Ambac Financial Group Inc (AMBC) 2002 Q4 法說會逐字稿

Good morning. My name is Carol and I will your conference facilitator today. At this time, I would like to welcome everyone to Ambac's 2002 Fourth Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question and answer period. If you would like to ask a question during this time, simply press star then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Mr. Bivona, you may begin your conference.

Thank you Carol. Welcome to Ambac's Fourth Quarter Conference Call. My name is Frank Bivona. With me today are Peter Poillon, Investor Relations and also Tom Gandolfo. As many of your know last month, I announced my intention to leave Ambac, which I will doing shortly. At the board meeting, this past Tuesday I am very, very happy to announce and say that Tom Gandolfo was named Chief Financial Officer of the company and I couldn't be happier with that.

Having worked very closely with Tom over the past 9 years, it's a pleasure to hand over the reins to him. And I would just like to say before we go into the remarks that Ambac is certainly a great company and I will truly cherish my 18 years associated with this organization. Most of you know Tom, but for those of you who don't, I really do encourage you to give him a call at your convenience or come visit him or he'll come visit you. Whatever, but get to know him. And at this point what I would like to do is hand the main discussion over to Tom. I will be around for some remarks and questions afterwards.

Great, thanks Frank. As you know we released earnings today at 8a.m. Our earnings press release and statistical supplement are on the web and will be mailed out to those who have requested it. If you did not receive it and would like to, please give us a call or visit our website at ambac.com. This call will be replayed beginning this afternoon at 2p.m. Please give us a call if you want the telephone number. The call is also being broadcast on the web. You can access that through our website. Please mark you calendars, first quarter 2003 earnings will be released on April 17th at 8a.m. with a conference call at 11a.m.

During this conference call, we may make statements that would be regarded as 'forward-looking' statements. These statements are based on management's current expectations. I refer you to our press release for factors that could change actual results.

I would like to jump into the highlights of the fourth quarter. On an operating basis it was a very strong quarter for Ambac. Net income came in at $64.2m or $0.59 per diluted share. This was down from $116.7m or $1.07 per diluted share in the fourth quarter 2001. This decrease was due entirely to our previously announced capital loss on the National Sentry which I will discuss in more detail later in this call.

While Ambac reports net income in accordance with generally accepted accounting principles, the research analysts have not adjusted their estimates accordingly. Therefore we continue to provide information on the items that analysts adjust out of GAAP net income to arrive at their current estimates to eliminate any confusion.

The first item is net after-tax gains and losses from sales and investment securities and mark-to-market gains and losses on derivative contracts. For the fourth quarter of 2002, that amounted to a loss of $72.4m or $0.66 per diluted share. This compares to a net loss of $300,000 or $0.01 per diluted share in the fourth quarter of the prior year.

The other item that is adjusted out is accelerated premiums earned on guaranteed obligations that have been refunded or simply refundings. This amounted to $17.8m or $0.09 per diluted share in the fourth quarter 2002. This was up significantly from the $11.4m or $0.06 per share in the fourth quarter of the prior year.

Let me move on to adjusted gross premiums written. We had an extraordinary quarter with record top-line production. AGP which we define as gross upfront premiums written, plus the present value of installment premiums written during the period. In the fourth quarter was $505.3m. This was a record quarter and compares to a very strong $328.2m in the fourth quarter of the prior year. This is up 54%.

In fact, we produced more AGP in this one quarter than we produced in the full year of 1998. Contributing to the strong performance was significant issuance, strong demand for our products and numerous large insured transactions. Although demand for our product remains strong, the extraordinary writings of this quarter are not indicative of future production.

Let me take you through some of the detail of the 3 major areas of our business, Public Finance, Structured Finance and International Finance. First Public Finance. Ambac's Public Finance AGP written was $217.1m growing 85% from the fourth quarter of the prior year. Municipal volume continues to be very high coming at $103.5b, this is up 13% compared to the fourth quarter of 2001.

Market penetration was relatively flat period-on-period, but still favorable at approximately 45%. Ambac continues to focus on the more highly structured segment of this market that carries higher premiums and risk-weighted returns. Importantly, we accomplished this without compromising our historical underwriting standards.

In the fourth quarter, Public Finance experienced strong transaction flow. Particularly in the transportation and municipal lease segments. The fourth quarter also included a very large public utility transaction.

In the Structured Finance segment. Structured Finance AGP written was $174.6m, growing 65% from the fourth quarter 2001. This sector includes mortgage back and home equity asset-backed securities; other consumer finance transactions; collateralized debt obligations; lease-backed securitizations; investor-owned utilities and asset-backed commercial paper conduits. Increases in this market were driven by strong flow in several areas, including consumer asset-backed, primarily to mortgage back and credit card transactions and investor-owned utilities.

In the International Finance sector, AGP increased to $113.6m. This is up 8% from the prior year quarter. This was a solid quarter for International, an area where new writings can be lumpy. Deal activity was strong across several sectors including future flow and CDOs. The quarter was also highlighted by increased activity in privatization transactions in Western Europe. Demand for our product remains solid in this growth market. And pricing and structure are strong as well.

Let me comment on pricing. As we consistently stated throughout this year, the competitive and pricing environment for our product remains favorable. We expect this favorable environment to be sustainable, at least into the near future. While general credit spreads have narrowed some in the broader market since the third quarter, they remain wide compared to historical norms. Municipal spreads are generally less volatile. However in this environment, which is largely characterized by state and local budget deficits, spreads for certain credits have widened considerably. The investment community continues its flight to quality and demand for our product is strong.

Moving on to premiums earned. In total, net premiums and other credit enhancement fees earned in the quarter, excluding refundings increased to $122.6m up a very strong 27% from the fourth quarter of 2001. This growth was driven by a 49% improvement in International. Our smallest yet highest return market. Public Finance grew 17%. Very impressive considering this is our most mature business. Structured Finance also displayed strong growth at 22%.

Accelerated premiums which result from refundings, were $17.8m or $0.09 per diluted share in the quarter. As compared to $11.4m or $0.06 per diluted share in the fourth quarter of 2001. Municipal refunding activity remains high in the current interest rate environment. We expect refunding activity to moderate, unless rates continue to decline further.

We had $505m of AGP and $114m of earned premium. This equates to a 3.6 times ratio of top-line production to earnings. So basically, we are writing business at three and a half times the rate that we are recognizing it in our earnings. Also, our warehouse of future earnings grew to $3.6b. Representing future earnings that are either in-hand or contractually due us. This is up 27% in one year.

Moving on to investment income. Investment income was $75.3m up 6% in the quarter. Primarily due to increase in the investment portfolio from ongoing operations. Partially off-setting investment earnings growth is lower market interest rates on new money invested. Another factor offsetting growth is our movement of investments from taxable securities, which have a higher pre-tax yield, to tax exempt securities which have a higher after-tax return. Our financial guarantee investment portfolio remains very high quality, with 96% of the portfolio rated 'A' or better.

Moving on the Financial Services segment. Financial Services revenues were $13.1m. This is down 17% from the fourth quarter of the prior year. Investment Agreement revenues were $2.9m down 8% from the prior year. Investment Agreement revenues were impacted by a $2.4m premium amortization adjustment, due to prepayments on certain mortgage back investments held in the investment portfolio.

Derivative Products revenues came in at $5.7m. This is down 25% from a very strong fourth quarter 2001. Although the $5.7m is still a good quarter there. As discussed in the past, the Derivative Products segment can be lumpy. Cash management revenues were relatively flat during the quarter.

As previously disclosed, we incurred a loss on an investment held by our Financial Services segment. The investment was in notes of the National Sentry Financial Enterprised sponsored asset-backed security program, backed by healthcare receivables. We purchased this security when it was rated triple A by two major rating agencies. Early in the fourth quarter, it was discovered that reserved funds were drawn down in nearly their entirety in one of the trusts and used by the company for non-permitted purposes. And collateral had been inappropriately diverted. Ambac has written this investment down by 80%, resulting in a $91m after-tax charge. Ambac as part of a formal creditors' committee is working diligently along with other major investors to re-mediate this situation to ensure the maximum possible recovery.

Moving on to operating expenses. Total operating expenses were up 20% quarter-on-quarter, reflective of our growing franchise. And is right in line with our revenue growth. This performance is reflected in our industry leading expense ratio of 14.9%. Return on equity. Excluding net investment and mark-to-market gains and losses and the impact of the unrealized gains in our investment portfolios was a very healthy 16.4% for the quarter.

So in summary, this is a very strong operating quarter with record top-line AGP of $505m and very vibrant markets for the Ambac product. Before we move on to the Q & A, I would like to hand the discussion back to Frank for a few more items.

Thanks Tom. Just a couple of comments. First the past 3 years has been a very difficult corporate credit environment, both domestically and abroad. With defaults in that sector reaching quarter century highs. Ambac's insurance portfolio continues to perform very well in the face of this economic stress. Over the past year, one area of our credit portfolio, the healthcare portfolio traditionally which is our highest risk sector has actually seen substantial progress in terms of reducing the likelihood of any kind of material claims from troubled names there. So we have seen an improvement in that particular sector.

The CDO and CLO area sector has received considerable media attention of late. And scrutiny as well from various parties, including the rating agencies who as you know spend a lot of time with us and review our book constantly. The rating agencies have completed very detailed reviews of the CDO and CLO portfolios. And have confirmed that our portfolio quality is high. And that future claims, if any to the degree they actually materialize, should be modest and spread over years in the future. And of course, this is confirmation of precisely what we have been saying for quite some time in terms of that book.

Elsewhere in our Structured and asset-backed portfolios, we do have actually one mortgage deal in that very large and high quality book. But there is one mortgage transaction there that we are currently paying claims on and have established reserves against. And there is one other mortgage deal where claims may materialize down the road there, but not of a material nature. All others in this class are really performing very well and well within our risk guidepost.

Bottom line despite intense credit and economic stress, I think the point here is that Ambac's portfolio has performed very, very well. The business reality is that these difficult times have actually created far more business upside potential in terms of insurance opportunities. And increased value of our product on the service side than the downside in terms of increased insurance claims. So it's a very good environment for our product.

Just the next point, a reminder. We have said this before. Our stock option expense, as we have previously disclosed in the first quarter Ambac will be expensing stock options. We plant to expend options prospectively. And what that means is that the 2003 expense will only be for options granted in 2003. Our estimate for the amount of stock option expense in 2003 is just that, it's an estimate and it's likely to change before we finalize our valuation methodologies. Our current estimate though is in fact, we will add an expense on our net income in 2003 of approximately $0.04 to $0.06 per share.

Next and final point before we open it up for questions. Guidance, as per earnings guidance for 2003. We continue as we have for many years to target our long-established growth rate of 15% in underlying earnings. Which certainly excludes net investment and mark-to-market gains in losses and refundings. I know some analysts still project refundings and our comment there is that refundings may be lower next year or in 2003 than they are in 2002 in the event interest rates rise. Additionally earnings will be lower for the impact of expensing stock options as I mentioned just before.

So with that I would like to open it up for questions for Tom and myself.

Yes sir. At this point I would like remind everyone. In order to ask a question, please press star then the number 1 on your telephone keypad. We will pause for just a moment to compile the Q and A roster. Sir, your first question comes from Rob Ryan.

Good morning. Can you give a comment on the sequential up-tick in the loss provision? Let us know where the unallocated loss reserves stands as at the end of the year? And comment on any shifts in the number or type of watch list items?

Sure. We added $9m to our general loss provision during the quarter. And that was an up-tick from what you have seen in the past. But it is solely due to really the exceptional writings this quarter. It was a record quarter for us in terms of writing. And that line should move around as we add exposure to the book. So it's totally due to the significant writings during the quarter.

As far as the reserves. We have $168m of loss reserves. Of that amount $115m is unallocated. As far as the book, as Frank mentioned earlier, we do have one mortgage deal that we did pay claim on during the quarter. We are watching very carefully. We do expect that we could have additional claims and we have our estimated exposure fully reserved for.

That was really the only negative during the quarter. The positives, we have seen some good improvement in the healthcare book. In particularly, two names that we were fairly sure several months ago we were going to pay some claims on. It would now appear that we will likely get out of those either whole or with much smaller claims that we thought.

If you look at the allocated portion of our reserve, you will see an increase of about $7m during the quarter.

Okay. In terms of the improvement of certain healthcare credits. Have you brought back that case specific reserve into unallocated? Or is it still there in case specific for now?

No. We left some of it up but we did take some down. We took some down and reallocated it back to the unallocated reserve.

Okay. Fair enough. Thank you.

Thank you.

Sir, your next question comes from Geoffrey Dunn.

Morning guys. First you provide two different municipal par numbers in your release. Normally the timing reconciliation is much smaller than this quarter. Can you comment as to why the big up-tick in the difference this quarter?

Are you talking about the level of issuance?

No, just the par insured, the two different numbers you provide? Normally there is a timing difference between the two?

Geoff, I think what that is, you know we provide something that is out there on first SEC I think it is, and so there is always a timing difference between sold and closed. So we try not to reconcile it because it's very difficult to do. We don't control the outside service, but we can tell you what we did during the period. So typically there is a lag here.

So nothing unusual?

No, nothing at all. Although the market was very strong.

And can you quantify the allocated reserve you put up for that mortgage back deal?

We don't issue or make public credit by credit basis the amount of case reserves we set up. But you know I think the important thing to look at there is the net change in case for the period, which is the $7m.

And then the last question. Can you give us an update on that one CDO deal, where we do have exposure and there is a reserve up against it?

Sure. That's our one deal as we mentioned in the past where we have paid a claim. We've paid about $5m there. We think that we can potentially pay another $5m, anywhere from $5m to $15m on that. We have that fully reserved. That deal matures in the spring of 2005. But we think, once again that we are boxed between a $5m to $15m, fully reserved potential payment.

Okay. Thanks.

Sir, your next question comes from Marco Pinzon.

Yes, good morning. Two questions. One was just to clarify. The unallocated amount of your reserves, was that $116m?

$115m.

$115, okay great thank you. And then the second one, you know I kind of calculate loss ratios maybe a little bit different, in that I look at loss and [LAE] to normal earned premiums. Well really I calculate it a couple of different ways. It looks like the ratio itself you saw a pretty meaningful up-tick in the quarter. You were running, based on this calculation, I am looking at 7.9% versus more like 5.8% in the preceding 3, 4 or more quarters. Should we expect this elevated level to be a run-rate going forward?

No Marco. Why you are seeing that this quarter, it's pretty much entirely due to the $9m we added because of the writings that we did this quarter. We mentioned that we don't anticipate doing $500b of AGP every quarter. We would love to do so and if we did you would see loss reserves appropriately put up to reflect that. But we would expect that to moderate or go down in a quarter where the writings weren't so significant.

No, I understand the fact that the dollar value goes up with the increased writings. But I was just saying the relationship, the ratio relationship. Just the fact that that moved up. So you are saying that's just in line with just a significant production in the quarter?

Marco, this is Frank. The point to be made is that earned premiums are earned over long periods of time. So the $500m plus that we wrote this period will be earned over a long period of time. What we did was in response to the incremental par that we put on our books during the period which is a point in time type of thing.

So I think you are seeing that ratio change when you are comparing the increase in absolute reserves that we put up now versus an earnings number which is going to be earned out over time. So there is really no change in our methodology whatsoever and actually on an earned basis over the total life, it will be consistent with what we have done in the past.

Okay. By the way thank you.

Sir, your next question comes from Brian Wright.

My question has been answered thank you.

Thank you sir. The next question will come from Terry Shue.

Hi. I have a couple of questions. One as far as the visibility into 2003. It's fair to say that the visibility ought to be very good because the premiums earned trend should be very strong just from the business written this year and the reinvestment rate comparisons should get easier? So barring from unforeseen situation, I can't imagine, you know losses that you see, earnings progression should be pretty assured? Is that a correct statement?

Terry, that's true. You saw our earned premium, growth rate actually accelerate a bit. But that's due to the very strong writings that we are putting together. So we are pretty comfortable with the guidance that we put out of the 15% on the -

You almost can't help seeing extremely strong premiums earned growth, just because of the huge writings you did this year?

Absolutely.

And two, on the pricing front. I think you commented qualitatively that pricing remains strong. Have you looked at the par relative to AGP comparisons 2002 versus 2001? I know we have talked about it in the past and it's not risk adjusted and it depends on the deal, so you can't tell. But on the surface, it looks like a big jump as you did the division AGP divided by par for both Public Finance and Structured Finance. Anything to read into that other than just the type of deals and pricing generally is strong?

I think you just nailed it. I mean pricing is strong, but it's very difficult to do that comparison because of the mix of business that you see written in any one quarter.

Are there any pockets of weakness or anything on the horizon that you see or you don't see anything?

Right now there really isn't any pockets of weaknesses in pricing. In fact, the CDO area for example, we have seen significant increase in pricing. Even for the triple-A which is where we primarily participate now. We can't really predict the future, but right now the pricing is very strong across all sectors.

As far as the mark-to-market adjustments where the comparison was negative this quarter. Can we still be pretty assured that these are really accounting adjustments, that the underlying economic values you remain comfortable that it has no economic implications, so it does come back into earnings? Can we assume that?

Well in the mark-to-market, I mentioned earlier. We do have one CDO where we could potentially pay for the plans and then you would actually realize apportion that. However, for the most part, we feel that mark-to-market it is an unrealized loss that will reverse as we approach maturity of those deals. And just one note on that, in the, I think it was $8.9m this quarter, $5m of that mark-to-market is actually a result of just the pricing increases we are seeing in the market. So we are doing new deals at significantly higher pricing than we did the same deals for 2 years ago. As a result we have to mark those old deals to new markets.

So therefore it's actually a positive implication rather than negative?

It's a good mark-to-market. Yes.

And on that one CDO though, you have already put up reserves. So that shouldn't, I mean there should be an offset there, right?

That is fully reserved. And the one thing when we talk about unallocated reserves and I threw up the number earlier of $115m. What you don't see on top of that, we also have about $31m in mark-to-market reserves above and beyond the $115m of unallocated reserves that are just built through mark-to-market capital.

Okay. And then finally. When you look at the adjusted book value analysis. And the number, the $2.76 unrealized loss on investment agreement liabilities. How should one interpret that? Is it a real loss or is it just more kind of market pricing loss?

Terry, well basically because interest rates declined. We have certain fixed rate debts. We will hold those [gics] to maturity. So we don't, we will never trade out of those. So we don't expect to lose it. But they are in an unrealized loss position simply due to interest rates.

And the reason Terry we have backed that out is because in that business we are forced to mark-to-market our assets and not our liabilities. So if we were able to mark-to-market our liabilities -

They should wash out right?

Corrrect.

Theoretically. Therefore the economic impact should be zero.

Should be zero.

Okay. Thank you very much.

Sir, you next question comes from Joshua Shanker.

Hi there. I just wanted to say this is Josh Shanker from Blaylock & Partners. I am calling about, looking at the balance sheet comparing it with last year's. I notice that there is changes from the December 31st, 2001 balance sheet. Investment income due and accrued income dropped $15m from the previous statement; other assets dropped $25m from the previous statement; derivative product dropped $25m from the previous statement. Is there anything going on why there is a restatement of the balance sheet?

No. The investment income due and accrued, that is just a matter of timing when interest was paid. There is really nothing, out of $15b balance sheet, nothing really unusual there.

No, no, no. I'm saying it's different. The 12/1 balance sheet prepared in this report was a little bit different than the 12/1 balance sheet reported a year ago today.

We did some reclassifications Josh to what we think to hopefully better provide more detail. One of the examples would be in the derivative products. We tried to break those out further to highlight those on the balance sheet. Derivative product assets and liabilities. That's driving a chunk of it.

And since the September 30th, 2002 balance sheet, other liabilities has tripled. And the short portfolio has dropped by two-thirds. What is actually happening there with your capital position?

What this is, there were borrowings that were in the, I don't have the September balance sheet in front of me, but I think what you are referring to is, we had some [repo] borrowing in the prior period. That has been reclassified down, it's really the same borrowing, it's just now in other liabilities. It's just short-term borrowing basically.

And it was allocated in the short portfolio before and now it's been put into other liabilities.

Correct.

Okay. Thank you.

Sir, your next question comes from Angelo Gracie.

A couple of questions. Looking at the supplement on the pooled debt obligations, the two pager?

Yes.

The cash flow of CDOs looks like it went up a little over a billion compared to the prior period from ten in changed $12b. I was just wondering what the increase is there? Are there more secondary transactions being conducted in the cash flow CDOs?

Well yes. There is not a whole lot of new issuance I think as you probably know. So we have been somewhat active in the secondary market where we see very high quality cash market CDOs which meet our criteria. And as Tom mentioned we are seeing a great price advantage in this market right now in the sense that spreads have widened and there is an opportunity for us. And we actually do continue to like this market very selectively. But also operating in a secondary market, it gives us the ability to be very, very selective.

Now while the economics kind of make sense there. How do the rating agencies approach the secondary transactions?

No different really than a new issuance. Our process is identical. If anything we have the ability to pick and choose a little more there. And the rating agencies again review our transactions. We show them everything we do. And as Tom mentioned, or I did, I forget who, they have just completed a very thorough review of the book in this area.

Okay. Looking at the business mix and also looking at the graph on the next page. The numbers might just be a coincidence, but you have got high yield at $6.3b. And if you add up all the pre-2000 deals, you are at $6.3b. I'm just trying to get a handle here as to most of the high yield transactions, are they pretty much all prior to 2000?

Yes. I think most of our CDOs of the high yield transactions were done pretty long ago. And our focus is generally on the super senior [traunches] of more bank type deals today. So there has been a shift over time. But again, some of our high yield CDOs have been our best performers. So one should not necessarily equate high yield with bad CDOs at least based on our underwriting performances.

Now, I'm just trying to kind of understand the progression here over the past few years. And in 2000 there was a jump in the number of deals and the par outstanding. And it just looks like you have been doing a very basic size per deal jump in 2000 and then came back down in 2000 and 2001. And I am trying to get an idea as to what really happened in 2000? And can you explain the transition from cash flow CDOs to synethic during that year and how you--?

We started to actively participate in this market in 1998 in a meaningful way. 1999 and 2000 were just significant growth periods for this market. And it's also a period when we started doing what we call the super triple-As or triple-As. Those tend to be very large notional deals. The super triple-As. And that might be part of the trend that you are seeing there.

Okay, because then it came back down. And I just wondered if you take that $15.9m and divide it by 30 you are a little over half a billion per deal -

I wouldn't read any, there is no trend. I mean these are the deals that we are seeing and we are very selective on these deals. But there is not a trend or a conscious decision on our part to either go out and look for bigger deals or smaller deals. It just happens to be the way that they were executed for those periods.

Great. Thank you.

Thank you.

Sir, we have no further questions at this time.

Okay. You want to check one more time?

Yes I would like to remind everyone. If they wish to ask a question, please press star, then the number 1 on your telephone keypad. We will pause for just a moment to compile the Q and A roster. And sir, now you do have questions. Your next question will be from Ethan Broadsley.

Good morning. A theoretical question for you. If the current tax legislation as proposed goes through, removing the dividends or the tax on dividends. What impact do you think that would have on your business at all, if the municipal spreads widen out?

That's a good question. We don't think it's going to have a significant impact. We don't know what the final bill is going to look like, or even if it will pass. But if it did as currently proposed, there could be a slight increase in the cost to capital for municipalities. But we do think it would be slight. Primarily because just the risk profile of the investor in tax exempt bonds.

Even with the dividend being tax exempt, it's still an extremely different risk profile than a municipal bond. So we can't imagine that there would be a meaningful exodus from the municipal bond market into dividend paying stocks. So it could have some small impact on their cost to capital. But no meaningful impact in our opinion.

Well could that be a benefit as well? As you are able to capture more of that spread?

Yes. If spreads widened as a result of this, that would be to our advantage.

Great. Thank you.

Thank you.

Sir, your next question will come from Rob Ryan.

Hi, I apologize [indecipherable] I haven't stepped away. Just on the issue of reinsurance capacity. A lot is going on in the market currently. Most recently a plan to exit by a fairly large market share company. What do you see as the implications for the primaries and specifically for Ambac, a relatively light user reinsurance compared to some others?

Yes. Two things, I guess SMP recently downgraded rating to double-A. I think you are referring to AXA who announced that they are exiting the business and as a result, SMP downgraded them from triple-A to triple-B, which important to note there, that was not necessarily a credit related downgrade. It's SMP's policy of when a book is put into run-off that's an automatic downgrade to triple-B. We have looked at this carefully. We still value and will continue to use the double-A re-insurers for risk transfer. We consider them to be very important to our business.

SMP actually published a report back in July commenting on it, it's called What if, you know the downgrade of re-insurers. And in that report SMP clearly concluded that such a downgrade would not have a significant impact on the overall margin of safety of the primary financial guarantors. You know we agree with that report. We don't think it will have a significant impact on our business. And we will continue to use those re-insurers.

The only thing I would add Tom, is that you know to the extent in the future there is less capacity and it would affect our competitors more than it would affect us. In the market, new deals of a large size a reduction in capacity could be favorable in terms of pricing conditions for us.

Okay. Great. Now specific to AXA, based on the capital credit that you are going to receive from Standard & Pours. Are you contemplating commutation? And what would you plan to do with that reassumed exposure?

We have about $8b, a relatively small amount with AXA. We have the ability to take that back now as a result of this downgrade. We are looking at that carefully. We likely will take some back if not all. And either retain some or place it with others but we don't for sure. This just happened within a week or two ago. So we are looking at it carefully to see what option would be most benefit to Ambac. But we do have obviously the ability to pull that back and place it with others if we choose to do so. But as far as the capital hit in the model, because of the relatively small amount there wouldn't be a significant impact in the margin of safety.

Great. Thank you.

Thank you.

Sir, your next question comes from Robert Hottensen.

Yes, I apologize too. I've been in and out. And it's just a broad question on the state and local picture as you see it today. Maybe describe the pricing and demand characteristics and whether there is any outliers or any pattern with respect to those states that are seemingly posting the biggest budget deficits? And then secondly, whether there is any watch list implications as we move through 2003? And how we can get an understanding of how you are handling these surveillance and watch lists aspects of the state and local situations more broadly? Thanks.

Sure. The municipal environment has been in the press frequently. Many municipalities are facing fairly large budget deficits, California and New York City being in the news the most. This actually provides a tremendous opportunity for us. I think we have said in the past we like economic cycles. When we get into an environment where all the municipalities are being upgraded and everything is great, that actually the demand for our product and the value we bring is limited. So we like this environment.

We don't think the State of California is going to default. We think they have a lot of tools at their availability to solve their problems. And we think actions are being taken, raising taxes, cutting expenses. So we are real comfortable with the municipal credit. And we are seeing in these particular sectors, pricing really being outstanding. We have capacity issues, so we are very careful on how we use our capacity. But when we do use it, we are getting paid very, very well in those sectors.

Regarding a watch list. In the municipal area, we have not seen any, zero, significant impact on our watch list in the municipal sector as a result of the current environment.

And what would prompt, what would be the catalyst that you would look to with respect to how the watch list is administered in the state and local area?

Well the independent surveillance process here is very intense. We have a huge group of talented people, independent of the deal side that does a continuous and ongoing review of the book. Every deal is looked at. So we are constantly looking at developments in municipality states, authorities, etc. So we would have to get to a point where we thought that the situation was so bad that it couldn't be remedied by the available remedies that the politicians have at their disposal, i.e. the ability to tax, raise taxes and cut expenses. But for the most part, the ability to tax is pretty strong which has historically been the case. And we think will continue to be the case.

Okay thanks.

Thanks Rob.

Sir, your next question comes from Eric Fell.

Hi, just a question on the sizeable increase for the year in derivative assets. I'm sorry if someone else already asked this. But can you characterize that increase? And in what instruments? I mean are credits default swaps also a significant part of that increase or are there other derivative instruments?

Sure. There is 2 primary, actually the credit default swaps are in there. But also all our derivatives and our interest rate swap business are in that line item. And that's actually a bigger piece. The interest rate, if you call on that business what we do is we will enter into interest rate swaps with municipalities and for the most part we go out, move back entirely, we go out and hedge out all the interest rate risk and we try to capture basis as our profit. So what happens is as we enter into interest rate swaps, we always go out in terms of reciprocal interest rate hedge. So as that book grows, you are going to have unrealized gains in one side of the trait and you are going to have unrealized losses on the other side of the trait.

On the balance sheet if you look down below, you will see as derivate product assets increase. You will see a pretty much a corresponding increase down below in derivative product liabilities because the book is substantially hedged. Although credit derivatives are in there, it's probably about 20% of that number. Because where we don't go out and hedge we are a buyer of credit risk in that case. But for the most part it's the interest rate swaps.

Okay. And sorry what percentage for credit default swaps?

Probably about 20%.

20%? Great. And then just one other question. The auto-securitisation, just hearing a lot lately, obviously with Amera credit and others about deterioration in used car prices, etc. Are you concerned, do you have any significant exposure to securitised receivables of automobiles, used automobiles in particular?

First we have no Amera credit. We do have I think it's a $2.2b of consumer auto receivables that we have done really most of those are relatively new deals. We entered that market slowly. When we underwrite those deals, we have the same concerns that you do. Obviously one of the risks there would be the resale values of used autos. That is a very important consideration in our underwriting. So when we decide to write a deal, our models we use fairly conservative functions in terms of resale value, delinquency rates, etc. So that's all built into the deal when we write it in terms of our demand for over-collaterization or subordination.

The only think I'll add there is a lot of the trouble you are seeing in that market has been on pretty seasoned legacy type deals. Where our entry into the market recently with higher default rates and lower values has given us the opportunity to underwrite to the current period as opposed to the prior period.

Okay. Would you characterize any of those as on your watch list currently or no?

No, the only thing that is on our watch list is a deal we did a long time ago now for a rental company that we fully disclosed in the past. And actually that is paying off quite quickly and we don't expect any kind of problem in that credit.

Great. Thank you and congratulations.

Thank you.

Sir, your next question comes from Angelo Gracie.

Hi I have a very quick follow-up from the last question. Looking at that last graph with the percentage of the CDOs. Looking at 1998/1999 over what period of time do you expect those deals to run off?

For the most part 2005. They are generally 5 year transactions.

Okay great thank you.

2003 to 2005.

Excellent.

Sir I have no further questions at this time.

Great. Well thank you very much. And Pete, Frank and myself are here to answer any questions that you may have. So please feel free to give us a call. Thank you very much.

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