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April 29, 2008 / 9:05 PM / in 10 years

Ambac's deferred tax assets could punish the firm

By Dan Wilchins - Analysis

NEW YORK (Reuters) - Ambac Financial Group Inc’s ABK.N net worth is shrinking as it writes down bad assets linked to subprime mortgages, but another potential problem elsewhere on its balance sheet could also eat into the company’s value.

The issue of Ambac’s net worth is important, both because it has already dipped below the minimum net worth required to maintain a $400 million credit line and because too low a net worth will make it harder to raise additional capital.

Ambac said last week its shareholder equity, an accounting measure of net worth, shrank about 40 percent in the first quarter. The company now has about $1.3 billion of shareholder equity and writing down insurance on risky securities such as subprime mortgage bonds could further reduce Ambac’s net worth.

But the company could also see shareholders’ equity hit by a $3.57 billion deferred tax asset -- which can be seen as a type of prepaid tax -- that currently sits on the company’s balance sheet.

Ambac must generate enough taxable income in future years to take advantage of its deferred tax asset, or else it could be forced to essentially write that asset down.

Those write-downs -- which show up on the balance sheet as valuation adjustments -- could conceivably be big enough to leave Ambac with a negative net worth, at least on an accounting basis.

“The question with deferred tax assets in general is, if the company will not be highly profitable in the future, how will they generate the taxable income to take advantage of the asset?” said Theodore Sougiannis, a professor of accounting at University of Illinois at Urbana-Champaign who has worked on deferred tax assets.

That proved to be a problem for General Motors Corp (GM.N) in November, when it recorded a $39 billion loss driven largely by a deferred tax asset valuation adjustment, leaving it with a negative net worth.

Ambac’s management says the bond insurer does not need to raise new capital and its latest analysis of expected payouts and receipt of insurance premiums indicates it will generate enough taxable income to enjoy the benefit of the deferred tax asset. The company also has mechanisms to boost taxable income.


But Ambac’s profits will likely be under fire for at least a few quarters, if not longer. Ambac Chief Executive Michael Callen said during a recent conference call that the company will not likely be able to generate much new business until losses show evidence of reaching a plateau, which could take until the beginning of next year.

Amid write-downs and weak new business generation, Ambac posted a $1.66 billion first quarter loss last week. After results, Ambac was below its net asset requirements for a $400 million credit facility it is not using. The company is talking to its banks and says its liquidity position is strong.

Some investors speculate Ambac could have to raise capital sooner rather than later after its abysmal results and, if it does, its net worth could raise thorny questions for investors.

    The company worked for weeks to raise capital earlier this year and eventually sold $1.5 billion of shares and convertible securities in March, in a deal that helped preserve its main unit’s top credit ratings.

    Those ratings are crucial for winning new business. Any downgrades could have forced investors that can only hold top rated securities to dump billions of dollars of bonds into the markets.

    Ambac shares closed at $4.38 on Tuesday, down about 95 percent over the last 12 months.


    Deferred tax assets arise because U.S. companies are allowed to keep two sets of books: one for shareholders and one for the tax man.

    Ambac’s recent write-downs have cut into income reported to shareholders. But many of those write-downs have not affected income reported for tax purposes. That is because the company only takes deductions on taxable income as it sets aside reserves on specific insurance policies or makes payments on derivatives contracts.

    So Ambac has higher income recorded for tax purposes compared with the results it reported to investors. Over time, as adjustments in the market value of assets end up translating into actual payouts, Ambac will be able to deduct those payments from taxable income.

    In a telephone interview, Chief Financial Officer Sean Leonard said Ambac has forecast its expected payouts, combined with its expected incoming premium, and it expects to generate enough taxable income to take advantage of the losses and payouts in the future.

    The company also has steps it can take to boost taxable income, Leonard said. For example, Ambac could also switch its tax-exempt investment portfolio to being taxable.

    Editing by Andre Grenon

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