Ambac Financial Group Inc (AMBC) 2006 Q1 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Ambac Financial Group Inc. first quarter earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS).

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Sean Leonard, Chief Financial Officer of Ambac Financial Group Incorporated.

Thank you, sir. You may now begin.

Thank you and good morning. Welcome to Ambac's first quarter conference call. I'm Sean Leonard, Chief Financial Officer of Ambac. With me today are Robert [Eismann], Controller, and Peter Poillon, Investor Relations. This call is also being broadcast on the Web. Our earnings press release, quarterly operating supplement and a short slide presentation that summarizes the quarter's results are on our website. Second quarter 2006 earnings will be released on July 26, 2006, at 8 AM with a conference call at 11 AM.

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 risk results.

I will start with highlights of the first quarter. Net income was $221.1 million or $2.06 per diluted share, up 24% on a per diluted share basis from the first quarter of 2005. While Ambac reports net income in accordance with generally accepted accounting principles or GAAP, research analysts make certain adjustments to net income to calculate their reported estimates.

Therefore to enhance investors' understanding of our financial results, we continue to provide information on the items that analysts adjust out of GAAP net income to arrive at their current estimates.

Those items are net after-tax gains and losses from sales of investment securities; and mark-to-market gains and losses on credit, total returns and non-trading derivative contracts.

In the first quarter 2006, net after-tax gains amounted to $8.1 million or $0.08 per diluted share. This compares to net gains of $5.8 million or $0.05 per diluted share impact in the first quarter of 2005. Some analysts also back out the after-tax effect of accelerated premiums earned on obligations that have been refunded, and other accelerated premiums such as reinsurance cancellations.

Total after-tax accelerated premiums amounted to $12 million or $0.11 per diluted share in the first quarter of 2006, which compares to $18.9 million or $0.17 per diluted share at first quarter of 2005.

Turning to credit enhancement production, or CEP. CEP - which represents gross upfront premiums plus the present value of estimated and installment premiums on insurance policies and structured credit derivatives issued or assumed in the period - came in at $233.5 million, up 17% from $199 million in the comparable prior period. As a reminder, we reported to you last quarter that we were changing the discount rate used in our calculations of CEP.

The discount rate used for the first quarter of 2006 was 5.1%, a rate that more closely approximates the prevailing market rate considering credit quality and tenor of our existing installment book. That compares to the 7% discount rate used in the first quarter of 2005.

Let me now take you through some of the details of our production by segment. In public finance, CEP was $99.2 million down 9% from first quarter 2005 as fewer opportunities existed in the market. Ambac did, however, produce strong [writings] in the healthcare sector. Overall municipal market issuance as reported by third-party sources was down 29% from $98 billion in the first quarter 2005 to approximately $70 billion in the first quarter of 2006 while insured penetration declined from about 62% in first quarter of 2005 to a more sustainable 54% this quarter. Ambac's market share in the quarter, based on prior written, was approximately 25% up from about 21% in the first quarter 2005.

In structured finance, our CEP was $90.7 million up 18% from the first quarter of 2005. We closed deals across a wide array of sectors with commercial asset back, full debt obligations and auto securitizations - once again providing the strongest growth.

In the MBS markets, spreads remained quite challenging but we are writing enough new business to offset the runoff of that book. International CEP in the first quarter came in at $43.6 million, significantly higher than first quarter 2005 production of $13 million. Our first quarter international production was spread across a wide range of asset classes and geographies.

We remain very optimistic about the international markets and I'm happy to report that we have closed some prominent deals in the UK in April. They will be included in our second quarter production analysis.

Next, premiums earned. Net premiums and other credit enhancement fees earned excluding refundings increased to $183.4 million up 3% from the first quarter of 2005. Public finance earned premium excluding accelerations grew 1%. Public finance earnings have been impacted by the level of refundings in the book over the past two years and by the mix of business written over the past several quarters.

Structured finance grew 12%. Excellent production in asset classes such as commercial, ABS and [auto] securitizations has more than offset the negative growth trend we discussed in the past quarters related to MBS. Additionally our CDO business picked up in recent quarters especially so in the U.S. so we are benefiting from that earnings impact.

International earned premiums declined by 5% due primarily to the following factors. Runoff and early terminations in that book during 2005, lower new business production over the past several quarters and an increase in the weighted average LIFO business originated in recent years. While we insured about 11.9 billion of net par and international over the past five quarters, our total international book actually declined by more than 19 billion over that period. We expect that trend to moderate over the next several quarters as pipeline deals get executed.

Deferred earnings - which represented future earnings on premiums already collected and the future value of installments - increased to $5.6 billion. These deferred earnings will be recognized as earned premium and other credit enhancement fees in the future over the life of their related exposures.

Investment income excluding VIE income was $101.7 million, up 12%. The increase in investment income was primarily due to growth in the portfolio, driven by strong operating cash flow including cash received during the quarter related to the reinsurance buyback and the sale of aircraft and the $200 million capital contribution from the parent in the fourth quarter of 2005. Rising interest rates have also had a moderate positive impact on our net investment income.

Next, other income. Other income in the first quarter was $29.5 million, which is much higher than the more typical $2.4 million recorded in the first quarter of 2005. Included in the current period is $25 million gain on the sale of three aircraft from the EETC transaction that defaulted in 2005. As most of you will recall we sold four aircraft at that time of the default and helped three to release to the market.

Had the sale taken place in the second quarter 2005 at the time of default we would have reported as lost recovery and reported a reduced net loss in operating earnings. Instead the gain has been reported in other income because these aircraft have been on our balance sheet as operating assets. We have not excluded this amount from operating earnings to be consistent with prior reporting.

Next, losses and loss adjustment expenses. Loss provisioning amounted to $.1 million, down from $23.5 million in the first quarter of 2005. Our $.1 million provision was the result of increased case reserves, offset almost entirely by net improvement in the active credit reserve or ACR. Total net loss reserves in March 31st, 2006, amounted to $293 million, down from $301 million at December 31, 2005.

Total loss reserves include case basis reserves of $121 million and ACR of $172 million. Additional case reserves amounted to $26 million were driven primarily by additional reserves for public finance infrastructure transaction and an MBS transaction. That activity was offset by positive migration within our ACR, amounting to $25.9 million. During the quarter, we paid claims amounting to $7.8 million.

With regard to our Hurricane Katrina reserve estimate there still has not been enough observable improvements in the region to warrant adjustments to our reserve estimates in either direction. Our reserve - which originally was booked at 92 million - currently stands at about 91 million. There have been minor adjustments to the classified exposure list related to Katrina but certainly nothing material. We are actively involved in meetings and discussions with the appropriate parties and as with all stressed credits within our portfolio we will continue to be rigorous in our surveillance and remediation efforts.

Ambac will continue to assess the impact of Hurricane Katrina on subsequent periods as more information becomes available to us. We anticipate that developments over the next four quarters will provide additional clarity.

As an update, the Financial Accounting Standards Board's review of financial guarantee -- financial reporting remains a work in progress. As a result our accounting policies are subject to change in the future. Our 2005 Form 10-K that was filed with the SEC last month provides a thorough discussion over our loss reserve policy, our loss reserve methodology and the potential for future changes.

One short note about regarding our operating expenses. Our first quarter 2006 includes an expense for equity-based compensation granted to retirement eligible employees. We have also included the impact of adopting FAS 123R on stock-based compensation. Under provisions of that new statement the Company will begin accruing the 2007 stock-based compensation for those employees that are retirement eligible in 2006. Previously, such awards were recognized on the date of grant. Net pretax impact is approximately .8 million and similar amounts will be accrued at future quarters throughout 2006.

Turning to Financial Services. Financial Services net revenues - excluding realized and unrealized gains and losses - were $11.7 million compared to $15 million in the comparable prior period. Our Financial Service segment is comprised of the investment agreement business and derivative products business. Financial Services net revenues declined as a result of lower inception revenues in our derivatives products business, partially offset by increased spreads in the investment agreement business. Our return on equity was 16.3% for the quarter.

Regarding share buyback, in our Form 10-K - filed with the SEC on March 13th - we reported that we had bought back about 396,000 shares for a total of almost $30 million between January 1st and March 3rd, 2006. Between March 4th and the end of the quarter Ambac did not buy back any additional shares. We will continue to analyze capital usage in 2006 as we seek to optimize our capital position consistent with a AAA-rated company while maximizing shareholder value.

In summary Ambac continues to fare very well under the present market conditions. We are confident that as actual business conditions improve we will be well-positioned to take advantage.

That concludes my prepared remarks. I would now like to open it up for questions.

(OPERATOR INSTRUCTIONS) Geoff Dunn of KBW.

Good morning, gentlemen. It's actually Matt. Geoff had to take a call. First question, looks like you recaptured the [accent] on American re treaties this quarter. Any plans on where theses positions might go? Whether you might send them off to other treaties or whether you are going to keep the business to yourself right now?

At this particular time, that's right, we did recapture [Re]. We disclose the recapture of those two treaties in January of 2006. We intend to hold those -- hold that business in our portfolio. The impact, we disclosed some of the impacts on acceleration of premium. The net impact after DAC and commissions and takebacks, some modest losses, is approximately $2 million. We expect the run on that to be about $2 million for this year in 2006.

Also any way you can provide a little bit of color on the positive ACR development? Just what types of deals they were? Any trends or anything any more color on the ACR development?

Yes. We've had -- it's made up of a lot of credits but generally in each particular sector - CDO, MBS, kind of a broad other sector which includes a variety of public finance and other types of transactions. - We had favorable net development in each one. In the CDO what you'll see in the second quarter is we actually close out a transaction pay to claim and sold out the collateral. So that resulted in a decrease in ACR based upon that event that occurred in April before this call.

Likewise on the MBS. There's some net. There's a net improvement there. Some of that was related to a transfer of ACR to a loss expense reserve and we are also settling out that particular transaction, too, in the second quarter. So we had positive development due to an actual transaction that is occurring. So that actually happened as well.

And then in one particular public finance transaction we were able to secure a much better security package than what had existed and we had that particular credit on our classified list. And that was -- we were able to upgrade that credit and that had an impact as well.

That's very helpful. Just one last quick question. With a little bit of maybe the positive capital developments, I know you talked about where you might be share repurchase-wise going forward in the year, but any added color on what you might do with the capital?

Yes. We are going through that. Obviously we look at that on a regular basis. There's a number of factors that would go into capital estimation and trying to develop what a true excess capital position would be. We would like to keep, obviously, a reasonable and prudent cushion above minimum capital standards; so there's some art involved there.

But we think at this particular point in time, we are prudently capitalized. We're going through the -- an exercise now with the ratings agencies, their normal annual reviews. So that's a process that will be going on through summertime as well. So not to -- we will, however, as the situations change, some of the variables such as underlying credit, business prospects or other transactions that occur, we will reserve the right to be opportunistic if you will, on the capital side.

Thank you.

Ken Zerbe of Morgan Stanley.

A couple of small questions. First of all, how much did the lower discount rate effect your CEP growth this quarter?

The lower discount rate affected -- we had a 17% growth rate. If we had used a 7% rate on this quarter's production, the growth rate would have been approximately 13%. And that translates into a little bit short of $9 million.

And then in turn, just to follow up on that last question that you said - I forget the exact wording - you use a prudent amount of capital. Right now do you believe that you have just that cushion above the minimum or do you have excess capital above your cushion now? Just to -- directionally on that.

Yes; I think we're what we're saying is we think we have an appropriate amount, considering that cushion. So we think we are at appropriate point within our capital level that, considering all the variety of elements that are existing out there, with credit and whatnot.

All right. The last question I had was within structured finance your net earned premiums were up about 12% this quarter. Could you tell us how much of that was due to very short transactions or at least maybe discuss the duration of the business that’s being put on, that resulted in that strong premium.

Yes. Just to give you a sense for the growth. If you are looking at first quarter over first quarter, largest growth is coming from the asset backed in the conduit area offset a little bit by the mortgage-backed securities portfolio for the runoff there. Net runoff. Also there's been some positive writings in the CDO sector so if you look at the other credit enhancement fees - which is normally where we would put the revenues from the derivatives from CDS type business, full debt obligations you'll see a pretty healthy growth there. So that's where the growth is coming from.

And, generally, those just to center on those transactions who would be -- I don't have an average life. We can probably maybe get back to you with that. But generally this other credit enhancement fee transactions with the [lifes] would be approximately five to seven years normally. So that's kind of what you are looking at.

Thank you very much.

Darin Arita of Deutsche Bank.

Good morning. Taking a look at the runoff on the mortgage [stock] and home equity book and it seems to have -- the case of the runoff seems to have declined in the first quarter. It was kind of around the 6.5 billion per quarter runoff level over the past few quarters and it's coming down to about the $5 billion level. Is there anything happening there?

Nothing remarkable. I think you do have appropriate numbers regarding the runoff and some system termination maturities but there is nothing that I'm aware of that's causing the trend rate that's greater than it was in prior periods.

And I guess moving on to the operating expenses and the compensation expense in the first quarter for Financial Guarantee was up about 14% and I noticed in '05 that first quarter did jump up but then it sort of came down to maybe a steadier level for the other three quarters in '05. Is that sort of the trend we should expect in '06?

Yes; a couple of things to note about the first quarter of '06 and that includes two things, primarily. One, it includes the grants that were January grants to the retirement eligible folks. If you recall last year in the first quarter we had a charge for that. Since they are eligible they vest upon since meeting a certain age requirement they immediately vest, requires an expensing upon grant-based rather than over a period of time. That has an impact on the first quarter. So that's a one-time impact, if you will. Approximately gross about $6.4 million.

Also in the first quarter as we mentioned it in the script, we are also accruing for the anticipated 2007 grants for that same pool of individuals. So the first quarter gross expense for that is about $1.8 million; so you'll see that coming through the second, third, and fourth quarter. So we won't have this type of a one-time charge in 2007 in the first quarter.

Thank you very much.

Mark Lane of William Blair & Co.

Good morning. My first question is on reserves. The reduction in the active credit reserve, this is the third quarter in a row where we've seen a pretty material reduction presumably driven by the improvement in the credit environment. But it's really the first time that we've seen a material move down in the history of the Company, really.

My question, really, is because reserves have been so volatile and losses have been so volatile the last four to six quarters, when - on a go forward basis typically the loss ratios kind of been mid to high single digit as a percentage of scheduled earned premium. But how do these changes affect the loss ratio going forward? How should we think about that?

Yes; clearly our reserving process is affected by our views on our classified portfolio. I think this quarter, in particular, you're seeing - and into April - you're actually seeing a closeout of some of the problematic, some of the classified items that were lower on our portfolio so we're actually settling out these particular items.

From a go-forward basis, it's difficult to project based upon our methodology what will actually happen. Because we are trying to pick up events as they occur in the portfolio. Clearly, another big piece of our ACR reserve is the Hurricane Katrina reserve. So I think we will see additional clarity over the next four quarters on that. So that could add a little bit to the volatility of the numbers, Mark, so it's hard to normalize if you will our loss reserving process.

Well, see, that's kind of my question. I mean, you say it's difficult to predict based on your methodology but historically it hasn't been difficult to predict. I mean, if it is the same methodology I mean you go back two to four years and it's been pretty steady increase in the provision on a quarterly basis. I mean, sometimes, it's a little bit higher because of deterioration in the credit environment. But that's kind of the point of the question.

Yes; I think -- wasn't around for those back years but I can tell you that we are seeing actual events occurring. As I mentioned this quarter is clearly events occurring that were closing out these particular transactions and there's not anything that's coming on the list that's filling up -- problematic credits that's filling up those amounts. So I think it's a little bit the environment and it's a little bit of us closing out. So, some of the transactions that have been on our adverse and classified list for quite some time.

On the CDO business, has there been a change in the market for CDOs? I mean, issuance was huge last year but spreads were really tight so you didn't really write that much business and spreads arguably have even gotten tighter in the first quarter. So what happened in the market that allowed you to write some of the pool business?

I think it's more a function of volume and us being able to select certain particular transactions that we were able to write. So I think it's more of a function of just the market volume than it is a tremendous increase in pricing. But there are opportunities out there and we are able to participate in those opportunities.

Then, finally, within structured finance in the fourth quarter, I know there was some impact from large deals. Was there any one or two deals that contributed in a big way this quarter?

No. This quarter was -- would be characterized by a few large deals and they were not in the structured finance area. We had one in the international and one in public finance but none that were in structured finance.

Thank you.

(OPERATOR INSTRUCTIONS) Rob Ryan of Merrill Lynch.

Good morning. I was hoping you could comment on the general competitive environment. There was some mention of it in the press release. It doesn't sound like anything particularly new but is there anything at the margin that you would like to discuss?

Rob, I think that's true. Clearly in the public finance sector we saw a decline in volume - overall volume - in the marketplace. We enjoyed a healthy market share there due to some larger transactions that closed but as market issuance kind of declines, you still have the same number of participants looking at those transactions. So that will be something to perhaps watch over the balance of the year.

I think the overall environment in structured finance still characterized by let’s say tight credit spreads and competition from alternative forms of execution, senior sub so nothing there. We were able to enjoy some commercial ADS deals which is perhaps unique so that kind of helps us a little bit, gives Ambac a little bit of an advantage and then international marketplace. Don't really have additional commentary there other than it still characterized by complex large transactions. But we're starting to see some more opportunities from different geographies there.

Seen a little bit more of a flow but still characterized by strong competition.

Okay. Just switching gears a bit. Now that we are at four-year highs for the ten-year treasury yield, could you go over the pros and cons of a higher interest rate environment and whether net net at the end of the day, you are happier in today's environment compared to a year ago?

Sure. Net net net will kind of go through I guess by sector - it just seems to make sense. Public finance - just from the business side and then maybe we will turn to the investment portfolio. On the business side on public finance, negative of higher rates clearly is less refundings, less - which means less refunding accelerated premiums for us. Generally a good thing as we earn those premiums as the risk goes away.

On the positive side, increasing rates would impact presumably spreads and the ability of us to charge premium, which is typically done on principal plus interest. So that would be the positive and negative that is I see there.

On the structured finance side, increasing rates presumably would slow down prepayments under mortgages so you would think we would have a longer installment pattern there. So that would be an impact to our installment premium collections.

Then you have similar types of -- overseas, potentially, you would have increased interest rates which could have an impact on issuance levels but may impact the ability to charge more premium.

On the investment portfolio, we look at two sets of rates there. One would be as you mentioned the taxable rates, treasury rates with considerations of spreads for a variety of different asset classes that we potentially invest in. We also keep obviously an eye on municipal markets and you are looking at the after-tax yields between the taxables and the tax exempts.

You mentioned the taxables going up, the municipal rates have also gone up. That helps us clearly in our investment portfolio and putting our operating cash flow and any additional cash that we have to use at higher rates. So clearly -- clearly that would be -- have an impact. Net net, I think increasing rates would have a net positive impact.

Just on the net investment income, what would you estimate a new money rate to be currently, compared to your existing portfolio yield?

I think the new money rates, pretty much all of our many as you can see from our supplements going into tax-exempt municipal high-grade municipals. Those rates, I think, towards the end of the quarter were a little bit above 4%. Maybe about 4.15 and that, actually, the net -- I think the net, that's a little bit below our net yield but it's above what we would have been investing in the first quarter of last year.

Thank you.

Gary Ransom of Fox-Pitt Kelton.

Just a couple of quick questions on numbers. Was there anything unusual in the tax rate which seemed to be a little bit lower in the first quarter?

No; I don't think there's anything unusual there other than, as I just remarked, we are purchasing -- using our cash flow to purchase tax-exempt securities.

And another question. On the change of the discount rate for installment premiums, how did that play into the calculation of adjusted book value?

It did not. Because what we do with adjusted book value is we had a rate at the end of the year of 5.1% which was consistent with what we used for the quarter for CEP. The rate at the end of the quarter, 331, was 5.6%. So that's to reflect the increase in rates across the yield curve.

So the CEP would obviously -- the production would go into adjusted book value but the installments [with that at the] end of the period would be discounted at a 5.6% rate.

That was it; thank you.

(OPERATOR INSTRUCTIONS). Tony [Delapiena] of John Hancock.

I guess generally in terms of the portfolio, obviously you disclosed your underlying shadow ratings. But I guess generally in terms of the real estate area in your structured finance group, could you comment in terms of specially residential and a little commercial that you do but residential. Have you tightened underwriting criteria? How have you looked -- how have you re-looked at that sector given what's been going on in terms of some markets?

Yes, we have clearly looked at a variety of the most public issues there being housing bubbles, different types of new products, and the makeup of the new products, in particular pool. So clearly from an underwriting perspective, we are considering all those and the makeup of the pools, considering changes to our actual models that we use in underwriting, and different types of stress scenarios that are involved in underwriting a credit.

So clearly that's been looked at. I think certainly they will need -- MBS side, we are looking at clearly price return characteristics and we didn't see a lot of opportunities in the beginning of '05. We are seeing some more opportunities there to write what we feel is good business. So we've done that. The comment, generally, on the MBS portfolio is a function of our loss reserves. Kind of mentioned a net reduction in ACR on the MBS side. That's largely due to the settling out of claims that we were -- had a larger reserve up for that versus what is being -- what the settlement amount is.

We did have, you may notice in the operating supplement there will be an increase in the below investment-grade in the mortgage facts that due to some slight deterioration on something that we already had on our classified list that's built into our ACR reserves. But you'll see those numbers go up a little bit due to the performance of the underlying portfolio but not dramatically different performance. Just we are seeing negative trends.

A follow-up in terms of Katrina. I know you talked about some things but what's your exposure and from the underlying shadow ratings, what percent of that has the rating agencies taken to below investment grades? And I guess given the whole idea of catastrophes, natural catastrophes like that, has that impacted any of your underwriting in any of your other business? And certainly we just talked about the residential mortgage product but has that changed your thoughts in how you do some of the things you do?

Yes. Currently we had classified, Ambac got classified about 1.1 billion of credits relating to the region affected by Hurricane Katrina. Don't have the statistics on the rating agencies in front of me. So I don't want to comment there. I don't have the statistics there.

Overall from an underwriting perspective, I would say clearly the uniqueness of this particular catastrophe is the flooding and the displacement of the population which has been unique, compared to other potential -- or catastrophes that have happened before where we haven't had any major impacts on the underlying credits.

So I think that's a particular area that we would be sensitive to in underwriting that that particular point of information is an area subject to that type of displacement for a variety of reasons - in this case flooding - then obviously that would be something we would think very hard about in the underwriting process.

So that 1 billion, you talked about that’s your total Katrina exposure and --

Yes that's the net par of the obligations that we have on our classified portfolio list.

And finally last question. Reinsurance. Do you have any that are in the BBB area in terms of financial strength ratings and if you do who would they be?

No all of our reinsurers are either AA or AAA. Split pretty much 50-50 between those two ratings captions.

Mike Thrasher of Piper Jaffray.

Questions have been asked and answered. Sean, thanks very much and congratulations on the quarter.

Thank you.

Thank you. At this time I would like to turn the floor back over to management for any additional or closing comments.

Thank you very much for attending our conference call. We will be available to answer any additional questions that you may have. Please give myself, Pete Poillon a call. Thank you very much.

Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference.