Ambac Financial Group Inc (AMBC) 2004 Q2 法說會逐字稿

Good morning, ladies and gentlemen. And welcome to the Ambac Financial Group Incorporated second quarter earnings conference call.

(Operator Instructions).

It is now my pleasure to introduce your host, Mr. Tom Gandolfo, Chief Financial Officer of Ambac Financial Group Incorporated. Thank you Mr. Gandolfo, you may begin.

Thank you, welcome to Ambac second quarter conference call. I'm Tom Gandolfo, CFO and with me are Rob Eisman, our Controller, and Pete Poillon, Head of Investor Relations.

Our earnings press release and quarterly supplement are on our web site and will be mailed out to those who have requested it. The call is also being broadcast on the web and will be accessible through the end of September. Third quarter, 2004 earnings will be released on October twentieth, 2004, at 8:00 a.m. with a conference call at 11 o'clock.

During this conference call we may make statements that will 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.

Let me jump into the highlights for the second quarter.

Net income came in at $180.7 million, or $1.63 per diluted share, that is up 10% on a per diluted share basis from the second quarter of '03. While Ambac reports net income in accordance with generally accepted accounting principles, the research analysts have not adjusted the reported estimates. Therefore, we continue to provide information on the items that analysts adjust out of their GAAP net income to arrive at the current estimates to eliminate any confusion.

Those items are first, net after-tax gains and losses from sales and investment securities and mark-to-market gains and losses on credit derivative contracts and derivative hedge contracts which, in the second quarter of '04, came in at net gains of $4.9 million or 4 cents per-share. This compares to a net gain of $17.9 million or 16 cents per share in the prior year.

Some analysts also back out after-tax effect of accelerated premiums earned on obligations that have been refunding and other accelerations. Total after-tax accelerated premiums amounted to $17.4 million or 16 cents per diluted share in the second quarter. This compares to $12 million or 11 cents per diluted share in the second quarter of the prior year. That is up 45% on the per share basis.

The after-tax refunding component of accelerated premiums in the second quarter of 2004 amounted to $12.9 million or 12 cents per diluted share. The balance of the accelerated premiums amounted to $4.5 million or 4 cents a share resulted from the buyback of certain portions of our reinsurance treaties with Axa and American Re.

I will discuss the buybacks of the reinsurance in further detail later in this call. All of the 2003 amounts related to refunding activity.

Let me talk to adjusted gross premiums, top-line or AGP. AGP came in at $411.2 million, a strong quarter yet down 10% from the $455 million we reported in the second quarter of the prior year. AGP this quarter was about 2.4 times the rate of our normal premiums earned in other credit enhancement fees, and now I'll take you through the three major business areas.

First, public finance. Public finance AGP came in at $237.7 million, that is up 9% from the first quarter of '03. While muni issuance was down modestly quarter-to-quarter from $114 billion in the second quarter of '03 to $103 billion in the second quarter of '04, still a very strong issuance quarter, insured penetration was up sharply at 59.5% and that compares to 52% in the second quarter of '03.

Ambac continues to focus its attention on those segments where we bring the most value, typically the more highly structured segments of the public finance business. Ambac's market share in the quarter was approximately 22%, slightly higher than the 19% share that we displayed in the second quarter of '03 and about flat to the first quarter of '04.

Moving on to structured finance. Structured finance AGP written was $89.6 million, that is down 40% from the second quarter of '03. Transactions closed in this segment were broad and activity was fairly strong. Mortgage backed securities writings were moderately lower in comparison to the second quarter of '03.

We have recently seen more opportunities in the assured mortgage-backed securities market where the Senior sub-structure had been very competitive earlier in the year. It is difficult to predict, the Senior sub-competitive environment but presently we're satisfied with the increased number of insured opportunities in this segment.

The primary factor contributing to the decrease in AGP in this sector was a large commercial asset-backed transaction which was a film securitization that closed in the second quarter of last year. That one transaction alone represented 21% of the total structured finance premium last year in that quarter.

Additionally, we wrote fewer investor utility transactions in the second quarter of '04 as that market has experienced narrowing credit spreads. The commercial asset-backed area is a broad and growing segment of the U.S. structured market, however, as can be seen from this quarter's comparison, it is a business that will tend to be lumpy.

Moving on to international AGP, international AGP in the second quarter came in at $83.9 million and that is down 5% from the second quarter of '03. The quarter's results were highlighted by a large transportation deal on a couple of attractive future flow transactions.

However, this segment continues to be impacted by the lack of acceptable CDO opportunities internationally compared to the prior year. Beyond CDOs, the primary international markets have experienced some spread narrowing and increased competition but activity continues to be robust and our pipeline is quite active.

Moving on to premiums earned. Net premiums earned and other credit enhancement fees, excluding refunding increased to $168.3 million. That is up 18% from the second quarter of '03. Public finance, our most mature product, continues to display strong growth coming in at 20%. Structured finance grew 15% while international grew 20%.

As discussed last quarter, while the growth in U.S. structured finance and international is still quite good, it is moderated compared to the prior year as the respective books of business have grown and the comparisons become more difficult. Also, the growth is being negatively impacted by run-off in the mortgage-backed security book, driven by low interest rates and competition from the Senior sub market.

Additionally, the CDO book has experienced run off due to lower insured volumes resulting from tight credit spreads in that market. As these less stable, shorter term exposures have been running off, we have been replacing them with more stable, long-term business at attractive returns.

So, although we will see some short-term fluctuations in earned premiums growth, we believe that the resulting stability in the long-term growth is positive. Deferred earnings, representing future earnings that are in-hand or contractually due us, grew to $4.9 million at June thirtieth. These deferred earnings will be recognized in earned premium in the future over the life of the related exposures.

Let me talk a little bit about the reinsurance cancellation. Late in the second quarter, Ambac completed the cancellation of a portion of its reinsurance contracts with Axa and American Re. The net part that was brought back on the books as a result of this cancellation totaled approximately 8.5 billion.

Included in seeded premiums, in our consolidated statement of operations, is approximately $64.8 million in return premiums from this cancellation of which 54.4 million was deferred in unearned premiums. The difference of about $10 million, included in accelerated premiums, results from the difference between the negotiated amount of return premiums from the reinsurers and, the associated unearned premium remaining on the underlying guarantees.

Offsetting these accelerated earnings is approximately $3.5 million of reinsurance commissions. The net impact, included as part of refundings and other accelerations, amounted to $7 million or $4.5 million after-tax or 4 cents per diluted share.

The remaining UPR, which totals 54.4 million, and future installment premiums amounting to approximately 50 million on a net present value basis, resulting from this reinsurance cancellation, will be recognized over the lives of the related exposures in normal earned premiums.

I want to emphasize this buyback had no impact on AGP. None of this $411 million of AGP was impacted by this cancellation.

Moving on to losses and LAE or loss adjustment expenses, losses and LAE increased to $17.5 million. That is up $6.6 million from the second quarter of '03 and it is flat since the first quarter of '04.

Based on our current projections, we expect the loss provision will remain relatively flat, probably in the $16 million to $19 million per quarter range for the rest of the year. Of course, these estimates can change if unforeseen events either positive or negative arise during the remainder of the year.

Net insurance loss reserves at June thirtieth were $236 million, that is an $8.3 million increase from March thirty-first. To further breakdown reserves, our ACR increase -- our ACR, which is our unallocated reserve, increased $13.1 million and now sits at $150.8 million and our case reserve decreased $4.8 million to $85.2 million.

In addition to insurance reserves, we have a $21.1 million reserve which we established through mark-to-market accounting on our credit derivative book.

Moving on to financial services. Net revenues excluding realized gains and losses were $12.8 million, and that compares to a loss of $4.2 million in the comparable prior period. The increase was primarily driven by, if you recall, a $12 million mark-to-market adjustment that we made in the second quarter of '03 resulting from the increase in the ratio of taxes after interest rates, the taxable rates.

During the second quarter of last year, that ratio had risen higher than the historical averages and it was impacted by the historically low interest rate environment and large supply of municipal debt. Most of that mark-to-market adjustment has reversed back into income and subsequent quarters as that ratio came back down to the historical levels.

Comment on return on equity. Return on equity, which excludes net investment gains and unrealized gains on our investment portfolio, came in at an impressive 16.8% for the quarter.

I would like to mention Ambac today did announce that it is increasing its quarterly dividend by 13.6% from 11 cents to 12.5 cents per share per quarter. Ambac has raised its dividend every year since going public in 1991.

In summary, another solid quarter, highlighted by strong top-line production, under-pinned by our continued, disciplined, underwriting for solid long-term results. And with that, I would like to open it up for questions and, Diego, happy to take questions now.

Thank you.

Thank you.

(Operator Instructions.)

Our first question comes from Rober Hottensen with Goldman Sachs. Please state your question.

Hi, Tom. I have a three part question relating to the claw back. The first part of it is how much of the reinsurance claw back was reflected, if any, in earned premiums in the quarter as opposed to the accelerated premiums? I think you had about 4 cents recognition from accelerated but, is there any impact on the earned premium in the quarter?

Secondly, you know, by my calculations, you're going to recognize about 60 cents a share in earnings power from the claw back, everything else being equal, so that if our models had X, it is going to be X plus 60 cents over the course of the next number of years. My question would be, is that 60 cents front-end loaded, back-end loaded or should we sort of anticipate 10 or 15 cents a year for the next 4 or 5 years or so?

And the third question is, on the loss reserves, if you're taking back this business, is there any questionable credit that is taken back or did you, in fact, are you able to leave the questionable credit and, in effect, do you have -- how do you feel about your reserves needing to be adjusted relative to the business that you took back?

Sure, thanks for that question, Bob.

The first part of the question, how much of the impact, obviously this is going to have an impact on increase in our earnings going forward. We took back, you know, after refundings $54 million of up-front premium and about $80 million in installment premiums, $50 million on a PV basis.

What we did this quarter, Bob, is we completed this buyback late in the quarter, so the impact in the quarter was relatively minimal. It was about $1 million. What we're going to do going forward -- what I'll give you is what we project the increase in earnings to be for the next three years. I hesitate giving beyond three years because of things like refundings and prepayments and things like that.

But there's two components to this. There is the additional premium we're going to earn, and then there is some additional expense or GAAP that gets written off, so I'll give you the net of the two for your models. On a pre-tax basis we think we're going to increase pre-tax income about $4.5 million, $4.5 million to $5 million for the rest of 2004, about $8 million to $9 million for 2005, about $8 million 2006, and about $7 million 2007.

That is a pre-tax number so you would have to tax affect that to get your bottom line and I would tax affect that at 35%. Regarding the loss reserve question, this was a tremendous transaction for us. We went through -- this was a very high-quality book of business that we brought back. As you know, we didn't bring all of the book back, we brought the treaty portions back which was, you know, a book that we're thrilled to have.

So, no, this did not have a significant impact on our reserve level at all nor should it. Very high quality book of business. Did I answer all the questions, Bob?

Thank you.

Our next question comes from Geoffrey Dunn with KBW. Please state your question.

Good morning, Tom.

Hi, Geoff.

Could you provide some color on the international pipeline? Are there a lot of big deals floating out there that just, you know, you're not getting your hands around to close or, is it really the story there that the CDO business was such a big chunk that, until that comes back we're really kind of looking for those one-off deals to hit off and on but not as steadily as we have seen before?

It is really two things. The pipeline is actually quite good. The problem is that what we're finding with these deals, you know, particularly what we call the "elephant deals," you know, the big premium, the $20-plus million premium deals. It is taking 12 to 18 months to close these transactions. They're very long lead times, so you're going to see, you know, we're going to go 2 or 3 quarters and then you get a pop.

Unfortunately, that is the way that business is going to be we think for a while and, it doesn't have the established flow business that the U.S. public finance has. So pipeline is good, we're looking at some attractive transactions, but you're going to see volatility in that line item.

Now the CDO market certainly has impacted that in a negative way but, I wouldn't say that is the major reason. I think the major reason is still the lumpiness of the large transaction.

CDOs -- you know what the problem with CDOs is right now? Is you just can't get paid. Credit spreads are so tight that you can't get a reasonable return for taking the risk, so we're just going to walk away from that business until the spreads widen again.

In the mean time we're faced with some run off in the book, so we will have some lumpiness as a result of that.

We are trying to develop flow businesses international, but it is going to take some time. We have made some progress this quarter. We have had, actually, some pretty interesting transactions in Australia, which is, we did our first ever mortgage-backed securitization in Australia and that was a very attractive transaction.

We did a nice mortgage-backed transaction in the U.K. which was a great transaction. So we're starting to see some interesting, you know, new business outside of the mega-deals, but I still think that will take some time to play out. But pipeline looks good.

Alright. And can you provide a little more detail on the financial services businesses between the swaps and the investment agreements? I think last quarter you indicated that some of the less profitable business had rolled off and we're looking more positive going forward. It doesn't seem necessarily the case this quarter, so what was behind that?

Yes, the primary reason in financial services, unfortunately we have a little volatility in that book as well. What happens, particularly in our GIT (ph) book, we have about a $7-plus billion guaranteed investment contract business which is quite simple: we take money in on deposits, we invest the money and we earn a spread. But a fair amount of the money that we invest, gets invested in very high quality mortgage-backed securities.

The problem with that, although you get a nice yield, there is some volatility in the yield from quarter-to-quarter because, as interest rates move around on you, those assets extend or shorten and that impacts the amortization of the premium or discount on those securities.

So what happened this quarter, we actually -- even though we have all seen rates rise for the quarter, if you compare March thirty-first to June thirtieth, on average we use a six-month trailing speed, and I'll try not to get too technical here -- on average speeds -- prepayment speeds actually sped up on the mortgage book and that caused the mortgages to prepay and it caused an acceleration of premium or discount.

That cost about $2 million during the quarter. So that had an adverse impact. We think that volatility will moderate, you know, if we reach -- you know, who knows if we reach the bottom of the interest rate cycle, but the popular view out there seems to think rates are going to moderate or slightly increase, so that should reduce the volatility or cause volatility on the positive side but we -- no one knows for sure where interest rates are going. But that is the reason for the volatility there.

OK, thanks.

Thanks, Geoff.

Our next question comes from Rob Ryan with Merrill Lynch. Please state your question.

Good morning.

Hi, Rob.

Could you just confirm for us the effect on operating expenses from the reinsurance transaction and an expectation, you know, going forward for, you know, a certain amount not to be there?

Yes, are you talking about the accelerated Dak (ph) write-off?

Yes.

This quarter because of the -- you know, we accelerated about $3.5 million and that offsets the $10 million of accelerated premium. Going forward, the numbers I gave you for the future earnings, was net of the accelerated Dak write-off. So generally speaking, you know, 30% to 40% of the earned premium you would see in accelerated Dak write-off.

So the projections I gave you through 2007 incorporated those numbers. So that is net of the Dak.

Right, thank you. OK.

Our next question comes from Mark Lane with William Blair & Company. Please state your question.

Excuse me, good morning.

Hi, Mark.

First question on expenses. Just -- operating expenses, in general, have been kind of running a little bit higher as you've kind of suggested the last few quarters. Are you pre-spending, pre-funding certain initiatives, international expansion given the strong growth in net earned premium or are we at a higher level now? Can you give us a little bit of color there?

Yes, operating expenses, in general, have been rising, although the quarterly increase that you see, is a little misleading in that, it is due primarily to premium taxes, which we view as a good expense because that goes up with the level of premium writings.

But, you know, we have been investing in the business. We have been hiring people. We have been expanding both domestically and internationally and, you have seen that being reflected in the growth rate and expenses really over the last couple of years. I will say you should see that moderate because, you know, although we're going to continue to hire, we're going to continue to invest in the growth segments of the business, you know, we have geared up quite a bit.

So, I think you will still see some increase in expense but you should see some moderation in the rate.

OK. And on the international side, how many -- what were the number of deals you actually wrote in the quarter?

Oh, let's take a look here. Well, let me give you this, what I can give you is the number of deals where the AGP was over $1 million because there is a lot of deals below that but I don't have the number available. There were 9 deals where the AGP exceeded $1 million and in most cases, you know, far exceeded $1 million.

There are a number of deals that were below a million but I don't have the number handy.

OK. In developing flow business internationally, the small PFI business in the U.K., you know, I understand has long lead-time just like the big deals. Has that been a thought at all to try to develop, you know, something that is a little bit more consistent? Or...

Perhaps long-term, Mark. You know, because we have -- resources are precious and we have limited resources, we've decided to focus those resources more on the, you know, high ROE, big premium transactions.

Although, like I said earlier, we are trying to, and I think we're succeeding, in making some good head-way into some of the more flow, like the mortgage-backed sectors in Australia and the UK and the nice thing about that is, although there is a little bit more of a flow aspect to it, they're high premium deals.

So you can make a lot of money on those as well. So that is, you know, because we have limited resources that is where we decided to focus today. Maybe over the long term you may see that change.

And you cited competition internationally. I'm assuming that is coming from non-financial guaranteed related sources, banks or high yield market or....

International, the competition -- the primary competition is the following sources: it is NBAA, FSA, which has always been the case; it's the European banks, which has always been the case; and to a lesser extent over there, Senior sub and the big infrastructure deals, you know, they pretty much want either financial guarantee or a bank involved, so you don't really have too much Senior sub competition there.

We do see the Senior sub competition internationally more on the CDO business.

But the competition you're citing, which of those three areas are you seeing an increase?

I wouldn't say there is an increase. The only increase has been in the CDO area in the Senior sub market. The rest of it, you know, NBAA, FSA and banks from day one, you know, has been our -- that has been our competition from day one and it still is our competition today and I would say it really has been no change there. The only increase has been Senior sub on the CDO business.

And has the NBS conditions in the US, have those become continually more favorable or are we in a period right now that was similar to the second quarter overall?

Yes, good question. NBS, as you know, in the fourth quarter, first quarter and first couple of months, excuse me, fourth quarter, first couple of months of the first quarter, we were pretty disappointed. We were seeing tight spreads, stiff competition from Senior sub.

Really late in the second quarter -- first quarter, like March, and throughout the first quarter we actually had -- we're pretty pleased with the second quarter, pretty pleased with the production there and the amount of insured opportunities. But it is really too early to tell whether that trend is going to continue. We don't know whether it is going to continue or the Senior sub market can come back strong. It really depends a lot on investor appetite for risk going forward. We hope...

You have seen no deterioration so far this quarter versus last quarter?

No. Actually this quarter was --

I mean meaning third quarter?

So far no, too early to tell.

Yes.

Too early to tell.

OK, I asked this question on the last call but just to continue to try to understand these relationships, the relationship between AGP and, also, just gross par guarantee within public finance, last quarter one of your explanations was, that you had written a pretty high premium transaction in California.

Was there anything in the second quarter that would help explain the relationship between higher AGP or is this just sort of the way that you do business and you're able to find higher premium per exposure deals?

I think there's two things in public finance. There were... a lot of opportunities in the second quarter for everybody because, you know, you still came in, you know, $103 billion, you know, issuance was very strong. So, number 1, there was a lot of opportunities, folks.

We maintained our market share at about 22%, but Ambac still -- our focus and that finance system, more structured sector within the public finance, so we're not really interested in writing a whole lot of GOs. I'll give you an example.

The California economic recovery bonds went out and some of those went insured and, you know, we had an opportunity to bid on those and we saw our competition bidding where they were only taking 25% of the spread. That is not acceptable to us. We don't think that's a good use of our capital and, more importantly, we don't think that's a good use of our shareholders' capital. We walked away from those transactions.

We were able to close, you know, I'll give you a sense of the type of deals we closed in the quarter. Very large transportation transaction, some good lease transactions, we did do some GOs where we could get paid and get more of the spread. We had a great healthcare quarter, some tax backs, really a good variety. We did do some a military housing transaction, which is more structured.

Those are the types of transactions we like to focus on and we think we get a better premium for.

OK, so there wasn't really any large deal that kind of swung those numbers?

No. There was a nice variety.

Yes, OK. Thank you.

Thank you.

Our next question comes from Felis Gilman (ph) from SuNova Capital. Please state your question.

Actually, my question has been answered. Thank you.

Our next question comes from Ken Zuckerberg with Stadia Capital, please state your question.

Good morning, Tom.

Hi, Ken.

Mark Lane actually asked the question but just to clarify the increase in insured opportunities in the Senior sub market and the rationale -- more rational behavior there. Can you just elaborate a little bit more, it sounds like investors are bit more risk-averse looking through the rap, but I just wanted to flush that out a little.

Yes, what happens there, it's a bit of a cycle what we saw and we were kind of surprised, you know, in the fourth quarter and first quarter where you just saw investor appetite for risk, I guess, and investor perception of risk change. You know, look at the corporate world right now where spreads are so tight.

You know, we're kind of amazed at how tight spreads are. But it's really just, you know, the investor's appetite for risk, you have got a lot of fixed-income players out there that are starving for yield and chasing yield and, I think that was the phenomenon we saw. So, you might have seen a situation and I'm guessing here, where the investors filled up and now they're coming back and wanting insurance.

Once again, though, I don't know if that trend will continue, we hope it does, second quarter trend was positive.

Great. And Tom, just a housekeeping question going back to the cancellations, the pre-tax earnings benefit for 2007, I think I heard $8 million for '06 or is it $7 million for -

Yes, $6.5 million to $7 million.

Great, thanks very much.

OK.

(Operator Instructions.)

Our next question comes from Terry Shue with JP Morgan. Please state your question.

Hi, Tom. You have indirectly really answered the question about pricing broadly. I think all the comments you have made, the implication is pricing is pretty steady across the board. Is that correct?

Actually, what we have seen, Terry, in pricing is some, actually, narrowing of spreads mildly and really I'll just briefly talk about the few sectors.

You know, we have seen some narrowing in public finance but, you know, to keep it in perspective it's narrowing off of record levels. So, even with that narrowing we're just seeing very good opportunities to generate long-term business at very attractive returns. You know, we're still at a multiple of where we were just a few years ago.

In structured finance, it really depends what sector we're talking about within the structured finance. We had seen some pretty significant spread narrowing in the mortgage sector, now once again that seems to be coming back a little but, you know, we're going to take a wait-and-see attitude to see if that can be sustained.

International, we have seen some mild spread narrowing but, once again, off of relatively huge spreads so we're not concerned. The only place where we have seen, I guess, the only place we have seen dramatic spread narrowing is the CDO market. You know, if you remember two years ago when we're sitting here on the call.

Right.

Everybody was concerned that spreads were wide and we wrote a lot of --

Right.

Great business. Unfortunately we can't write that great business now.

Right. I guess my question was more referring again to opportunities for you, that you really had not had the need to give up return in doing your deals.

Oh, absolutely not. I mean, look our ROE, came in at almost 17% this quarter.

Right.

This was the fourth best quarter of AGP we have ever had. So, now we are seeing plenty of opportunities.

Right, plenty of opportunities writing at close to the same kind of returns that you have been writing at over the last quarter or two, that was the question. So, that's correct, right?

Yes. Although, although we're seeing -- I don't want to be -- I want to be clear, we're seeing some spread narrowing in various segments within the three sectors.

Right, and where it's excessive, you would walk away.

Oh, absolutely and we have walked away, given the California example where -- this was a strategy, that has always worked great for us and if you remember back in the late '90s, couldn't get paid with California and we walked away and came back when you could get paid. We like that strategy and we like that cycle.

When Assured had their offering and then also with FGIC, there hasn't been a question on this call on them. You see them more with Frank Bivona at FGIC, do you, are you seeing them more over the last few months?

Assured, no. FGIC, in some markets, you know, FGIC we have seen them actually be very disciplined in the public finance sector, which is a good thing.

Right, because the market conditions are good for everybody.

Market conditions are good for everybody and, I guess the one place where we have seen them more on a competitive front is in the -- I guess two places, is in structured finance, particularly in the mortgage back and utility area. Have not seen them internationally at all.

Right. And in terms of the overall credit quality of your book, I guess the general comment would be, it's stable and you don't see any trends going one way or the other? Correct comment?

I think that's right. It is stable. There has really been no change from the last several quarters.

Right.

You know, it's the same credits that we're paying claims on today, that, you know, the ones I disclosed last quarter and the quarter before that. So, nothing really new. You know I think we -- overall we're seeing economic improvement, but we still have some credits that we have -- we're not out of the woods on.

Right. And the IOU area, I gather it's just with very much a narrowing of spreads that right now there are not as many opportunities?

You're absolutely correct. That's a -- you know, just can't get paid there right now.

Right, OK. Thanks a lot.

Thank you.

Mr. Gandolfo, there are no further questions at this time.

Great. Well, I want to thank everybody for participating in the call and Rob Eisman, Pete Poillon and myself are here all day if anyone has any follow-up questions, please don't hesitate to call. Thank you very much.

Thank you for participating in today's teleconference. All parties may disconnect now. Thank you.