Ambac Sinks Into Deeper Turmoil: Analysis

A state insurance regulator takes control of Ambac, leaving bondholders and stockholders up in the air.
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NEW YORK (TheStreet) -- Wisconsin's insurance regulator helped create a storm of confusion, doubt and hope for Ambac Financial Group (ABK) with a partial takeover of bond-insurer subsidiary Ambac Assurance Corp. yesterday.

Aside from the debate over the likelihood of a bankruptcy filing, the insurer's stock has had more bounces than a game of basketball. Volatility is the name of the game, and speculators made, or lost, a small fortune yesterday.

As a result of mounting liabilities, dwindling resources and effective runoff of the business because of ratings downgrades, Wisconsin's insurance regulator, or OCI, has been involved in monitoring and evaluating the company.

The regulator concluded that a restructuring was necessary. The best way to do that was to create a "segregated account" operating as a separate insurer to remove the most risky securities from the remaining business, known as the "general account."

The OCI's move is unlikely to attract many lawsuits. Rival

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split itself in two to protect municipal-bond holders.

Ambac's settlement of $16.7 billion in collateralized debt obligations of asset-backed security counterparties for $4.6 billion is part of the plan but not the rehabilitation. That means Ambac needs to find $2.6 billion in cash it doesn't have and will, therefore, have to liquidate some of its investments.

As of Dec. 31, Ambac Assurance, the main subsidiary of Ambac Financial, had $8 billion in assets, $6.1 billion of which was in bonds, $625 million in cash and equivalents, and $836 million in stocks. The rest was inter-company debt and common stock.

The rehabilitation, while protecting the remaining policyholders, has a cost. First, the OCI has taken control of the runoff of the segregated account. It will be seeking a court-ordered distribution to claimants and creditors that will be presented to the court within six months.

The OCI considered the "segregated account" to be in such a poor state that continuing to operate normally risked harm to policyholders and creditors. It says that its actions won't substantially increase the risk of loss.

According to court filings, the OCI's rehabilitation plan will set out a payment program for the separate-account policies. It will call for payments of claims as they arise, in the form of a cash-and-interest-bearing note split to be determined. The OCI also intends to commutate and restructure liabilities.

The segregated account will be capitalized with a $2 billion demand note from Ambac Assurance, from which settlements, administrative and operational expenses, and commutations will be drawn. It's almost certain that the funding will require the sale of additional investment assets.

What's left, minus the $4.6 billion in cash payable to settle CDOs and the separate account, will be a significantly more streamlined operation. Ambac will have premium income and potential recoveries from remediation efforts. It will also have some residential mortgage-backed securities, which may continue to deteriorate in value, although they could be sold to provide part of the cash requirements.

The remaining company will have added liabilities -- $2 billion for the proposed CDO settlement and potentially more to settle the credit default swap contracts outstanding. Of course, that all overlooks what Ambac bondholders have to say.

Cash flow should improve, at least for the separate account, as all payments are suspended. The rate of negative operational cash flow had been unsustainable, as has been previously reported. Unfortunately, none of that benefit will be passed up to the holding company, which also won't get dividend payments.

Ambac will be seriously considering whether a pre-packaged bankruptcy is the best route, but it will no doubt enter into discussions with bondholders before reaching conclusions. Unfortunately for Ambac, the OCI's actions, while protecting policyholders, doesn't appear to favor stockholders.

-- Reported by Gavin Magor in Jupiter, Fla.

Gavin Magor is the senior analyst responsible for assigning financial-strength ratings to insurance companies. He conducts industry analysis and supports consumer products. Magor has more than 22 years of international experience in operations and credit-risk management, commercial lending and analysis. His experience includes international assignments in Sweden, Mexico, Brazil and the U.S. He holds a master's degree in business administration from The Open University in the U.K.