Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of Ambac’s financial instruments are interest rate risk, credit spread risk and foreign currency risk. As a result of declines in interest rates and increases in credit spreads during the six months ended June 30, 2020 , related to the impact of the COVID-19 pandemic, along with portfolio adjustments during the period, the sensitivities of Ambac's financial instruments have changed from those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019.
Interest Rate Risk:
Financial instruments for which fair value may be affected by changes in interest rates consist primarily of fixed income investment securities, long-term debt and interest rate derivatives. Fixed income investment securities that are guaranteed by Ambac have interest rate risk characteristics that behave inversely to those associated with future financial guarantee claim payments. Accordingly, such securities are excluded from the interest rate sensitivity table that follows. Financial instruments of VIEs that are consolidated as a result of Ambac financial guarantees are also excluded from Ambac's measures of interest rate risk. Changes in fair value resulting from changes in interest rates are driven
primarily by the impact of interest rate shifts on the fixed income investment portfolio (which produce net fair value losses as rates increase), long-term debt and the interest rate derivatives portfolio (which produce net fair value gains as rates increase). Interest rate increases would also have a negative economic impact on expected future claim payments within the financial guarantee portfolio, primarily related to RMBS and student loan policies. Ambac performs scenario testing to measure the potential for losses in volatile markets. These scenario tests include parallel and non-parallel shifts in the benchmark interest rate curve.
The interest rate derivatives portfolio is managed as a partial economic hedge against the effects of rising interest rates elsewhere in the Company, including on Ambac's financial guarantee exposures (the "macro-hedge"). At June 30, 2020 , the interest rate sensitivity of the interest rate derivatives portfolio attributable to the macro-hedge position would produce mark-to-market gains or losses of approximately $0.2 million for a 1 basis point parallel shift in USD benchmark interest rates up or down. This sensitivity is down from $0.4 million per 1 basis point shift at December 31, 2019.
The following table summarizes the estimated change in fair value (based primarily on the valuation methodology discussed in Note 7. Fair Value Measurements to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q) on these financial instruments, assuming immediate changes in interest rates at specified levels at June 30, 2020 :
($ in millions)
Estimated Change in Net Fair Value
Estimated Net Fair Value
300 basis point rise
$
18
$
(503
)
200 basis point rise
17
(504
)
100 basis point rise
15
(506
)
Base scenario
—
(521
)
100 basis point decline (1)
2
(519
)
200 basis point decline (1)
5
(516
)
(1)
Incorporates an interest rate floor of 0%.
Due to the low interest rate environment as of June 30, 2020 , stress scenarios involving interest rate declines greater than 200 basis points are not meaningful to Ambac's portfolios.
| Ambac Financial Group, Inc. 74 2020 Second Quarter FORM 10-Q |
Credit Spread Risk
Financial instruments that may be adversely affected by changes in credit spreads include Ambac’s outstanding credit derivative contracts, certain interest rate derivatives and investment assets. Changes in spreads are generally caused by changes in the market’s perception of the credit quality of the underlying obligor. Market liquidity and prevailing risk premiums demanded by market participants are also reflected in spreads and impact valuations.
The following table summarizes the estimated change in fair values on Ambac’s net derivative liabilities assuming immediate parallel shifts in reference obligation credit spreads related to written credit derivatives and counterparty credit spreads related to uncollateralized interest rate derivatives at June 30, 2020 . It is more likely that actual changes in credit spreads will vary by obligor:
($ in millions)
Estimated Change in Net Fair Value
Estimated Net Fair Value
250 Basis Point Widening
$
(24
)
$
(61
)
50 Basis Point Widening
(6
)
(43
)
Base Scenario
—
(37
)
50 basis Point Narrowing
5
(32
)
250 basis Point Narrowing
25
(12
)
Also included in the fair value of derivatives is the effect of Ambac’s creditworthiness, which reflects market perception of Ambac’s ability to meet its obligations. Generally, the need for an Ambac credit valuation adjustment is mitigated by the existence of collateral posting agreements under which adequate collateral has been posted. Derivative contracts entered into with credit exposure to financial guarantee customers are not typically subject to collateral posting agreements. As a result of runoff of uncollateralized interest rate and credit default swap liabilities, Ambac’s credit valuation adjustment included in the determination of fair value has resulted in $0.1 million reduction to derivative liabilities as of June 30, 2020 . Refer to Note 7. Fair Value Measurements to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q for further information on measurement of the credit valuation adjustment.
Ambac’s fixed income investment portfolio contains securities with different sensitivities to and volatility of credit spreads. Fixed income securities that are guaranteed by Ambac and were purchased in Ambac's investment portfolio have credit spread risk characteristics that behave inversely to those associated with future financial guarantee claim payments. Accordingly such securities are excluded from the company's spread sensitivity measures. The following table summarizes the estimated change in fair values of Ambac’s fixed income investment portfolio assuming immediate shifts in credit spreads across all holdings other than Ambac guaranteed securities at June 30, 2020 . It is more likely that actual changes in credit spreads will vary by security:
($ in millions)
Estimated Change in Net Fair Value
Estimated Net Fair Value
250 Basis Point Widening
$
(134
)
$
1,895
50 Basis Point Widening
(27
)
2,002
Base Scenario
—
2,029
50 Basis Point Narrowing
25
2,054
250 Basis Point Narrowing
75
2,104
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.