Octave Specialty Group, Inc. (OSG) Q3 2020 Earnings Report, Transcript and Summary

Greetings, and welcome to the Ambac Financial Group, Inc. Third Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Lisa Kampf, Head of Investor Relations; Claude LeBlanc, Chief Executive Officer; and David Trick, Chief Financial Officer. I will now turn the call over to Lisa.

Thank you. Good morning, and thank you all for joining today's conference call to discuss Ambac Financial Group's third quarter 2020 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 of 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 Conditions and Results of Operations under Risk Factors. Ambac is not under any obligation, and expressly disclaims any obligation to update any forward-looking statements, 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 Web site at ambac.com. Please note that presentations have been posted to the Events & Presentations section of our IR Web site, which support our comments today. Management is participating in this call from remote locations. If technical difficulties occur and we have to terminate the call, you will be able to read the transcript of our prepared remarks, which we posted to the Investor Relations section of our Web site. In addition, management will be available to address any questions that remain unanswered. Please feel free to contact me via the contact information in our press release to schedule a call. I would now like to turn the call over to Mr. Claude LeBlanc.

Thank you, Lisa. For those of you joining us on today's call, we hope that you and your families are keeping safe and healthy. Last night, Ambac reported a net loss of $108 million, or $2.33 per diluted share, and an adjusted loss of $93 million or $2.01 per diluted share for the quarter. Results for the third quarter were driven by higher loss and loss expenses primarily related to Puerto Rico and RMBS exposures. This increase reflects evolving credit conditions stemming from the COVID-19 pandemic, as well as costs incurred from our ongoing actions to defend our rights and recover losses through litigation. David will speak to our results in greater detail in a moment. Turning to our insured portfolio, during the quarter our insured portfolio continued to fair well with no COVID-19-related claims paid. Net par exposure was $34.8 billion at September 30, 2020, down 1.5% from June 30, and 9% year-to-date. Excluding the impact of the weakening U.S. dollar, total net par would have been down 3% for the quarter. Watch List and Adversely Classified credits were $14 billion at September 30, 2020, down 3% from the second quarter, and 5% year-to-date. Additionally, during the third quarter no new credits were downgraded to the Adversely Classified category. The relative strength and resilience of our insured portfolio reflects in large part the material benefits of our active de-risking strategy, and the ongoing seasoning of our portfolio. We continue to actively monitor the credits in our insured portfolio, stressed as a result of the pandemic. At this time, we believe that there are sufficient revenue streams or alternative funds available for the majority of these issuers to mitigate longer-term losses. However, significant uncertainties remain, including the magnitude and timing of relief, if any, for state and local governments through additional fiscal stimulus. During the quarter, we were also able to restart a number of key de-risking and credit strengthening efforts which were helped by the improving economy, the stronger municipal new issuance market, and the stabilization of credit markets. Key de-risking transactions during the quarter included, one, the refinancing of an international stadium transaction with a net par of $217 million; two, the commutation of refinancing or cancellation of several municipal and structured credit exposures; and three, the enhancement of credit and liquidity protections of key COVID-stressed exposures, including two of our largest exposed credits. We're optimistic that the regained de-risking momentum achieved during the third quarter will continue, although looking forward it is expected to be more choppy than what we experienced in the pre-pandemic environment. Turning now to Puerto Rico, over the past few months the political landscape in Puerto Rico has changed materially, starting with the resignation of four Oversight Board members in recent months, and the appointment of Justin Peterson to the Oversight Board. In addition, the gubernatorial and legislative elections were held last week, leading to the election of a new governor, Pedro Pierluisi, which is expected to lead to changes to Ambac. We are hopeful that a new political leadership and composition of the Oversight Board will focus on transparency, accountability, and good-faith negotiations with creditors to an even more prolonged restructuring process. We look forward to constructive engagement with the new Oversight Board and Commonwealth leadership over the coming months. Turning now to our loss recovery efforts, we have been advancing our rep and warranty case against Bank of America Countrywide and ramping up our preparation for the trial, which is scheduled to begin in February of 2021. As expected, during the third quarter, Countrywide filed a motion to dismiss Ambac's fraud claim. The issue was fully briefed in September, and the judge scheduled oral arguments for November 13. While there remains risk of further delays due to COVID and other factors, we look forward to proceeding to trial and resolving our longstanding claims against Countrywide and Bank of America as expeditiously as possible. Turning now to new business, as previously announced, our Everspan subsidiary was repositioned under a holding company, AFG, with the goal of pursuing opportunities in the specialty program insurance business. During the third quarter, we continued to progress our initiatives by, amongst other steps, applying to re-domesticate Everspan to Arizona, and to expand the company's licenses to broader property and casualty lines. We also continue to explore opportunities to invest in or acquire managing general agents and other fee-based businesses as part of our broader strategic priorities, which we believe could achieve attractive risk-adjusted returns for our shareholders and maturely accelerate the use of our NOLs over time. We are pleased with the progress we have made so far, and look forward to updating you as we progress. I will now turn the call over to David Trick to discuss our financial results in more detail. David?

Thank you, Claude, and good morning, everyone. During the third quarter of 2020, Ambac reported a net loss of $108 million, or $2.33 per diluted share. This compares to a net loss of $35 million or $0.70 per diluted share in the second quarter. Third quarter results were mostly driven by incurred RMBS and public finance loss and loss expenses. Compared to the second quarter, the increase in incurred loss and loss expense was mostly due to RMBS. Adjusted loss for the third quarter was $93 million or $2.01 per diluted share. This compares to an adjusted loss of $24 million or $0.52 per diluted share in the second quarter. The variance between adjusted net loss and GAAP results for the third quarter is primarily the exclusion of the insurance intangible asset amortization of $14 million. Briefly touching on some notable highlights, premiums earned were $15 million in the third quarter, compared to $11 million during the second quarter. The increase was driven by higher accelerated premiums stemming from our active de-risking efforts with regards to an international transaction. The investment portfolio performed well during the quarter on the heels of the strong rebound in the second quarter. Third quarter investment income was $37 million, compared to $52 million in the second quarter. Third quarter investment income was comprised of mark-to-market gains on pooled investments of $13 million, and income from available-for-sale securities of $24 million. Gains on pooled investments for the third quarter, of $13 million, compared to $26 million the second quarter, reflected continued recovery of investments in hedge funds, high-yield leveraged loans and equities, all of which were significantly impacted by the economic and financial market turmoil stemming from the COVID-19 pandemic during the first quarter. Performance of the third quarter also benefited from the redeployment of some additional capital. Income from available-for-sale securities was $24 million in the third question, compared to $26 million for the second quarter. The decline was primarily due to lower rates, redemption of LSNI notes, and a slightly lower asset base. Since the market dislocation experienced in the first quarter, we generated consolidated investment portfolio total returns of 4.7% and 2.4% during the second and third quarters, respectively. Loss and loss expenses incurred were $83 million in the third quarter, compared to $16 million in the second quarter. Third quarter incurred losses were driven by the public finance and RMBS sectors, more than half of which related to expenses from our ongoing aggressive efforts to mitigate risk and defend our rights in certain insured transactions through litigation and other means. RMBS incurred losses of $27 million in the third quarter, compared to a benefit of $35 million in the second quarter. The $62 million quarter-over-quarter swing resulted from higher expected losses driven by the prolonged stress in the economy from the COVID-19 pandemic, as increased loss expenses related to litigation costs from our representation and warranty cases. The $35 million benefit in the second quarter was due to the impact of lower interest rates on excess spread recovers, partially offset by higher loss expenses. Public finance losses incurred were $43 million in the third quarter and $42 million in the second quarter. Incurred losses in both periods were predominantly driven by increased Puerto Rico reserves related to the higher loss expenses and assumption changes. Operating expenses for the third quarter of $23 million increased $2 million from $21 million in the second quarter. The increase is primarily due to variable compensation cost and lower capitalized software development cost. Interest expense decreased $9 million in the third quarter up to $50 million. $6 million of this reduction related mostly to senior surplus notes. The discount on which as of June 2020 has been fully accreted. Remaining $2 million of savings related to the redemption of $26 million of secured notes at the end of the second quarter and lower interest rates. Shareholders equity decreased $0.75 per share to $2.59 per share or $1 billion at September 30, 2020. The decrease was due to the net loss for the quarter, partially offset by unrealized gains on securities of $42 million and foreign exchange translation gains of $29 million. Unrealized gains include in part the recovery of unrealized losses experienced in the first quarter related to the COVID-19 pandemic. Adjusted book value decreased to $891 million or $19.44 per share at September 30, 2020 from $965 million or $21.06 per share at June 30, 2020. This adjusted book value decrease is mostly driven by the adjusted loss for the third quarter, partially offset by the impact of foreign exchange rates. Unlike book value, ABV is not impacted by changes in unrealized gains and losses. That’s why AFG on a standalone basis, as of September 30, 2020, AFG had cash, investments, and receivables of approximately $465 million or $10.16 per share including approximately $318 million of liquid assets. These amounts exclude $11 million AFG has invested Everspan insurance which was purchased from AAC in July. I’ll now turn the call back to Claude for some brief closing remarks.

Thank you, David. While the pace of economic recovery remains uncertain, we continue to pursue our strategic priorities which include improving our risk profile through active de-risking, proactively and persistently defending our rights and recoveries, and progressing our new business initiatives. We are excited about new business initiatives which we believe will create long-term value for our shareholders. Our bar for new business opportunities remains very high and in consistent with our past practices will be accessed against the return of capital to our shareholders. We look forward to updating you on the progress in the coming quarters. Operator, please open the call for questions. Thank you.

Thank you. We will now be conducting the question-and-answer session. [Operator Instructions] Our first question comes from the line of Mark Palmer with BTIG. Please proceed with your question.

Yes, thank you. Good morning. You mentioned in your prepared remarks that the vast majority of the losses incurred during the quarter related to incremental reserves on Puerto Rico exposures. Did the company during the quarter receive any claims that could be attributed to stress arising from COVID-19?

Good morning, Mark. No, we did not receive any direct claims for COVID-19 as I mentioned, but we are evaluating scenarios around the potential effects of COVID-19 across our portfolio. As it relates to Puerto Rico, as we consider all elements of credit, certainly COVID has had an impact on Puerto Rico and that is something that we’ve considered and will continue to consider going forward as it relates to Puerto Rico, but the reserve increase this quarter in Puerto Rico specifically had to do with a variety of assessments that we made relating to our assumptions, relating to the court rulings, redress of COVID amongst other things, and every quarter, as we have in the past, we will look at the various inputs, evaluate our assumptions and our scenarios and adjust them accordingly. So, it's hard to pinpoint anything specific from COVID on Puerto Rico, but certainly there's a factor that we consider, but it is certainly something that we considered across our entire portfolio as we evaluate credits that had been or could be impacted directly in the future.

Thank you, and one more, you mentioned a couple of risk mitigation actions taken during the quarter including refinancing, commutation, what is the outlook or the pipeline for additional refinancings and commutations that you're seeing right now given the stress in the environment.

Yes, that's a good question, Mark. I think we’ve got a fairly deep pipeline still for some of these transactions as you point out that are directly impacted by COVID if there are narrow revenue streams or -- they're just heavily impacted by reduction of inflows or multiple inflows, clearly they are more challenged to get refinance. However, we do believe that some of these credits could [restore] [ph] their debt or look for short-term financing that could address their near-term liquidity concerns as they plan forward for perhaps medium to longer term refinancings. As I mentioned also, in the parable, one of the things that we've stepped up maturely and had some very meaningful success this quarter is on working with some of the issuers to restructure their deals. So, in some cases, we’re using our control rights and our position as a creditor to assist the issuer in many respects to address their liquidity or funding concerns, but as part of that, we are seeking additional collateral, additional security or better terms for Ambac. So, we’ve had two significant successes this quarter, and I expect we’ll also continue to see those in the coming quarters, but they won't necessarily show up as a reduction of adversely classified credits immediately, but we are -- some of these restructurings have been very promising.

Thank you very much.

Thank you. Our next question has come from the line of Giuliano Bologna of Compass Point. Please proceed with your question.

Good morning. Just trying to turn it over to the Everspan topic for a minute, when I think about capitalizing Everspan and be available with creating assets of the holding company, obviously we don’t know the exact amount that -- of additional capital allocation that will go into it, David, at this point, but it doesn’t seem like you're choosing over $450 million of capital into Everspan. I'm just kind of curious how you’re thinking about the remaining liquidity of the holding company that hasn’t been allocated to Everspan or -- when you think about -- after allocating capital to Everspan, what you may end up doing with some of that capital?

Sure, that's a good question. So, at this point -- we view the capital of the holding company as being strategic capital, and part of our strategy is clearly in line with what you described in terms of a Property and Casualty Specialty Program and sure -- that we’ve been working on, and that is a -- perhaps more than just an entity, it could involve the platform, and that will be one area that we will be looking to capitalize depending on the path forward that we select for the platform which has variations depending on market conditions and opportunities that we see, but beyond that, we have also indicated that we are pursuing other transactions, some by form of M&A, others in the form of [Genevo] [ph] that would also require capital focus on the MGA markets or other fee-based business, and these could be controlled transactions or investment transactions, but we believe that there are attractive opportunities in that sector that would be creative and strategic in working alongside of our insurance platform, and those are entities that we’ve been exploring out for a number of months, and we intend to continue to pursue some of those options. So, I think those are probably the two categories I would say that we’re focused on deploying capital from the holding company besides potential -- other strategic investments, and again, as I mentioned in my closing remarks, we're always winning those opportunities and return profiles of those investments against the return of capital to our shareholders which is also something that we may do at some point.

That made sense, and then, thinking about -- on the AAC side, when I think about some of the investments and kind of the capital structure, I'm curious if there are any benefits to buying different securities in the debt stack just because you have some pretty all-day deals and discounts in some of those securities today. So, I'm kind of curious if there are any merits to looking at some of those securities that may have a higher PIK rate or a bigger discount to -- created value at this point in the portfolio to kind of reduce the interest expense on one side but also actually realize some gains.

Yes, Giuliano, that's something we have looked at and done in the past as you may recall. In particular, we’ve done some purchases and sales so that no matter in the higher-tier securities, like the LSA 9 notes, and you know, we have to weigh a couple of things when we consider purchases of our own issued securities. One is opportunities in our own wrapped securities which we’ve been very active in, as you know in -- whether it be RMBS or Puerto Rico over the years, and the risk-adjusted returns, we can obtain from doing that as well as liquidity considerations, and perhaps most importantly is capital considerations. So, now for the securities you referenced, we get regulatory capital treatment for, and we have to be very thoughtful about repurchasing those securities, what the impact on regulatory capital is, and in many cases, we do need regulatory approval to repurchase those securities. So, while there may be attractive opportunities here and there, we’re not always able to necessarily execute on all those opportunities based on the constraints that I referenced.

That made total sense. Well, thank you for answering my questions, and I will jump back in the queue.

Thank you. [Operator Instructions] Thank you. Our next questions come from the line of Sean Perkins with Waterfall Asset Management. Please proceed with your question.

Well, thanks for hosting the call. I appreciate your disclosures today. Just a little bit on the upcoming oral arguments or hearings, is there any other current filings that you have to go through in terms of being dismissed in order to keep and maintain the February 2021 trial date at this point?

Thanks for your question. So, currently, I see all arguments will be later this week on the motion to dismiss the fraud claim that's at November 13th. There could be an appeal of any additional decisions by the court including any decision reached by the judge in relation to the fraud claim. Although he may not make any decisions on the fraud claim and may just decide that he will hear that case as part of a trial. So, I think at this point we're not expecting any other decisions, but we can really predict the decision that the judge will make, how that might influence vis-à-vis our decisions on appeal, but we believe that we have a clear path to trial in February at this point, and expect that they will stick us unless things change, I think probably the biggest risk that we see out there is the COVID risk, how it might influence the court system.

Thank you, and if I can, one more question on the municipal bond market, you mentioned that senior issue activity took place during the quarter, and I'd want to understand a little bit more given some of the rate moves that we’ve seen, whether or not you expect that to continue and how that impacts your overall profitability. Thanks.

Yes. So, for us, given we’re not writing a business, it doesn’t directly impact our earnings, but I think we view the new issue market as velocity and volume being encouraging for a number of reasons. It means that one, the -- [technical difficulty] effectively I think is the first point, and doing it at -- what we believe to be very tight spreads generally, and when we look at some of our exposures relating to COVID, I think the more challenged ones, you know, story [indiscernible] surrounding COVID are going to find it more difficult to access the new issue markets currently if they were looking to refinance. However, we think that with improving economy and working with issuers to look to restructure or result the debt, some of these issuers are very strong. They just have this near-term liquidity challenge relating to COVID. So, we believe that there's a number of ways that that can be addressed, but certainly having the new issue market as strong as it is, is certainly helpful for the issuers and for us as we work with the issuers in helping them address their near-term liquidity issues.

Thank you so much.

Thank you.

There are no further questions at this time. This does conclude today's teleconference. We thank you for your participation. You may disconnect your lines at this time. Have a good day.