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| ABK > SEC Filings for ABK > Form 10-K on 16-Mar-2009 | All Recent SEC Filings |
16-Mar-2009
Annual Report
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 the Annual Report on Form 10-K.
Any or all of management's forward-looking statements here or in other
publications may turn out to be incorrect and are based on Ambac 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) difficult economic conditions, which may not improve
in the near future, and adverse changes in the economic, credit, foreign
currency or interest rate environment in the United States and abroad; (2) the
actions of the U. S. Government, Federal Reserve and other government and
regulatory bodies to stabilize the financial markets; (3) the risk that market
risks impact assets in our investment portfolio or the value of our assets
posted as collateral in respect of investment agreements and interest rate swap
and currency swap transactions; (4) changes in Ambac's and/or Ambac Assurance's
credit or financial strength ratings; (5) risks relating to the re-launch of
Connie Lee as Everspan Financial Guaranty Corp.; (6) competitive conditions,
pricing levels and reduction in demand for financial guarantee products;
(7) credit and liquidity risks due to unscheduled and unanticipated withdrawals
on investment agreements; (8) inadequacy of reserves established for losses and
loss expenses; (9) changes in capital requirements whether resulting from
downgrades in our insured portfolio or changes in rating agencies' rating
criteria or other reasons; (10) the risk that we may be required to raise
additional capital, which could have a dilutive effect on our outstanding equity
capital and/or future earnings; (11) our ability or inability to raise
additional capital, including the risks that regulatory or other approvals for
any plan to raise capital are not obtained, or that various conditions to such a
plan, either imposed by third parties or imposed by Ambac or its Board of
Directors, are not satisfied and thus potentially necessary capital raising
transactions do not occur, or the risk that for other reasons the Company cannot
accomplish any potentially necessary capital raising transactions; (12) credit
risk throughout our business, including credit risk related to residential
mortgage-backed securities and collateralized debt obligations ("CDOs") and
large single exposures to reinsurers; (13) market spreads and pricing on insured
CDOs and other derivative products insured or issued by Ambac; (14) the risk
that holders of debt securities or counterparties on credit default swaps or
other similar agreements seek to declare events of default or seek judicial
relief or bring claims alleging violation or breach of covenants by Ambac or one
of its subsidiaries; (15) default by one or more of Ambac Assurance's portfolio
investments, insured issuers, counterparties or reinsurers; (16) Ambac's
financial position and lack of financial flexibility, resulting principally from
the uncertainty of Ambac Assurance's ability to pay dividends to Ambac without
the consent of the office of the Commissioner of Insurance of the State of
Wisconsin; (17) legislative and regulatory developments, including the Troubled
Asset Relief Program and other programs under the Emergency Economic
Stabilization Act and other similar programs; (18) changes in accounting
principles or practices relating to the financial guarantee industry or that may
impact Ambac's reported financial results; (19) changes in expectations
regarding future realization of gross deferred tax assets; (20) the risk of
volatility in income and earnings, including
volatility due to the application of fair value accounting, required under SFAS 133, to the portion of our credit enhancement business which is executed in credit derivative form; (21) the risk that our underwriting and risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss as a result of unforeseen risks; (22) operational risks, including with respect to internal processes, risk models, systems and employees; (23) factors that may influence the amount of installment premiums paid to Ambac; (24) 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; (25) changes in tax laws; (26) other factors described in the Risk Factors section in Part I, Item 1A of this Annual Report on Form 10-K for the fiscal year ended December 31, 2008 and also disclosed from time to time by Ambac in its subsequent reports on Form 10-Q and Form 8-K, which are or will be available on the Ambac website at www.ambac.com and at the SEC's website, www.sec.gov; and (27) other risks and uncertainties that have not been identified at this time. Readers are cautioned that forward-looking statements speak only as of the date they are made and that Ambac does not undertake to update forward-looking statements to reflect circumstances or events that arise after the date the statements are made. You are therefore advised to consult any further disclosures we make on related subjects in Ambac's reports to the SEC.
Ambac Financial Group, Inc., headquartered in New York City, is a holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. Ambac, through its subsidiaries, provides financial guarantees and financial services to clients in both the public and private sectors around the world. The long-term senior unsecured debt of Ambac is rated "BBB" with a negative outlook by Standard & Poor's Ratings Service, a division of the McGraw-Hill Companies, Inc. ("S&P"), and Ba1 on review for possible downgrade by Moody's Investors Services, Inc. ("Moody's"). Ambac's activities are divided into two business segments: (i) Financial Guarantee and (ii) Financial Services.
Ambac has historically provided financial guarantee insurance for public and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation ("Ambac Assurance"). Ambac Assurance's financial strength ratings were downgraded during 2008; it now has a Baa1 financial strength rating on review for possible downgrade from Moody's and is rated A with a negative outlook from S&P. As a result of these rating agency actions, as well as investor concern with respect to these actions, Ambac Assurance and its operating subsidiaries have been able to originate only a de minimis amount of new financial guarantee business since November 2007.
Ambac Assurance has two financial guarantee insurance operating subsidiaries, Ambac UK and Everspan Financial Guarantee Corp. (previously Connie Lee Insurance Company) ("Everspan"). Ambac UK, insures a wide array of obligations in the international markets including infrastructure financings, asset-securitizations, CDOs, utility obligations, whole business securitizations (e.g. securitizations of substantially all of the operating assets of a corporation) and other obligations, generally within Western Europe. Everspan is a financial guarantee insurance company that was purchased by Ambac Assurance in 1997 and placed into runoff. Ambac Assurance is seeking to capitalize and reactivate Everspan which would allow it to write new financial guarantee business in the U.S. public finance and regulated utility markets.
As an alternative to financial guarantee insurance, credit protection was
provided by Ambac Credit Products LLC, a subsidiary of Ambac Assurance, in
credit derivative format. Ambac Assurance insures the obligations of Ambac
Credit Products under these transactions. These credit derivatives, which are
privately negotiated contracts, provide the counterparty with credit protection
against the occurrence of a specific event such as a payment default or
bankruptcy relating to an underlying obligation. Upon a credit event, Ambac
Credit Products is generally required to make payments equal to the difference
between the scheduled debt service payment and the actual payment made by the
issuer. In a small number of transactions, Ambac Credit Products is required to
(i) make a payment equal to the difference between the par value and market
value of the underlying obligation
or (ii) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation. Substantially all of Ambac Credit Product's credit derivative contracts relate to structured finance transactions. As part of its refocused business strategy, Ambac decided to discontinue the execution of credit enhancement transactions in credit default swap format. However, Ambac may execute restructuring or hedging transactions in derivative format for purposes of mitigating losses and/or improving our position relative to existing credit exposures. See "Quantitative and Qualitative Disclosures About Market Risk" located in Part II, Item 7A for further information about credit derivatives.
Through its financial services subsidiaries, Ambac provided financial and investment products including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to its clients of the financial guarantee business. The obligations of the various subsidiaries which write the financial services business are insured by Ambac Assurance. As part of its refocused business strategy, Ambac decided to discontinue writing new business in its Financial Services segment. The interest rate swap and investment agreement businesses are being run off. In the process of doing so, we expect to execute hedging transactions to mitigate risks in the respective books of business to the extent that we are able to do so; the ratings and financial condition of Ambac Assurance, which acts as credit support provider with respect to these subsidiaries, will make execution of any such hedging transactions more difficult. Such hedging transactions may include execution of swaps or other derivative instruments for the purpose of re-hedging risks inherent in the investment agreement business and the interest rate and currency swap business. Please see Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" for further discussion.
As a holding company, Ambac is largely dependent on dividends from Ambac Assurance to pay dividends on its common stock, to pay principal and interest on its indebtedness and to pay its operating expenses. Ambac Assurance is unable to pay dividends to Ambac in 2009 without the consent of the Office of the Commissioner of Insurance of the State of Wisconsin. See Part I, Item I, "Insurance Regulatory Matters-Wisconsin Dividend Restrictions" section and Part II, Item 7, "Management's Discussion and Analysis-Liquidity and Capital Resources" for further information.
Financial information concerning our business segments for each of 2008, 2007
and 2006 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, which are in Part II, Items 7, 7A and 8 of this Annual Report on 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
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934, 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:
212-208-3333.
Business Restructuring
In 2008, Ambac undertook a review of all its businesses in its Financial Guarantee segment. In conducting this review, Ambac considered the risk exposure within each business (including the view of the probability of default, the potential loss given default and the relevant correlations), the risk adjusted returns over the course of an economic cycle and Ambac's franchise value and competitive advantages. As a result of this review, Ambac has decided to emphasize global public finance (including municipal finance, healthcare, infrastructure and global utilities) and re-evaluate and/or discontinue its participation in certain sectors of the structured finance market. Additionally, Ambac has revised its underwriting and risk management guidelines and determined to discontinue executing credit enhancement transactions in credit default swap or other derivative formats; however, we may execute restructuring or hedging transactions in derivative format for purposes of mitigating losses and/or improving our position relative to existing credit exposures.
During the first quarter of 2008, Ambac announced that it would discontinue writing new Financial Services business (except for hedging transactions to mitigate risks in the portfolio) as part of its refocused strategy. The interest rate swap and investment agreement businesses are in active runoff, which may include termination settlements, restructuring, assignments of and scheduled amortization of contracts.
Ambac is seeking to reactivate Everspan, which would allow Everspan to begin writing financial guarantee insurance in the U.S. public finance market as a separate, stand-alone legal entity. The management team of Everspan would be primarily assembled from within Ambac Assurance's Public Finance division.
Receipt of financial strength ratings which are sufficiently high to enable Everspan to successfully market its financial guarantees is critical to Everspan's business plan. To that end, we are engaged in discussions with Moody's and S&P and are attempting to address their requirements. Foremost among these requirements is the infusion of third party capital, and we are actively seeking third party capital providers. We plan to finance our investment in Everspan by means of a capital contribution by Ambac Assurance. Any such contribution requires the approval of the OCI, which is currently considering our request for approval of such a contribution. The OCI has indicated that it will not approve an investment in Everspan by Ambac Assurance unless Everspan receives financial strength ratings of at least "AA" from S&P and "A2" from Moody's. Everspan's success is dependent on the willingness of municipal issuers to use Everspan's financial guarantees and the willingness of municipal bond investors to purchase such securities.
The November 5, 2008 downgrade of Ambac Assurance, by Moody's, resulted in a significant amount of collateral being posted by Ambac's investment agreement and derivatives businesses. To enable the non-insurance companies to meet the collateral posting obligations in a prudent manner, Ambac Assurance petitioned the OCI to permit various liquidity enhancing activities between these entities and Ambac Assurance. On November 5, 2008, the OCI issued a "nondisapproval letter" with respect to the following transactions between these entities:
• Ambac Assurance is permitted to purchase up to $3.0 billion of investment securities presently owned by the investment agreement business;
• Ambac Assurance is permitted to provide a revolving unsecured credit facility to the investment agreement business of up to $1.6 billion for the purpose of providing such affiliates liquidity for collateral postings or liquidation of investment agreements;
• Ambac Assurance is permitted to provide a revolving unsecured credit facility to Ambac Financial Services of not more than $750 million (subsequently increased to $850 million through March 31, 2009) for the purpose of providing liquidity for collateral postings or liquidation of interest rate and/or currency swap arrangements; and
• Under a separate non-disapproval, Ambac Assurance is permitted to lend up to $1.3 billion to the investment agreement business on a secured basis.
As described above, the financial strength rating downgrades have adversely impacted Ambac's ability to generate new business and will impact Ambac's future business, operations and financial results. Although Ambac is considering various strategic alternatives, there can be no assurance that any actions taken by Ambac will improve its current ratings, that further rating downgrades will not occur, or that Ambac will be able to recommence writing significant amounts of new financial guarantee business in the near term or at all.
The discussion and analysis of our financial condition and results of operations are 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 the accounting for loss and loss expenses of non-derivative financial guarantees, the valuation of financial instruments, including the determination of whether an impairment is other-than-temporary and the 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 and Risk Assessment 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:
Financial Guarantee Insurance Losses and Loss Expenses. The loss reserve for financial guarantee insurance discussed herein relates only to Ambac's non-derivative insurance business. 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.
The liability for losses and loss expenses consists of active credit and case basis credit reserves. Ambac discounts estimated net claim payments using discount rates that approximate the average taxable equivalent yield on our investment portfolio in accordance with Statement of Statutory Accounting Practices No. 60, Financial Guaranty Insurance ("SSAP 60"). SSAP 60 permits the use of a discount rate equal to the average rate of return on the admitted assets of the insurance enterprise in discounting claim liabilities. As of December 31, 2008 and 2007, the discount rate utilized was 4.5%. SAB Topic 5N, Discounting By Property-Casualty Insurance Companies, notes that the SEC will not object to an insurance enterprise using the same rates to discount claim liabilities for short-duration contracts for U.S. GAAP reporting that it uses for statutory reporting with the same claim liabilities. As such, we have utilized the discount rate as determined in accordance with SSAP 60 for the purpose of discounting both our U.S. GAAP case basis and active credit reserves.
Active credit reserves are established only for adversely classified credits. Ambac establishes an active credit reserve to reflect probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported as of the reporting date. The active credit reserve is generally established through a process that estimates probable losses inherent in the adversely classified credit portfolio. These estimates are based upon: (i) Ambac's internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severity assumptions; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by the Enterprise Risk Management Committee ("ERMC"). The ERMC is comprised of Ambac's senior risk management professionals and other senior management. Our Surveillance Group is responsible for designating the credit classification of individual credits and assigning credit ratings, which in turn affect default probabilities used in estimating active credit reserves.
Ambac may use market accepted models and software tools when a more precise view of expected claim payment cash flows can be derived. We have utilized this approach for residential mortgage-backed exposures as discussed in the RMBS section below. These tools, in conjunction with detailed data of the historical performance of the collateral pools, assist Ambac in the determination of certain assumptions, such as default and voluntary prepayment rates, which are needed in order to estimate expected future net claim payments.
For certain adversely classified credit exposures, such as residential mortgage backed securities exposures and other credits that have deteriorated significantly, Ambac's additional monitoring and loss remediation efforts may provide information relevant to the estimate of the active credit reserve. Additional remediation activities which impact our estimates of the active credit reserves can include various actions by Ambac. Common actions may include investigating breaches of contractual representations; obtaining detailed appraisal information on
collateral; more frequent meetings with the issuer's or servicer's management to review operations, financial condition and financial forecasts; and more frequent analysis of the issuer's financial statements. In estimating the active credit reserve Ambac uses relevant credit-specific information and an analysis of rights and remedies obtained from its remediation efforts to supplement the statistical approach discussed above.
Case basis credit reserves are established for losses on insured obligations that have already defaulted. We believe our definition of case basis credit reserves differs from other financial guarantee industry participants. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral, contractual and subrogation rights.
The primary assumptions impacting the establishment of loss reserves for a particular credit are the probability of default for that credit and severity of loss given a default. The probability of default assumption represents the percentage chance that a particular insured obligation will default over its remaining life. Probability of default assumptions are based upon rating agency studies of bond defaults given a particular asset class, rating and remaining tenor of an underlying obligation, modified as appropriate by Ambac's experience and judgment. Severity of loss given a default represents the amount of loss that would be incurred on a defaulted obligation due to the difference in the amount of net par guaranteed and the value of the related collateral and other subrogation rights. Loss severity estimates are based upon available evidence such as rating agency recovery rates with respect to debt obligations in the particular asset class, review of financial statements, collateral performance, and/or surveillance data such as collateral appraisals. However, when credits are in default or have specific attributes that warrant an adjustment, we typically develop a best estimate of the loss based upon transaction specific elements rather than a statistical loss as our knowledge is greater as to the ultimate outcome of these credits due to our surveillance and remediation activity.
For the active credit reserve component of our total reserves, as the probability of default for an individual credit 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. Downgrades to the underlying rating of an adversely classified credit, particularly those individual credits with a large net par balance, could have a significant impact on our reserves. Case basis credit reserves for public finance or other non-collateral dependent transactions are only sensitive to severity assumptions because the underlying financial obligation has already defaulted (that is a 100% probability of default). Case basis credit reserves for collateral dependent transactions (such as mortgage-backed security transactions) will be sensitive to both severity assumptions as well as probability of default of the underlying collateral.
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