OCTAVE SPECIALTY GROUP INC quarterly report, Q2 FY2015

Ambac Financial Group, Inc. — Form 10-Q Summary

Reporting period: Three and six months ended June 30, 2015; filed August 10, 2015. The supplied filing identifies the registrant as Ambac Financial Group, Inc., not OCTAVE SPECIALTY GROUP INC. The financial statements are unaudited and prepared under U.S. GAAP.

Business Context

Ambac is a financial services holding company with two reportable segments: Financial Guarantee and Financial Services. Its financial guarantee business is in runoff and has been unable to write new business since deterioration in its insured portfolio beginning in 2007. The Financial Services businesses are also being wound down through terminations, settlements and scheduled amortization.

Ambac Assurance’s Segregated Account remains subject to Wisconsin rehabilitation proceedings. Management disclosed substantial doubt about Ambac’s ability to continue as a going concern, although the financial statements were prepared assuming continued operations.

Key Financial Metrics

Metric	Three months ended June 30, 2015	Six months ended June 30, 2015
Total revenues	$230.8 million	$386.2 million
Net premiums earned	$60.9 million	$126.6 million
Net investment income	$64.8 million	$137.7 million
Losses and loss expenses	$147.5 million benefit	$298.4 million benefit
Pre-tax income	$286.1 million	$502.7 million
Net income attributable to common shareholders	$282.7 million	$497.4 million
Diluted earnings per share	$6.05	$10.62
Operating earnings, non-GAAP	$266.0 million	$513.6 million
Operating earnings per diluted share, non-GAAP	$5.70	$10.97

Reported earnings were materially affected by reserve benefits, derivative fair-value gains, VIE-related gains and changes in Ambac’s credit valuation adjustment. These results should not be viewed as representative of recurring operating profitability.

Balance Sheet, Debt and Liquidity

Total assets were $25.5 billion at June 30, 2015, compared with $25.2 billion at December 31, 2014.
Total liabilities were $23.5 billion, versus $23.5 billion at year-end 2014.
Total stockholders’ equity increased to $2.05 billion from $1.67 billion, primarily due to comprehensive income and accumulated earnings.
Investments totaled $5.48 billion, including $4.89 billion of fixed-income securities and $197.1 million of short-term investments.
Cash and cash equivalents were $34.0 million, down from $73.9 million at December 31, 2014.
Long-term debt outside consolidated VIEs was $977.8 million. Consolidated VIE long-term debt was $13.6 billion and is generally supported by VIE assets rather than being directly payable by Ambac.
Ambac Financial Group reported cash and liquid investments of approximately $157.4 million, plus $92.2 million of less-liquid investments in Ambac Assurance-insured RMBS and surplus notes.
Ambac Assurance statutory policyholder surplus was $235.2 million, above the $100.0 million minimum surplus amount required for payments under specified arrangements.

Cash Flow and Capital Activity

Six-month operating cash flow was $38.3 million, compared with $172.3 million in the prior-year period.
Investing activities used $14.7 million, compared with $14.8 million provided in the prior-year period.
Financing activities used $63.6 million, including $49.9 million of investment-agreement draws and $13.8 million for debt extinguishment.
Net cash flow was negative $39.9 million, leaving $34.0 million of cash and cash equivalents at June 30, 2015.
No common-stock repurchases occurred during the quarter. A warrant repurchase program of up to $10 million was authorized; by August 7, 2015, 538,678 warrants had been repurchased for $4.7 million.

Material Changes Versus Prior Comparable Period

Second-quarter net income attributable to common shareholders improved to $282.7 million from a $207.9 million loss. Six-month net income improved to $497.4 million from a $52.0 million loss.
Total revenues increased to $230.8 million from $57.3 million in the second quarter and to $386.2 million from $166.5 million for the six-month period.
Loss and loss expenses shifted to benefits of $147.5 million for the quarter and $298.4 million year to date, compared with losses of $175.3 million and $35.3 million, respectively, in 2014. The improvement primarily reflected lower projected claims, positive reserve development, commutations and substantially lower interest accrued on Segregated Account Deferred Amounts.
Interest on Deferred Amounts was $39.6 million in the quarter and $79.5 million year to date, compared with $308.1 million in the prior-year periods, when the amended rehabilitation plan caused significant catch-up accruals.
Net premiums earned declined 6.3% in the quarter and 14.2% year to date because the insured portfolio continued to run off. Net investment income also declined because of a smaller invested-asset base.
Derivative product revenue changed to a $51.0 million gain in the quarter and a $13.2 million gain year to date, compared with losses of $48.0 million and $101.8 million, largely because of interest-rate movements.
Net par outstanding declined to $130.0 billion from $144.7 billion at year-end 2014. Below-investment-grade exposure declined to $22.2 billion from $25.3 billion.

Outlook, Risks and Unusual Items

No formal earnings or revenue guidance was provided. Management’s strategy remains focused on runoff, asset and liability management, commutations, recoveries and possible new financial-services opportunities.
Ambac Assurance explored a possible exchange of surplus notes and Deferred Amounts with a counterparty, potentially involving cash and new 7% surplus notes due 2020. No agreement had been reached as of filing, and any transaction would require regulatory and possibly court approval.
The company disclosed substantial doubt about its ability to continue as a going concern, principally because of restrictions and uncertainty surrounding the Segregated Account and the Rehabilitator’s authority.
Deferred Amounts and accrued interest were $3.37 billion at June 30, 2015, including $2.96 billion of Deferred Amounts and $408.6 million of accrued interest. Payment timing is controlled by the Rehabilitator and represents a major future liquidity use.
Management’s reasonably possible reserve stress analysis identified potential additional loss reserves of approximately $160 million for RMBS, $350 million for student loans, $1.36 billion for public finance and $535 million for other credits, including Ambac UK. These are stress estimates, not recorded liabilities or forecasts.
Recorded RMBS representation-and-warranty subrogation recoveries were approximately $2.6 billion. Recoverability depends on litigation outcomes, sponsor solvency, contractual interpretations and regulatory oversight.
Ambac UK continued to report a shareholder-funds deficit of £10.1 million under UK GAAP and a regulatory capital deficiency of £306.4 million. Discussions with regulators were ongoing.
In July 2015, Ambac Assurance completed a re-securitization involving 17 insured RMBS, receiving $146.0 million of cash before expenses. The securities remained recorded as invested assets at June 30, 2015.
Significant market, credit, liquidity, foreign-exchange, fair-value, litigation, regulatory and rehabilitation risks remain. Ambac Assurance was not rated by Moody’s or S&P, and rating-related collateral and termination provisions had been triggered for many derivative and investment-agreement contracts.

Investor Verification Checklist

Confirm that the source filing and registrant are Ambac Financial Group, Inc., rather than OCTAVE SPECIALTY GROUP INC.
Assess the sustainability of earnings excluding reserve releases, VIE fair-value movements, derivative gains and credit valuation adjustments.
Review the going-concern disclosure and the authority of OCI and the Rehabilitator over claims, surplus-note payments and dividends.
Evaluate the adequacy of reserves against the disclosed stress-case additional losses, particularly public finance, student loans and RMBS.
Test the collectability and timing of the approximately $2.6 billion of RMBS subrogation recoveries.
Monitor liquidity, collateral requirements, investment-agreement withdrawals, derivative terminations and future Deferred Amount payments.
Review the status and potential economic effect of litigation, regulatory proceedings and any proposed surplus-note or liability-management transaction.