Sell Side

Ambac to Settle a CDO Exposure

Ambac Financial Group Inc. has agreed to pay Citi $850 million to settle one of its largest collateralized debt obligation exposures, improving the excess capital position of insurer subsidiary Ambac Assurance Corp., the companies announced Friday.

The agreement terminates the guarantee on a $1.4 billion collateralized debt obligation squared transaction, a CDO of a double-A rated CDO of asset-backed security tranches - most of which have now fallen below investment grade. Ambac Financial nevertheless expects to record a pre-tax $150 million gain on the settlement, because it had already recorded approximately $1.0 billion of mark-to-market losses on the instrument. It reports its second-quarter earnings Wednesday.

The "primary benefit" of the transaction is a reduction in uncertainty, Ambac chairman and chief executive officer Michael Callen said in a statement.

"We view the final outcome as favorable in light of the numerous widely circulated models that assumed a 100% write off for this transaction," Callen said in a statement. "This settlement also confirms our view that transaction mark-to-market adjustments are not indicative of ultimate credit impairment. This is an important milestone in our efforts to work with counterparties as we evaluate settlement as well as other restructuring opportunities related to our CDO exposures."

Ambac still has exposure to three other CDO squared transactions, although AA-Bespoke, as the terminated one is known, is by far the largest, according to quarterly filings as of March 31. Two other 2007 transactions of approximately $500 million each have also fallen below investment grade. The third outstanding CDO squared is a 2005 transaction of $79 million.

In a research note, Goldman, Sachs & Co. analysts Monica Gabel and Daniel Zimmerman called the move "a positive" for Ambac as it settled the debt at 61% of par value, compared to Goldman's estimate of potential losses on CDO-squared transactions of between 75% and 95%. Wisconsin insurance commissioner Sean Dilweg said his office viewed the deal "favorably."

Ambac's stock jumped 50.4% on the news to close at $3.79. Credit-default swaps on Ambac Assurance fell to 16 points upfront on Friday, down from 20 points on Thursday, according to Markit, reflecting the market's lower perceived threat of default.

The deal follows another announced last Monday night in which Security Capital Assurance Ltd. agreed to pay Merrill Lynch & Co. $500 million to commute eight credit-default swaps. Along with a separate agreement between SCA and its former parent XL Capital Ltd., the termination helped SCA avoid insolvency, New York insurance regulators said.

New York insurance superintendent Eric Dinallo said that pact between SCA and Merrill could serve as "template" for others between insurers and counterparties. Merrill has said it is negotiating settlements on CDO hedges with MBIA Inc. and other lower-rated bond insurers.

Analysts said other bond insurers and counterparties will likely strike more deals to terminate guarantees. Shares of other insurers rose in Friday's trading, with MBIA Inc. up 29.34% to close at $7.67, Assured Guaranty Ltd. up 8.9% to $12.48, and SCA up 12.63% to finish at $2.14.

"While the SCA/ML agreement to commute certain CDS contracts relating to ABS CDOs doesn't mark the beginning or the end of the mortgage saga for the bond insurers, it is a good indication that we have entered a new chapter," wrote Bank of America Securities LLC analysts Michael Barry, Seth Levine, and Brian Turner in a report last week.

The deals will further "tarnish" the reputations of bond insurers, because they set a precedent of them settling, rather than paying out full claims, said Richard Larkin, director of research at Herbert J. Sims & Co. But for existing bondholders the deals are "generally positive because it's going to assure that somewhere down the road maybe some money will be left to pay existing claims," Larkin said.

For bond insurers facing insolvency, though, some deals may actually hurt existing policyholders, according to Rob Haines, a senior analyst at CreditSights.

New York insurance law says that credit default swaps are not considered insurance, and, in the event of regulatory takeover, the claims of CDS holders would be subordinate to insured policyholders, even if the CDS contracts say otherwise, Haines wrote in a recent report. This gives the counterparties an incentive to get capital now - essentially jumping municipal policyholders - rather than wait for regulatory intervention, which could make their holdings "worthless".

"We think [commuting CDS exposure] will backfire and erode capital at an accelerated rate since both the cash used to commute contracts and the installment premiums associated with those canceled policies will head out the door," Haines wrote. "Ultimately, we believe that structured contract holder will crowd out their municipal book as they race to get as much capital as they can before a potential rehab event."


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