(Update 1: added discussion of SFAS 157) After being left for dead by some investors, monoline bond insurer Ambac Financial Group Inc. (ABK) posted a surprise Q2 profit Wednesday morning, as gains on hedges and a reduction in loss reserves more than offset $1.06 billion in mortgage-related write-downs. Ambac said it earned $823.1 million, or $2.80 per share, compared with with $173 million, or $1.67 per share, in the year-ago period. But all is not entirely as it seems. The company’s paper profit was largely the result of a $5.1 billion gain tied to a recently-enacted accounting quirk adopted by the company in Q2, that allows companies to report gains when market prices for their liabilities fall. In other words, as investors bid up risk premiums on Ambac’s own debt over concerns about the company’s solvency, the value of the company’s bond guarantees was similarly lowered — and that drop in fair-value of the company’s liabilities is allowed to be booked as a gain under SFAS 157. Hedging gains in credit derivatives amounted to $961.6 million, as a result, Ambac said. A $314.1 million reduction in loss reserves tied to the insurer’s second-lien direct RMBS portfolio is also equally telling. The monoline said the reduction was tied to “substantiated representation and warranty breach recoveries in certain transactions” — meaning that the company found substantial fraud of some sort in much of its second lien portfolio. Back in April, Ambac indicated that it intended to comb over its mortgage exposure to find deals it could put back to issuers, as part of an effort to preserve capital in the face of ratings pressure; both Standard & Poor’s Rating Services and Moody’s Investors Service downgraded the monoline from its previous AAA perch in June, citing substantial uncertainty around the monoline’s mortgage exposure. It’s not clear exactly what rep and warranty breach triggered the second-lien putbacks — Ambac did not provide further details to the press — but it’s clear that the insurer is attempting to attack its mortgage exposure directly. Without the benefit of the accounting change and a reduction in loss reserves, however, Ambac’s operating profit swung to a loss of $1.53 a share; analysts had expected a loss between 65 cents and $1.19 per share, according to published estimates. Ambac is the second-largest bond insurer, behind MBIA Inc. (MBI), and a downgrade to both insurers has hit investors and banks hard; last month, Ambac said the downgrades had forced it to terminate $270 million in business while boosting collateral requirements by roughly $500 million. Insurers like Ambac provided the top-rated portions of RMBS and related CDO deals with a guarantee that essentially was designed to serve as a private-party proxy for the implicit and explicity government guarantees that exist on Fannie/Freddie/Ginnie mortgage bond issues. But the strength of any such guarantee is only as good as the credit rating of the firm that provides it, which means that increasing MBS losses have led to downgrades affecting both the securities in question, as well as the insurers that guaranteed principal payments to investors. In the wake of the downgrades, Ambac has moved to establish a AAA-rated public finance monoline insurance subsidiary, looking to move capital to its Construction Loan Insurance Co. subsidiary; the company said Wednesday that it had filed paperwork with its insurance commissioner seeking approval for the proposed operation. The company also cut its direct exposure to subprime mortgages by paying $850 million to Citigroup Inc. (C) to terminate a guaranty contract on $1.4 billion in mortgage-related securities earlier this week, a move that cheered investors and has led to speculation that other monolines will look to commute existing contracts going forward. Shares in Ambac were at $5.00, up 5.71 percent, when this story was published. Disclosure: The author held no positions in ABK when this story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.