assurance or the Segregated Account of Ambac Assurance are recorded at fair value at the date of issuance and subsequently reported at amortized cost within Long-term debt on the Consolidated Balance Sheets.

The fair market values of financial instruments held are determined by using independent market sources when available and valuation models when market quotes are not available. ASC Topic 820, Fair Value Measurements and Disclosures requires the categorization of these assets and liabilities according to a fair value valuation hierarchy. Approximately 85% of our assets and approximately 59% of our liabilities are carried at fair value and categorized in either Level 2 of the valuation hierarchy (meaning that their fair value was determined by reference to quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in inactive markets and other observable inputs) or Level 3 (meaning that their fair value was determined by reference to significant inputs that are unobservable in the market and therefore require a greater degree of management judgment). The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. In addition, the use of internal valuation models for certain highly structured instruments, such as credit default swaps, require assumptions about markets in which there has been a negligible amount of trading activity for several years. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position owned by Ambac, may be significantly different from its recorded fair value. Refer to Note 7 to the Consolidated Financial Statements in Item 8 of this Form 10-K for discussion related to the transfers in and/or out of Level 1, 2 and 3 fair value categories.

 

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

 

Investment in Fixed Income Securities

Investments in fixed income securities are accounted for in accordance with ASC Topic 320, Investments—Debt and Equity Securities. ASC Topic 320 requires that all debt instruments and certain equity instruments be classified in Ambac’s Consolidated Balance Sheets according to their purpose and, depending on that classification, be carried at either cost or fair market value. The fair values of fixed income investments held in the investment portfolios of Ambac and its operating subsidiaries are based primarily on quoted market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Refer to Note 7 to the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of the valuation methods, inputs and assumptions for fixed income securities. Ambac performs various review and validation procedures to quoted and modeled prices for fixed income securities, including price variance analyses, missing and static price reviews, overall valuation analyses by senior traders and finance managers and reviews associated with our ongoing impairment analysis. Unusual prices identified through these procedures will be evaluated further against separate broker quotes (if available) or internally modeled prices, and the pricing source values will be challenged as necessary. Price challenges generally result in the use of the pricing source’s quote as originally provided or as revised by the source following their internal diligence process. A price challenge may result in a determination by either the pricing source or Ambac management 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. Valuation results, particularly those derived from valuation models and quotes on certain mortgage and asset-backed securities, could differ materially from amounts that would actually be realized in the market.

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

 

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Ambac’s investment portfolio includes certain securities that are guaranteed by Ambac Assurance. As described further in Note 8 to the Consolidated Financial Statements in Item 8 of this Form 10-K, future cash flows used to measure credit impairment of Ambac-wrapped bonds represents the sum of (i) the bond’s intrinsic cash flows and (ii) the estimated fair value of Ambac claim payments. Under the Segregated Account Rehabilitation Plan, which has been confirmed but is not effective and is subject to change, future claim payments made by Ambac Assurance on these securities would be satisfied 25% in cash and 75% in surplus notes. It is uncertain whether the actual form and amount of claim payments will conform to that set forth in the Segregated Account Rehabilitation Plan. The 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. Pursuant to the injunctions issued by the Rehabilitation Court, claims on policies allocated to the Segregated Account were not paid from the commencement of the Segregated Account Rehabilitation Proceedings until the third quarter of 2012. As further described in Note 1 of the Consolidated Financial Statements included in Item 8 of this Form 10-K, on September 20, 2012, in accordance with published Policy Claim Rules, the Segregated Account commenced paying 25% of each permitted policy claim that arose since the commencement of the Segregated Account Rehabilitation Proceedings. The Segregated Account will continue to make cash payments of 25% of each policy claim submitted and permitted in accordance with such Policy Claim Rules, subject to any further orders of the Rehabilitation Court. As further described in Note 1 of the Consolidated Financial Statements included in Item 8 of this Form 10-K, no decision has been announced with respect to effectuating or amending the Segregated Account Rehabilitation Plan. Possible modifications to the Plan, with respect to the form and timing of satisfying the remaining balance of unpaid claims, could have a material effect on the recognition of other-than-temporary impairment for Ambac-wrapped securities. The Rehabilitator has previously announced that more specific information regarding the status of the Segregated Account Rehabilitation Plan, including possible modifications, will be provided as soon as appropriate. Estimation of the fair value of future claim payments from the Segregated Account is highly subjective.

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

VIE Assets and Liabilities

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

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

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

 

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Derivatives

Ambac’s operating subsidiaries’ exposure to derivative instruments is created primarily through interest rate swaps, US Treasury futures contracts and credit default swaps. These contracts are accounted for at fair value under ASC Topic 815, Derivatives and Hedging. Valuation models are used for the derivatives portfolios, using market data from a variety of third-party data sources. Several of the more significant types of market data that influence fair value include interest rates, credit spreads, default probabilities, recovery rates, and pricing and credit ratings of referenced obligations for credit derivatives. The valuation of certain interest rate swaps, as well as all credit derivative contracts, also require the use of data inputs and assumptions that are determined by management and are not readily observable in the market, including the amount that Ambac’s own credit risk which impacts the fair value of derivative liabilities. Refer to Note 7 to the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of the models, model inputs and assumptions used to value derivative instruments. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of derivative instruments, actual value realized in a market transaction may differ significantly from the estimates reflected in our financial statements.

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

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

Ambac employs various procedures to corroborate the reasonableness of quotes received; including comparing to other quotes received on similarly structured transactions, observed spreads on structured products with comparable underlying assets and, on a selective basis when possible, values derived through internal estimates of discounted future cash flows. Each quarter, the portfolio of CDS transactions is reviewed to ensure every reference obligation price has been updated. Period to period valuations are compared for each CDS and by underlying bond type. For each CDS, this analysis includes comparisons of key valuation inputs to the prior period and against other CDS within the bond type. No adjustments were made to the broker quotes we received when determining fair value of CDS contracts as of December 31, 2012. Another potential weakness of our valuation model is the lack of new CDS transactions executed by financial guarantors, which makes it difficult to validate the percentage of the reference obligation spread which would be captured as a CDS fee at the valuation date (i.e. the relative change ratio). Changes to the relative change ratio based on internal ratings assigned are another potential weakness as internal ratings could differ from actual ratings provided by rating agencies. However, we believe our internal ratings are updated at least as frequently as the external ratings. We believe the approach we have developed to increase the relative change ratio as the underlying reference obligation experiences credit deterioration is consistent with a market-based approach to valuation. Ultimately, our approach exhibits the same weakness as other modeling approaches, as it is unclear if we could execute at these values.

Valuation of Deferred Tax Assets

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

 

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

RESULTS OF OPERATIONS

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

Ambac’s loss was ($256.7) million or ($0.85) per share in 2012, compared to ($1,960.4) million or ($6.48) per share in 2011. The year ended December 31, 2012 financial results compared to 2011 were primarily favorably impacted by (i) a lower provision for loss and loss expenses; (ii) net gains related to consolidated variable interest entities as compared to net losses in 2011; (iii) lower losses in derivative product revenues; (iv) higher other income; (v) lower other-than-temporary impairments; (vi) higher realized gains; (vii) lower reorganization items, and (viii) a lower provision for income taxes, partially offset by (i) realized losses on extinguishment of surplus notes and (ii) net losses from the change in fair value of credit derivatives as compared to a net gain in 2011.

The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for 2012 and 2011 and its financial condition as of December 31, 2012 and 2011.

Commutations, Terminations and Settlements of Financial Guarantee Contracts. A key business strategy for Ambac is to increase the residual value of its financial guarantee business by mitigating losses on poorly performing financial guarantee contracts, including insurance policies and credit derivative contracts, via the pursuit of commutations, refinancings, terminations, or other claims reduction or defeasance strategies (collectively, “commutations”). Ambac considers the cash payment, if any, as well as the potential for lost future premium receipts in its review of an economic impact of executing commutation transactions. For both 2012 and 2011, Ambac executed a number of such transactions as follows:

During 2012, the Segregated Account of Ambac Assurance completed the commutation of insurance policies or portions of insurance policies on several student loan transactions. Total gross par commuted was $2.0 billion with an aggregate cash payment of $56 million. There were no Surplus Notes issued during 2012 related to commutations, terminations or settlements of financial guarantee or credit derivative transactions.

During 2011, the Segregated Account of Ambac Assurance completed the commutation of insurance policies or portions of insurance policies on several student loan transactions, two multiple-assets securities programs, and a transportation bond issuance. Total par commuted, was $4.0 billion, including $513 million through a bond tender, with an aggregate cash payment of $256 million and the issuance of Segregated Account Surplus Notes with a par value of $3.0 million.

 

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Net Premiums Earned. Net premiums earned during 2012 were $414.6 million, an increase of 2% from $406.0 million in 2011. Net premiums earned include accelerated premiums, which result from refunding, calls and other accelerations. Ambac had accelerated earnings of $127.6 million during 2012 versus $60.3 million in 2011. The net increase in accelerated earnings was primarily driven by an increase in overall volume of calls of Ambac insured debt within the public finance market due to low interest rates and refinancings by healthcare providers and a toll road authority. Additionally, certain installment paying structured finance policies had negative accelerations during 2012 and 2011. Ambac recognizes negative accelerations on policies when the GAAP premiums receivable for the policy exceeds the policy’s unearned premium reserve at termination. International finance accelerations increased during 2012 due to the de-risking of a utility and the termination of transportation exposure. Normal net premiums earned, which exclude accelerated premiums, have been negatively impacted by the runoff of the insured portfolio either via transaction terminations, refundings or scheduled maturities. Normal premiums earned were also adversely affected by the write-off of a premium receivable from a non-investment grade obligation that was deemed uncollectible. For the year ended December 31, 2012, net premiums earned relating to this obligation deemed uncollectible and written off was $25.9 million. Normal net premiums earned and accelerated premiums are reconciled to total net premiums earned in the table below and are included in the Financial Guarantee segment. The following table provides a breakdown of net premiums earned by market sector:

 

($ in millions)

   2012      2011  

Public Finance

   $ 153.0       $ 165.1   

Structured Finance

     49.9         97.3   

International Finance

     84.1         83.3   
  

 

 

    

 

 

 

Total normal premiums earned

     287.0         345.7   

Accelerated earnings

     127.6         60.3   
  

 

 

    

 

 

 

Total net premiums earned

   $ 414.6       $ 406.0   
  

 

 

    

 

 

 

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

 

($ in millions)

   2012     2011  

Public Finance

   $ 116.6      $ 66.8   

Structured Finance

     (4.2     (8.9

International Finance

     15.2        2.4   
  

 

 

   

 

 

 

Total accelerated earnings

   $ 127.6      $ 60.3   
  

 

 

   

 

 

 

Net Investment Income. Net investment income in 2012 was $382.9 million, an 8% increase from $354.8 million in 2011. The following table provides details by segment for the years ended December 31, 2012 and 2011:

 

($ in millions)

   2012      2011  

Financial Guarantee

   $ 365.9       $ 326.2   

Financial Services

     16.8         28.3   

Corporate

     0.2         0.3   
  

 

 

    

 

 

 

Total net investment income

   $ 382.9       $ 354.8   
  

 

 

    

 

 

 

The increase in Financial Guarantee net investment income in 2012 reflects the benefit of higher yielding assets in the portfolio compared to 2011. Higher yields in 2012 were primarily the result of greater holdings of Ambac-wrapped securities purchased as part of the company’s loss remediation strategy. The amortized cost basis of Ambac-wrapped securities as of December 31, 2012 was $636 million compared to $467 million at December 31, 2011. Additionally, the portfolio yield has benefited from the continued shift toward taxable municipal and corporate bonds as tax-exempt municipals mature. The average invested asset base for 2012 was slightly lower than for 2011 as receipts of installment premiums and investment receipts were more than offset by the resumption of partial claim payments on Segregated Account policies, payments made to commute certain financial guarantee exposures and the repurchase of surplus notes in the second quarter of 2012. Cash available for investment benefitted in both 2011 and 2012 from the non-payment of all claims on Segregated Account policies. As described in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K, effective March 24, 2010 claim payments on policies allocated to the Segregated Account had been enjoined pursuant to an

 

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

 

order of the Rehabilitation Court. However, the Rehabilitation Court subsequently approved rules under which, effective August 1, 2012 holders of policies allocated to the Segregated Account were, and continue to be, allowed to submit policy claims for review and partial payment equating to 25% of the permitted policy claim amount.

The Financial Services decrease in investment income for the year ended December 31, 2012 was driven primarily by a smaller portfolio of investments in the investment agreement business. The portfolio decreased primarily as a result of sales of securities to fund repayment of investment agreements and the partial repayment of intercompany loans from Ambac Assurance.

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

Net Other-Than-Temporary Impairment Losses. Net other-than-temporary impairment losses recorded in the statement of operations include only the credit related impairment amounts to the extent management does not intend to sell and it is not more likely than not that the Company will be required to sell before recovery of the amortized cost basis less any current period credit impairment. Non-credit related impairment amounts are recorded in accumulated other comprehensive income on the balance sheet. Alternatively, the non-credit related impairment would be recorded in net other-than-temporary impairment losses in the statement of operations if management intends to sell the securities or it is more likely than not the Company will be required to sell before recovery of amortized cost less any current period credit impairment. Charges for net other-than-temporary impairment losses were $6.0 million and $63.8 million for 2012 and 2011, respectively. As further described in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 of this Form 10-K, on March 24, 2010, the OCI commenced the Segregated Account Rehabilitation Proceedings in order to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account. As a result of actions taken by the OCI, financial guarantee payments on securities guaranteed by Ambac Assurance that were allocated to the Segregated Account were suspended in March 2010 and are no longer under the control of Ambac management. Claim payments under Segregated Account policies remained suspended throughout 2011 and into the third quarter of 2012. On September 20, 2012, in accordance with published Policy Claim Rules, the Segregated Account commenced paying 25% of each permitted policy claim that arose since the commencement of the Segregated Account Rehabilitation Proceedings. The Segregated Account will continue to make cash payments of 25% of each policy claim submitted and permitted in accordance with such Policy Claim Rules, subject to any further orders of the Rehabilitation Court. No decision has been announced with respect to effectuating or amending the Segregated Account Rehabilitation Plan. Possible modifications to the Plan, with respect to the form and timing of satisfying the remaining balance of unpaid claims, could have a material effect on the recognition of other-than-temporary impairment for Ambac-wrapped securities.

Since commencement of the Segregated Account Rehabilitation Proceedings, changes in the estimated effective date of the Segregated Account Rehabilitation Plan and the resumption of claim payments with respect to Segregated Account policies have resulted in adverse changes in projected cash flows on certain impaired Ambac-wrapped securities. Net other-than-temporary impairments for the years ended December 31, 2012 and 2011 resulted primarily from such adverse changes to projected cash flows on Ambac-wrapped securities and from credit impairments on certain other non-agency RMBS securities. As of December 31, 2012, management has not asserted an intent to sell any securities from its portfolio that are in an unrealized loss position. Future changes in our estimated liquidity needs could result in a determination that Ambac no longer has the ability to hold such securities, which could result in additional other-than-temporary impairment charges.

 

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

 

Net Realized Investment Gains. The following table provides a breakdown of net realized gains for the years ended December 31, 2012 and 2011:

 

($ in millions)

   Financial
Guarantee
    Financial
Services
     Corporate      Total  

December 31, 2012:

          

Net gains on securities sold or called

   $ 45.1      $ 27.1       $ —        $ 72.2   

Foreign exchange (losses)

     (0.1     —          —          (0.1
  

 

 

   

 

 

    

 

 

    

 

 

 

Total net realized gains

   $ 45.0      $ 27.1       $ —        $ 72.1   
  

 

 

   

 

 

    

 

 

    

 

 

 

December 31, 2011:

          

Net gains on securities sold or called

   $ 13.1      $ 2.8       $ —        $ 15.9   

Foreign exchange gains

     1.4        —          —          1.4   
  

 

 

   

 

 

    

 

 

    

 

 

 

Total net realized gains

   $ 14.5      $ 2.8       $ —        $ 17.3   
  

 

 

   

 

 

    

 

 

    

 

 

 

Change in Fair Value of Credit Derivatives. The net change in fair value of credit derivatives was a loss of $(9.2) million for the year ended December 31, 2012 compared to a gain of $48.0 million for the year ended December 31, 2011. The net loss for 2012 resulted from a more significant reduction of the Ambac Assurance credit valuation adjustment (“CVA”) during the year than occurred in 2011. Reductions to the CVA result in losses within the overall change in fair value of credit derivative liabilities. In addition, 2012 realized gains from credit derivative fees were lower than 2011, reflecting runoff of the portfolio. Results for both 2012 and 2011 included comparable net mark-to-market gains from improvement in average reference obligation prices and the reversal of unrealized losses associated with runoff of the portfolio. The CVA has been lowered periodically to reflect observed increases in the market value of Ambac Assurance’s direct and guaranteed obligations as they occur. See Note 8 to the Consolidated Financial Statements located in Item 8 of this Form 10-K for a further description of Ambac’s methodology for determining the fair value of credit derivatives.

Realized gains and other settlements on credit derivative contracts were $13.7 million and $17.0 million for the years ended December 31, 2012 and 2011, respectively. These amounts represent premiums received and accrued on written contracts. There were no losses and settlements included in net realized gains for the years ended December 31, 2012 and 2011.

Unrealized gains (losses) on credit derivative contracts were $(22.9) million and $31.0 million for 2012 and 2011, respectively. The net unrealized gains (losses) in fair value of credit derivatives reflect the same factors as the overall change in fair value of credit derivatives as noted above, excluding the impact of realized gains and other settlements.

Derivative Product Revenues. Derivative product revenues resulted in a net loss of ($125.0) million for the year ended December 31, 2012, down from a loss of ($280.8) million for the year ended December 31, 2011. The losses in derivative product revenues for both 2012 and 2011 resulted primarily from mark-to-market movements in the portfolio caused by declining interest rates. Additionally, 2012 included a realized loss from the negotiated termination of a British Pound inflation indexed swap derivative asset. The derivative products portfolio is positioned to benefit from rising rates as an economic hedge against interest rate exposure in the financial guarantee portfolio (the “macro-hedge”). This additional interest rate sensitivity contributed losses of ($41.8) million and ($282.1) million for the years ended December 31, 2012 and 2011, respectively. Excluding the impact of the macro-hedge, derivative products revenue resulted in losses of ($83.2) million for 2012 and gains of and $1.2 million for 2011. Losses for 2012, excluding the macro-hedge, resulted primarily from the negotiated termination discussed above and decreases in the Ambac CVA on certain customer swap liabilities discussed below. Excluding the macro-hedge, 2011 results included mark-to-market losses on swaps related to falling interest rates net of the CVA, offset by gains on a British Pound inflation indexed swap.

The fair value of derivatives includes a valuation adjustment to reflect Ambac’s own credit risk when appropriate (Ambac “CVA”). Within the financial services derivatives portfolio, an Ambac CVA is generally applicable for uncollateralized derivative liabilities that may not be offset by derivative assets under a master netting agreement. Inclusion of an Ambac CVA in the valuation of financial services derivatives resulted in (losses) gains within derivative products revenues of ($44.9) million and $98.1 million for the years ended December 31, 2012 and 2011, respectively. The impact of the CVA for 2012 primarily reflects observed increases in the market value of Ambac Assurance’s direct and indirect obligations. In 2011, the amount of the CVA increase is attributable to the change in value of the underlying liabilities during the period.

 

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Net Realized (Losses) Gains on Extinguishment of Debt. During June 2012, Ambac Assurance exercised options to repurchase surplus notes with an aggregate par value of $789.2 million for an aggregate cash payment of $188.4 million. These surplus notes were issued in connection with the settlement of credit derivative liabilities in 2010 and were recorded at their fair value at the date of issuance. This fair value was at a significant discount to par value and since 2010 Ambac has accreted the discount into earnings using the effective interest method. As described further under “Other Income” below, certain of these options were free-standing derivatives for accounting purposes and were carried at fair value as assets on the Consolidated Balance Sheets. The carrying value of extinguished surplus notes and accrued interest less the fair value of the free-standing derivatives were below the call option exercise prices and, accordingly, for the year ended December 31, 2012, Ambac recognized a realized loss of $177.6 million. Refer to Note 11 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further information on the repurchase of surplus notes.

Net realized (losses) gains on extinguishment of debt also included gains from the settlement of investment agreements below their carrying value of $0.2 million and $3.1 million for the years ended December 31, 2012 and 2011, respectively.

Other Income. Other income in 2012 was $106.1 million, as compared to $25.5 million in 2011. Included within other income are mark-to-market gains and losses relating to options to call certain Ambac Assurance surplus notes, non-investment related foreign exchange gains and losses, deal structuring fees and commitment fees. Other income for the year ended December 31, 2012 primarily resulted from: mark-to-market gains of $100.7 million related to Ambac’s option to call $500 million par of bank surplus notes which were free-standing derivatives for accounting purposes. Such options were exercised in June 2012. Changes in fair value of these options through the date of exercise are reported within Other income. Other income for the year ended December 31, 2011 primarily resulted from mark-to-market gains of $6.1 million related to Ambac’s option to call certain Ambac Assurance surplus notes and income relating to structuring fees, amendment fees, waiver and consent fees of $14.3 million.

Income (Loss) on Variable Interest Entities. Income (loss) on variable interest entities for the year ended December 31, 2012 was $27.8 million, compared to ($214.4) million for the year ended December 31, 2011. Included within Income (loss) on variable interest entities are income statement amounts relating to VIEs consolidated under ASC Topic 810, including gains or losses attributable to consolidating or deconsolidating VIEs during the period reported. Generally, the Company’s consolidated VIEs are entities for which Ambac has provided financial guarantees on its assets or liabilities. In consolidation, most assets and liabilities of the VIEs are reported at fair value and the related insurance assets and liabilities are eliminated. Differences between the net carrying value of the insurance accounts under ASC Topic 944 and the carrying value of the consolidated VIE’s net assets are recorded through income at the time of consolidation or deconsolidation.

Income on variable interest entities for 2012 resulted from positive changes to the fair value primarily attributable to accretion of the present value discount of net VIE assets into income. The net loss for 2011 primarily related to a VIE consolidated effective April 1, 2011 and deconsolidated in December 2011 which contributed losses of $224.3 million reported during the year. These losses were partially offset by income from the operations of other consolidated VIEs during the year, primarily reflecting accretion of the present value discount on net VIE assets. For financial guarantee transactions a loss upon deconsolidation typically arises from re-establishment of the carrying value of insurance loss reserves and other insurance accounts which have an aggregate net liability balance greater than the aggregate net liabilities of the VIEs in consolidation. The VIE that was both consolidated and deconsolidated within 2011 involved an adversely classified credit for which Ambac temporarily had control rights requiring consolidation. During the period that the VIE was consolidated, credit deterioration of the transaction occurred such that the loss from deconsolidation was greater than the gain from consolidation. Refer to Note 3 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for further information on the accounting for VIEs.

Losses and Loss Expenses. Losses and loss expenses are based upon estimates of the aggregate losses inherent in the non-derivative financial guarantee portfolio for insurance policies issued to beneficiaries, including unconsolidated VIEs. Loss and loss expenses were $683.6 million and $1,859.5 million in 2012 and 2011, respectively. Loss and loss expenses in 2012 were primarily driven by higher estimated losses in the RMBS portfolio and international asset-backed credits. Loss and loss expenses in 2011 were primarily driven by higher estimated losses in the first-lien RMBS, student loan and structured insurance portfolios, offset by a decrease in estimated losses for the second-lien RMBS portfolio and higher estimated recoveries under representation and warranty breaches for certain RMBS transactions.

Please refer to the “Critical Accounting Estimates—Financial Guarantee Insurance Losses and Loss Expenses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to the Loss Reserves section located in Note 5 of the Consolidated Financial Statements located in Item 8 of this Form 10-K for further background information on loss reserves.

 

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

 

The following table summarizes the changes in the total net loss and loss expense reserves for 2012 and 2011:

 

($ in millions)

  Year Ended
December 31, 2012
    Year Ended
December 31, 2011
 

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

  $ 6,230.8      $ 4,424.5   

Provision for losses and loss expenses

    683.6        1,859.5   

Gross paid claims and loss expenses (1)

    (982.8     (201.5

Recoveries of losses and loss expenses paid from reinsurers

    18.8        19.6   

Other adjustments (including foreign exchange)

    24.3        (5.9

Net deconsolidation of certain VIEs

    —          134.6   
 

 

 

   

 

 

 

Ending balance of net loss and loss expense reserves, net of subrogation recoverable and reinsurance

  $ 5,974.7      $ 6,230.8   
 

 

 

   

 

 

 

 

(1) As further described in Note 1 of the Consolidated Financial Statements in Item 8 of this Form 10-K, on September 20, 2012, in accordance with published Policy Claim Rules, the Segregated Account commenced paying 25% of each permitted policy claim that arose since the commencement of the Segregated Account Rehabilitation Proceedings. The Segregated Account will continue to make cash payments of 25% of each policy claim submitted and permitted in accordance with such Policy Claim Rules, subject to any further orders of the Rehabilitation Court.

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

The losses and loss expense reserves as of December 31, 2012 and December 31, 2011 are net of estimated recoveries under representation and warranty breaches for certain RMBS transactions in the amount of $2,523.2 million and $2,720.2 million, respectively. Please refer to the “Critical Accounting Estimates” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to Notes 2 and 5 of the Consolidated Financial Statements in Item 8 of this Form 10-K for further background information on the change in estimated recoveries.

The following tables provide details of net claims recorded, net of recoveries received for the years ended December 31, 2012 and 2011:

 

($ in millions)

   2012      2011  

Net claims recorded (1):

     

Public Finance

   $ 18.1       $ 132.2   

Structured Finance (2)

     1,534.3         1,372.7   

International Finance

     —           —    
  

 

 

    

 

 

 

Total (2)

   $ 1,552.4       $ 1,504.9   
  

 

 

    

 

 

 

 

(1) Claims recorded include (i) claims paid and (ii) changes to claims presented and unpresented through the balance sheet date for policies which were allocated to the Segregated Account. Item (ii) includes permitted policy claims for policies allocated to the Segregated Account that were presented through to the balance sheet date and approved by the Rehabilitator of the Segregated Account in accordance with the Policy Claim Rules as discussed in Note 1 of the Consolidated Financial Statements in Item 8 of this Form 10-K. Amounts recorded for claims not yet permitted are based on management’s judgment.

Claims permitted in accordance with the Policy Claim Rules in 2012 were $4,246.7 million, including $3,712.9 million related to the moratorium period, March 24, 2010 through July 31, 2012. As of December 31, 2012 and 2011, respectively $3,388.1 million and $2,768.6 million of claims remain unpaid. Refer to table of Contractual Obligations by Year in the “Liquidity and Capital Reserves” section below for expected future claims to be presented or paid.

Please refer to the “Critical Accounting Estimates—Financial Guarantee Insurance Losses and Loss Expenses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to the Loss Reserves section located in Notes 2 and 5 of the Consolidated Financial Statements located in Item 8 of this Form 10-K for further background information on loss reserves.

 

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

 

Underwriting and Operating Expenses. Underwriting and operating expenses of $139.0 million in 2012 decreased by 2% from $141.3 million in 2011. Underwriting and operating expenses consist of gross underwriting and operating expenses plus the amortization of previously deferred expenses (included in Financial Guarantee segment). The following table provides details of underwriting and operating expenses by segment for the years ended December 31, 2012 and 2011:

 

($ in millions)

   2012     2011  

Underwriting and operating:

    

Financial Guarantee

   $ 135.5      $ 125.8   

Financial Services

     3.7        10.5   

Corporate

     (0.2     5.0   
  

 

 

   

 

 

 

Total

   $ 139.0      $ 141.3   
  

 

 

   

 

 

 

The increase in Financial Guarantee underwriting and operating expenses for year ended December 31, 2012 were primarily due to higher compensation and premises expenses, partially offset by lower consulting and legal expenses. Compensation costs increased primarily as a result of increases in forfeitures of previous stock option and RSU awards in 2011. As a result of the termination of Ambac’s corporate office lease in May 2011 all existing assets (leasehold improvements) and liabilities (deferred rent) relating to this lease were reduced to zero. Deferred rent was caused by the free rent periods during the life of the lease, whereas the expense of the lease was recognized on a straight-line basis.

As a consequence of the Segregated Account Rehabilitation Proceedings, the Rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including the hiring of advisors. During 2012 and 2011, expenses incurred in connection with legal and consulting services provided for the benefit of OCI amounted to $13.1 million and $17.1 million. Accordingly, future expenses may include a significant amount of advisory costs for the benefit of OCI that are outside the control of Ambac’s management.

Corporate expenses include the operating expenses of Ambac. The decrease is primarily due to the provisions of the new expense sharing agreement where Ambac Assurance reimburses Ambac for certain operating expenses.

Interest Expense. Interest expense includes accrued interest and accretion of the discount on surplus notes issued by Ambac Assurance and the Segregated Account, interest expense relating to investment agreements, and interest expense related to a secured borrowing transaction closed in December 2011. The following table provides details for the years ended December 31, 2012 and 2011:

 

($ in millions)

   2012      2011  

Interest expense:

     

Surplus notes

   $ 103.6       $ 119.9   

Investment agreements

     6.3         8.1   

Secured borrowing

     2.4         0.1   
  

 

 

    

 

 

 

Total

   $ 112.3       $ 128.1   
  

 

 

    

 

 

 

The decrease in interest expense on surplus notes for the year ended December 31, 2012 resulted primarily from the lower average par amount of surplus notes outstanding than in 2011. The lower par balance of surplus notes outstanding resulted from the exercise of certain options to repurchase surplus notes in June 2012. Refer to Note 11 to the Consolidated Financial Statements included in Item 8 of this Form 10-K for further information on the repurchase of surplus notes. The impact of the lower outstanding balance was partially offset by compounding of unpaid interest and the effect of applying the level yield method as the discount to the face value of the surplus notes accretes over time. Surplus note interest payments require the approval of OCI. On June 1, 2011 and May 15, 2012 OCI issued its disapproval of the requests of Ambac Assurance and the Rehabilitator of the Segregated Account, acting for and on behalf of the Segregated Account, to pay interest on all outstanding surplus notes issued by Ambac and the Segregated Account on scheduled interest payment dates of June 7, 2011 and June 7, 2012, respectively. Such interest was accrued for and the Company is accruing interest on these additional amounts.

 

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The decline in interest expense related to investment agreements stemmed primarily from reductions on outstanding investment agreements as the portfolio declined to $362.0 million at December 31, 2012 from $546.5 million at December 31, 2011.

Reorganization Items. Reorganization items are primarily expenses directly attributed to our Chapter 11 reorganization process. Reorganization items in 2012 and 2011 were $7.2 million and $49.9 million, respectively, including professional advisory fees of approximately $7.5 million and $35.8 million in 2012 and 2011, respectively. On March 1, 2011, Ambac, Ambac Assurance, the Segregated Account and One State Street, LLC (“OSS”) entered into a settlement agreement (the “OSS Settlement Agreement”) to terminate the Company’s office lease with OSS and to settle all claims among the parties. The OSS Settlement Agreement provides that OSS will have an allowed general unsecured claim in Ambac’s bankruptcy case for approximately $14.1 million.

Provision for Income Taxes. Income tax expense was $2.8 million and $77.4 million for the years ended December 31, 2012 and 2011, respectively. The income tax for 2011 related predominantly to the accrual of additional federal income tax expense to bring the overall reserve for income taxes in line with Ambac’s intent to pay the IRS to settle the IRS Dispute, including amounts contributed by both the Company and Ambac Assurance as contemplated by the Mediation Agreement dated September 21, 2011 among Ambac, Ambac Assurance, the Creditor’s Committee in Ambac’s Chapter 11 case, OCI and the Segregated Account (the “Mediation Agreement”). The income tax for 2012 related predominantly to Italian tax obligations of Ambac UK that can not be offset by net operating losses in other jurisdictions and New York State/New York City alternative minimum tax obligations. Please refer to Note 1 to the Consolidated Financial Statements located in Item 8 of this Form 10-K for additional information on the Mediation Agreement.

 

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

 

Ambac Assurance Statutory Basis Financial Results

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

On March 24, 2010, Ambac Assurance established the Segregated Account. Under Wisconsin insurance law, the Segregated Account is a separate insurer from Ambac Assurance and accordingly is subject to all of the filing and statutory reporting requirements of Wisconsin domiciled insurers. The purpose of the Segregated Account is to segregate certain segments of Ambac Assurance’s liabilities. The total assets, total liabilities, and total surplus of the Segregated Account are reported as discrete components of Ambac Assurance’s assets, liabilities, and surplus reported in Ambac Assurance’s statutory basis financial statements. Accordingly, Ambac Assurance’s statutory financial statements include the results of Ambac Assurance’s general account and, to the extent allowable under a prescribed accounting practice by OCI, the Segregated Account. Pursuant to this prescribed practice, the results of the Segregated Account are not included in Ambac Assurance’s financial statements if Ambac Assurance’s surplus is (or would be) less than $100 million (“Minimum Surplus Amount”). Maintaining the Minimum Surplus Amount will result in a reduction in the liabilities assumed by Ambac Assurance from the Segregated Account. Please refer to Note 1 of the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for additional information on the establishment of the Segregated Account as well as the operative funding documents between Ambac Assurance and the Segregated Account.

Ambac Assurance’s statutory policyholder surplus and qualified statutory capital were $100.0 million and $628.3 million at December 31, 2012, respectively, as compared to $495.3 million and $684.6 million as of December 31, 2011, respectively. The Segregated Account reported statutory policyholder surplus of $(61.8) million and $105.9 million as of December 31, 2012 and December 31, 2011, respectively. At December 31, 2012, Ambac Assurance’s surplus as regards to policyholders is at the Minimum Surplus Amount and therefore $163.7 million of the Segregated Account’s insurance liabilities were not assumed by Ambac Assurance under the Reinsurance Agreement. In the event that Ambac Assurance does not generate future surplus in the amount of insurance liabilities not assumed under the Reinsurance Agreement because of the applicability of the Minimum Surplus Amount, the Segregated Account would experience a shortfall in funds available to pay its liabilities to the extent that such liabilities exceed amounts available under the Secured Note and Reinsurance Agreement. This shortfall will be a consideration for the Rehabilitator in the determination of whether any changes to the Segregated Account Rehabilitation Plan and/or the amount of partial policy claim payments are necessary or appropriate or whether to institute general rehabilitation proceedings against Ambac Assurance.

As further described in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, no decision has been announced with respect to effectuating or amending the Segregated Account Rehabilitation Plan. Possible modifications to the Plan, with respect to the form and timing of satisfying the remaining balance of unpaid claims, could have a material effect on the measurement of statutory policyholder surplus.

The decline in Ambac Assurance’s policyholder surplus for the year ended December 31, 2012 was due to (i) contributions to contingency reserves of $339.0 million as a result of adverse development of non-defaulted policies that remain in the general account of Ambac Assurance; (ii) insurance losses and loss expenses of $696.9 million; (iii) impairment losses of $144.0 million on guaranty of subsidiary liabilities (primarily from the interest rate swap business); and (iv) the extinguishment of $789.2 million of surplus notes for a cash payment of $188.4 million. These declines were partially offset by (i) net investment income, (ii) earned premiums, and (iii) a $163.7 million reduction in the liabilities assumed by Ambac Assurance from the Segregated Account for losses on policies allocated to the Segregated Account.

 

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

 

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

The Wisconsin Insurance Commissioner has prescribed the following additional accounting practices for Ambac Assurance and the Segregated Account of Ambac Assurance:

 

   

NAIC SAP allows for a deduction from loss reserves for the time value of money by application of a discount rate equal to the average rate of return on the admitted assets of the financial guaranty insurer as of the date of the computation of the reserve. Additionally, NAIC SAP requires an insurance company to record probable losses on its subsidiaries for which it guarantees their obligations, using a discount rate equal to the average rate of return on its admitted assets. The Company’s average rates of return on its admitted assets at December 31, 2012 and December 31, 2011 were 8.01% and 7.45%, respectively. OCI has directed the Company to utilize a prescribed discount rate of 5.10% for the purpose of discounting both its loss reserves and its estimated impairment losses on subsidiary guarantees.

 

   

NAIC SAP states that proceeds received by the issuer of surplus notes must be in the form of cash or other admitted assets having readily determinable values and liquidity satisfactory to the commissioner of the state of domicile. Accordingly, surplus notes issued in conjunction with commutations or the settlement of claims would be valued at zero upon issuance. OCI has directed the Company to record surplus notes issued in settlement of liabilities at full par value upon issuance as in these instances the surplus notes do not represent a contribution of capital, but rather a distribution of value from the common and preferred shareholders of the Company. The surplus notes issued have a claim against surplus senior to the preferred and common shareholders. OCI has extended this prescribed practice to the evaluation of other-than-temporary impairments for Ambac Assurance guaranteed securities held in the investment portfolio. NAIC SAP states that when an other-than-temporary impairment has occurred, the amount of the other-than-temporary impairment recognized as a realized loss shall equal the difference between the investment’s amortized cost basis and the present value of cash flows expected to be collected, discounted at the loan-backed or structured security’s effective interest rate. Under NAIC SAP, the present value of cash flows expected to be collected should include the fair value of surplus notes received from Ambac Assurance, as required under the Segregated Account Rehabilitation Plan. OCI has directed the Company to utilize par value rather than fair value of these surplus notes in this computation. Refer to Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for additional information on the Segregated Account Rehabilitiation Plan.

The Wisconsin Insurance Commissioner has permitted the following accounting practice for Ambac Assurance:

 

   

Under NAIC SAP, contributions to and releases from the contingency reserve are recorded via a direct charge or credit to surplus. This differs from the prescribed practices of the Wisconsin Administrative Code, which requires contributions to and releases from the contingency reserve be recorded through underwriting income. The Company received permission from OCI to record contributions to and releases from the contingency reserves in accordance with NAIC SAP. This permitted practice also applies to Everspan.

 

   

The Company received permission from OCI to report investment holdings of Ambac Assurance insured securities, with coverage under financial guaranty policies that have been allocated to the Segregated Account, as a separate invested asset on the balance sheet rather than combined with other bond investments. This permitted practice only impacts the balance sheet line items discussed above and has no impact on the valuation of the securities to which it applies.

 

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As a result of the above prescribed and permitted practices, Ambac Assurance’s statutory surplus at December 31, 2012 and December 31, 2011 was greater by $81.8 million and lower by $13.9 million, respectively, than if the Company had reported such amounts in accordance with NAIC SAP.

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

 

   

Loss reserves are only established for losses on guaranteed obligations that have defaulted in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default, less estimated recoveries under subrogation rights (currently discounted at 5.1% as prescribed by OCI). Under U.S. GAAP, in addition to the establishment of loss reserves for defaulted obligations, loss reserves are established (net of U.S GAAP basis unearned premium reserves) for obligations that have experienced credit deterioration, but have not yet defaulted using a weighted-average risk-free discount rate, currently at 1.6%.

 

   

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

 

   

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

 

   

Wholly owned subsidiaries are not consolidated; rather, the equity basis of accounting is utilized and the carrying values of these investments are subject to an admissibility test. When Ambac Assurance’s share of the subsidiaries’ losses exceeds the related carrying amounts of the wholly owned subsidiary, Ambac Assurance discontinues applying the equity method and the investment is reduced to zero. For those subsidiaries that have insufficient claims paying resources and whose obligations are guaranteed by Ambac Assurance, Ambac Assurance records an estimated impairment for probable losses which are in excess of the subsidiaries’ claims paying resources.

 

   

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

 

   

All issued surplus notes are included in Policyholder Surplus at an amount equal to par regardless of the amounts received in consideration for issuance of the notes. Under U.S. GAAP, surplus notes are included in long-term debt obligations recorded at their estimated fair value at date of issuance and accrete up to face value via the effective interest method.

 

   

Upfront premiums written are earned on a basis proportionate to the remaining scheduled debt service to the original total principal and interest insured. Installment premiums are reflected in income pro rata over the period

 

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covered by the premium payment. Under U.S. GAAP, premium revenues for both upfront and installment premiums are earned over the life of the financial guarantee contract in proportion to the insured principal amount outstanding at each reporting date.

 

   

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

 

   

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

LIQUIDITY AND CAPITAL RESOURCES

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

Ambac’s liquidity is dependent on its current cash and investments of $30.4 million at December 31, 2012, and consummation of Ambac’s Fifth Amended Plan of Reorganization (as it may be further amended, the “Reorganization Plan”). Pursuant to the Mediation Agreement, Amended TSA and Cost Allocation Agreement (as each such term is defined in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K), Ambac Assurance is required, under certain circumstances, to make payments to the Company with respect to the utilization of net operating loss carry-forwards (“NOLs”) and to reimburse certain costs and expenses. Any expected receipts with regards to the utilization of NOLs will only occur after Ambac Assurance utilizes NOLs generated after September 30, 2011, which amount to $424.8 million as of December 31, 2012. See Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for descriptions of the Mediation Agreement, the Amended TSA and the Cost Allocation Agreement. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future and therefore the aforementioned payments and reimbursements will be Ambac’s principal source of funds in the near term. The principal uses of liquidity are the payment of operating expenses, professional advisory fees incurred in connection with the bankruptcy, and amounts related to the settlement of the IRS litigation. Ambac’s liquidity requirements are being funded by cash on hand and reimbursements of certain expenses, including a portion of IRS litigation expenses, from Ambac Assurance, and any contingencies could cause material additional liquidity strains.

 

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

 

     Contractual Obligations by Year  

($ in millions)

   2013      2014      2015      2016      2017      Thereafter  

Surplus note obligations (1)

   $ 255.2       $ 64.5       $ 64.5       $ 64.5       $ 64.5       $ 1,513.8   

Investment and repurchase agreement obligations (2)

     7.2         190.9         53.3         5.3         118.3         —     

Operating lease obligations (3)

     5.2         5.2         5.1         —           —           —     

Purchase obligations (4)

     16.7         0.5         0.5         0.2         —           —    

Post retirement benefits (5)

     0.5         0.5         0.6         0.6         0.6         3.6   

Loss and loss expenses (6)

     4,306.2         928.5         576.8         390.9         222.6         5,539.9   

Federal Taxes (7)

     101.8         —          —          —          —          —     

Secured borrowing (8)

     13.0         2.2         —           —          —          —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 4,705.8       $ 1,192.3       $ 700.8       $ 461.5       $ 406.0       $ 7,057.3   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Includes principal of and interest on surplus notes when due. All payments of principal and interest on Surplus Notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the surplus notes, such interest will accrue and compound annually until paid. OCI disapproved interest payments scheduled for June 7, 2011 and 2012. Amounts in the table assume approval by OCI for all principal and interest payments in the future, including payment of previously deferred interest on the next scheduled payment date of June 7, 2013.
(2) Includes principal of and interest on obligations using current rates for floating rate obligations. Certain investment agreements have contractual provisions that allow our counterparty the flexibility to withdraw funds prior to legal maturity date. Amounts included in the table are based on the expected withdrawal date.
(3) Amount represents future lease payments on lease agreements existing as of December 31, 2012.
(4) Purchase obligations represent future expenditures for contractually scheduled fixed terms and amounts due for various technology-related maintenance agreements and other outside services.
(5) Amount represents future benefit payments on the Ambac Assurance postretirement benefit plan for the next 10 years.
(6)

The timing of expected claim payments is based on deal specific cash flow payments, excluding expected recoveries. These deal specific cash flow payments are based on the expected cash flows of the underlying transactions (e.g. for RMBS credits we model estimated future claim payments). The timing of expected claim payments for credits with reserves that were established using our statistical loss reserve method is determined based on the weighted average expected life of the exposure. Refer to the Loss Reserves section located in Note 2 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of our statistical loss reserve method. The timing of these payments may vary significantly from the amounts shown above, especially for credits that are based on our statistical loss reserve method. Pursuant to the injunctions issued by the Rehabilitation Court, claims on policies allocated to the Segregated Account were not paid from the commencement of the Segregated Account Rehabilitation Proceedings until the third quarter of 2012. As further described in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, on or about September 20, 2012, in accordance with published Policy Claim Rules, the Segregated Account commenced paying 25% of each permitted policy claim that arose since the commencement of the Segregated Account Rehabilitation Proceedings. The Segregated Account will continue to make cash payments of 25% of each policy claim submitted and permitted in accordance with such Policy Claim Rules, subject to any further orders of the Rehabilitation Court. As further described in Note 1 of Part 1—Notes to the Unaudited Consolidated Financial Statements, no decision has been announced with respect to effectuating or amending the Segregated Account Rehabilitation Plan or whether surplus notes will be issued with respect to the remaining balance of unpaid claims as provided in the Segregated Account Rehabilitation Plan. Possible modifications to the Plan with respect to the form and timing of satisfying the remaining balance of unpaid claims could have a material effect on Ambac Assurance liquidity. The Rehabilitator has previously announced that more specific information regarding the status of

 

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  the Segregated Account Rehabilitation Plan, including possible modifications, will be provided as soon as appropriate. Unpaid claims, including deferred policy claims amount to $3,388.1 million at December 31, 2012. Although the Rehabilitator has not established an effective date for the Rehabilitation Plan, we have included such unpaid amounts as obligations due in 2013. Additionally, all future claim payments are included in their respective year at the estimated permitted claim amount.
(7) Includes a Federal tax settlement estimated to be concluded in 2013.
(8) Includes estimated interest and principal payments on the secured borrowing. These estimates are based on modeled expected future cash flows from the underlying RMBS securities which collateralize and fund repayment of the secured borrowing. Refer to Notes 11 and 8 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further discussion of the secured borrowing and of our cash flow estimation process for RMBS securities, respectively.

Ambac Assurance Liquidity. Ambac Assurance’s liquidity is dependent on the balance of liquid investments and, over time, the net impact of sources and uses of funds. The principal sources of Ambac Assurance’s liquidity are gross installment premiums on insurance and credit default swap contracts, investment coupon receipts, scheduled investment maturities, sales of investment securities, proceeds from repayment of affiliate loans, claim and reinsurance recoveries, and RMBS subrogation recoveries. Termination of installment premium policies on an accelerated basis may adversely impact Ambac Assurance’s liquidity. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claim and commutation payments on both insurance and credit derivative contracts, ceded reinsurance premiums, surplus notes principal and interest payments, additional loans to affiliates and tax payments to Ambac. Interest and principal payments on surplus notes are subject to approval of Ambac Assurance’s insurance regulator, which has full discretion over deferral of payments regardless of the liquidity position of Ambac Assurance.

The exercise of surplus note call options used $188.4 million of liquidity in 2012, and a $100 million payment of the IRS Settlement amount is likely to be a use of liquidity in 2013.

Ambac Assurance manages its liquidity risk by maintaining a comprehensive analysis of projected cash flows. Additionally, the financial guarantee business maintains a specified level of cash and short-term investments at all times.

Pursuant to the injunctions issued by the Rehabilitation Court, claims on policies allocated to the Segregated Account were not paid from the commencement of the Segregated Account Rehabilitation Proceedings until the third quarter of 2012. As further described in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, on or about September 20, 2012, in accordance with published Policy Claim Rules, the Segregated Account commenced paying 25% of each permitted policy claim that arose since the commencement of the Segregated Account Rehabilitation Proceedings. The Segregated Account will continue to make cash payments of 25% of each policy claim submitted and permitted in accordance with such Policy Claim Rules, subject to any further orders of the Rehabilitation Court. During the year ended December 31, 2012, the Segregated Account paid $1,061.7 million, which represents 25% of claims permitted in accordance with the Policy Claim Rules. Permitted policy claims will be a future use of liquidity. Requests of Ambac Assurance and the Rehabilitator of the Segregated Account, acting for and on behalf of the Segregated Account, to pay interest on all outstanding surplus notes issued by Ambac and the Segregated Account on the first two scheduled interest payment dates of June 7, 2011 and 2012 were disapproved by OCI.

Ambac Assurance is 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 above, 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.

Our ability to recover RMBS subrogation recoveries is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties (and/or their respective parents and affiliates), timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. Our current estimate considers that we will receive subrogation recoveries of $28 million, $2,119 million and $415 million in in 2013, 2014 and 2015, respectively. The amount of these subrogation recoveries is significant and if we are unable to recover any amounts our future available liquidity to pay claims would be reduced materially.

 

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A wholly-owned subsidiary of Ambac Assurance is a party to credit default swaps (“CDS”) with various commercial counterparties. Ambac Assurance guarantees its subsidiary’s payment obligations under such CDS. The terms of such CDS include events of default or termination events based on the occurrence of certain events, or the existence of certain circumstances, relating to the financial condition of Ambac Assurance, including the commencement of an insolvency, rehabilitation or like proceeding. If such an event of default or termination event were to occur, the CDS counterparties could claim the contractual right to terminate the CDS and require Ambac Assurance, as financial guarantor, to make termination payments. Ambac Assurance estimates that such potential termination payments amounted to $839.9 million as of December 31, 2012. However, the court supervising the rehabilitation of the Segregated Account has issued an injunction barring the early termination of contracts based on the occurrence of events or the existence of circumstances like those described above. As a result, Ambac Assurance does not expect to make early termination payments in respect of CDS where such amounts are claimed based on the occurrence of events, or the existence of circumstances, relating to the financial condition of Ambac Assurance.

A subsidiary of Ambac Assurance provided a $360 million liquidity facility to a reinsurance company which acted as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility, which was guaranteed by Ambac Assurance, provided temporary funding in the event that the reinsurance company’s capital was insufficient to make payments under the reinsurance agreement. At December 31, 2011, $8.8 million was drawn on this liquidity facility. In 2012, the subsidiary received notice that the reinsurance treaty was terminated; as such, there will be no further draws on the facility. During 2012, Ambac Assurance received full repayment of the previously drawn amount of $8.8 million.

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

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

Investment agreements subject Ambac to liquidity risk associated with unanticipated withdrawals of principal as allowed by the terms of contingent withdrawal provisions within all remaining outstanding investment agreements. Investment agreements outstanding as of December 31, 2012 were issued in connection with either municipal bonds or structured credit-linked notes (“CLNs”). The investment agreements contain contingent withdrawal risk in the event of either an early redemption of the related bond issue or certain credit events pertaining to the underlying borrower. As of December 31, 2012, Ambac had $314.4 million of contingent withdrawal investment agreements related to CLNs and $47.7 million related to municipal bonds. The investment agreement business manages liquidity risk by closely matching the maturity schedules of its invested assets with the maturity schedules of its investment agreement liabilities. Additionally, management performs regular surveillance of the related transactions. This surveillance process is customized for each investment agreement transaction and includes a review of past activity, recently issued trustee reports, reference name performance characteristics and third party tools to analyze early withdrawal risk.

The interest rate swap business maintains cash and short-term investments and closely matches the date swap payments are made and received. Liquidity risk also exists in the derivative contract and investment agreement portfolios due to contract provisions which may require collateral posting or early termination of contracts. Both the investment agreement swap businesses borrow cash and securities from Ambac Assurance to meet liquidity needs when such borrowing is determined to be most economically beneficial to Ambac Assurance. Intercompany loans are made under established lending agreements with defined borrowing limits that have received non-disapproval from Ambac Assurance’s insurance regulator.

Credit Ratings and Collateral. Ambac Assurance is no longer rated by Moody’s and S&P, which resulted in the triggering of required cure provisions in nearly all of the investment agreements issued. In many cases, Ambac chose to terminate investment agreements, particularly when it was able to do so at levels that resulted in meaningful discounts to book value. In addition, Ambac posted collateral of $375.7 million in connection with its outstanding investment agreements, including accrued interest, at December 31, 2012.

Ambac Financial Services (“AFS”) provided interest rate and currency swaps for states, municipalities, asset-backed issuers and other entities in connection with their financings. AFS hedges most of the related risks of these instruments with standardized derivative contracts, which include collateral support agreements. Under these agreements, AFS is required to

 

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post collateral to a swap dealer to cover unrealized losses. In addition, AFS is often required to post independent amounts of collateral in excess of the amounts needed to cover unrealized losses. AFS also hedges part of its interest rate risk with financial futures contracts which require it to post margin with its futures clearing merchant. All AFS derivative contracts possessing rating-based downgrade triggers that could result in collateral posting or a termination have been triggered. If additional terminations were to occur, AFS would be required to make termination payment but would also receive a return of collateral in the form of cash, U.S. Treasury or U.S. government agency obligations with market values approximately equal to or in excess of market values of the swaps. In most cases, AFS will look to re-establish the hedge positions that are terminated early. This may result in additional collateral posting obligations or the use of futures contracts or other derivative instruments which could require AFS to post margin amounts. The amount of additional collateral required or margin posted on futures contracts will depend on several variables including the degree to which counterparties exercise their termination rights and the ability to replace these contracts with existing counterparties under existing documents and credit support arrangements. All contracts that require collateral posting are currently collateralized. Collateral and margin posted by AFS totaled a net amount of $262.6 million, including independent amounts, under these contracts at December 31, 2012.

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

BALANCE SHEET

In 2012, total assets decreased by approximately $107 million to $27.00 billion at December 31, 2012, primarily as a result of Segregated Account claim payments, the exercise of call options to purchase surplus notes issued by Ambac Assurance, lower premium receivables and subrogation recoverables, and lower derivative assets, partially offset by higher variable interest entity assets. As of December 31, 2012, total stockholders’ deficit was $3.25 billion; compared with total stockholders’ deficit of $3.15 billion at December 31, 2011. This increased deficit was primarily caused by the net loss for the year ended December 31, 2012, partially offset by unrealized gains on investment securities during the period.

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

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

The Financial Services non-VIE investment portfolio consists primarily of assets funded with proceeds from the issuance of investment agreement liabilities. The primary investment objective is to invest in a diversified portfolio of high-grade securities that produce sufficient cash flow to satisfy all investment agreement liabilities and their collateral requirements. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

 

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The following table summarizes the composition of Ambac’s investment portfolio, excluding VIE investments, at fair value by segment at December 31, 2012 and 2011:

 

($ in millions)

   Financial
Guarantee
    Financial
Services
    Corporate     Total  

December 31, 2012:

        

Fixed income securities:

        

Municipal obligations (1)

   $ 1,814.7      $ —       $  —       $ 1,814.7   

Corporate obligations

     1,047.4        64.8        —         1,112.2   

Foreign obligations

     70.1        —         —         70.1   

U.S. government obligations

     105.2        22.1        —         127.3   

U.S. agency obligations

     78.4        4.1        —         82.5   

Residential mortgage-backed securities (2)

     1,362.5        93.1        —         1,455.6   

Collateralized debt obligations

     22.3        11.0        —         33.3   

Other asset-backed securities

     520.0        186.6        —         706.6   
  

 

 

   

 

 

   

 

 

   

 

 

 
     5,020.6        381.7        —         5,402.3   

Short-term (1)

     629.7        1.7        30.3        661.7   

Other

     0.1        —         —         0.1   
  

 

 

   

 

 

   

 

 

   

 

 

 
     5,650.4        383.4        30.3        6,064.1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Fixed income securities pledged as collateral:

        

U.S. government obligations

     265.8        —         —         265.8   

Residential mortgage-backed securities

     —          —         —         —     
  

 

 

   

 

 

   

 

 

   

 

 

 
     265.8        —          —         265.8   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

   $ 5,916.2      $ 383.4      $ 30.3      $ 6,329.9   
  

 

 

   

 

 

   

 

 

   

 

 

 

Percent total

     93.4     6.1     0.5     100

December 31, 2011:

        

Fixed income securities:

        

Municipal obligations (1)

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

Corporate obligations

     1,015.6        111.9        —         1,127.5   

Foreign obligations

     94.8        —         —         94.8   

U.S. government obligations

     86.2        25.4        —         111.6   

U.S. agency obligations

     82.6        4.3        —         86.9   

Residential mortgage-backed securities (2)

     1,054.5        358.0        —         1,412.5   

Collateralized debt obligations

     31.7        14.5        —         46.2   

Other asset-backed securities

     669.6        278.2        —         947.8   
  

 

 

   

 

 

   

 

 

   

 

 

 
     5,038.0        792.3        —         5,830.3   

Short-term (1)

     729.5        18.7        34.9        783.1   

Other

     0.1        —         —         0.1   
  

 

 

   

 

 

   

 

 

   

 

 

 
     5,767.6        811.0        34.9        6,613.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Fixed income securities pledged as collateral:

        

U.S. government obligations

     260.8        —         —         260.8   

Residential mortgage-backed securities

     2.7        —         —         2.7   
  

 

 

   

 

 

   

 

 

   

 

 

 
     263.5        —         —         263.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

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

 

 

   

 

 

   

 

 

   

 

 

 

Percent total

     87.7     11.8     0.5     100

 

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

 

75


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

 

The following table represents the fair value of mortgage and asset-backed securities at December 31, 2012 and 2011 by classification:

 

($ in millions)

   Financial
Guarantee
     Financial
Services
     Corporate      Total  

December 31, 2012:

           

Residential mortgage-backed securities:

           

RMBS—First-lien—Alt-A

   $ 582.5       $ 0.2       $  —         $ 582.7   

RMBS—Second Lien

     502.9         —          —          502.9   

U.S. Government Sponsored Enterprise Mortgages

     66.9         89.6         —          156.5   

RMBS—First Lien—Sub Prime

     177.9         —          —          177.9   

Government National Mortgage Association

     2.1         3.3         —          5.4   

RMBS—First Lien—Prime

     30.2         —          —          30.2   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total residential mortgage-backed securities

     1,362.5         93.1         —          1,455.6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Other asset-backed securities

           

Military Housing

     379.7         —          —          379.7   

Credit Cards

     —          154.4         —          154.4   

Auto

     13.1         32.2         —          45.3   

Structured Insurance

     56.9         —          —          56.9   

Student Loans

     16.7         —           —          16.7   

Other

     53.6         —           —          53.6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total other asset-backed securities

     520.0         186.6         —          706.6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,882.5       $ 279.7       $  —        $ 2,162.2   
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2011

           

Residential mortgage-backed securities:

           

RMBS—First-lien—Alt-A

   $ 443.0       $ 224.4       $  —        $ 667.4   

RMBS—Second Lien

     386.8         —          —          386.8   

U.S. Government Sponsored Enterprise Mortgages

     93.7         128.7         —          222.4   

RMBS—First Lien—Sub Prime

     126.0         —          —          126.0   

Government National Mortgage Association

     3.3         4.9         —          8.2   

RMBS—First Lien—Prime

     4.4         —          —          4.4   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total residential mortgage-backed securities

     1,057.2         358.0         —          1,415.2   
  

 

 

    

 

 

    

 

 

    

 

 

 

Other asset-backed securities

         &n