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CHICAGO (Dow Jones)–Bond insurer Ambac Financial Group Inc. (ABK) has hired
outside legal and forensic experts to examine 17 of its financial guarantee
transactions and may seek to cancel the contracts if the experts uncover evidence
of fraud, David Wallis, Ambac’s chief risk officer, said Wednesday.

He singled out two specific transactions as examples of the type of transaction
that is under scrutiny and said the company was taking a two-pronged approach to
examining transactions that have performed much worse than expected.

One way, “difficult and time-consuming,” is going through the securities loan by
loan, which Wallis said the company is doing.

The second “grander theory” approach is “not loan by loan, but a more grand scale
fraudulent inducement.”

One transaction that has performed below expectations is a deal with Bear Stearns
Co. (BSC) that closed in April 2007.

On its Web site, Ambac lists three Bear deals under the 2007-1 name, with a total
net par exposure of $790.6 million in second mortgages and home equity lines of
credit as of the end of March. Originally, all three were rated A+ but are all
considered below investment grade now, Ambac said.

Another deal, with First Franklin, a unit of Merrill Lynch (MER), has a current
net par exposure of $396.95 million and a below-investment-grade internal rating,
down from A+.

Ambac originally projected that losses on the underlying collateral of the Bear
Stearns transaction would be between 10% and 12%, but now expects losses of 81.8%
of underlying collateral, a transaction that has seen an unexpectedly “rapid
escalation of losses.”

These two deals represent an outsized percentage of the insurer’s $940 million
credit impairment, Wallis said.

Presumably, if the deals are invalid, those impairments could be reversed, though
Wallis did not discus financial implications.

Some of the factors the company will examine include loan-level document review
and a review of legal documents “focusing on representations and warranties,”
Wallis said. “Hypotheses are being built which involve fraudulent activity in
various guises.”

“If they can demonstrate there was fraud, they don’t pay” is the general legal
standard for such contracts, Gregory Hindy, a partner with Newark law firm
McCarter & English LLP told Dow Jones Newswires Wednesday.

Hindy said that such lawsuits in the bond insurance industry are rare but that he
expects to see more of them in coming months.

To get out of a contract, the insurer would have to make the case that “had these
been accurately described,” the insurer would not have entered the contract.

In recent months, Security Capital Assurance (SCA) has sought to cancel seven
financial guaranty contracts it wrote for Merrill Lynch, and FGIC Corp. sued to
cancel $1.7 billion in financial guarantee contracts it wrote for IKB Deutsche
Industriebank (IKB.XE) of Dusseldorf, Germany.

During its first-quarter conference call last week, investment bank Merrill Lynch
said it had canceled $1.1 billion in contracts with MBIA Corp. (MBI) and was
working to resolve its conflict with Security Capital Assurance.

Ambac’s share price fell Wednesday as the company reported a net loss of $1.66
billion, or $11.69 a share, compared with year-earlier net income of $213.3
million, or $2.02 a share.

Shares of Ambac recently traded down $2.83, or 46.9%, to $3.20, MBIA traded down
$4.39, or 33%, to $8.89, Security Capital Assurance traded down 16.2% to 83 cents
and Assured Guaranty Ltd. (AGO) traded down 1.4% to $25.25.

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