Octave Specialty Group, Inc. (OSG) Q2 2017 Earnings Report, Transcript and Summary

Good morning, my name is Lisa, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Ambac Financial Group, Incorporated Second Quarter 2017 Earnings Teleconference. Our hosts for today's call are Lisa Kampf, Head of Investor Relations; Claude LeBlanc, Chief Executive Officer; and David Trick, Chief Financial Officer. Today's call is being recorded and will be available for replay beginning at 11:30 Eastern Standard Time. To dial-in number is 1-800-585-8367 domestic or 416-621-4642 internationally using ID number 55278932. At this time, all participants have been placed in a listen-only mode and the floor will be open for your questions following the presentation. [Operator Instructions] It is now my pleasure to turn the floor over to Ms. Lisa Kampf. Please go ahead.

Thank you. Good morning and thank you all for joining today's conference call to discuss Ambac Financial Group's second quarter financial results. We'd like to remind you that today's presentation may contain forward-looking statements, which are based on management's current expectations and are subject to uncertainty and changes in circumstances. Any forward-looking statements are not guarantees of future performance or events. Actual performance and events may differ, possibly materially from such forward-looking statements. Factors that could cause this include the factors described in our most recent SEC-filed quarterly or Annual Reports under Management's Discussion and Analysis of Financial Condition and Results of Operations and under Risk Factors. Ambac is not under any obligation and expressly disclaims any obligation to update any forward-looking statement whether as a result of new information, future events, or otherwise. Today's presentation contains non-GAAP financial measures. The reconciliations of such measures to the most comparable GAAP figures are included in our earnings press release, which is available on our website at ambac.com. Please note we have posted slides on our website to accompany this call. I will now turn the call over to Claude LeBlanc.

Thank you, Lisa, and welcome to everyone joining today's call. I'm pleased to report we've had another very active and successful quarter resulting in an achievement of several key strategic milestones over the past few months. Our results for the quarter, along with our recent announcement that we reached agreement on a holistic restructuring transaction to conclude the rehabilitation of AAC's Segregated Account, with the full support of our regulator, reflects our ongoing commitment to advance our stated strategic objectives where the ultimate goal is to deliver value to our shareholders. The process represented by these achievements is a result of our proactive approach towards managing the risks in our insured portfolio and improving the overall quality of our balance sheet. Yesterday, after market closed, we reported net income for the second quarter of $7.1 million, or $0.16 per diluted share and adjusted earnings of $70.4 million or $1.54 per diluted share. In addition, book value increased from $1.08 to $37 per share and adjusted book value increased to $1.26 to $28.35 per share. David Trick will go into more detail regarding our financial results for the quarter momentarily. Active management of our assets and liabilities contributed materially to the results with accretive to both our earnings and our regulatory capital position and materially reduced our risk profile during the quarter. I would like to take a moment to highlight a few of these transactions. First, AEC successfully commuted an assured interest rate swap at a material discount, which led to the termination of the associated 185 million adversely classified insured structure finance transaction. This transaction combined with other actions contributed to a 4% reduction in adversely classified credits during the second quarter to $15.2 billion from $15.8 billion at March 31. Second, Ambac UK successfully negotiated a de-risking transaction resulting in a reduction of future expected losses associated with an Ambac UK insured structured finance deal. Third, Ambac also purchased $33.4 million par of AEC general account surplus notes and the remaining $4 million of unpaid accrued interest related to certain surplus notes that were previously repurchased under a call option. Lastly, AEC acquired additional insured Puerto Rico and other bonds during the second quarter. AEC now owns approximately 30% and 12% of its insured COFINA and PRIFA bonds respectively. Going forward, we will remain proactive and aggressive in our pursuit and execution of some of our transactions in our ongoing efforts to reduce risks and strengthen our balance sheet. As I mentioned earlier, we recently announced that we have successfully reached agreement on a holistic restructuring transaction, which if consummated will conclude the rehabilitation of AEC’s segregated account and materially improve Ambac’s overall financial condition. This transaction represents a major milestone for Ambac and we believe it will create material near term and potential significant future value for our shareholders as a result of: one, a material increase in book and adjusted book value; two, the deleveraging of our balance sheet; three, a significant reduction in future operating expenses because of the reduced regulatory oversight and the elimination of certain other costs and restrictions; four, streamlining of our governance structure; and fifth, improvement to Ambac’s overall operating flexibility, which will provide for greater optionality as we explore new business initiatives. The transaction has been positively received evidenced by the increase in Ambac’s security prices and the receipt of several additional credit or commitments since the announcement in mid-July. The DPO beneficial interest owners and general account surplus note holders who fully support the transaction now total 34% and 52% respectively of the total outstanding balances held by third parties. While the process of reaching agreement on holistic restructuring transaction is behind us, there were many steps involved in bringing this transaction to a close. We are working diligently alongside our external professionals and the OCI through the detailed and multifaceted execution process. Towards that end, the Wisconsin State Court overseeing the rehabilitation of AAC's segregated account has scheduled a pre-trial hearing for November 30, 2017 and a confirmation hearing from December 12 through December 14, 2017. Based on these dates it is likely that the closing will occur in early 2018, however there is still a possibility the transaction may close by year-end. During the quarter, we also remain focused on our RMBS litigation efforts, which remain a key value driver as we aggressively pursue remedies to protect our rights and recover losses. In our main RMBS suit against Countrywide, our request to appeal certain rulings of the intermediate Appellate court to the New York Court of appeals, the highest state Appellate Court in the in New York was recently granted. The rulings were requested to appeal are; one, the applicability of the contractual sole remedy provisions; two, the applicability of insurance law to Ambac's fraudulent inducement and material breach claims; and three, Ambac's rights to reimbursement for its attorneys fees and expenses and enforcing its rights. We believe our claims against Countrywide are strong and we are preparing to go to trial hopefully by mid next year. While our other cases are not as far along as Countrywide, we are prosecuting each in a diligent, aggressive, and prudent manner to progress them to more deterministic phases. With regard to Puerto Rico, our primary focus is defending our rights and interest in seeking to ensure that the Commonwealth and its instrumentalities are complying with their obligations. At the same time, we are proactively exploring ways to efficiently limit and mitigate our losses and ultimately bring closure to our various exposures. In particular, we have been actively involved in the premise to Title cases filed on behalf of the Commonwealth COFINA and HTA. Among other actions, we have filed an adversary proceeding challenging the constitutionality and legality of the Commonwealth's Club Act of funds pledged HTA bonds and the fiscal and economic growth plan and related loss. Our HTA lawsuit also serves that HTA revenues must continue to be applied to HTA’s bonds even in title three and that reserve funds are the property of the bondholders and not subject to Title 3’s automatic stay. We were also prior to litigation concerning events of default at COFINA and which COFINA bondholders are entitled to the COFINA funds held by the trustee. Ambac's position is that there have been covenant defaults, which have resulted in events of default under the bond documents and our COFINA senior bondholders have absolute priority over COFINA’s subordinated bondholders with respect to the funds held by the trustee. Ambac insurers only COFINA’s senior debt. We are monitoring developments in these and other cases and are in regular conversation with other creditors of the Commonwealth and its instrumentalities. With the Title III cases and related litigation still in the early stages it’s currently unclear when the issues raised in those cases will be fully resolved. That said, we will vigilantly assert our rights and exercise remedies to protect our interest, while seeking to work with the oversight board and the Commonwealth to achieve durable solutions to Puerto Rico's economic and liquidity problems. In particular, we’re hopeful that the new mediation process will serve as a productive venue for achieving consensual resolution of the challenges facing Puerto Rico. The way forward, Ambac believes, is to have a much-needed focus on capital market access and debt sustainability as an engine of economic growth. To that end AMBAC stands ready to engage constructively with the Commonwealth, the oversight board, and other creditors and stakeholders in pursuing holistic consensual solutions. However, should mediation be unsuccessful, Ambac will litigate and assert our rights and demand that the oversight board honor the laws that are in place. Finally during the quarter, we advance our initiatives to evaluate operational improvements and future business plans for Ambac. We’re viewing these strategic options focusing on strategies that will create long-term sustainable shareholder value. We look forward to providing you with an update on these initiatives and other related matters next quarter. I’ll now turn the call over to David Trick to walk you through our second quarter financial results. David?

Thank you, Claude and good morning. Before I address the specific results for the quarter, I note that following our announcement last month of our holistic restructuring transaction to conclude the rehabilitation of the segregated accounts, we posted on our website as part of our broader investor presentation a summary pro forma March 31, 2017 balance sheet, reflecting regulatory capital accretive transactions expected to be executed, and the impact of the amendment, exchanges, and issuance of the Tier 2 note. It is important to note that the items identified in the one column of the pro forma titled regulatory capital and accretive transactions, other than approximately $2.6 million of accelerated premiums, which will be recognized in the third quarter, were executed and reflected in our second quarter results. The impact of the amendment, exchanges, and Tier 2 notes provided in those pro forma’s will be recognized primarily upon closing of the transaction. Other than the estimated impact of accelerated income on our investments in Ambac's insured RMBS, which is likely to be realized through closing of the transaction. Now, I will walk through our second quarter 2017 results. During the second quarter of 2017, Ambac produced net income of $7.1 million or $0.16 per diluted share, compared to a net loss of $125.4 million or $2.77 per diluted share for the first quarter of 2017. Adjusted earnings in the second quarter was $70.4 million or $1.54 per diluted share, compared to an adjusted loss of $91.2 million or $2.01 per diluted share in the first quarter. These positive results reflect the impact of transactions successfully executed during the quarter related to our proactive asset and liability management program Claude discussed earlier, as well as lower public finance incurred losses and lower foreign taxes. During this quarter, we did however experience higher operating expenses as a result of an increase in legal and consulting fees related to the holistic restructuring transaction. Premiums earned were $43.2 million during the second quarter versus $47.6 million during the first quarter. Normal earned premium is decreased during the quarter to $30 million from $31.3 million or 4%, primarily due to the continued run-off of the insured portfolio, including previously pre-refunded policies. Accelerated premium declined by approximately $3.1 million to $13.2 million, due to a lower level of collectivity and a change in mix of public finance ensured transactions calls, particularly a lower level of healthcare calls. Premium receipts were $16 million during the quarter, a decline of $2 million versus the first quarter, due to the continued run-off of the portfolio in addition to relative timing differences. Net investment income for the second quarter and the first quarter of 2017 was $85.2 million and $81.6 million respectively. Net investment income for the second quarter of 2017 increased as a result of improved performance from AAC's investment in insured RMBS securities, and a higher allocation to insured non-RMBS bonds, partially offset by lower investment income from corporate and other invested assets. Mark-to-market gains on invested assets classified as trading were $3 million in the second quarter of 2017, compared to $7.2 million in the first quarter of 2017. Lower equity and hedge fund returns in the Ambac UK investment portfolio accounted for the quarter-over-quarter decline in trading income. During the second quarter, we acquired $241.9 million of distressed Ambac insured securities, including $25.9 million of insured RMBS and $216 million of other insured securities, including Puerto Rico insured bonds. Our investment in deferred amounts, including interest thereon totaled $1.5 billion or 41% of the total amount outstanding as of June 30, 2017. Our losses incurred were $66.1 million for the second quarter down from $135 million for the first quarter. The second quarter incurred loss was primarily driven by adverse development in the public finance portfolio, offset by improved credit performance in RMBS and a benefit associated with an additional loss mitigation transaction related to an Ambac UK insured structured finance deal. This compares to the first quarter, which was driven by adverse loss development in Puerto Rico, partially offset by the benefit realized from the Ballantyne litigation settlement. More specifically, public finance produced incurred losses of $52.3 million, due to adverse development in two military housing deals and several others insured exposures, including Puerto Rico, which was driven primarily by a decrease in discount rates. These developments were partially offset by favorable developments in a few transactions, including those from our active remediation efforts. Student loans produced incurred losses of $20.3 million, resulting entirely from higher expected long-term default rates and to a much lesser degree higher prepayment rates. We decided to increase our forecasted default rates after undertaking a review of actual historical default and severity rates. This impact was partially offset by the benefit of lower interest rates during the quarter. RMBS produced an incurred benefit of $15.9 million in the second quarter, driven by improvements in credit performance and lower interest rates, primarily in the first liens. The RMBS incurred benefit included a reduction of just over $8 million and our estimate of rep and warranty recoveries linked to the overall improvement in performance. Our estimated representation and warranty recovery amount as of June 30, 2017 is now just under $1.9 billion net of reinsurance. Ambac UK produced an incurred benefit of $34.5 million, the main source of the benefit was Ambac UK’s successful negotiation of another loss mitigation transaction further reducing future expected losses on the largest distressed transaction in that portfolio. Foreign exchange rates also provided a benefit of about $11.8 million as a pound Ambac U.K.'s functional currencies strengthened relative to the dollar in Europe. Net gains reported in interest rate derivatives for the second quarter were $34.1 million, compared to $1.5 million of losses in the first quarter. The net gain for the second quarter included $43.4 million of gains associated with the commuted insured interest rate swap, linked to an adversely classified insured structured finance transaction, partially offset by a loss of $9.4 million from the macro hedge stemming from lower forecasted interest rates. The interest rate driven loss was more than offset by interest rate related gains and insured and investment portfolios. Second quarter operating expenses increased by $3.1 million from the first quarter to $31.1 million. The increase compared to first quarter 2017 was mainly due to a $5.8 million increase in legal and consulting fees related to our recently announced holistic restructuring transaction, partially offset by the elimination of legal contingency expenses and lower compensation expenses. As we noted previously, we remain focused on reducing our core operating expenses, but also anticipate that we will experience volatility quarter-to-quarter associated with normal course operations and various other initiatives, including those that are related to the segregated account and our ongoing efforts towards successful exit from rehabilitation. That said restructuring and OCI fees accounted for a total of just over $11.4 million in the second quarter, compared to approximately $5.7 million in the first quarter. These amounts equate to approximately 60% and 40% of our non-compensation expenses during the second and first quarters of 2017, respectively. On completion of the holistic restructuring transaction, we expect to be able to eliminate all such restructuring cost and a majority of our OCI related cost. With regards to taxes, the second quarter provision was 6.9 million, compared to 19.6 million for the prior quarter. The second quarter provision was driven by 6.6 million of foreign taxes, resulting from the positive loss development related mostly to Ambac U.K.'s risk remediation efforts. First quarter included $19.3 million foreign taxes, mostly associated with the impact of the Ballantyne litigation settlement on Ambac UK. Second-quarter total comprehensive income of $48.7 million led to an increase in stockholders’ equity at June 30, 2017 to $1.7 billion or $37 per share, up 49.3 million from March 31, 2017. Second-quarter comprehensive income was driven by $29.3 million of foreign exchange translational gains and $12.6 million of unrealized gains on investment securities. Adjusted book value was up $57.5 million to nearly $1.3 billion with $28.35 per share at June 30, 2017, compared to just over $1.2 billion and $27.09 per share at March 31, 2017. The main contributor to the increase in adjusted book value was second quarter adjusted earnings and foreign exchange gains. That concludes my formal remarks; I will now turn the call back to Claude for some brief closing remarks.

Thanks David. I want to emphasize that the board, executive management, and all employees at Ambac remain committed to and are working diligently towards generating future value for shareholders. We believe our recent achievements serve a strong evidence of this commitment and focus, which we plan to progress. Looking forward towards the second half of 2017, we’re continuing these strategies by focusing on finalizing the transactions to conclude the rehabilitation of the segregated account, reducing and managing the adverse and classified credits in our insured portfolio, actively prosecuting our RMBS rep and warranty litigations, and progressing our strategic planning process. We look forward to updating you on our progress later in the year. Operator, we will now open the call for questions.

[Operator Instructions] And our first question comes from the line of Andrew Gadlin from Odeon Capital Group. Your line is open.

Hi good morning. Claude you talked a little bit about the strategy with Countrywide pursuing a trial date in mid next year while simultaneously appealing in the first Department's rulings, could you talk about how you prosecute those at the same time and what would happen if in fact you got some of the decisions from the first Department over current while you're in a trial setting in the Supreme Court?

Thanks and good morning Andrew. Great question. So, we obviously, as one of our key strategies we will focus on the resolution of this key litigation. We were very pleased with the decisions to grant us leave on these appeals. I think the process and timing involving the appeals will work independently, but in parallel with the trial process and we will be working on establishing the trial scheduled with the judge. We hope in the coming few months that we expect will happen in parallel to the extent decisions are reached in the appeals during that process. We expect that those will also be factored into the judges’ decision process as we move to the trial. So again we expect it to be in parallel that’s where we are hoping and planning for and we will be looking forward to progressing the trial schedule as soon as we can.

Thanks very much.

[Operator Instructions] Our next question comes from the line of Andrew Hain from Stifel. Your line is open.

Hi, good morning.

Good morning.

Quick question on the exchange, if you get the necessary court approval in December, how soon after that could you sort of effectuate or complete the exchange or what kind of timeline are we looking at?

Thanks, good question. We are still working through the timeline. At this point there are some - some of the aspects of the transaction that can be sequenced, others that will be parallel. We still believe that assuming we get a hearing, final hearing set for late December that it is likely that we should be able to have the exchange completed either prior to or maybe subsequent to the court decision, which would allow us to close in the early 2018 or possibly even by year end, if we’re able to effectuate the exchange immediately prior to the completion of the hearing.

Okay great.

Scheduling is still being evaluated, but again we are contemplating and exploring both a sequencing of the exchange to the plan hearing or something that could happen in parallel, so by the time we get to the end of the hearing we would have both completed.

Okay, great. And I might have missed it in the paperwork, is there a minimum participation threshold for the exchange you guys have outlined?

There is. It is set at 85%, and that’s a condition waivable only by Ambac.

Okay great. And then just lastly, if I may, just get some clarity on your bond buybacks, the 33 million you repurchased during the quarter those were the 5.1 senior surplus notes?

Yes it was. Now it is at the holding company.

Okay and then in your 8-K you guys filed on 20 July, I think you had also had a chart in the back that you had repurchased about $45 million junior surplus notes, did I read that right?

We had entered into an agreement to acquire those notes that’s correct. That was something that occurred in the third quarter.

Right, that was mid-July and then - so there were two transactions right? There was a repurchase of the notes and then there was an option to repurchase the additional $45 million, am I reading that right?

I think that is correct.

Did you guys disclose your option price there, your strike there on the $45 million?

No, we did not.

Can you do that or will you do that?

To be specific, those are the accrual notes that were issued as part of a financing transaction related to the junior surplus notes back in 2014.

I understand that, I just didn't know if you guys would be willing to disclose your option price?

Not at this time.

Okay great. Thank you very much for the…

Andrew let me go back here; I just want to clarify one point on the exchange offer participation threshold of 85%. That this for the surplus notes only, general account surplus notes and that includes AFG’s participation.

Okay, great. Thanks for the questions guys, appreciate it.

Thanks for the questions.

Thank you.

[Operator Instructions] And we have no further questions in queue. Ladies and gentlemen this concludes your conference call for today. We thank you for participating. You may now disconnect.