Freddie Mac Wades Into Ambac Litigation

By Alistair Barr

Freddie Mac (FMCC), the government-owned mortgage giant, has waded into litigation against Ambac Financial Group Inc. (ABK), joining a group of hedge funds that are challenging the reorganization of the troubled bond insurer.

Freddie Mac owns about $4.5 billion of mortgage-related securities that are insured by Ambac Assurance Corp., the main subsidiary of Ambac Financial.

Earlier this week, Freddie joined hedge funds including King Street Capital in arguing against a deal Ambac struck earlier this year with major banks including Citigroup Inc. (C) and Deutsche Bank AG (DB).

The mortgage giant also joined a related legal challenge launched earlier this year by investment-management firms including Eaton Vance (EV), according to a letter sent by Freddie's attorney Thomas Armstrong to the Wisconsin Court of Appeals on Sept. 20.

The litigation will decide the fate of policies backing more than $60 billion of securities. It also has broader implications because critics argue Ambac policyholders are being treated differently, undermining a basic tenet of the insurance industry.

The legal battles stem from Ambac's doomed foray into guaranteeing mortgage-related securities at the height of the housing boom.

Originally an insurer of sturdier municipal bonds, Ambac sold guarantees on billions of dollars of mortgage-backed securities and more complex vehicles known as collateralized debt obligations, or CDOs. When the housing meltdown hit, many of these securities turned toxic, leaving Ambac with heavy losses that threatened its survival.

In March, the Wisconsin Insurance Commissioner, the main regulator of Ambac Assurance, seized the most-troubled parts of its business to protect hundreds of billions of dollars in muni bond guarantees.

Policyholders with guarantees on $64 billion worth of soured assets like residential mortgage-backed securities and CDOs were put into a so-called Segregated Account.

The regulator has halted claim payments on the policies until the seizure plan is approved in court. Once the Segregated Account is able to pay claims, policyholders will get roughly 25 cents on the dollar in cash. The rest will be paid in surplus notes, a type of IOU.

Meanwhile, policyholders that remain in Ambac's main General Account can still make claims and get paid in full. That's sparked criticism that the plan treats some policyholders better than others.

Freddie Mac's legal challenge focuses on the agreement earlier this year between Ambac Assurance and big banks including Citi. Ambac agreed to pay the banks $2.6 billion in cash and $2 billion of new surplus notes. In return, the banks agreed to commute, or tear up, $16.4 billion of guarantees on CDOs that they bought from Ambac.

This settlement may "jeopardize the prospects for successful rehabilitation of the Ambac Segregated Account [which is completely dependent upon the General Account for funding]," Armstrong, Freddie's attorney, wrote in the Sept. 20 letter.

The banks involved in the deal may be getting better treatment than Ambac policyholders in the Segregated Account, the lawyer added.

Freddie Mac owns $2 billion of residential mortgage-backed securities that are insured by Ambac and have ended up in the Segregated Account. It owns another $2.5 billion of commercial mortgage-backed securities and mortgage-revenue bonds that are insured by Ambac and "appear" to still be in the General Account, Armstrong noted.

Wisconsin laws suggest that the banks should be paid after, not ahead of, Segregated Account policyholders like Freddie Mac, the lawyer wrote.

-Alistair Barr; 415-439-6400; [e-mail]