Sean Leonard – Senior Vice President and Chief Financial Officer
David Wallis – Chief Executive Officer
Arun Kumar - J.P. Morgan
Darin Arita – Deutsche Bank
Donna Halverstadt – Goldman Sachs
Ambac Financial Group, Inc. (ABK) Q2 2009 Earnings Call August 7, 2009 11:00 AM ET
Welcome to the Ambac Financial Group, Inc. second 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 for Ambac Financial Group, Inc.
Welcome to Ambac's second quarter conference call. I'm Sean Leonard, Chief Financial Officer of Ambac. Presenting with me today is David Wallis, Chief Executive Officer. [inaudible], Ambac’s Deputy Chief Risk Officer, is also with me and will be available to answer questions later on when I open the call up to questions and answers.
Our earnings press release and a quarterly operating supplement are available on our website. Please note that we have not prepared a slide presentation, but we have prepared and put some of the key information that was in prior slide presentations in our operating supplement.
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. 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 for the fiscal year ended December 31, 2008, and also disclosed from time to time by Ambac in its subsequent reports on Form 10-Q and Form 8-K. 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.
As Sean will summarize, the quarter’s results are very disappointing as continued core performance of the RMBS related portfolio and rising forward interest rates that escalated projections of future claims. In the face of this continued degradation, we have refined the focus of our activities in order to heighten our concentration on risk management and holding company liquidity issues. Let me briefly comment.
On June 19th, we announcement the postponement of our efforts to launch Everspan—our intended public finance only financial guarantor. This decision was taken after an extensive but ultimately unsuccessful effort to raise external capital in order to satisfy rating agency requirements. Given the Everspan decision, together with the recent rating agency downgrades clearly resultant from the pre-release of this quarter’s results, we have no ability to write insurance business. It is therefore abundantly clear that our focus has to be management of our balance sheet with an intensifying emphasis upon risk management activities.
Given the holding company’s liquidity position, we’re seeking any and all possible alternatives to resolve the situation. Along these lines, per the announcement of last week, we have elected to discontinue payments of interest on Ambac Financial Group’s subordinated debt securities. We’ve also discontinued payment of monthly dividends on Ambac Assurance’s auction market preferred shares.
In relation to our key risk management objectives, we have recently expanded our capabilities in two related areas, these being mortgage servicing and risk analytics. Given the acute pressure that mortgages services are under, never having been properly equipped to handle currency stresses, we have grown a specialist group to focus upon our own interests in this important area. This group will seek to enforce rights, monitor the fulfillment of agreed servicing protocols, and seek to enhance the efficiency and overall economics of the servicing function with respect to RMBS transactions.
Given the difficulties experienced in predicting and analyzing the performance of many insured transactions throughout the freefalling housing market, we have acquired a new group—NSM Capital Management to assist us in this process. Once fully assimilated, this group will be an important fulcrum around which we will be able to better predict, manage, and mitigate the risks that we face.
These mortgage servicing and analytics related groups together with existing expertise and resource will progressive constitute a center of excellence in an overall platform of risk management activity.
Finally, a brief note on CDO of ABS commutation activity, where we have reduced our exposure by approximately $2.8 billion at a cost of around $750 million. From a purely internal perspective, commutations and settlements represent a difficult balance between large cash outlay and risk reduction. Although we are satisfied that the balance of these elements has been satisfactory thus far, it will likely become increasingly difficult to make further progress as we weigh the prevent value of these two elements as against any available alternatives and our general liquidity requirements.
With that, let me turn it back to Sean.
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 brief overview of our statutory results and surplus levels and finally a brief overview of the company’s liquidity position, but one reminder though before we get to the quarter results. As of January 1, 2009, Ambac’s implemented the new accounting standard for financial guarantee insurance contracts called FAS163. The most significant changes related to the implementation of FAS163 are the recognition of premium revenue, recognition on the balance sheet of future installment premiums, and reporting of losses. Due to the changes in accounting for these items 2008 and 2009 results are not comparable.
Now, I’ll discus the financial results for the quarter. Net loss for the second quarter of 2009 was $2,386.6 million, or a loss of $8.33 per share. That compares to a net income of $823.1 million or net income of $2.80 per diluted share in the second quarter of 2008. The second quarter 2009 loss was primarily driven by three factors—first our net provision for loss and loss adjustment expenses amounting to $1230.8 million; second, other than temporary impairment losses on securities in our financial guarantee and financial services investment portfolios amounting to $862.1 million on a combined basis; and third, additional valuation reserves on our deferred tax assets. I will discuss each of those items during my prepared remarks, but it should be clear that once again our financial results were highly impacted by our exposure to deteriorating mortgage related exposures and securities.
Total net premiums earned in the second quarter 2009 amounted to $177.7 million, a decrease of 45% from the second quarter of last year. The majority of the decrease was due to lower accelerated premiums, which are a component of total net premiums. Accelerated premiums for the second quarter of 2009 amounted to $33.8 million during the quarter, down significantly from $159.2 million in the comparable prior quarter.
In 2008, a lack of liquidity in the auction rate and variable rate bond markets had resulted in significant refinancing activity in the municipal sector, especially in the healthcare segment.
Investment income amounted to $120.4 million, down 5% from the second quarter of 2008. The decrease was driven by cash payments made for commutations and other losses since the second quarter of 2008. Those negative factors were partially offset by the $800 million of Ambac Assurance preferred stock issuance 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 second quarter, Ambac Assurance and the investment agreement business reported other than temporary net security losses of $675 million and $187 million respectively. During the quarter, we decided to designate certain securities for sale with an objective of repositioning the portfolio.
We are seeking to achieve two main objectives with the repositioning. First is to move a greater percentage of our portfolio into taxable securities and the second is to seek better relative value opportunities within our Alt A investment portfolio.
During the second quarter, Ambac recorded net mark to market gains related to its credit derivative portfolio amounting to approximately $1 million. A number of offsetting market factors were observed during the quarter. Positively impacting the mark was improved pricing within the CLO portfolio and CDO of ABS portfolio amortization during the period. Negatively impacting the mark was internal downgrades within the CDO of ABS portfolio and overall movements in Ambac Assurance credit spreads during the quarter.
Total RMBS incurred losses for the quarter were $1123.5 million, primarily related to deterioration in second lien and alt-A. During the quarter, Ambac paid $340 million in RMBS claims, most of which related to second lien transactions. Second lien RMBS incurred losses of approximately $453 million were largely driven by a combination of stubbornly high default rates and loss severities. Incurred losses in our first lien exposures were approximately $670 million, largely driven by servicers more aggressively liquidating backlogs of non-performing loans. Loss severities continue to be elevated. In the second lien asset class, severities are often significantly higher than 100% while those in the first lien asset class have often breached 70%. The vast majority of incurred losses resulted from transactions which were previously reserved.
During the quarter, Ambac also incurred losses amounting of approximately $107 million related to non-RMBS transactions and were concentrated in two transactions—one was a previously reserved structured insurance transaction which experienced increased stress and higher modeled losses and second was a transportation transaction that was also previously reserved.
Ambac increased its estimate of remediation recoveries on RMBS transactions due to breaches of recs and warranties by about $280 million during the second quarter. Our total RMBS reserves are net of approximately $1.2 billion of estimated remediation recoveries at June 30th. The increase in the estimate of remediation recoveries is the result of additional breaches discovered during the quarter. We applied methodologies consistent with those applied in previous quarters.
While we’re actively investigating other exposures with similarly suspicious profiles, the increase this quarter is solely a result of additional breathes discovered and exposures where we had taken recoveries in previous quarters. As of the end of the quarter, we had over 4000 additional loans re-underwritten compared to year end 2008 for a total of just under 13,000 re-underwritten loans. Our hit rate of loans with apparent breaches continues to exceed 90%.
During this quarter and as with past few quarters, Ambac has not taken any tax benefit related to the pre-tax operating loss because any deferred tax asset that is generated as a result of the loss has attracted a valuation allowance. Additionally, during the second quarter, as a result of continued deterioration in the company’s insured RMBS transactions and our resultant inability to reliably project future taxable income, Ambac reported a $573.9 million valuation allowance against the unreserved deferred tax asset from the prior quarter. Ambac currently has only about $100 million of deferred tax asset related to unrealized investment security losses remaining on our balance sheet.
Now, I’d like to provide a brief overview of our statutory accounting results. As most of you now, the statutory basis of accounting for certain financial statement line items can be quite different from the generally accepted accounting principles or GAAP basis. For the purposes of this call, I will limit the discussion to loss and loss expense reserves and impairment losses on credit derivatives.
Statutory loss and loss expenses incurred amounted to $751 million during the second quarter. Obviously, that amount differs from GAAP losses that I discussed earlier. The reason for the difference is that stat accounting permits recording of loss reserves only for transactions that have defaulted, while GAAP requires that we estimate loss reserves for troubled transactions that have defaulted and those that have not yet defaulted.
Statutory impairment losses on credit derivatives amounted to $1,568.7 million in the second quarter. This represents the amount we expect to pay out over time for our CDO of ABS transactions including the expected payments of both interest and ultimate principal. The increased impairment during the quarter was driven by rising forward LIBOR rates which increases estimated future cash outflows for interest payments and further deterioration of the underlying collateral of the CDOs of ABS transactions. Statutory accounting allows us to discount our estimates of future payments of losses and impairments using the investment portfolio yield at the end of the prior fiscal year end. Ambac uses a discount rate of 4.5% for statutory accounting purposes.
At June 30, 2009, Ambac Assurance’s statutory capital and surplus amounted to $305.6 million, and statutory contingency reserves amounted to $173.6 million. Ambac Assurance has petitioned the Wisconsin Office of the Commissioner of Insurance or the OCI to release a significant portion of the contingency reserves as of June 30, 2009. Ambac received permission to release approximately $1.8 billion, and the aforementioned balances reflect such release. As a result, Ambac Assurance’s statutory capital and surplus at June 30, 2009, has not breached the minimum surplus requirements of any state in which we are licensed to write business.
Now, I’d like to discuss the company’s liquidity both at our holding company and operating company. Starting with the holding company, total cash and short-term securities amounted to approximately $164 million at June 30, 2009. That amounts to approximately 1.8 times the holding company's annual debt service needs of approximately $89 million. Due to statutory operating losses recorded by Ambac Assurance in 2008, Ambac Assurance will not be able to declare and pay dividends to the holding company in 2009 without first receiving approval from OCI. Dividends from the operating company to the holding company in 2010 will depend on Ambac Assurance’s ability to generate statutory income in 2009. Based on our 6-month result to date, it is unlikely we will generate statutory net income in 2009, thereby negating any 2010 ordinary dividend capacity.
As David mentioned earlier, we recently announced that in order to preserve cash at the holding company, we have elected to discontinue paying the semi-annual interest on Ambac’s directly issued subordinated capital securities or DISCs beginning August 1, 2009. Deferment of interest payments on these subordinated securities is permitted for a period of 10 years.
With regard to operating company liquidity, Ambac Assurance’s claims paying resources at June 30, 2009, amounted to $11.9 billion, or approximately $11.2 billion adjusted for the CDO settlement and commutation that occurred in July. Those resources are primarily supported by Ambac Assurance’s fixed income investment portfolio.
Total financial guarantee investments not including VIEs had a fair value of approximately $7.5 billion at quarter end at an amortized cost basis of approximately $7.8 billion. Ambac Assurance’s cash flow has been significantly impacted by the level and timing of loss payments in the quarter, and we expect approximately $1.3 billion of loss payments on our RMBS and CDO exposures over the remainder of the year, and as previously mentioned cash payments totaling $750 million related to the two CDO of ABS transactions that settled or commuted in July will have a further negative impact. Offsetting those outflows for balance of 2009, we expect to receive principal and interest related to the high quality investment portfolio amounting to approximately $339 million. Additionally, we expect to receive about $200 million of installment premiums over the remainder of 2009 and approximately $275 million in tax refunds expected to be collected in the third quarter related to taxes paid in 2007 and 2006.
In order to preserve cash and surplus at Ambac Assurance, we recently announced that we will discontinue paying the monthly dividend on Ambac Assurance’s outstanding auction market preferred shares beginning August 1, 2009.
That concludes my prepared remarks on the financial results. Now, I’d like to turn it over to the operator to start the question and answer session.
(Operator Instructions). Your first question comes from the line of Arun Kumar - J.P. Morgan.
Arun Kumar - J.P. Morgan
The theme among several of your peers in the industry has been recoveries, commutations, and so on. While you have been able to commute a fair amount of the CDOs that you’re wrapped, I wondered if you could give us any progress on the recovery efforts going forward. I know that has been an area of emphasis over the past several quarters, if you will. If you could just tell us where you stand in terms of recoveries, dialogue with the institutions that put those structures together, and also if you could give a little bit of color on expectations for future commutations. I know you said it’s going to be fairly difficult, but given the financial condition of the firm, I would think that it’s probably not going to be all that difficult to get commutations down the road, at probably even better terms than what you have achieved so far.
Obviously, we intend across all aspects of our business to actively pursue in our eyes wrongdoings, so we have obviously launched litigation with respect to certain of our exposures, and if we think that bad things are being done, we will continue to do that, but I don’t want to go into those sorts of comments any further than that. Let’s say that we continue to enforce our rights. With respect to commutation discussions, as I briefly indicated at the end of my script, it’s a balance. Yes, it’s risk reduction, but also obviously it’s large cash out the door, and whilst we still have considerable claims paying resource, you have to balance the risk reduction as against the cash out the door and the alternative uses for that cash. What we’ve done is we know what we’re happy with. We’ve analyzed it carefully. To take your point, in terms of being cognizant of others’ views of ourselves as perhaps encapsulated in our CDO spread, but we’re certainly not in a position and are not willing to just commute. I think it’s obvious to all that we can’t commute our way out of this, so to speak, so we need to be very selective and very disciplined in any conversations that we have, and I think candidly we’ll find commutations increasingly difficult as we have alternative uses for that cash.
Arun Kumar - J.P. Morgan
The question to follow up would be given the amount of statutory capital that you have based on the regulatory approval that is granted to you, if you continue to have losses in your CDO portfolio, RMBS, or elsewhere, the amount of capital that you have would be depleted even further. Wouldn’t that strengthen your hand in commutations and get something substantially better than the $0.26 that you commuted the transactions in the past month or so for?
Perhaps you’d like to offer your role as a consultant? That’s possible, and if it does that, that’s great, but we’ll see.
Your next question comes from the line of Darin Arita – Deutsche Bank.
Darin Arita – Deutsche Bank
With respect to $1.6 billion in impairments in credit derivatives in the quarter, can you give a breakdown of the contribution from the LIBOR rate movement versus the deterioration of the underlying collateral?
The contributions would be about 55% coming from the forward LIBOR curve shifts and the balance coming from portfolio deterioration.
Darin Arita – Deutsche Bank
With respect to your loss reserves, you changed the discount rate that you are using to the risk-free rate. Can you give some sensitivity on how the loss reserves would change with maybe with 50 or 100 basis point change in the risk-free rate?
I’m assuming you’re talking about the GAAP. Clearly, on our statutory numbers, we’re still using as I mentioned the portfolio the 4.5% rate. I don’t have an answer for the sensitivity. I’d have to get back to you on that. I don’t have that information at my fingertips.
Darin Arita – Deutsche Bank
In terms of the holding company liquidity without being able to declare an ordinary dividend in 2010, what are the other plans that you have to improve the holding company liquidity?
Obviously as we mentioned, Darin, we’ve cut coupon and preference share payments, and we’ll explore any alternatives that may or may not be available. As you pointed out, the traditional, if you will, means of servicing debt at the insurance or holding company has been dividends from the operating company which will depend upon improved performance in terms of RMBS related matters.
Your next question comes from the line of Donna Halverstadt – Goldman Sachs.
Donna Halverstadt – Goldman Sachs
I think the answer to my question is going to be no, but given that unless you live 24 x 7 with stat accounting, I don’t think you really know all the ins and outs, so I’m going to ask it anyways. Now that you’ve released the contingency reserve or the bulk of it, are there any other statutory maneuvers you can use in the future to materially bolster surplus?
It would be very unhealthy to live with statutory accounting 24 x 7. That’s a general comment, but what we can do is there are some sensitivities to surplus levels, and the obvious ones are loss development which we’ve brought the levels down quite a bit, but we are talking to our reinsurers. We can commute contracts, but we would only do so not with a view towards statutory accounting results, but a view towards proper economics. The pay-down of the inter-company loans, since the unsecured piece of the loans we have a 30% reserve on, there are sensitivities there as those loans get paid down. There will be some benefit to increased values on the Alt A securities and just general accretion because we’ve written those securities down to a level to a market yield type of level, so we’ll get a boost from that, and then there’s the whole realm of permitted practices which are something that could be discussed, but that would be the last thing in the line of things we would do, and then just any commutations if we have any of those that are successful that would reduce our levels of impairment.
Donna Halverstadt – Goldman Sachs
The other thing I wanted to ask is I know in the past you all have said that even if you breach the $2 million Wisconsin minimum that the regulator has discretion as to what he does. Can you give us some color on the limits of his discretion or what sort of pathway we should expect in that event?
I don’t think they have pretty broad discretion, so the limits I don’t believe would be significant. I think it’s at their discretion based upon the facts and circumstances as they see it, and how they want to treat the situation considering what else may be out there relating to contractual provisions and other things that would be detrimental to the policy holders. They have a view obviously of protecting the policy holders, so I think they would think about how potential action would affect that over perhaps a longer term horizon.
There are no further questions at this time. I’d like to turn the floor back over to management for closing comments.
Thank you for attending our second quarter conference call.
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