Ambac Financial Group, Inc. (ABK) Q3 2008 Earnings Call November 5, 2008 8:30 AM ET
Welcome to the Ambac Financial Group, Inc. third quarter fiscal year 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Mr. Sean Leonard, of Ambac Financial Group, Inc.
Welcome to Ambac's third quarter conference call. I'm Sean Leonard, Chief Financial Officer of Ambac. Presenting with me today are David Wallis, Chief Executive Officer and Cathy Matanle, Managing Director Portfolio Risk Management who will discuss our credit portfolio.
Our earnings press release quarterly operating supplement and a slide presentation that follows along with this discussion are available on our web site. I recommend that you view the slide presentation as we speak today. This call is being broadcast on the internet at www.ambac.com
During the conference call we may make statements that would be regarded as forward-looking statements. These statements may relate to among other things, management's current expectations of future performance, future results, and cash flows and market outlook. You are cautioned not to place undue reliance on these forward-looking statements which reflect our current analysis of existing trends and information as of the date of this presentation, and there is an inherent risk that actual results, performance or achievements could differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.
These differences could arise from a number of factors. Information concerning factors that could actually cause results to differ materially from the information we will give you is available in our press release and on our most recent Form 10-K and subsequently filed Form 8-K. You should review these materials for a complete discussion of these factors and other risks. A copy of these documents may be obtained from the SEC website.
I will now turn it over to David Wallis who will comment on the current market environments, our discussions with the Treasury and Ambac's strategic priorities.
Since we last reported on August 6, few if any would have predicted the tumultuous events of the last few months. These events have been somewhere between significant and transformational in nature and have touched most areas of the globe. Similarly, financial markets have been exceptional volatile and have generally declined significantly. Many institutional participants in these markets have been transformed, or in a few exceptional cases, no longer exist.
In the U.S. specifically and far from alone in this, house prices have declined significantly, consumer confidence has hit record lows and credit markets have suffered more or less complete seizure. Unsurprisingly official and consensus views on the economic outlook have deteriorated. That is the story of the last three months, and this quarter's results are reflective of this distressing context.
More strategically, it is reasonable to characterize our position as being balance sheet denuded by our exceptional historic standards, but on a forward-looking basis is possessing valuable skills in connections in an environment crying out for just those assets. The real question, is how to get from where we are presently to an appropriate and remunerative usage of those skills in connections in the future.
Let me review the present position. The current spotlight is on our ratings, more specifically Ambac's Moody's rating post our release concerning Ambac of September 18. Crystallization of the referenced downgrade would precipitate the significant liquidity issue within our financial services business. Let me take these rating and liquidity items in turn.
First the ratings. Clearly we can neither speak for nor predict what rating agency opinions might or could be. Let me clear that there are many elements of the ratings analysis with which we would wholly agree and there's no doubt this is a difficult task. However, let me also say that there are significant elements and assumptions within some of the analytics that leave us confused and somewhat incredulous. Sean will discuss some of these issues a little later.
Suffice to say that under our current business model where our ratings have always been an essential cornerstone, this quarter's production numbers amply demonstrate that even current ratings are seemingly irrelevant to new business underwritings. To some, this unfortunate state of affairs is a matter of confidence in general and confidence in ratings in particular.
Secondly, liquidity. Whilst one can debate the precise causes of this rating contingent liquidity issue which largely emanates from mortgage market woes within the guaranteed investment contracts business, the essential point is that we believe the issue is to be a liquidity issue and not a solvency issue. Naturally, we are in constant touch with our regulators with whom we can continue to have a completely open and constructive relationship.
I'll now comment upon the major drivers of this quarter's results. Cutting to the chase, there are really two major elements; a meaningful deterioration in the performance of our second lien mortgage book, and amendments to some of the assumptions underlying our high grade ABS and CDO portfolio.
Regarding second liens, last quarter we observed an apparent topping out of certain key credit metrics. This quarter we have seen an apparent reversal of these metrics, and therefore using the same type of methodologies as previously, we have been compelled to reflect these changes in increased projected losses.
On ABS CDO's which account for a significantly larger element of this quarter's reserves and impairments, we have revised and refined our assumptions and I'm going to briefly walk through these.
Within our high grade ABS CDO's, we commence with an analysis of the underlying RMBS looking at booked cumulative losses and individual delinquency pockets. We've given delinquency pockets and certain prescribed roles to default from these together with assumed pre-payment speeds, then for severity assumptions it is possible to infer what proportion of loans that are current would need to default at these prescribed severities in order to generate certain future ultimate cumulative losses.
Focusing on the change from the last quarter, we have chosen to raise our severity assumptions, now 55% to sub prime and 45% for all pay which given the role analysis have let us to project with 2006 sub prime cumulative loss for the Q6 underlying our high grade transactions, will be 19% on average whereas the altay equivalent depending on product, is projected at 8% to 13%.
For reference, the 19% sub prime assumption compares to around 8% for the exceptionally poor 2000 vintage and the present booked cumulative loss within the vintage of around 5%. A strengthening for mortgagees, these assumptions infer that around 40% of 2006 borrowers will default, a staggeringly high number.
Obviously, there is an inevitable crystal ball uncertainty in any and all of these very forward-looking projections. Aside from the economy patently correlated to it are the apparently current public and private sector measures designed to stem the tide of delinquency and foreclosure activity in order to reduce ultimate loss.
Just as it is hard to comprehend the current state of distress, it is at least as hard to comprehend the scale of the collective public and private sector response. Our judgment is that these activities or their successes will have a materially beneficial impact upon the targeted metrics. Just as many soothsayers proclaim this time is different as optimism abounds, many utter the same words now as pessimism mounts. Very seldom is either extreme born out.
I'll close by reviewing present priorities and a view of the future. The underlying industry is an essential loop in some critical credit markets, both municipal and asset backed. These markets are presently more in involved in staggering expense of all. The industry is systemic to the efficient operations and existence of these markets.
The industry gives issuers access to them and by virtue of the enormous insured volume outstanding is impactful on the balance sheet to ensure debt holders and other counter parties. Just as issuers have confidence of frozen to back market and consequent flow of credit, an analysis position is occurring within the mono line dominated markets.
For the major mono line participants, the issues are confidence, and/or liquidity but not solvency. In this systemic insolvent context, it should not surprise anyone that some participants within the industry have commented upon the TARP proposals and have a great interest in them. Here at Ambac, we consider ourselves as imminently eligible and aligned to assist in the restoration of liquidity and stability to the financial system per the revoke of the act. This is therefore, a primary focus for us and some of the remaining participants in the industry. Page 4 lists some of these programs.
A second major activity is to ensure an unchanged focus on managing and de-risking our portfolio. Whilst the collective term is mono lines, this lamenture belies the range of value adding activities going on underneath the traditional hood of financial guarantee. We remain confident that these important activities will continue to produce value for our shareholders.
The third major activity continues to be Connie Lee, our intended limited focus subsidiary. We've put in an extraordinary effort across a multiple facets of business plan, production and validation and eagerly await the considered response of the rating agencies. It is clear that there have been different levels of understanding of our proposal which we believe will give rise to a stable and attractive proposition, and we are presently working hard to assist any and all in analysis of it.
Finally, I started off by commenting upon the fact that within Ambac, we possess valuable skills and connections in an environment crying out for just those assets. I absolutely believe this to be the case. We are fortunate in having the business model to see us through the present extreme environment whilst being able to plan and act for the future.
These activities are vital as an extended status quo is simply not an option for us or any business. We have to use our qualities and appropriately flex or potentially shift our business model so as to create value by serving our core issuer and investor stakeholders. We have a terrific alignment with those stakeholders and especially in this environment, can serve them whilst providing satisfactory returns to our shareholders.
Rest assured, we are working very hard to get back to this happier state of affairs. Now I'll turn it back to Sean.
I will now provide a brief overview of the financial results focusing primarily on factors driving our results and I will also briefly comment on rating agency reviews and liquidity.
If you would please turn to Page 8 in the slide presentation for a summary of our financial results. Net loss for the third quarter of 2008 was $2.4 billion or $8.45 per share. That is down from a net loss of $360.6 million or $3.53 per share in the comparable prior year quarter. Driving most of the decline is net non-cash mark to market losses in our CDO of ABS portfolio.
Also contributing to the quarterly loss are increased net provision for loss and loss adjustment expenses primarily related to second lien RMBS transactions and realized losses in our financial services investment portfolio. Partially offsetting these losses are increased accelerated earned premiums resulting from re-fundings.
To assist you with our financial statements and analysis of our reported earnings, we also report our earnings on an operating and core basis. Page 9 summarizes these earnings measures. Both of these earnings measures are considered non-GAAP.
Operating earnings excludes the net income loss impact of net gains and losses from sales of investment securities and mark to market gains and losses on credit, total return and non-trading derivative contracts that are not impaired. Core earnings further excludes the net income impact of accelerated earned premiums from re-fundings.
Operating earnings per share in the third quarter 2008 were $7.81 per share. That's a loss. Remember that in calculating operating earnings, we exclude the impact of unrealized gain losses from our CDO portfolio but do not exclude the impact of estimated credit impairments within that portfolio.
In the third quarter, Ambac reported credit impairment of $2.51 billion pre-tax, or $5.67 on a per share basis. This amount is reflected as a reduction in our operating core earnings results. In calculating CDO impairments for the quarter, we decided to increase our assumption as David stated of cumulative loss related to the RMBS as is within these transactions.
Cathy will provide greater detail about our credit portfolio and various loss assumptions that led to our impairment estimate, but I would like to address a point about the TARP and other government programs and actions.
Ambac believes that these initiatives are expected to have a positive impact on the liquidity and credit throughout the markets and therefore, we have considered them when selecting management's global assumptions of cumulative losses and the underlying collateral of the CDO of ABS transactions.
Turning to core earnings, which is operating earnings less net income per share impacted re-fundings amounted to $8.11 loss per share. Normal earned premium amounted to $155 million in the quarter, down 13% from the comparable prior year quarter primarily due to the reduced premiums written, runoff and accelerations of the portfolio due to re-fundings and the issuant guarantee transaction that took place late last year.
Accelerate premiums of $127.3 million increased significantly, one again up about $111 million over the third quarter of 2007. Refunding activity remains heavy in option rate and variable debt notes due to the extreme illiquidity experienced in those markets since early this year. This heavy refunding activity enhances our capital position as we free up capital as the exposure comes off our books.
Our net core outstanding at September 30, 2008 amounted to $461.5 billion. That's down 12% from the beginning of the year.
Investment income increased $9.8 million or 8% to $126.8 million on increased volume driven by net positive cash flows from operations and the net proceeds from the March capital raise, partially offset by cash flows related to the $850 million commutation payment made in August and claim payments on second lien RMBS transactions.
Now turning to Page 10, we summarize financial guarantee revenues. While business writings are down drastically, total financial guarantee core revenues which includes normal earned premiums fees on credit derivatives and investment income remains fairly steady, having only declined about 6% quarter on quarter. Year to date core revenues are down less than 1%.
This demonstrates the advantage of our long term book of business and our business model that allows us to collect a large portion of our premiums up front, invest those funds in a conservative fixed income investment portfolio and to earn the premiums over the long lives of the bonds.
Our deferred earnings represent future earnings on premiums already collected and the future value of installment premiums that amount to $5.6 billion at September 30. That balance is made up of $2.2 billion of premiums already collected and invested in our conservative investment portfolio and $3.4 billion of premiums we estimate will be paid to us in installments over the lives of the transactions.
Turning to Page 11, I will discuss mark to market and impairment activity. During the third quarter Ambac reported net mark to market losses related to its credit derivative portfolio amounting to approximately $2.7 billion. Mark to market losses were once again impacted by deteriorating price performance in the underlying RMBS collateral of the CDO of ABS transactions and significant internal down grades in the portfolio.
As a brief reminder, that is 157 retained back to adjust the estimated fair values of its derivative liabilities to incorporate the risk of the company's own non-performance. Client Ambac's credit spreads as required had a $1.38 billion positive impact on the mark to market loss for the quarter.
I would like to now discuss our loss provisioning on our direct RMBS insurance portfolio. During the quarter we paid $187 million in RMBS claims. Total RMBS losses for the quarter were $540 million. The increase we incurred is primarily a result of deteriorating results in our second lien RMBS portfolio. It's notable that four second lien transactions represent about 50% of our total RMBS reserves. Those transactions and several others are the subject of very detailed reviews by our remediation team and outside consultants.
As discussed last quarter Ambac is in the process of reviewing performing transactions for breaches of reps and warranties. Our efforts to date have uncovered significant such breaches and in the third quarter Ambac recorded estimated expected recoveries of approximately $250 million. Cathy will provide information on those efforts.
In addition, during the quarter Ambac increased non RMBS reserves by $73 million primarily related to other classes of asset backed securities.
Very quickly on Page 12, we have summarized the losses and impairments that we have taken over the last four quarters. On Page 13, I'd like to spend a few minutes discussing rating agency reviews.
As most of you know, Moody's put us on review for down grade in mid September and as a result of changes in ultimate loss estimates primarily in sub prime RMBS securities. That review is ongoing. Ultimate future loss estimation is not an exact science. We don't profess to have a crystal ball, but we do believe that certain factors about the ratings model, our business model or even the global economic environment need to be considered before reaching conclusion on Ambac's capital position and financial strengths. We have met several times with Moody to discuss these factors.
On this slide we show certain cumulative loss assumptions published by the rating agencies compared to our own. We will be able to update our capital position once both Moody's and S&P have completed their reviews. Later, I will discuss our regulatory capital position.
Now I'd like to discuss the company's liquidity from a few perspectives; Ambac's Assurance and the Assurance company liquidity, holding company liquidity and liquidity impacted by rating changes.
Let me start with Ambac Assurance liquidity on Page 14 with a snapshot of our financial guarantee investment portfolio. Ambac Assurance claims resources at September 30 amount to $15.4 billion. The backbone to those resources are our conservative fixed income investment portfolio. That portfolio totals $9.9 billion and is made up primarily of high quality municipal bonds, U.S. government obligations and U.S. agency obligations.
In the fourth quarter alone, we expect to receive principal interest related to this high quality portfolio amounting to $143 million. In addition, we expect to receive about $91 million of installment premiums during the quarter. Those amounts total $234 million and compare to expected claim payments for the quarter of $258 million.
Also of note in late October Ambac received $546 million in tax refunds related to taxes paid in 2007 and prior.
On Page 15, let me briefly discuss components of liquidity at the holding company. Total holding company had cash amounts to approximately $187 million at September 30. Ambac Assurance paid a quarterly dividend amounting to approximately $54 million and in October we plan to end the year with approximately $200 million in cash at that entity. That's approximately 1.9 times the holding company's annual debt service needs.
On Page 16, we have laid out the statutory capital as of the end of the quarter. Based on Ambac Assurance financial results year to date, it is not likely that Ambac Assurance will be able to declare and pay dividends for the holding company in 2009 without first receiving approval from the office of the Commissioner of Insurance for the State of Wisconsin. We would expect that they will make those decisions at the time we make the quarterly requests.
As a reminder, Ambac announced back on September 19 that we suspended the previously announced authorization to repurchase up to $50 million in common shares. We did so in order to support the company's goal of maintaining sufficient parent company liquidity.
In early October the Board of Directors of Ambac declared a quarterly dividend of $0.01 per share common stock. That dividend is payable on December 3 of this year. As a result of the net loss recorded in the third quarter, Ambac's GAAP stock holders equity is now negative. Corporate laws prevent us from paying any further dividends until our stockholders equity is positive.
Lastly, I would like to discuss our liquidity requirements which will be triggered by ratings changes. This is outlined on Page 17. The severe dislocation in the structured credit markets continues to negatively impact our GIC investment portfolio. The negative mark to market on the highly rated securities that comprise the GIC portfolio has created a gap between the realizable values of the GIC liabilities and the GIC assets.
That gap may lead to a current liquidity obligation because of down grade triggered structure in most of the GIC contracts which require us to collateralize or terminate them upon down grade to certain rating levels. Similarly, a down grade of Ambac Assurance as a result of collateral posting obligation, and potential cash termination payments on our currency and interest rates swaps in our derivatives business.
Our presentation provides the updated collateral posting needed under various down grade scenarios for all of our financial services businesses. On a down grade to Single A flat, you see that our collateral posting requirement increases to $2.8 billion. On a down grade to BBB flat the collateral posting requirement increases by an incremental $400 million to $3.2 billion. We continue to work closely with our regulators to receive permission to use the resources of Ambac Assurance to support this liquidity issue.
That concludes my prepared remarks on the financial results. Cathy Matanle will not talk to you with some detailed elements of the credit portfolio.
Let me move on to the portfolio. Although the mortgage crisis and now weak economy have heightened our surveillance of vulnerable credit financial types across our portfolio, mortgage related assets continue to be our major concern. Therefore, my prepared remarks will address this portfolio.
I'll start with the high level overview, then move to address the direct MBS book then the CDO of ABS book, in both cases covering reserves, performance and remediation. Please note we've provided in the appendices an update on the CLO portfolio as well as an updated MBS claims projection chart.
Turning to Page 19, let me start by summarizing the key sub sectors of both the direct MBS and CDO books of business. Exposures are down slightly due to extremely low voluntary pre-payment rates underlying the mortgages in both of these portfolios. The direct MBS book now stands at $42 billion versus $45 billion at the end of the second quarter.
The second lien portfolio which comprises closed-end seconds and HELOC stands at about $15 billion or essentially flat to the second quarter. The CDO of ABS portfolio was $30 billion. We have high grade CDO of ABS exposure of about $25.5 billion. The CDO squared portfolio has been reduced dramatically from $2.5 billion to $1 billion after the commutation of the double A B book transaction back in August.
On Page 20 we provide a current snapshot of Ambac's current reserves and impairments. As of the end of the third quarter Ambac has approximately $6 billion in total mortgage related reserves and impairments. 78%, $4.8 billion relates to the CDO of ABS book while the remainder relates to the direct MBS book.
Of the direct MBS portfolio on the left, the majority of Ambac's reserves relate to the second lien product shown in the top two boxes. The majority of the category labeled Other comprises affordability products and lot loans. In the quarter we increased reserves by $15 million for the former and took a new reserve of $61 million for the latter. Our total exposure to lot loans is the four deals that are now reserved. They have a total par of $344 million.
There are impairments against each of the 18 CDO of ABS transactions that we now rate below investment grade. $1 billion of the impairment relates to the two remaining CDO squares which are unchanged in the quarter.
Next, I'll make some brief comments of MBS followed by CDO of ABS. Moving to Page 22, I'm planning to move through the next two pages quickly. They are just snapshots to provide context. The pie chart on the left shows the composition of the direct MBS portfolio. The chart on the right shows the vintage distribution of the current exposures.
On Page 23, the two pie charts show Ambac rating distribution of the book as of June 30 on the left, and September 30 on the right. Ratings deterioration in the MBS book is driven by the second lien product which accounts for 70% of the ratings now below investment grade.
Let's now discuss the MBS collateral performance trends in the quarter. As David explained, we use the same models in the quarter that we used to model performance in the past, revising assumptions to reflect deal performance in this quarter.
During the quarter, it was the increase in initial roll rates; meaning those homeowners who moved from current to 30 days delinquent that predominantly drove the higher model losses. Additional factors include continued severe roll rates into the later stage delinquencies and foreclosure, more front loaded claims payments and slower pre-payments.
As mentioned earlier, our Alt-A and sub prime portfolios continue to perform within the parameters that we established for them. Lot loans moved to below investment grade in the quarter. Falling home prices and ample inventory of existing homes contribute to underperformance of these transactions. We modeled these deals consistently with our other MBS assets but take into account the repayment terms that are unique to these deals and the potentially higher severity that exists over our other first lien product.
Given the significance of the second lien portfolio on the quarter's results, the next few pages address this part of the direct MBS portfolio. Page 25, seven of our 46 HELOC transactions are now rated BIG, below investment grade. This represents 36% of our HELOC net par. 8 of our 31 closed-end second transactions are now rated BIG, in this case representing 66% of the net par.
Turning to Page 26, in prior quarters we've shown you deal performance on select underperforming MBS transactions. On the next two pages we have done this again, graphing the two most important drivers to those selected deals underperformance. The first page, Page 26 shows the rising trend in this 30 to 60 days delinquency bucket that I mentioned. And on Page 27, we show the declining voluntary pre-payment rates for these same deals.
These rates are approaching zero as homeowners over levered against declining home values cannot refinance out of the pool.
On Page 28 turning to the HELOC, although we've been distinguishing HELOC deals from closed-end seconds in our reporting, we find that the lines really blur between these two asset types once the deals are underperforming. Nevertheless the distinction does help us to explain the apparent root causes of the underperformance as shown in the next two pages.
For example, on Page 28 the diversion performance of bank and non-bank originated HELOC product that we reported to you in the past continues to hold. You should note that HELOC claims in the quarter were $79 million, 42% of the company's total paid claims in the third quarter.
On Page 29, and also as reported in prior periods, the majority of the reserves in the closed-end second product continue to be related to the piggy back second lien product, usually a high LTB purchase loan. Closed-end claims in the quarter totaled $106 million which is 56% of the company's total paid claims. The majority of our remediation efforts relate to the closed-end second product.
Turning to Page 30, let's move on to progress in remediation. This page summarizes our work in the quarter investigating breaches in our pools and separately addressing servicer matters ranging from servicer replacements to loan modifications. For the quarter as Sean mentioned, we increased our estimated remediation recovery by $249 million to an aggregate of $521 million.
This is based upon additional re-underwriting of mortgage loans on a total of nine transactions. An average of 78% of all the loans we have re-underwritten evidenced breaches of reps and warranties, in most cases exhibiting multiple breaches. We're making significant head way with sponsors sending 17 breach notices or claims in the quarter.
Where our efforts to put back loans or otherwise work with sponsors of transactions prove to be ineffective and we failed to receive cooperation, we have no alternative but to enforce our rights and remedies through legal action. We are presently filing a complaint in connections with four transaction involving EMC, a mortgage subsidiary of Bear Stearns which is now owned by J.P. Morgan. This action is the culmination of over a year long effort to come to a cooperative resolution in these transactions.
Turning now to CDO on Page 32. As I indicated, the majority of our exposure is now rated below investment grade having started at AAA by Ambac and the rating agencies. We've seen considerable rating deterioration quarter over quarter. For example, at the end of the first quarter we have three high grade deals rated below investment grade. By the end of the second quarter 11, and now 15.
Until this quarter, the driver was rapid deterioration of the CDO buckets within the high grade transaction. This quarter however, we saw a dramatic deterioration in the RMBS underlying the high grade deals. Despite initial ratings in the A and AA category, many of these underlying RMBS's are not able to withstand the increased cumulative losses that we are assuming.
Turning to Page 33, as with all underperforming credits in our portfolio, we take an aggressive approach to loss mitigation with the CDO credits, as you can see from this list of select activities. We are fully exercising our control rights as they relate to structure, the manager and the collateral. We've accelerated four transactions to divert cash flows from the junior classes to pay down our trance and we are also restructuring transactions to achieve the same end.
Finally, Page 34 on the subject of commutation, there has been a modest slow down in our CDO commutation momentum due to the uncertainty of the various government programs designed to stabilize the financial system and the individual homeowner. Nevertheless, we continue to believe that this is the most cost effective way of reducing risk in the near term and we are confident that our discussions will continue to advance fruitfully.
Our commutation strategy is focuses on transaction where our counter parties have significant exposure to us and the views of projected performance start to converge. In other words, our bid and ask gets closer. The price that we are willing to pay will depend of Ambac's view of the ultimate loss, the timing of claims payments and the capital implications.
Let me end by saying that we have had meaningful discussion with all of our key counter parties and we will continue to advance these discussions to settlement. With that I will turn it back to Sean.
That's the end of our prepared remarks. We would now like to open it up for questions.
(Operator Instructions) Your first question comes from [Arun Umar – J. P. Morgan]
[Arun Umar – J. P. Morgan]
The comments you made earlier regarding liquidity based on a potential rating action, if Moody's does take you down a couple of notches, how do you expect to remediate the situation and cover the shortfall. Have you had any recent dialogue with the Wisconsin Insurance Commission in terms of allocating assets especially in light of the fact that the statutory capital has dropped quite a bit in the third quarter? If you look beyond this year and getting into next year with the fact that if you don't have any dividend capacity, what kind of liquidity position do you expect to have given that you don't have any bank lines currently?
In talking about discussions with the Wisconsin Insurance Department, we've had quite active discussions as David pointed out in his remarks, and this goes back quite some time so this is not obviously an issue that's crept upon us. It's been out there and it's an issue that Wisconsin Insurance Department is well briefed on.
Regarding our plans to solve those liquidity issues, are to utilize the resources of the insurance company to meet collateral posting requirements and termination requirements in both GIC and the interest rate swap business. That will be a combination of purchases of assets out of the business. It will be a bit of secured lending to the business which we've done some of already, and it will be some unsecured lending to the business to accomplish the result of either terminating or collateralizing.
Obviously, if we were to be down graded, we'll take an economic view of whether or not to terminate or to collateralize contracts based upon the terms of the liabilities, rates and the like and what type of posting requirements are required under those contracts. For example, long term fixed rate collateralizing with Treasuries would not be in our best interest. Those are the plans to handle that and we've had active discussions and up to date.
Relating to the holding company liquidity, we've provided a pretty good overview in the materials, Page 15 of the material which gives you a sense for where we expect to be at the end of the year relating to our cash balances. We will need to discuss with Wisconsin the plans to take dividends next year but in the case that we were not able to take those, we do have approximately 1.9 coverage over that debt service requirements for 2009.
[Arun Umar – J. P. Morgan]
In terms of your book equity largely being wiped out and your stat capital down substantially, is there any further deterioration in your portfolio RMBS or other exposures you have. The Wisconsin commissioner arguably could be very concerned that your stat capital may also go the way of your GAAP capital. In that case what is the likelihood that they'll let you do anything in terms of the GIT portfolio rather wouldn't they be focused your core business as opposed to in any way making the GIT holders whole?
Those are issued that obviously are on the table and clearly the regulator in Wisconsin is primarily concerned with policy holders. I'd say as Sean commented, we have a very open and transparent relationship with Wisconsin. This is not news. They have spent a lot of time with us and their advisors also and they are fully cognizant of what our position is.
Obviously we can't speak for them. We work with them continually more or less on a daily basis. So I think they're very aware of all the issues that you raised as are we and as Sean replied, this isn't news.
You made some comments about statutory capital. We provided a reconciliation where we stand as of the end of the third quarter, and what's not on this page is a substantial contingency reserve that we have established that we have not taken down. The statutory rules would allow a petition to the Insurance Commissioner in situations where the wash rates are onerous and there's certain requirements that surround that and where policies were to be expired so refundings and the like. So that would be a discussion we would have with them at that appropriate time.
Your next question comes from [Sy Lund – Morgan Stanley]
[Sy Lund – Morgan Stanley]
On the ABS CDO exposure, I'm looking at Slide 32, and I'm trying to get some more detail on the notes still outstanding on the CDO of ABS. Can you give us the numbers of what CDO's exposure is right now and what the percent impairment is on that as well.
There's Slide 19 provides detail where there's heavy mortgage related securities and the CDO. That number is approximately to $30 billion so that obviously corresponds to the bar chart. And you see the break out that we have there, $25.5 billion high grade, $0.5 billion in mezzanine, $1.1 billion in CDO squares and then we have a commitment to provide a guarantee of $2.9 billion. When you add that up it gets you your number.
If you were to flip the page, on Page 20 shows you the estimated impairment for the CDO of ABS portfolio of $4.8 billion.
[Sy Lund – Morgan Stanley]
Can you walk us through any strategic changes or any transition issues that have come up with Michael Cowen stepping down over the past several weeks.
There are no transition issues whatsoever. In terms of the strategic issues, I think our priorities are as we've laid out. Clearly there's a lot of activity right off. That's in a sense sprung up over the last few weeks. It's always a current focus for us.
I'd emphasize we don't see that as a silver bullet and as the be all and end all. We think we're eligible. It depends on the terms of eligibility should we in fact be eligible. We think there's a business beyond TARP if TARP doesn't occur in relation to ourselves, and that brings us onto a more internal focus in relation to the portfolio as I described and the [Connie Lee] initiatives I described.
It's clear, you look at the municipal markets right now year on year volume is down 57%. You look at the cost of funds to municipalities its way above taxable rates. These are extraordinary times and I think the markets are under distress and we act as I described as a lubricant between investors and issuers. I think there are real opportunities for us. I think we need to take advantage in a helpful way in terms of the systemic position I think we are in to meet the needs of issuers and investors and get the thing going. We think we can, and we're looking forward to it.
[Sy Lund – Morgan Stanley]
If I assume a further increase in cumulative losses of CDO of ABS from 23 to 25 is there a linear progression from the 16 to 18 you had up to the 19 to 21? Should we assume a linear progression as potential losses are increased on the CDO portfolio?
You probably shouldn't. It's not really linear. The deterioration should those projections occur is faster than linear. Clearly one's view depends on one's view of the world. As we outlined we do think that the terrific by the public sector will have an impact there. We believe that pretty firmly and we think there is some evidence that there will be an impact.
The impact isn't linear. If you turn back the clock though, just to make a point I think we made on a prior call, one of the meaningful things that's occurred in relation to the CDO of ABS has been the very fast unexpected write off of CDO buckets. That obviously is a one hit wonder. We disclosed pretty fully on our web site the extent to which that component of these deals is written off.
That leaves the performance of mortgages as the real variable here. We've chosen for the reasons we outlined to up our assumptions. These are very forward-looking estimates. We're not expecting claims in some cases for 10, 20 even 30 years. 5% is roughly where the loss is right now. We're forecasting 19%.
The basic math of this stuff is such that the losses or the future impairments are not linear in their nature.
Your next question comes from Darin Arita – Deutsche Bank.
Darin Arita – Deutsche Bank
Can you give a little more color on your discussions with Treasury post your posting of comments to them last week?
We believe absolutely that we are systemic. I'm talking about the industry. This is an Ambac begging bowl. This is an industry move. Why are we systemic? Well I think we all know our place in the municipal industry. I think also there are other effects. There are effects upon the holders of insured debt and counter parties.
Banks have clearly written down their exposure to us. That's capital depleted. That isn't helpful in the context of the need to get bank credit going. I think there are also other issuers and other sectors aside from municipal sectors that would welcome a return to a healthy industry. I think that some of the health care issuers, student loan issuers, and also one or two other asset backed issuers would welcome our return. So the first point is a systemic point, and I think the facts speak for themselves.
The second point is the solvency point. Clearly it's not in the interest of tax payers and we are absolutely at one on this to prop up a failing institution. We think our issues are liquidity along the lines we've discussed, not solvency. Clearly Treasury and others need to be persuaded of that fact because they don't want to throw good money after bad. I hope and believe that argument is a very tenable one and that we'll win it.
The next point comes down to the precise nature of any measures that could be undertaken here. We posted some suggestions as did others in relation to the request to comment from the TARP so I think there are many alternatives here and I think all those details have yet to be played out.
In summary the main points are systemic. That's what it's about. That's the state of the world right now. Solvent, we think yes clearly in our case, and then getting down to the detail both in relation to the size of any perspective measures and also the precise structure. I think it's those last two elements where more work needs to be done.
Darin Arita – Deutsche Bank
Has Treasury responded at all since October 29? Have there been any dialogue?
There has been dialogue as you would expect, but no formal response.
Darin Arita – Deutsche Bank
With respect to your current loss reserves, how much worse do you expect things to get with respect to home prices and delinquency trends?
It's a crystal ball and we're making very forward-looking estimates of pretty complicated matters. What we try to do is take a decent run at this in relation to the assumptions and the rational for the assumptions that we've outlined. One way of looking at this, if you imagine the normal kind of normal distribution, I think hence the TARP, hence all the concerns in the markets at present, we're way out there in the tail of that distribution now.
I think that the TARP and other private sector measures are and we believe will pull in that tail. I think what we're seeing or what we will see is a compression from where we are now which is a very, very stressed environment, but we expect that some of the more extraordinary stress losses that have promulgated, we think they're prove to be not well founded and that the tail, the extreme end of what might happen will be surmounted by the TARP.
What's the joker in the pack? It's the broader economy. I think what you have to do is balance out the incentives for home owners now, the fact that we are in a terrifically stressed environment, the fact that the TARP will have a tremendously beneficial impact. It's beginning to have an impact in the banking markets now and the other side of the argument is what's the economy.
There's a huge amount of connectivity between all these issues but in our view, we've taken a very good run at this and it's tough to project the future. We've been consistently wrong, but we're feeling comfortable in the estimates we've made.
Darin Arita – Deutsche Bank
What is your estimate for home price declines underlying these?
What we've done is upped our severities quite considerable so we're standing at 55% in relation to sub prime and 45% in relation to Altay and obviously that reflects the dilution in house prices, longer liquidation time frames which incur carrying costs so all that adds up to a cumulative loss estimate of around 19% or '06 sub prime. Another thing is we've move commensurately and 8% to 13% were the numbers in relation to mid prime.
Your next question comes from Gary Ransom – Fox-Pitt
Gary Ransom – Fox-Pitt
I noticed you took a write off of some of the deferred tax assets. Could you talk a little bit about what strategies you might have either in the investment portfolio? I believe you still have a lot of tax exempt bonds there where there might be ways to speed the realization of some of those.
When you're looking at the realizability of the deferred tax asset, one needs to consider what type of taxable income one would have in the future to allow you to use those future tax deductions. In our case, the preferred tax asset is being driven largely by the extensive nature of mark to market unrealized losses that we've taken to date.
What we're looking at is the scheduling out of our revenues utilizing certain assumptions for expenses and scheduling out those losses and loss payments, losses for insurance policies and losses on credit derivatives that are on our balance sheet.
There are tax claiming strategies that could be considered. The most obvious one is what you mentioned. We do have a portfolio of tax exempt securities. We've brought that in a bit. We'll be looking to bring that in further to optimize the portfolio from a standpoint of tax planning and utilization of net operating losses into the future.
Since June 30 we brought the tax exempt portfolio down by about $2 million on the investment side.
Gary Ransom – Fox-Pitt
On the PLO's corporate spreads have moved a lot. I couldn't tell if there was any mark to market of any significance on the CLO's. Is that in fact the case?
I would characterize that as the case as compared to what's going on in the CDO of ABS portfolio. We do have mark to market in the CLO portfolio that is primarily lower due to the high grade nature of that portfolio and the lack of significant internal down grades that have been apparent in the CDO of ABS portfolio.
We do have mark to market portfolio for CLO's and it's a little bit shy of $20 billion. It's a smaller balance. It's a more highly rated balance. We have a slide that goes through that, of the ratings and the quality of those transactions. If you look on Page 50, you'll see our combination of CLO's and other transactions for par on the derivative side not all these are derivatives, but the derivatives side close to $30 billion.
Gary Ransom – Fox-Pitt
On the loss mitigation, you filed claims in some cases. I'm just trying to understand what the process has been. You've tried to work with them to come to some settlement and you just can't reach a settlement so then you have to file a claim? Is that basically the process that happened?
You basically kick off looking at loans, re-underwriting loans, individual loans and pointing out where those loans are deficient in relation to the representation warranties that were made pursuant to the description of what loans should have gone into that particular shell and that particular issue.
You say, well this loan is deficient, here's why. Please take the loan out and put in a loan that fits the criteria that were agreed upon or inject cash. What happens is, generally speaking that the issuer has 90 days to consider this, in fact should usually replace the loan or inject cash on the earlier of 90 days or being aware of the deficiency in the first place.
What you get into very slowly because of the 90 day point is a phase about is that representation warranty breached or not. We have to have a very strong view on some of these reps and warranties. At the end of that 90 day period, assuming that not sufficient loans have been taken out and cash put in, then you're into filing a claim and getting into court. That's what is beginning to happen.
We're not surprised by that. We have prior experience of these sorts of issues. In the estimates that we've made we've allowed a period of about three years to come to a satisfactory solution on these things. This is an extended event. It will take a time to come through but we do believe it will come through.
Gary Ransom – Fox-Pitt
Are your estimates for the recovery, is that a conservative estimate in the sense that you could conceivably recover much more than that?
We believe it's conservative. We cannot recover more than claims will pay so you can't make a profit on this. The upper bound is set, but as Cathy pointed out, when you've got transactions where we believe serious breaches in reps and warranties, so this is not small stuff, serious rep and warranty breaches of 70% to 80%. If you have a tranches deal, and some of these deals are tranched and we take the top tranche, it implies some terrific coverage to any projected gross claim that we might incur. But we can't take a profit above that which we projected on a gross basis.
Your next question comes from Steve Stelmach – SBR Capital.
Steve Stelmach – SBR Capital
Is it your expectation that TARP participation guaranteed program would somehow reverse out previous credit impairments, and if not you mentioned a business model beyond TARP. Could you describe how you would expect to execute that business model given the negative equity position?
I've described TARP, and I don't know all the details particularly until it's worked out, but you could broadly classify that as being direct or indirect. There are programs that are beginning to be put in place that will affect the mortgage markets directly, not strictly TARP but the FDIC for example is making all sorts of noises in relation to trying to keep people in homes.
What that would do and other similar measures in the private sectors, J.P. Morgan announced a pretty major series of steps last week, what that would do is tend to reduce the upward march of delinquencies, foreclosures and cumulative losses. So to the extent to which worst forecasts losses did not accrete to those levels that would be a very helpful fact to us.
Secondly, in relation more particularly to ourselves, and I should probably say the industry, as with the banks, there are all sorts of possibilities. One thing that is well known is the capital purchase program in relation to injection of preference share. I'm not saying that's what will happen, but there is a precedent for that in the banking sector.
There are other ideas under the insurance part of the act and some of those we talked a little bit about in the submission that we made in response to questions. So it makes sense to have some kind of excessive loss policy. It could some other form of reassurance or other structure. All these things are possible.
I think there are mortgage direct things and industry direct steps that can and will happen.
I would just mention one last piece of the program within the asset purchase program, there could be some benefits to our residential mortgage backed securities that we own, are all A securities in our GIT portfolio, and we set out some ideas that we had in the submission that David mentioned that we sent out at the end of last month.
It may not change the intrinsic view particularly if we were to take the credit risk for those underlying assets but what it would do is increase the values of those assets which would obviously help book value and potentially help some of the impairment values. That would be dependent upon the price and the level of participation there was in the program.
In relation to the second part of your question, you referenced our negative equity position. I think the core is evident from our figures that the asset position is fairly largely a function of mark to market as I tried to describe. I think if you look at the world today, and think about the stills we have in our core markets and municipal related markets, does the man from mars think there are more or less need for those skills today than there was six months ago or a year ago?
I think the answer is pretty evident that there's more need for those skills. So the question is, how can we position ourselves? Possibly through some form of restructuring activity like the Connie Lee initiative for example to take advantage of that and serve our fixed income and issue stakeholders. We believe we can do that and we're working extremely hard to do that.
Your last question comes from Douglas Makepeace – Sperry Fund Management.
Douglas Makepeace – Sperry Fund Management
The current environment makes the adjusted book value number even less calculatable than it was before but can you give us an update about that?
Adjusted book value numbers at the end of the quarter are slightly more than $7.50. I believe we also have a slide that shows the components that you might want to refer to. That's on Page 55. It shows the progression. At the end of the third quarter, $7.18 is the end of the quarter number and it shows the components for that.
One could also depending on your view could to the points that David mentioned, a significant depressing impact on these numbers is the extend of reductions that we've taken from mark to market on our credit derivative portfolio as well as the full mark to market that we've taken in our Alt A GIT portfolio. So depending on one's view, you can adjust the numbers for that as well.
There are no further questions at this time. I would like to turn the floor back over to Mr. Sean Leonard for closing comments.
There's just a couple of additional points that might be helpful. If you take adjusted book value and exclude those unrealized gains and losses that I had just mentioned, the numbers come out slightly less than $20 per share.
The other point in on Ambac Assurance corporation, the GAAP financial statements of the Assurance company on a consolidated basis, the equity at that level, on a GAAP basis is positive largely due to the guaranteed investment contract business being outside of that and the equity investments made by the parent company through the debt.
We appreciate everyone participating in the call. We are available to answer questions as they arise. Thank you very much.
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