AMBAC FINANCIAL GROUP INC - Quarter Report: 2009 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended June 30, 2009

Commission File Number: 1-10777

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

(212) 668-0340

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act): (Check one):

Large accelerated filer  ¨        Accelerated filer  x        Non-accelerated filer  ¨        Smaller reporting company  ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨    No  x

As of August 4, 2009, 287,560,541 shares of Common Stock, par value $0.01 per share, (net of 6,112,109 treasury shares and 705,632 restricted nominee shares) of the Registrant were outstanding.

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Ambac Financial Group, Inc. and Subsidiaries

INDEX

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PART 1- FINANCIAL INFORMATION

Item 1 – Financial Statements of Ambac Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

See accompanying Notes to Consolidated Unaudited Financial Statements.

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Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

See accompanying Notes to Consolidated Unaudited Financial Statements.

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Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

See accompanying Notes to Consolidated Unaudited Financial Statements.

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Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

Supplemental schedule of non-cash investing and financing activities:

The Company consolidated certain variable interest entities during the period. In conjunction with the consolidation of these entities, liabilities were assumed as follows:

See accompanying Notes to Consolidated Unaudited Financial Statements.

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Ambac Financial Group, Inc. (the “Company”) is a holding company incorporated in the state of Delaware. Ambac, through its subsidiaries, provides financial guarantees and financial services to entities in both the public and private sectors around the world. The long-term senior unsecured debt of Ambac is rated CC with a negative outlook by Standard & Poor’s Ratings Service, a division of the McGraw-Hill Companies, Inc. (“S&P”), and Ca, with a negative outlook, by Moody’s Investors Services, Inc. (“Moody’s”). Ambac’s principal financial guarantee operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance”), a guarantor of public finance and structured finance obligations, has a CC financial strength rating with a developing outlook by S&P, and a Caa2 financial strength rating with a developing outlook from Moody’s. These ratings reflect multiple downgrades in Ambac Assurance’s financial strength ratings from June 2008 through July 2009.

Ambac Assurance has not written meaningful financial guarantee business since November 2007. As such, Ambac is actively mitigating losses in Ambac Assurance’s insured portfolio and increasing the yield on its investment portfolio in order to maximize the residual value of Ambac Assurance. Further, the Company’s existing investment agreement and derivative product portfolios are in active runoff, which may result in transaction terminations, settlements, restructuring, assignments of and scheduled amortization of contracts. In the course of managing the inherent risks of these portfolios during runoff, the Financial Services segment may enter into new financial instrument transactions for hedging purposes to the extent we are able to do so.

Ambac’s principal business strategy going forward is to (i) grow our business by developing new business initiatives which capitalize on our expertise and relationships in the capital markets and (ii) reactivate Everspan Financial Guarantee Corp. (“Everspan”) for purposes of writing financial guarantee insurance in the U.S. public finance market when market conditions allow the Company to raise third party capital. Ambac has been unable to raise capital for Everspan and as a result, has determined to postpone its efforts to launch Everspan. Management believes that Everspan will require substantially more capital, including third-party capital, and at least a AA S&P and A2 Moody’s rating in order to compete in the U.S. public finance market. Further, the Company has not yet received permission from the OCI (“Office of the Commissioner of Insurance”) to capitalize Everspan at a level enabling it to compete in that market.

Receipt of financial strength ratings which are sufficiently high to enable Everspan to successfully compete in the U.S. public finance market is critical to Everspan’s business plan. There can be no assurance that the Company will achieve such ratings. The OCI has indicated that it will not approve an investment in Everspan by Ambac Assurance unless Everspan receives financial strength ratings of at least AA from S&P and A2 from Moody’s.

As described above, the financial strength rating downgrades have adversely impacted Ambac’s ability to generate new business and will negatively impact Ambac’s future business, operations and financial results. There can be no assurance that Ambac will be successful in realizing any of the foregoing strategies. If such initiatives are ultimately unsuccessful, Ambac’s activities may resort solely to loss mitigation and eventual run-off of the existing book of business. Additionally, if we are unable to accomplish the reactivation of Everspan in a timely manner, Ambac Assurance will need to reduce its operating expenses.

On July 15, 2009, Ambac acquired the assets of NSM Capital Management LLC and Structured Credit Solutions (“NSM”). NSM provides investment advisory, consulting, valuation and research

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

services to the structured credit markets. In addition to using their services to augment Ambac’s management and its affiliates’ investment portfolios and mortgage related and other asset-backed financial guarantee liabilities, Ambac intends for NSM to continue to provide investment advisory and asset management services to outside parties and will seek to grow and expand such services.

Reclassifications:

Certain reclassifications have been made to prior periods’ amounts to conform to the current period’s presentation.

Regulatory Update:

As a result of significant losses on residential mortgage backed securities (“RMBS”), including financial guarantee insurance policies, credit default swap contracts on CDO of ABS securities and investments in RMBS securities as of June 30, 2009, Ambac Assurance’s statutory capital and surplus and qualified statutory capital (defined as the sum of Ambac Assurance policyholders’ surplus and contingency reserves) had been reduced to $305.6 million and $479.2 million, respectively. Statutory capital and surplus differs from stockholders’ deficit as determined under U. S. GAAP principally due to statutory accounting rules that treat loss reserves, consolidation of subsidiaries, premiums earned, policy acquisition costs and deferred income taxes differently.

Section 3.08 of the Wisconsin Administrative Code prohibits the Company from having total net liability in respect of any one issue of municipal bonds in excess of an amount representing 10% of its policyholders’ surplus. Total net liability, as defined by the Wisconsin Administrative Code, means the average annual amount due, net of reinsurance, for principal and interest on the insured amount of any one issue of municipal bonds. Additionally, Section 3.08 of the Wisconsin Administrative Code prohibits the Company from having outstanding cumulative net liability, under inforce policies of municipal bond insurance in an amount which exceeds qualified statutory capital. Cumulative net liability, as defined by the Wisconsin Administrative Code, means one-third of one percent of the insured unpaid principal and insured unpaid interest covered by inforce policies of municipal bond insurance.

The New York financial guarantee insurance law establishes single risk limits applicable to obligations insured by financial guarantee insurers. Additionally, the laws of the states of California, Connecticut and Maryland include single risk limits applicable to financial guarantee insurers which are similar to the corresponding provisions of New York law. The single risk limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits require that the insured net par outstanding and/or average annual debt service, net of reinsurance and collateral, for a single risk not be greater than the insurer’s qualified statutory capital. New York law also establishes aggregate risk limits on the basis of aggregate net liability and policyholders’ surplus requirements. Aggregate net liability is defined as the aggregate of the outstanding insured principal, interest and other payments of guaranteed obligations, net of reinsurance and collateral. Under these limits, qualified statutory capital must at least equal a percentage of aggregate net liability that is equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for municipal bonds to 4.00% for certain non-investment grade obligations. California, Connecticut and Maryland laws also include aggregate risk limits which are similar to the corresponding provisions of New York law.

As a result of the reduction in statutory surplus and qualified statutory capital in 2009, Ambac Assurance is not in compliance with the above requirements. Ambac Assurance submitted a plan to the

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

respective insurance regulators detailing the steps that Ambac Assurance has taken and will seek to take to reduce its exposure to no more than the permitted amounts. Following the submission of such plan, after notice and hearing, the regulators could require Ambac Assurance to cease transacting any new financial guarantee business until its exposure to loss no longer exceeds said limits.

FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities, clarified that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method, which Ambac has adopted in 2009. Retrospective application is required pursuant to this FSP. Ambac has participating securities consisting of nonvested common stock with the same voting and dividend rights as our common stock. Basic net income per share is computed by dividing net income available to common stockholders less income allocated to participating securities, by the weighted-average number of common shares outstanding during the period. No income was allocated to participating securities during the three and six month periods ended June 30, 2009. Income allocated to participating securities in the three and six months ended June 30, 2008 amounted to $0.01 per share and none, respectively. Common shares outstanding includes common stock issued less treasury shares plus restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding during the period, plus all dilutive potential common shares outstanding during the period. All dilutive potential common shares outstanding consider common stock deliverable pursuant to stock options, nonvested restricted stock units, nonvested common shares, and stock purchase contracts. There were no dilutive effects for the three and six months ended June 30, 2009. There was a dilutive effect of 6,459,734 shares for the three months ended June 30, 2008 and none for the six months ended June 30, 2008. The number of additional shares is calculated by assuming that outstanding stock options were exercised or purchased contracts were settled and that the proceeds from such exercises or settlements were used to acquire shares of common stock or retire existing debt as specified in the contract at the average market price during the year.

On May 23, 2008, the FASB issued SFAS 163, Accounting for Financial Guarantee Insurance Contracts, an interpretation of SFAS 60 Accounting and Reporting by Insurance Enterprises. This standard clarifies how SFAS 60 applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities (i.e. loss reserves). Ambac adopted SFAS 163 on January 1, 2009 except for the disclosures about the insurance enterprise’s risk management activities, which it adopted in the quarter ended September 30, 2008. SFAS 163 is required to be applied to financial guarantee insurance contracts inforce upon adoption and to new financial guarantee contracts issued in the future. As a result of adopting SFAS 163, a cumulative effect adjustment of ($381,716) was recorded to the opening balance of retained earnings at January 1, 2009. The impact of adopting SFAS 163 on the Company’s balance sheet is as follows:

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)