Friday, August 1, 2008 1 comments ++[ CLICK TO COMMENT ]++

Ambac Pays $850 million to Commute a CDO Insurance Contract

Ambac announced that it will pay $850 million to commute one of its CDO contracts (press release quoted in full):

Ambac Financial Group, Inc. today announced that it has settled one of its largest CDO exposures, AA Bespoke, in exchange for a final cash payment of $850 million to its sole counterparty. AA Bespoke is a $1.4 billion transaction that originally comprised AA rated CDO of ABS tranches, most of which have been downgraded to below investment grade since the inception of the transaction.

As of March 31, 2008, Ambac had recorded approximately $1.0 billion of mark-to-market losses, including an impairment loss of $789 million, against this transaction. As a result of the settlement, Ambac expects to record a positive pre-tax adjustment of approximately $150 million to its aggregate mark-to-market. In addition, the stress case losses in the rating agency capital models for this transaction exceeded Ambac’s final payment and therefore, the settlement will result in an improved excess capital position for Ambac Assurance Corporation.

Michael Callen, Chairman and CEO of Ambac, stated, “The primary benefit of this agreement is that it eliminates uncertainty with respect to future losses related to this transaction. We view the final outcome as favorable in light of the numerous widely circulated models that assumed a 100% write off for this transaction. This settlement also confirms our view that transaction mark-to-market adjustments are not indicative of ultimate credit impairment.” Mr. Callen continued, “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.”

According to some media sources, the counterparty seems to be Citigroup. This is a good deal and the market is bidding up Ambac's stock, which is up 50% today.

Because Ambac took a $1 billion mark-to-market loss, this deal actually results in a mark-to-market gain of $150 million.

Ambac is actually paying $61 million above the credit impairment it booked on this deal (850-789). Whether this is done to get the deal done, or whether it is due to potential further declines in the future is not clear.

From the detailed CDO exposure, we can see that this AA Bespoke deal happens to be a CDO-squared originated in 2007. All of it is composed of mezzanine CDOs, and it had 30% subordination originally. This, like practically every single CDO-squared out there on anyone's book, was downgraded below investment grade a while back.

This is one of the worst deals out there (CDO-squared, 2007 vintage, 100% mezzanine CDOs underneath, 30% subordination vs almost 50% for most other CDO-squareds) the commutation was a good move by Ambac.

Couple of reasons why the counterparties are willing to tear up these deals is because (i) liquidity reason: some of them would rather have some cash now ($800m is quite a bit of change) than try to dilute their shareholders by raising capital when their share prices are depressed, and (ii) mark-to-market uncertainty: bond insurers don't really care about mark-to-market losses (it impacts perceptions though) and are happy to pay claims over many years or decades, whereas banks would rather not carry the mark-to-market losses. If I'm not mistaken, mark-to-market losses impact capital reserve requirements for banks but not bond insurers.


1 Response to Ambac Pays $850 million to Commute a CDO Insurance Contract

August 1, 2008 at 4:30 PM

The market certainly loves this deal. If Ambac can ditch more of it's seriously bombed out insurance deals on similar terms the short-term future of our investment brightens rapidly.

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