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Executives

Sean Leonard – Senior Vice President and Chief Financial Officer

David Wallis – Chief Executive Officer

Gregory Raab – Chief Risk Officer

Analysts

Darin Arita – Deutsche Bank

Arun Kumar - J.P. Morgan

Alistair Lumsden – CQS

[Conrad Meyer] – UBS

Albert Feron – Private Investor

Scott Frost – HSBC

Tony Dalapenia – John Hancock

Patrick Dennis – DK Partners

Aline Van Duyn – Financial Times

Ambac Financial Group, Inc. (ABK) Q1 2009 Earnings Call May 11, 2009 11:00 AM ET

Operator

Greetings and welcome to the Ambac Financial Group, Inc. first quarter 2009 earnings conference call. (Operator Instructions). It is now my pleasure to introduce your host Sean Leonard, Senior Vice President and Chief Financial Officer. Thank you, Mr. Leonard. You may begin.

Sean Leonard

Good morning, everyone, and welcome Ambac's first quarter conference call. I'm Sean Leonard, Chief Financial Officer of Ambac. Presenting with me today are David Wallis, Chief Executive Officer, and Greg Raab, Ambac’s Chief Risk Officer.

Our earnings press release, quarterly operating supplement, and a slide presentation that follows along with this discussion are available on our website. I recommend that you view the slide presentation as we speak today. Also note that this call is being broadcast on the internet at www.ambac.com.

During this 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 in our most recent Form 10-K and subsequently filed Form 8Ks. You should review these materials for a complete discussion of these factors and other risks. Copies of these documents may be obtained from the SEC website.

I will now turn it over to David Wallis, who will comment on Ambac's strategic priorities.

David Wallis

Good morning, everyone. Ambac continues to focus all its energies on stabilizing the insured portfolio and proactively following strategies that will ultimately provide shareholder value. We have been pursuing these strategies within a credit environment that is as bad as one can remember, but perhaps also one that may now be beginning to show some tentative signs of reprieve. The primary shareholder value question remains a deceptively simple calculus of future claims as against future claims paying resource, but recall that the majority of claims are anticipated 20, 30, or more years into the future. It is between now and then that there is a major opportunity to manage the risk in the portfolio and execute upon other strategies which can also generate shareholder value.

Risk management remains the cornerstone of our proposition. As we announced on March 3rd, we have successfully recruited a new chief risk officer, Greg Raab, and he and we remain excited by the opportunities to manage our portfolio to the benefit of all our stakeholders. I’m not surprised by our ability to attract talent, and I believe we will have ample opportunity to proactively deploy it in a variety of areas in the coming years.

Another key objective is to lever off our existing assets and capabilities perhaps occasionally augmented to take advantage of the stressed credit markets that are breathing new opportunities as historical market practices and structures have been found inadequate. These needs and the consequent opportunities include those resolving around superior analytics, transparency, and the overall management and investment in risk.

A final major set of activities for Ambac involves the prospective launch of Everspan—our back to basics singularly focused municipal-only guarantor. We remain highly confident of the business proposition, and those that query this or Ambac’s almost unique opportunity to execute remain in a significant minority. However, the last few months have been frustrating in that we have been seeking outside capital to prove beyond reasonable doubt the notion of separateness from Everspan’s parent, Ambac Assurance, but has had to do this in the most capital constrained environment for a generation. Rest assured that we intend to pursue this initiative but will only do so on terms and pricing that are sensible in relation to the stakeholder value objectives that remain our guiding light.

A final feature of the quarter was Moody’s downgrade of Ambac Assurance to BA3 on April 13th. As we noted at that time, this is the 10th rating action since January 2008. This is not to say that familiarity breeds contempt, but is to say that any impact upon our markets, operations, or stakeholders is relatively minor.

I'll now hand it back to Sean.

Sean Leonard

For those viewing the slide deck, please turn to Slide 4. In my prepared remarks, I’ll provide an overview of quarter’s GAAP financial results and the primary factors driving them. I will also provide a summary of our statutory results and surplus levels and finally a brief overview of the company’s liquidity position, but before I get to the quarter results, I would like to address Ambac’s implementation of a new accounting standard for financial guarantee insurance contracts called FAS163. As you may recall, the Financial Accounting Standards Board initially took on the project a few years ago in an attempt to ensure that all financial guarantors account for losses consistently.

After deliberating, the FASB decided to greatly expand the project’s scope, ultimately delivering a standard that resulted in a substantially new accounting model for financial guarantee insurance contracts. The most significant changes relate to the recognition of premium revenues, recognition on the balance sheet of future installment premiums for existing contracts, which are typically structured finance exposures and recording of losses.

Due to these changes in accounting, 2008 and 2009 results are not comparable. Ambac implemented FAS 163 as of January 1, 2009. The effect of applying the provisions on that date was an increase to total assets of approximately $5.6 billion, primarily representing the present value of installment premiums receivable, an increase to total liabilities of approximately $6 billion, mostly relating to the recording of the unearned premiums related to these installment premium receivables, and changes to loss reserves, and approximately $381 million reduction in stockholders’ equity.

The single biggest component driving the reduction in the stockholders’ equity is the required use of a risk-free rate to discount loss reserves. We use the weighted average risk-free rate of 1.5% rather than 4.5% used previously based on the yield of our investment portfolio. As mentioned, the increases to assets and liabilities were primarily due to the impact of including amounts relating to installment transactions on the balance sheet. Under the new accounting standard, Ambac now reflects the present value of future installment premiums over the contractual term for all insurance policies except those with homogeneous assets, such as mortgage-backed security exposures as a receivable on our balance sheet with a corresponding adjustment to unearned premiums.

Related adjustments are also recorded in the financial statements for premium taxes and reinsurance. Over time, accounting for installment premiums will cause volatility in our premium earnings for two reasons. First, premium receivables denominated in foreign currency will be adjusted to US dollar at quarter end, and second, premium adjustments due to policy terminations and difference between actual and expected prepayments will be reflected as well.

Importantly with the implementation of FAS 163, we have changed the methodology of earning premiums from both upfront and installment premiums. Specifically, Ambac is required to recognize premium revenue for both upfront and installment paying policies by recognizing a fixed percentage of premium to the amount of exposure outstanding at each reporting date, referring to as the level yield approach, rather than recognizing premiums evenly over the term of each maturity for upfront paying policies.

For installment paying policies, FAS 163 also requires that the accretion of discount equating to the difference between the undiscounted installment premiums and the present value of installment premiums be recognized through the income statement. For loss reserve accounting, Ambac is required to recognize a loss reserve for the excess of (a) the present value of expected cash outflows to be paid under the insurance contract over (b) the unearned premium revenue for that contract. To the extent unearned premiums are greater than the expected loss, no loss reserve will be recorded. Additionally, the new standard requires that companies use the risk-free rate in discounting estimated future loss payments in the calculation of loss reserves. It’s important to note that accounting for investment securities and accounting for our credit default swap contracts did not change as a result of these new accounting standards.

Now turning to page 5, I’ll discus the financial results for the quarter. Net loss for the first quarter of 2009 was $392.2 million, or $2.36 per share. That compares to a net loss of $1,660.3 million or $11.69 per share in the first quarter of 2008. The first quarter 2009 loss was primarily driven by a net provision for loss and loss adjustment expenses amounting to approximately $740 million primarily related to alt-A affordability product RMBS transactions. Other than temporary impairment adjustments amounting to approximately $830 million taken on alt-A securities held in our investment portfolios and an increase of approximately $600 million to the valuation allowance on our deferred tax asset. These adjustments were partially offset by positive changes in the fair value of our CDO portfolio and increased accelerated earned premiums resulting from refundings.

Total net premiums earned for the first quarter 2009 amounted to $196.8 million, an increase of 5% from the first quarter of last year. Accelerated premiums, a component of total net premiums, amounted to $41 million during the quarter. Our net par outstanding at March 31, 2009, amounted to $413.3 billion, down 5% from the end of 2008 and down 19% from March 31, 2008. The structured finance portfolio is down about $35 billion or 21% from a year ago.

Investment income amounted to $97.5 million, down 19% from the first quarter of 2008. The decrease was driven by cash payments made for commutations and other losses since the first quarter of 2008. Also a decline in LIBOR rates combined with a repositioning of our investment portfolio to short term securities to provide enhanced flexibility contributed to the decline. Those negative factors were partially offset by proceeds received from the $1.3 billion capital raised in March 2008 and the issuance of $800 million of Ambac Assurance preferred in the fourth quarter of 2008 and the first quarter of 2009 as well as cash flows from premiums collected and net interest income from the investment portfolio.

During the first quarter, Ambac Assurance in the investment agreement business reported net security losses of $742.9 million, almost solely related to other than temporarily impairment writedowns for alt-A RMBS securities. Recall that Ambac Assurance purchased alt-A RMBS securities from the investment agreement business in the fourth quarter of 2008 and this quarter to provide that business with the appropriate levels of liquidity. Our detailed analysis indicates that certain of those securities experienced payment shortfalls and as such we were required to write those securities down to very severe market values. The current valuations are not indicative of the expected cash flows to be generated by these securities through maturity, but are reflective of a very high investment yields that will be recognized as future investment income.

During the first quarter, Ambac recorded net mark to market gains related to its credit derivative portfolio amounting to approximately $1546 million. Mark to market gains were primarily impacted by the larger discount effect of wider Ambac credit spreads in the calculation of fair value, partially offset by deteriorating price performance in the CDO portfolio and internal downgrades in that portfolio.

Total RMBS incurred losses for the quarter were $727.7 million of the total $740 million of losses incurred. These primarily related to deterioration in our alt-A affordability RMBS portfolio. During the quarter, we paid $267.5 million in RMBS claims, almost all related to second lien transactions. Greg Raab will provide greater detail about loss in our portfolio performance later on in this call.

During the quarter, the deferred tax asset valuation allowance increased to approximately $2.7 billion, an increase of about $600 million from December 31, 2008. For purposes of estimating future taxable income available to utilize net operating losses reported to date, during the quarter, Ambac revised its estimate of potential future increases in loss reserves to conservatively reflect the potential impact that further deterioration in Ambac’s insured portfolio would have on future taxable income. Additionally, due to the low interest rate environment currently encountered, management revised its estimate of future investment income generated by its investment portfolio. The revised estimates resulted in an increase in the valuable allowance.

To assist users of our financial statements in the analysis of our reported earnings, we also report our earnings on an operating and core basis. Please turn to slide 6 which summarizes these earnings measures. Both operating and core earnings measures are considered non-GAAP. Operating earnings exclude 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 exclude the net income impact of accelerated earned premiums and refundings.

Operating loss per share in the first quarter of 2009 amounted to $3.22 per share. In calculating the operating loss, we exclude the impact of unrealized gains from our credit derivatives portfolio, but do not exclude the impact of estimated credit impairment within that portfolio. However, for the second consecutive quarter, Ambac did not record any additional credit impairment. Core loss per share amounted to $3.31 per diluted share.

Now, I’d like to discuss the company’s liquidity both at our operating and holding companies. On slide 7, I’m going to discuss the components of liquidity at the holding company. Total holding company cash and short-term securities amounted to $178 million at March 31, 2009. That amount represents 1.57 times the holding company's annual debt service needs. As of March 31, 2009, all intercompany receivables from affiliates had been settled at the parent. Dividends in 2010 from Ambac Assurance will depend on 2009 statutory income and if positive may be limited to 10% of statutory surplus at the end of 2009.

On slide 8, we’ve laid out statutory capital as of the end of the quarter. Due to statutory operating losses recorded by Ambac Assurance in 2008, AAC will not be able to declare and pay dividends to the holding company in 2009 without first receiving approval from the Office of the Commissioner of Insurance of the state of Wisconsin or OCI. AAC did not seek approval or pay such dividends in the first quarter of 2009. AAC did receive approval from OCI to pay preferred stock dividends thus far in 2009 and has approval through June 30th.

AAC's statutory surplus at March 31, 2009, amounted to approximately $394 million. As mentioned in last quarter’s conference call, during the first quarter, Moody’s downgraded most of Ambac Assurance’s alt-A mortgage backed securities to below investment grade ratings. Under statutory accounting, we have required to carry these below investment grade rated investments at the lower of cost or fair value. Reductions to surplus in the first quarter for investment valuation adjustments amounted to approximately $1.3 billion.

Also note that Ambac Assurance’s contingency reserves amounted to approximately $2 billion at the end of the quarter.

Ambac Assurance’s claims paying resources at March 31, 2009, amounted to approximately $12 billion. Those resources are supported by Ambac’s fixed income investment portfolio. The portfolio had a market value of approximately $7.4 billion at quarter end at an amortized cost basis of $8.5 billion. Approximately 97% of the difference in market value and amortized cost in this portfolio relates to mortgage and asset-backed securities that were acquired from the investment agreement business mostly during the fourth quarter of 2008 and supported that business’s liquidity needs.

The remainder of the investment portfolio is made primarily of high-quality municipal bonds, US government obligations, and US agency obligations. Ambac assurance’s cash flow for the quarter has been impacted by the level of loss payments. For the balance of the year, we expect to receive principal and interest related to this high quality investment portfolio amounting to $395 million. You can see those numbers on slide 36. Additionally we expect to receive about $282 million of installment premiums over the remainder of 2009 and approximately $280 million in tax-free funds related to taxes paid in 2007 and 2006 during the second quarter of 2009. In summary, Ambac Assurance’s consolidation operating cash flow for the balance of the year is expected to be flat.

That concludes my prepared remarks on the financial results. Greg Raab will now talk through some detailed elements of the portfolio.

Greg Raab

Please turn to slide 10. Before I start discussing Ambac’s insured portfolio, I’d like to take a few minutes to elaborate on Ambac’s de-risking strategy. David has previously discussed the importance of risk management and reduction, and you have seen us make concrete progress against this extremely important initiative. As we look ahead, de-risking which is enterprise wide, will include, one, portfolio restructurings of our CDO exposure; two, a heightened focus on RMBS servicers to reduce losses through appropriate applications of loan modifications, REO disposition, and other loss mitigation actions; and three, a consolidation of collateral management activity to ensure that we’re working with the strongest asset managers and servicers.

Each of these activities will be supported by enhanced mortgage analytics and a new platform solely focused on distress workouts. We have an incredible amount of access to market data through our insured portfolio. This data will allow us to efficiently monitor the portfolio and evaluate the effectiveness of proposed solutions. All of our activities will be driven by a singular focus, which is to minimize the loss given default and to protect the capital base.

With that introduction, let’s move on to the RMBS and CDO of the ABS portfolio on slide 12. The housing market has continued to deteriorate in the first quarter of 2009. What started as a housing related recession has turned into a full blown economic recession with unemployment levels approaching those not seen since the early 1980s. While the government has introduced approximately $15 trillion in economic programs, we have not seen a stabilization of home prices. Early in the housing cycle, there was a great deal of focus on second liens. Aside from the greater leverage in these products, we discovered rampant non-adherence to loan underwriting standards and fraud.

In the last quarters, however, we have seen disturbing trends in the delinquency data for first lien mortgages. We have discussed this previously in the context of our alt-A portfolio. As of the end of the first quarter, we have approximately $2.5 billion in reserves against our RMBS portfolio. Almost half of these reserves, $1.2 billion, relates to our second lien portfolio, and we’re up slightly after adjusting for claims paid during the quarter. The remaining $1.3 billion is related to first lien product. Given these trends and the sharp increases in delinquencies against alt-A option ARM, neg-am, and interest only products, we’ve taken a fresh look at some of our classifications.

Turn to slide 13 briefly. As you can see from this slide, we have $24 billion of first lien collateral. Of this collateral, 82% relates to mid prime, sub prime, and affordability products. On slide 14 are the first lien collateral effects. Affordability product as most of you know was used primarily in parts of the country where home prices have seen the greatest increases such as California. Now that parts of California have seen home prices decline between 40% and 50% from their peak, we’re seeing dramatic increases in delinquencies. The mid prime bucket has been refined only to include alt-A product.

Alt-A continues to be a difficult category to define given its broad coverage between sub prime and prime. The main issue with these mortgages is that they were structured with credit enhancement levels closer to prime borrowers, but they have performed more like the sub-prime sector. During the first quarter, our analysis was driven by slowing voluntary repayment rates. Despite low mortgage rates for first lien borrowers, borrowers are finding it difficult to prepay and refinance due to a loss of equity and more stringent underwriting requirements. Over the next few quarters, we do expect to see some stability as a result of the plethora of government programs, but this expectation is not reflected in our analysis for this quarter.

During the quarter, we added $460 million in RMBS reserves, including $513 million and $164 million for neg-am and IO products respectively, and offset by lower second lien reserves which was mostly attributable to claims paid during the quarter. We paid $268 million RMBS claims in the quarter compared to $288 million in the fourth quarter of 2008. We will re-underwrite first lien mortgage pools with financially viable sponsors much like we’ve already done on our second lien deals.

As I mentioned earlier, we refined the second patient of our first lien affordability and mid prime portfolios. This change was necessitated by the unique credit characteristics of these collateral types. Our focus in analyzing these transactions is to start with late-stage delinquencies and assume liquidations in severities consistent with those of observed in these pools. For the current borrowers, we use a roll rate approach. The most important observation comes the timing of losses. In most cases, we are projecting a higher and more concentrated loss timeline than previously anticipated. Our analysis assumes that this front-end loss experience will persist for most of 2009. Beyond 2009, we’re anticipating that losses will abate over a period of about two years. This analysis is refined by product. In the case of neg-am collateral, we included an additional stress at the time of payment recess.

In summary, our analysis much like mortgage analytics across major mortgage market players is based on a combination of embedded losses and an expectation about the behavior of the mortgage borrowers who are still current. I can summarize our analysis by saying that on average our analysis assumes that slightly less than half of the remaining borrowers will default. This analysis supports our theory that deterioration due to fraud in investor-owned properties has largely worked through the system as the portfolio has seen.

In the prior quarter, we mentioned some deterioration in older vintage sub-prime collateral. The pre-2005 portfolio comprises approximately 15% of the net par outstanding and has been responsible for 1% of the aggregate claims to date and less than 8% of the total reserves.

Please turn to slide 15 for the second lien collateral effects. We’ve spoken about closed-end seconds—especially the piggyback seconds. These continue to represent the majority of our claims payments. The second lien trend that particularly concerns us relates to loss severity. In some cases, we’re seeing loss severities as high as 107%.

The HELOC deals are still bifurcated by origination channel. The broker-originated HELOCs have dramatically higher loss rates than the bank-originated deals. This quarter, however, we started to see the general stress of the economy affecting these borrowers. We will continue to monitor this portfolio closely. Ambac has not changed its loss reserving methodology as it relates to second liens. Our analysis is based on the assumption that home prices will not hit bottom until September 2010.

On slide 16, you will notice that to date we’ve recorded approximately $882 in remediation offsets with a 3-year expected recovery period. Adjustments to this value during the quarter were not significant. The remediation efforts have shifted from loan re-underwritings to aggressive putbacks of these loans to two counterparties. The litigation commenced during the fourth quarter continues to advance with the defendant’s motion to dismiss denied in the quarter. Let me remind of you of a startling statistic. The recoveries that are reflected in our results are based on the re-underwriting of only 8500 loans and 11 transactions. Of these loans, approximately 90% represent breaches of reps and warranties.

Please turn to slide 17. The quality of RMBS servicing is an area of concern. Servicers’ economic alignment of interest in these securities has deteriorated along with the recent deterioration in residential mortgage performance. If servicers do not perform the contractual obligations, this may result in servicing transfers and potential legal action. Another area of focus is the proposed government actions to protect home owners. Ambac is actively involved in these programs, but the potential impact of loan modifications and buyback on mortgage performance is currently unclear. Stabilization of the housing market will likely have a positive effect on our insured portfolio.

Turning to slide 19, the ABS CDO impairment for the quarter remains relatively unchanged. We have $3.7 billion in impairments against 24 transactions. Twenty-two of the twenty-four are now rated below investment grade, down from AAA at inception. The profile of these transactions remains unchanged. The majority of the near term stress is expected in some of the synthetic high-grade ABS CDOs as well as one of our mezzanine ABS CDO transaction.

Slide 20: We’re actively exploring portfolio solutions that eliminate our exposure, cut off leakage of cash flows to junior tranches or that otherwise repackage or exposure to reduce risk. There’s been a disappointing lack of progress in CDO de-risk solutions. This is a function of the transaction complexity, document ambiguity, and the number of direct and indirect parties in these transactions. We believe momentum is building now, and we are cautiously optimistic about our efforts currently underway.

For the remainder of the insured portfolio, please turn to slide 21. We have seen a keen appreciation for all the credit sectors, and we’re monitoring them closely. We’ve provided portfolio updates for our corporate CDOs, our auto-related exposures, and our student loan exposures in the slide deck and in the appendix. We have approximately $445 million in reserves against the remainder of our portfolio. The largest non-RMBS reserve relates to a closed block structured insurance transaction which is suffering from a poorly performing investment portfolio. This is largely invested in RMBS. This transaction did not incur any significant additional reserves in the quarter. We did, however, commence legal action against one of the closed blocks’ investment managers.

With that, I’d like to hand it back over to Sean.

Sean Leonard

At this point, we’d now like to open up the conference call to questions.

Question-and-Answer Session

Operator

(Operator Instructions). The first question comes from the line of Darin Arita from Deutsche Bank.

Darin Arita – Deutsche Bank

I was wondering if you could share some of your macro assumptions underlying your loss reserve estimates. I think Greg you shared that you don’t expect to see home prices to stop declining until September 2010. I was wondering if you could share how much do you think they’ll decline from peak to trough? What’s your unemployment rate expectations and any other assumptions that you have?

Gregory Raab

No specific assumptions by group other than to say we do expect the housing prices to decline. The one encouraging note that I think sort of gives us some reason to believe that we may be bottoming out soon is that the 30-day bucket and the 60-day bucket in all these pools to be leveling out. The percentage decline is pretty much flat, and the dollar amount going from current into these buckets definitely seems to be declining, so the default rates seem to be slowing. There is still quite a bit in the late-stage delinquencies, but we took pretty big haircuts on those loans.

Darin Arita – Deutsche Bank

With respect to the remediation efforts, you mentioned 11 transactions and the 8500 loans underlying those. Can you remind us what sort of transactions those are?

Gregory Raab

Predominantly second liens, and we’re going to do the same on the first liens, Darin. It’s pretty startling the number of breaches in reps and warranties, so we’ll continue to do re-underwriting, particularly on the pools that we expect the highest losses on .

Sean Leonard

Greg’s right. It’s HELOCs and closed-end seconds particularly through the more financially viable sponsors obviously, but we have targeted an additional 6 deals in the second lien space and nine of the Alt-A mid-prime/affordability which is about $5.2, so that’s the next phase if you will as well as all the other litigation that we’re working on relating to the first batch if you will.

Darin Arita – Deutsche Bank

Of the $882 million of recoveries that you’ve had so far, how much has actually been realized?

Sean Leonard

Very small amounts have actually been realized. Our assumption is that this will take a while, and built into these assumptions is slightly less than a 3-year timeframe to bring these aground. Greg mentioned in his comments that one of the motions to dismiss by defendant in one of the actions transacted in the quarter, so we have more of a holistic approach rather than a loan by loan type approach. Even though there has been some of that, it’s been on a very small scale.

Operator

Your next question comes from the line of Arun Kumar - J.P. Morgan.

Arun Kumar - J.P. Morgan

Out of the $280 million tax refund coming in the second quarter, I wanted to check if that amount goes to the holding company and then it gets passed down or do you retain it at the holding company, could you just walk us through that? The second question is related to slide 33, where you have the affiliate support information and you have $2.9 billion of assets purchased and then the unsecured the secured amounts of $1 billion. Can you tell us what’s the carrying value of those assets are on the statutory balance sheet, the admitted assets and what haircuts have you taken to those numbers?

Sean Leonard

The first question is very simple. Tax refund is received by the holding company and then passed down to the operating company through an intercompany tax sharing agreement. Slide 33, the purchases of assets by Ambac Assurance’s statutory value, that’s created an issue in the first quarter relating to the downgrades of most of those securities—the Alt-A RMBS securities, it was part of that $2.9 billion. The carrying value we wrote down about as I mentioned in my script around $1.3 billion worth of value there. The unsecured lending from AAC, we’re carrying net at 70% of the value, so we’re carrying that at $800 minus a reserve of 30% of $240, so we’re carrying net approximately of $560. The secured lending is carried at its value, because it’s covered market value of assets.

Arun Kumar - J.P. Morgan

Just to follow up, the $2.9 billion, is that after the $1.3 billion adjustment or is that pre-$1.3 billion?

Sean Leonard

That’s the pre the adjustment, so those were the gross volume of purchases, so that’s cash that went out and then when we brought those on at the end of the year and through the first quarter, there’s been multiple downgrades in the portfolio, there are some impairments, and we then wrote those securities down by $1.3 billion.

Operator

Your next question comes from the line of Albert [Feron] – Private Investor.

Albert Feron – Private Investor

Any more comments regarding or what I read about Everspan and raising capital to launch that during the third quarter?

David Wallis

I couldn’t quite hear your question, but I think it was regarding Everspan, and where are we and so on and so forth, so let me try and take that. Following discussions with the rating agencies, it became clear rightly or wrongly that the additional separateness was required, i.e., all the measures that are currently in place in terms of separate government, separate board, separate staff and so on and so forth weren’t sufficient necessarily for the rating level that we desire to generate the rating that we need to get into business, and therefore we require external capital in order to fully augment and demonstrate separateness. So obviously over the last couple of months or so, we’ve been out there busily engaged and explaining the business proposition to would-be investors into Everspan. As we all know and as I commented upon, this isn’t an easy environment to raise capital. It’s an extremely difficult environment to raise capital. That said, we’re still right now in discussions with a number of counterparties who I think are very interested in the proposition. The question is are the return levels on a risk-adjusted basis satisfactory to those entities and equally satisfactory to ourselves. Clearly, we will not be taking forward the proposition if in effect we have to give away the store. That’s not to say that will be the case, but we’re continuing to at the opportunity and we remain positive that it’s a good one on the right terms.

Operator

Your next question comes from the line of Alistair Lumsden – CQS.

Alistair Lumsden – CQS

I remember in other quarter you used to give an idea about what marks you have taken against the HELOC position. If we were to look at that as a percentage of total exposure that you have, what sort of level would you be providing right now?

Sean Leonard

I think the question was what type of marks do we have against our HELOC portfolio. Actually our HELOC portfolio, we own very little investments that are backed by second liens, so that’s really not an issue in our investment portfolio. It’s largely not an issue in our credit default swap contracts. Those two areas are where we mark to market under US GAAP. Our exposures that we’ve been talking about and Greg Raab mentioned are under insurance policies where we have guaranteed RMBS securities that are backed by second lien collateral, so we’re not marking that portfolio to market. What we’re doing is estimating what we think future claim payments would be and discounting those back to present value. So what we do is a ground up approach that looks at all the problematic transactions, looks at the collateral performance, projects out the collateral performance, run that through the deal structure to calculate what is the potential for claim payments we have and that’s what shows up on our balance sheet as loss reserves, and changes to payments run through our income statements as losses incurred for loss and loss adjustment expenses. It’s not a mark to market portfolio.

Alistair Lumsden – CQS

I understand that, but if you express your provisioning as a percentage of total notional, what percentage are you expecting to actually have written down?

Sean Leonard

I don’t have that information right at my fingertips, but let me see.

David Wallis

Unfortunately we haven’t gotten that precisely. If we find it during the course of the questions, we will come back to you and declare that.

Alistair Lumsden – CQS

In terms of the drop in the surplus this quarter, I’m guessing if you have another quarter like this, you’re actually below the required minimum, what sort of action are you taking to avoid that?

Sean Leonard

I’m going to answer your question because I found the data. On page 19 of our operating supplement, it has three tables on it. The table at the bottom of the page shows net par outstanding by broad classification, and then it shows total impairment losses. If you were to look at that for our second lien exposures, we have $1.17 billion of total impairment reserves against a net par outstanding of $8.8 billion, and there’s a variety of other classifications that we show on that page.

The required minimum, what we potentially do, we could potentially petition Wisconsin OCI for what’s considered to be a redundant reserve in our contingency reserves relating to expired municipal policies. That is a pretty sizeable number, probably in the neighborhood of approximately $700 million, so that would be one item. The statutory, the NAIC, which is the National Association of Insurance Commissioners, is looking at this latest GAAP guidance as it relates to valuation of securities in active markets that you may have out in the press, that’s something that we’re also required to look at and adopt in the second quarter. We have not adopted that accounting standard in the first quarter, so we’ll look at that. The statutory rule makers are also looking at that as well. The writedown that I mentioned of approximately $1.3 billion was related to these Alt-A securities that some indications would lead you believe that the values are perhaps low that we’re getting from the pricing service, but we are looking into that, and we’ll have more to report on that in the second quarter.

Operator

Your next question comes from the line of [Conrad Meyer] – UBS.

[Conrad Meyer] – UBS

On page 46 of your slide presentation, you reflect the claims paying projections, at about 3 years out, you seem to project a very serious RMBS related recovery of perhaps $500 million. Could you explain what that number is?

David Wallis

It’s doing remediation again in relation to the mortgage loss that we’ve been talking about.

Sean Leonard

What we’ve done is we’re re-underwritten pools. We anticipate due to the high level of breaches of reps and warranties in those pools and our legal actions and pursing the sponsors of these trusts that we’ll be collecting some recoveries relating to those problematic assets, and that’s what that is. We made a broad assumption of a lump sum in a little bit less than 3 years’ time, so what you see there are payments less the recovery. The recovery is quite large, so that’s why you see it negative.

[Conrad Meyer] – UBS

What’s the relative confidence level of the remediation recovery though?

Sean Leonard

It’s good.

David Wallis

We think we’ve done a great deal of work. It’s pretty extraordinary when on a decent size sample, 8500 loans that were re-underwritten, that’s a real detailed process underwriting each loan, when you get something like 80% or more of those loans breaking at least a couple of major representations, then it tells you that something bad is going on. We’ve taken care to consider these gains only against creditworthy counterparties, and we’ll be pursuing these and are pursuing these very actively. So these are contractual claims, and we think we got good evidence for them, and we expect to collect.

Sean Leonard

The last point I would make is certain financial sponsors have disclosed in their own financial statements that they’ve established liabilities for just these types of things.

Operator

The next question comes from the line of Patrick Dennis with DKA Partners.

Patrick Dennis – DK Partners

One quick followup on the conversation of breaches of reps and warranties. Has Ambac actually recovered any claims on these breaches to date?

Gregory Raab

It’s relatively small.

David Wallis

Having said that, obviously the strategy here is a bigger more all encompassing one than a loan by loan flog. If that’s what we end up doing, then that’s fine, but clearly what we are aiming to do is to demonstrate a major level of almost systemic breach, contractual breach of reps and warranties and taking that through the appropriate overall process, and that’s what we will be doing.

Patrick Dennis – DK Partners

One quick question on the statutory capital. You mentioned that there’s an additional $2 billion in contingency reserve. Is that correct? Did I hear that correctly?

Sean Leonard

Yes, that’s correct.

Patrick Dennis – DK Partners

So the way we should be looking at that is there’s $394 million in surplus and an additional $2 billion in contingency reserve.

Sean Leonard

Yes, the way to look at that is under the statutory rules, under certain situations, you can petition the regulators to release that reserve. The reserve is a formulaic reserve that’s established over long periods of time, and it’s there to provide some level of conservatism, but when it relates to policies in which you already are booking losses or for policies that no longer exist, then there is a mechanism to petition and request relief from that kind of conservative accounting, so I wouldn’t look at it as the entire amount, I would look at it as a subset that relates to the expired policies or the piece that we can potentially petition our regulators to release.

Operator

The next question comes from the line of Scott Frost of HSBC.

Scott Frost – HSBC

On slide 8 you are saying that you got BIG investments not impaired in addition to the net loss. The net loss includes realized losses, and then you have other below investment grade investments you haven’t impaired. Am I double counting there??

Sean Leonard

That’s right. The number I quoted, the $1.3 billion, $992 relates to Moody’s downgraded securities, below investment grade.

Scott Frost – HSBC

Those were mortgage backed and asset backed, because that’s what you’re showing because the difference between on slide 24, is that the MBS impairment or whatever it is. Is that how to read that?

Sean Leonard

Yes, it is. Just to finish the point, the $1.3 billion, $992 relates downgraded securities, but that we don’t consider to be impaired based upon our detailed cash flow modeling. The balance to get you up to the $1.3 billion is considered, so that ran through the net loss line.

Scott Frost – HSBC

So some ran through, some did not?

Sean Leonard

That’s correct.

Operator

The next question comes from the line of Tony Dalapenia with John Hancock.

Tony Dalapenia – John Hancock

I have a similar question, and I’m trying to tie that into page 40. I guess on page 40 when you talk about your whole investment portfolio, on the front it says that it’s amortized cost, so I assume that’s a GAAP number or stat number you’re referring to on page 40?

Sean Leonard

That would be GAAP.

Tony Dalapenia – John Hancock

Those below investment grades there on page 40 where you say 17%, can you describe what some of things are, and I guess the issue is for stat purposes, how much of that 17% has been impaired if anything?

Sean Leonard

I believe most of the below investment grade securities relate to the Alt-A portfolio that we brought over, so that would be the lion’s share of that number. Most of the slides in the back relating to the investment portfolio are GAAP slides, so what we do when we impair securities, we write down the amortized cost. We reset the cost value if you will, so we squeeze some of the unrealized loss out and ran that through the income statement. As it relates to the statutory numbers, I think of the downgrade, out of the securities that we purchased over approximately $2.9 billion, $2.3 billion of the Alt-A portfolio is owned by Ambac Assurance, so $2.3 of the securities were All-A securities of which $2 billion is below an estimate grade, so 2 out of the 2.3, and the securities that are below investment grade, we took the mark down to fair value through our surplus section, so we took the lion’s share of that portfolio. We’ve already taken the hit for it if you will.

Tony Dalapenia – John Hancock

Once again I know you said it. How much of you taken hit to that through the stat numbers?

Sean Leonard

2 of the 2.3 that we purchased.

Tony Dalapenia – John Hancock

That have gone through the stat numbers?

Sean Leonard

That’s right. I just described to the previous questioner, a piece of it goes as a direct adjustment to surplus, and for those that we consider to be impaired, those that we do not think will collect all cash flow, principal, or interest, those would run through the income statement, but either way, that entire number below investment grade would be picked up as an adjustment to the surplus accounts.

Tony Dalapenia – John Hancock

So of your total Alt-A, $2 billion below investment grade and you have $2.3, I think you said, in total or that was just of the purchase, what’s the current mark on that stuff that has gone through the stat books?

Sean Leonard

I don’t have that specific split, but generally the portfolio between the entire portfolio of Alt-A securities, so we are talking about 65 positions and about $2.9 billion of par, I think the average price that we have is about $0.26.

Operator

The last question comes from the line of Aline Van Duyn – Financial Times.

Aline Van Duyn – Financial Times

I wanted to ask in light of the court filing against J.P. Morgan Investment Management related to the quality of the mortgage-backed securities and the information that they gave to you around that, I wondered if these types of legal actions, what your expectations are on those and whether you are considering similar actions in the CDO area. There seemed to be more and more of these cases emerging in this sector, and I just wondered if you could give some context as to how important this issue is for you.

David Wallis

Obviously it’s a very important issue. I don’t want to get into the individual cases for all the obvious reasons. Let’s be clear though that we believe we are not in the practice of bring forward frivolous cases. We are unusual as a security holder in once sense because we have the economies of scale in relation to the hold that we have of each security. We take down big units of risk. We also here and obviously through various folks that we know in the legal fraternity have a real expertise in terms of mining the documents and getting all sorts of forensic review of legal or other notion to really understand with the benefit of hindsight how certain transactions were put together, and frankly look at them aggressively where we think that people have acted inappropriately, so in terms of remediation and its importance to us, it’s highly important. We are highly incented to be diligent and aggressive as necessary, and yes, it’ll be surprising to me if you didn’t see more of these sorts of cases both potentially from ourselves and others. I think it’s evident to all that there was awful lot of bad behavior. We are a repository of that risk, and we are fighting and will fight very hard on behalf of our stakeholders to do the right thing.

Aline Van Duyn – Financial Times

That’s in the mortgage backed securities and also could apply in the CDO area?

David Wallis

It could apply in every area in our portfolio. In fact, it does apply in every area in our portfolio.

Operator

There are no further questions at this time. I’d now like to turn the floor back over to management for closing comments.

Sean Leonard

Thank you for everyone’s attention and good quality questions on today’s call. Thanks for attending, and we are available to answer any additional questions, so please call us here.

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Source: Ambac Financial Group, Inc. Q1 2009 Earnings Call Transcript
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