Ambac raises $1.5 billion to protect AAA ratings

Ambac Financial raises $1.5 billion in stock offering

Bond insurer protects rating, but dilutes existing shareholders

By John Spence & Alistair Barr, MarketWatch

Last Update: 7:38 PM ET Mar 7, 2008

SAN FRANCISCO (MarketWatch) — Ambac Financial announced Friday that it raised
$1.5 billion selling stock and convertible securities to protect its crucial AAA
rating.

Ambac’s (ABK) offering consisted of 171 million common shares, priced at $6.75
per share; 5 million equity units, priced at $50 each; and a private placement of
14 million shares with two unnamed institutions that raised $95 million.
Private-equity giant Cerberus Capital Management invested $50 million in the
equity units.

“This should shore up many of the worries about the company as a going concern,”
said David Stepherson, a portfolio manager at Hardesty Capital Management. “They
can probably handle their existing book of business now.”

Ambac may have raised enough capital to avoid losing its AAA ratings from
Standard & Poor’s and Moody’s Investors Service, the largest ratings agencies.
Without those top ratings, Ambac would struggle to win any new business and may
eventually have to shut down.

Shares of Ambac surged 28% to close at $9.50 on Friday.

When Ambac unveiled its plans Wednesday, S&P and Moody’s said that if the company
was able to complete the offering, that may be enough to secure its triple-A
ratings, Still, S&P said that it would probably keep a negative outlook on Ambac.
The two agencies haven’t commented since the offering was completed early Friday.

“The completion and pricing part of the unknown is over,” said Steward Johnson, a
portfolio manager at Philo Smith & Co., an investment firm that focuses on the
insurance industry. “The next step is a confirmation of AAA from Moody’s and S&P,
which will tell us if the size of the deal is sufficient — for now, at least.”

However, Ambac bought a new lease of life at the expense of existing investors.

The bond insurer had to sell more than 180 million new shares to raise what it
needed to satisfy the rating agencies, almost tripling the total outstanding.
Before this week, Ambac had just more than 100 million shares. When more shares
of a company are sold, that divides the future earnings of the business among
more investors, leaving a thinner slice for each backer.

The capital-raising “transactions have turned out to be more dilutive than
expected,” Gary Ransom, an analyst at Fox-Pitt Kelton Cochran Caronia Waller,
wrote to clients Friday.

Ambac raised $1.25 billion selling stock at $6.75 each, while Ransom was
expecting the company to collect $1 billion selling stock at $7 each.

The sale of equity units, which convert into Ambac shares in the future at $7.97,
an 18% premium, was reduced. That part of the offering was supposed to raise $500
million, but ended up raising half that, Ransom noted.

“They’ve diluted their existing shareholders by a massive amount,” Hardesty
Capital’s Stepherson said.

Ambac stock fell back 14% to $8.15 during after-hours trading Friday.

‘Short of Armageddon’

Ambac Chief Executive Michael Callen said during an interview on CNBC that the
stock offering was not a bailout, and that the company had ample liquidity and a
“strong” capital position. Doomsday predictions for bond insurers that
extrapolate the current tough market conditions “could be overstated” while the
perceived quality of Ambac’s assets is “misguided,” he added.

“Some of these reports are exaggerated,” Callen commented. “Short of Armageddon,
I don’t expect the ratings agencies to revisit the ratings.”

Ambac has $16.5 billion in claims-paying capacity, while in the “Armageddon”
situation Ambac would have to pay out $12 billion, he estimated. Still, he
acknowledged that rattled credit markets are in “uncharted territory.”

There has been an “erosion” of confidence in bond insurers and it will take at
least several months to get it back, Callen added. “It’s a tough environment, no
doubt about it.”

During an interview on Bloomberg television, Callen acknowledged that Cerberus
invested $50 million in Ambac’s new equity units.

Callen bought 25,000 shares at $6.75 a share while Chief Financial Officer Sean
Leonard bought 1,000 shares. A handful of other executives also bought a total of
about 67,250 shares in the company.

Ambac may need more capital

The executive wouldn’t completely rule out the possibility that Ambac may have to
raise further capital. He declined to reveal the identities of the two
institutions in the private placement, although he said they’re “private-equity
type companies.”

Some Wall Street analysts said that Ambac may be forced to raise even more
capital to protect its ratings.

“Ambac has had difficulty writing new business since November 2007, and it will
likely continue to have difficulty even after this capital raise,” wrote analysts
at Deutsche Bank in a note Friday.

Although Moody’s and S&P are likely to reiterate Ambac’s triple-A ratings, the
outlook is still unclear on losses in collaterized debt obligations and other
mortgage exposure, they said.

“Should credit conditions continue to develop worse than expected, loss estimates
could increase and the rating agencies might require Ambac to raise more capital
to retain the triple-A rating,” according to Deutsche Bank.

Bank involvement

Bond insurers like Ambac agree to pay interest and principal on debt in a timely
manner in the event of default. The $2.4 trillion business relies on AAA ratings
to win new business.

Those ratings are in jeopardy because of big claims from guarantees they sold on
complex mortgage-related securities known as collateralized debt obligations, or
CDOs. Many banks have tried to hedge CDO exposures by buying guarantees from bond
insurers in the form of credit-default swaps, a type of derivative.

If lots of bond insurers are downgraded or if some collapse, these banks may
suffer more write-downs because these derivatives contracts will be worth less.

That’s encouraged regulators, including New York State Insurance Superintendent
Eric Dinallo, to step in and try to persuade some of these counterparties to
inject new capital into the bond insurers.

Some of its largest counterparties such as Citigroup Inc. (C), the Royal Bank of
Scotland (UK:RBS), UBS AG (UBS) and Barclays PLC (BCS) were widely speculated to
have backed the deal in some fashion.

A bank bailout didn’t materialize, but some banks, including some not
underwriting the offering, agreed to buy some of the new stock to make sure Ambac
raised enough capital.

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