OSG

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2010, for Ambac Financial Group, Inc. (Ambac). The filing was submitted after Ambac filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code on November 8, 2010. Consequently, the company is operating as a "debtor-in-possession." The filing includes a substantial doubt about the company's ability to continue as a going concern. Ambac's principal operating subsidiary, Ambac Assurance Corporation, is subject to a Segregated Account Rehabilitation Proceeding in Wisconsin, which isolates high-risk liabilities (including RMBS and CDO exposures) from the general account.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Reversal: The company reported a net income of $76.0 million for the three months ended September 30, 2010, a significant turnaround from the $2.2 billion net income reported in the same period in 2009. The 2009 figure was heavily influenced by a $2.1 billion unrealized gain on credit derivatives due to widening credit spreads, which did not recur in 2010.
• Revenue Decline: Total revenues for the nine months ended September 30, 2010, dropped to $243.2 million from $3.3 billion in the prior year period. This decline is primarily due to the absence of the massive unrealized gains on credit derivatives seen in 2009 and a reduction in net premiums earned due to the runoff of the business.
• Loss Reserves: Losses and loss expenses for the nine months ended September 30, 2010, were $577.9 million, a decrease from $2.4 billion in the same period in 2009. This reduction is partly attributed to the deconsolidation of certain Variable Interest Entities (VIEs) and the claim moratorium on the Segregated Account.
• OTTI Reduction: Other-than-temporary impairment charges decreased significantly to $45.4 million for the nine months of 2010, compared to $1.45 billion in 2009, reflecting a stabilization in the investment portfolio and changes in accounting standards regarding credit impairments.
• Balance Sheet Expansion: Total assets increased to $31.3 billion from $18.9 billion at year-end 2009, driven largely by the consolidation of VIEs under new accounting standards (ASU 2009-17) and subsequent deconsolidations related to the Segregated Account.

Guidance, Outlook, and Risks

• Bankruptcy Proceedings: Ambac filed for Chapter 11 bankruptcy on November 8, 2010. The company is operating as a debtor-in-possession. There is substantial doubt about its ability to continue as a going concern. The financial statements do not reflect the consequences of the bankruptcy filing or a liquidation basis.
• Segregated Account Rehabilitation: A Segregated Account was established for Ambac Assurance to isolate high-risk liabilities. A Plan of Rehabilitation was filed on October 8, 2010. If confirmed, claims presented during the moratorium will be settled with 25% cash and 75% in surplus notes. The rehabilitator controls the management of this account, prioritizing policyholders over securityholders.
• Liquidity: Ambac's liquidity is dependent on cash on hand, dividends from Ambac Assurance (which are unlikely in the near term), and the residual value of Ambac Assurance. Management believes it has sufficient liquidity to finance bankruptcy costs for a few years post-emergence, but no guarantee is given.
• Subrogation Recoveries: Ambac estimates $2.4 billion in subrogation recoveries from RMBS transaction sponsors for breaches of representations and warranties. If these are not recovered, the stockholders' deficit could increase from $1.2 billion to $3.6 billion.
• Tax Risks: The IRS is examining the tax treatment of Ambac Assurance's credit default swap losses. If characterized as capital losses rather than ordinary losses, it could result in a substantial reduction of Net Operating Loss (NOL) carryforwards and a material tax assessment.
• Legal Proceedings: The company faces numerous lawsuits, including securities class actions, shareholder derivative suits, and litigation regarding the "dual rating system" and RMBS loan repurchases.

Investor Verification Checklist

• Bankruptcy Plan Status: Verify the progress of negotiations with the ad-hoc committee of senior debt holders and the likelihood of confirming a reorganization plan.
• Segregated Account Plan Confirmation: Monitor the Wisconsin court's confirmation of the Segregated Account Rehabilitation Plan and the specific terms of claim settlements (cash vs. surplus notes).
• Subrogation Recovery Realization: Assess the likelihood of collecting the estimated $2.4 billion in subrogation recoveries from RMBS sponsors, given the ongoing litigation and sponsor disputes.
• Tax Examination Outcome: Track the IRS examination regarding the characterization of CDS losses and the potential impact on the $7.6 billion NOL carryforward.
• Liquidity Runway: Evaluate the company's cash burn rate and ability to fund operations and legal fees without additional financing or dividend support from Ambac Assurance.
• Equity Value: Understand that equity holders may receive no recovery in a reorganization plan, as debt holders and creditors are likely to receive all equity in the reorganized company.