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Ambac Financial Group Inc. didn't see the subprime-mortgage mess coming until it was too late. Yet to trust its latest balance sheet, you must believe its executives can predict what Ambac's income will be for the next 20 years.
And if you buy that, then maybe Ambac's insurance unit really does deserve a AAA credit rating, just like Moody's Investors Service and Standard & Poor's say.
The line item to watch here is an asset called deferred taxes. As of March 31, Ambac said this was worth $3.6 billion, a figure almost three times as large as the New York-based bond insurer's $1.3 billion of shareholder equity.
Deferred-tax assets consist of tax-deductible losses and expenses carried forward from prior periods, which companies can use to offset future income-tax bills. There's a catch, though. These assets are valuable only to companies that are profitable and paying income taxes.
Ambac isn't profitable now. Its $5.3 billion of net losses for the past three quarters wiped out all its net income for the previous nine years. The only way Ambac is allowed to carry all $3.6 billion of these deferred taxes on its books is by assuming it will make tons of money in the future. Otherwise, it's supposed to set up an allowance to cover writedowns of the assets. By recording no allowance, Ambac is signaling it has the ability to use the assets entirely.
To do that, the company would have to generate about $10 billion of future taxable income, based on a 35 percent tax rate. By comparison, from 1991, the year the company held its initial public offering, through last quarter, Ambac's cumulative pretax profit was $89.2 million.
Here's How
This made no sense to me. So I asked Rich Alger, Ambac's managing director for accounting policy, to explain the company's analysis. Here's how he said Ambac got to $10 billion.
First, Alger said Ambac expects about $5.9 billion in "future premium earnings" from now until sometime after 2028, even if it never writes any new insurance policies. Next, he said Ambac expects about $10 billion in "future net investment income," which excludes capital gains. Ambac also is forecasting $387 million in other fees.
Something's missing from those projections, though. They include almost no expenses. For instance, the future premium "earnings" aren't earnings. They're revenue.
Alger declined to say what Ambac's estimates are for future operating expenses. Nor would he divulge Ambac's estimates for future interest expenses, an important matter for a company with debt that's 7.5 times its equity.
"We've gone through a very rigorous analysis, and our auditors have reviewed it very closely," Alger said. Ambac's outside auditor is KPMG LLP.
Trust Me
In other words, Ambac's numbers are trust-me numbers that the company offers scant grounds for trusting.
Last quarter, Ambac reported $186.9 million in net premiums earned. Yet it also had $49 million in related underwriting and operating expenses, along with a $1 billion loss for expected claims on policies tied to mortgage-related securities.
Not all the $5.9 billion in projected future premiums is assured either. Ambac has collected $2.5 billion of this upfront, which it will recognize as revenue over time. However, about $3.3 billion represents installment premiums not yet paid. In its financial filings, Ambac says that some installment-plan customers might terminate their policies early if investors continue to lose confidence in Ambac's financial strength.
As for the $10 billion in future investment income, Alger said this can be gleaned from the $123.6 million of income Ambac earned last quarter on the $12 billion investment portfolio held by its financial-guarantee operation. "You can extrapolate that number out over 20 years," he said.
Find the Evidence
Most of that income, $91.7 million, was from municipal bonds. Those investments don't generate taxable income, although Ambac could sell and replace them with taxable investments. And, again, Ambac isn't including interest costs. Ambac had $116.9 million of interest expense last quarter, compared with $209.4 of investment income for Ambac as a whole.
This brings us back to Ambac's decision to record no valuation allowance. The relevant accounting rules, known as Statement 109, say "forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years."
Another negative is the uncertainty over Ambac's AAA rating. Without it, Ambac wouldn't have much of a business. Moody's and S&P are considering downgrades.
To be sure, if a company can show strong evidence indicating enough future taxable income to realize the deferred-tax asset, then the accounting rules say a valuation allowance isn't needed.
See For Miles
The rules don't specify how far into the future a company is allowed to look when making such forecasts. Still, 20 years seems like a stretch, says Charles Mulford, an accounting professor at Georgia Institute of Technology in Atlanta.
"For Ambac, where the company's financial performance has been so strained and where future profits are so much in doubt, it would seem that the only reasonable conclusion would be to reserve those deferred-tax assets," Mulford says.
While I don't know what the correct valuation allowance is, I'm fairly sure the right answer isn't zero. Even a modest reserve -- say, 36 percent of deferred taxes -- would have eliminated Ambac's equity. Another quarter or two of big losses, and Ambac won't be able to keep this up much longer.
Moody's and S&P should just get the downgrade over with now.
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