Counterintuitive Accounting: Ambac Edition

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.

Comments

[texalope:]

Last Quarter MBIA booked gains on lawsuits in progress. Talk about fantasy and low quality earnings?

Nov 05 05:38 AM

[Tom Armistead:]

The treatment of liabilities under mark to market, while logically consistent, results in absurd results. Mark to market advocates would do well to give that some thought, since it demonstrates the logical weakness of the current implementation of the concept.

Ambac is not trying to fool anybody, they are just keeping the books according to the rules.

texalope, there is a discussion of MBIA's accounting for litigation on the last conference call. Briefly their accounting is consistent with what others in the industry have done. Countrywide, while still operating under their own name, carried substantial warranties and representations liability reserves, which is the other side of MBIA's litigation. Bank of Americal doesn't disclose any information on the topic.

GAAP seems to be moving in the direction of severely limiting management's ability to present their best estimate of the financial position of the business. As a shareholder, that is the information I am most interested in. MBIA has consistently presented management's best estimate, in the form of aaadjusted book value, so from there it is a question of whether you trust management's judgment.

Nov 05 06:37 AM

[JeffDB:]

Thanks for pointing out one of the absurdities in the accounting for us. Hopefully someone will figure out a way to fix things like this.

Nov 05 08:30 AM