Counterintuitive Accounting: Ambac Edition

Nov. 5.09 | About: Ambac Financial (AMBC)

Yesterday, Ambac Financial Group (ABK) (a big bond insurer) reported that it earned more than $2 billion in the third quarter, or $7.58 per share. As reported over at Marketwatch, these must be among the lowest quality earnings in accounting history:

Ambac Financial Group reported a $2.19 billion quarterly profit Wednesday as the company got a big accounting boost from deterioration in the perceived creditworthiness of its main bond insurance unit. …

Most the gain came as credit spreads widened on Ambac Assurance Corporation, the company’s main bond insurance subsidiary. When credit spreads widen, that implies investors are more concerned about a company not being able to meet its obligations. However, when this happens, it reduces some of the insurer’s liabilities. For example, if the insurer is deemed to be less capable of standing by its derivatives-based guarantees, the value of those liabilities falls. That results in a derivatives gain.

In short, earnings skyrocketed because investors became even more doubtful about Ambac’s ability to pay its future liabilities. I see many benefits in mark-to-market accounting generally, but this treatment of liabilities is counterintuitive to say the least. There must be a better way.

Ambac shares closed at a lofty $1.50 per share, up 35% on the day. It’s not often that you encounter a stock that trades for less than one-fifth of its quarterly earnings …

Disclosure: I have no investments in Ambac or any bond insurer.