OSG

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended March 31, 2011, for Ambac Financial Group, Inc. (Ambac). The company is operating as a Debtor-in-Possession following a voluntary Chapter 11 bankruptcy filing on November 8, 2010. Ambac's principal operating subsidiary, Ambac Assurance Corporation, is subject to rehabilitation proceedings regarding a "Segregated Account" established to isolate high-risk liabilities. Management has expressed substantial doubt about the company's ability to continue as a going concern, noting that liquidity is dependent on cash on hand and the residual value of Ambac Assurance, with dividend payments from the subsidiary unlikely in the foreseeable future.

Key Financial Metrics

Material Changes vs. Prior Period

• Increased Losses: The net loss increased by approximately $129 million compared to Q1 2010. This was primarily driven by a significant increase in "Losses and loss expenses" ($919.6 million vs. $89.2 million), largely due to higher estimated losses in the first-lien residential mortgage-backed securities (RMBS) portfolio and student loan credits.
• Revenue Decline: Net premiums earned decreased by 27% ($33.4 million) due to the runoff of the insured portfolio. Net investment income dropped 39% due to a reduced asset base and lower yields.
• Reorganization Items: The company recorded $24.8 million in reorganization items, including professional fees and a $14.3 million lease settlement, which did not exist in the prior year.
• Variable Interest Entities (VIEs): Loss on VIE activities decreased significantly to $6.1 million from $492.7 million in Q1 2010, reflecting the deconsolidation of many VIEs in March 2010.
• Balance Sheet Contraction: Total assets decreased by $1.6 billion, driven by the deconsolidation of VIEs.

Outlook, Risks, and Contingencies

• Bankruptcy and Reorganization: Ambac is negotiating a plan of reorganization with the Official Committee of Unsecured Creditors. There is significant uncertainty regarding the treatment of security holders; it is likely debt holders and creditors will receive all equity in the reorganized company. Failure to confirm a plan could lead to a Chapter 7 liquidation.
• Segregated Account Rehabilitation: A plan of rehabilitation for the Segregated Account was confirmed by the Wisconsin court in January 2011. Policyholders are expected to receive 25% of claims in cash and 75% in surplus notes. The rehabilitator retains control over these assets, limiting Ambac's ability to manage them for the benefit of shareholders.
• RMBS Subrogation Recoveries: Ambac estimates $2.5 billion in subrogation recoveries from RMBS transaction sponsors for representation and warranty breaches. However, the filing notes significant uncertainty regarding the timing and collectability of these amounts. If unrecovered, the stockholders' deficit could increase by over $2.4 billion.
• Tax Risks: The IRS is examining the characterization of credit default swap (CDS) losses. If reclassified as capital losses rather than ordinary losses, Ambac could face a material tax assessment and a reduction in Net Operating Loss (NOL) carryforwards.
• Liquidity: Liquidity is constrained. Ambac Assurance is unlikely to pay dividends. The company relies on cash on hand to fund bankruptcy professional fees and operating expenses.

Key Facts for Investor Verification

• Going Concern Status: Verify the company's ability to fund operations until emergence from bankruptcy, given the substantial doubt expressed by management.
• Reorganization Plan Progress: Monitor negotiations with the Creditors' Committee and the likelihood of a confirmed Chapter 11 plan versus a Chapter 7 liquidation.
• RMBS Recovery Realization: Assess the actual collection of the estimated $2.5 billion in subrogation recoveries, as failure to collect would materially worsen the deficit.
• IRS Tax Examination: Track the outcome of the IRS examination regarding CDS loss characterization, which could trigger significant tax liabilities.
• Segregated Account Plan Implementation: Confirm the effective date of the Segregated Account Rehabilitation Plan and the actual distribution of cash versus surplus notes to policyholders.