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Ambac Financial Group (ABK)Stock (Financial Services Industry, Surety & Title Insurance Industry)
 Ambac Financial Group, Inc. (NYSE:ABK) is a holding company which has two main subsidiaries: financial guarantee and financial services. Its primary business, the guarantee side, is known as Ambac Assurance Group. This company operates as a monoline insurer. Ambac and its competitors, such as M.B.I.A., insure securitized debt. This implies that if a bond/security fails, the company will cover the interest and the principal. They currently insure over $524 billion of debt.[1] Ambac built its reputation on low risk investments with predictable returns - such as municipal bonds and investment grade corporate debt. The company earned a top AAA rating from all major rating agencies because of its strong balance sheet. This meant that any security insured by Ambac took on the firm's AAA rating, allowing access to a larger population of investors and generally lower interest rates. In recent years, Ambac has insured large numbers of collateralized debt obligations(CDOs) such as mortgage-backed securities. These insurance policies were lucrative and allowed Ambac to double its revenues in the four years between 2002 and 2006. Risk management was completely lacking and like the firms that issued CDOs, Ambac vastly underestimated the probability of defaults. With the onset of the subprime lending crisis, Ambac was suddenly obligated to cover huge numbers of failed mortgage-backed securities. The company's assets do not approach the level of debt that it has incurred from these devalued CDOs. Ambac's financial problems threaten its pristine AAA credit rating, and the credit agency Fitch Ratings, Ltd. was the first to downgrade to company to AA.[2] Five months after Fitch's January downgrade, S&P downgraded the holding company and the firm's insurance unit to AA. Moody's claimed that it is currently reviewing the company for a downgrade.[3] Downgrades from the rating agencies for Ambac and its competitors are creating major waves in the financial industry. This fallout would effectively cause all the bonds insured by the downgraded firm to assume the new lower rating unless the underlying credit was AAA. Investors would suddenly hold billions of dollars in revalued securities that were worth much less than they previously thought. Additionally, many issues were bought on Ambac's AAA strength without concern for the underlying security's credit rating. The economic effect of such a situation is potentially drastic, and there is speculation that the U.S. government may intervene or further regulate the industry.
[edit] Business FinancialsAmbac brings in revenue by writing insurance policies on municipal bonds and other asset-backed securities, protecting the holders against default. It also collects interest on its own investments. Below is the amount of insured par and revenue breakdown.   In 2007, Ambac posted revenue of -$4.2 billion, with an operating income of -$5 billion and a .net loss of $3.2 billion.[6] [edit] Key Trends and Forces[edit] Credit SpreadsThe spread between the interest rates on credit instruments insured by Ambac and the risk-free rate is a major driver affecting the premiums earned by the company. Wide spreads mean larger premiums and generally higher margins, whereas narrow spreads decrease premiums. Spreads on most credit securities and derivatives have generally become wider in 2007, which leads to two offsetting trends for Ambac:
Generally, when markets are highly liquid, spreads narrow, competition for credit insurance business intensifies, and prices are driven down. When markets suffer from less liquidity, Ambac has generally fared well by demonstrating expertise in insuring complex and large (due to its size) transactions in a less competitive environment. Recently, Ambac has come under pressure from the current poor state of the securities market and market declines in some of the credit derivatives they underwrite. Furthermore, declining credit quality of mortgage backed securities underwritten by Ambac has investors skittish about the company's costs for these products; it is more expensive to underwrite these policies with a lower credit rating. [edit] Growth in Capital MarketsThe fixed-income markets that Ambac operates in have seen double-digit annual growth over the previous 3 years[7]:
This growth provides a more robust array of securities to be insured, though in the longer term it has also attracted new competition for business, driving down pricing and spreads. The international segment has been growing most rapidly as capital markets abroad begin to come into their own. The majority of this international exposure is in Western Europe and the UK.  [edit] Credit RatingsAmbac's business model is largely dependent upon its overall credit rating. It receives an insurance premium by guaranteeing the coupon and principal of bonds. This premium is entirely based on Ambac's financial strength. Fitch's has already downgraded Ambac two levels to AA. Many investors feel that downgrades from Moody's (MCO) and Standard & Poor's are simply a matter of time. This is evidenced by Ambac's decline in new business: 87% in the last quarter alone.[8] Credit ratings provide objective judgments about the insurer’s ability and willingness to pay insured parties when necessary. Declines in the credit quality of the company will cause its potential customer pool to shrink because of increased cost of capital.[9] [edit] Alternative ProductsAmbac faces the threat of competition from alternative credit enhancement products like credit default swaps, which have become much more widely available and liquid in recent years. There are very few barriers to entry in this business, since it is merely a counterparty agreement to pay in the event of default. Therefore, numerous banks and financial services companies provide these competing products. [edit] CompetitionThe guarantor/financial insurance business is highly competitive. The only barrier to entry, which deters smaller but not necessarily larger financial entities from entering the market, is a minimum capital requirement necessary to maintain a strong credit rating. Largely, companies compete on a mix of price and consumer trust and judgment of the insurer’s ability to pay. Ambac has the highest credit rating, and therefore tends to compete most directly with other triple-A guarantors, including:[10]
However, the company also competes with alternative forms of insurance, including derivative contracts like credit default swaps, etc, which are written by most major bank and financial institutions. This makes the effective playing field in the credit insurance business substantially larger and more competitive.
[edit] Market ShareAmbac's market share by par in its "core" U.S. Public Finance market, as a percentage of total insured par issued for the year, was:
[edit] Footnotes
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