Level 3 assets represented approximately 30% and 24% of total assets measured at fair value on a recurring basis as of December 31, 2011 and 2010, respectively. Level 3 liabilities represented approximately 77% and 78% of total liabilities measured at fair value on a recurring basis as of December 31, 2011 and 2010, respectively. Refer to “Note 7: Fair Value of Financial Instruments” in the Notes to Consolidated Financial Statements for additional information about assets and liabilities classified as Level 3.
Deferred income taxes are recorded with respect to the temporary differences between the tax bases of assets and liabilities and the reported amounts in our consolidated financial statements that will result in deductible or taxable amounts in future years when the reported amounts of assets and liabilities are recovered or settled. Our temporary differences relate principally to unrealized appreciation or depreciation of investments and derivatives, asset impairments, premium revenue recognition, deferred acquisition costs, deferred compensation, loss reserves and net operating losses.
The following table presents a summary of our consolidated financial results for the years ended December 31, 2011, 2010 and 2009:
For the year ended December 31, 2010, total revenues included in adjusted pre-tax loss increased compared with 2009 principally due to lower realized losses on other-than-temporary impairments and higher premiums on insured derivatives due to the termination of reinsurance with Channel Reinsurance Ltd. (“Channel Re”), partially offset by reductions in gains on extinguishment of debt and unrealized gains on financial instruments and foreign exchange. Total expenses included in adjusted pre-tax loss for the year ended December 31, 2010 decreased compared with 2009 principally as a result of a reduction in total insurance losses, a decrease in interest expense resulting from a reduction in outstanding debt within our asset/liability products program, and overall lower operating and policy acquisition expenses.
As of December 31, 2011, ABV per share (a non-GAAP measure) was $34.50, down from $36.81 as of December 31, 2010. The decrease in ABV per share was primarily driven by additional estimated credit impairments on insured credit derivatives and a reduction in the value of expected installment premiums resulting from the commutation and early settlement of policies during 2011, partially offset by the effect of repurchasing common shares during 2011.
OTHER NET REALIZED GAINS (LOSSES) Other net realized gains (losses) for the year ended December 31, 2011 included an impairment loss of $31 million, representing the full write-off of goodwill held by National.
Gross expenses represent total insurance expenses before the deferral of any policy acquisition costs. Gross expenses increased for the year ended December 31, 2011 compared with 2010 primarily due to higher legal costs associated with litigation and higher expenses related to support services provided by Optinuity Alliance Resources Corp. (“Optinuity”). Gross expenses increased for the year ended December 31, 2010 compared with 2009 primarily due to higher legal costs associated with litigation and building-related expenses associated with the Armonk, New York facility, which was acquired by National in the first quarter of 2010. Partially offsetting these increases was a decrease in compensation costs due to a reduction in headcount.
The following tables present our structured finance and international insurance segment results for the years ended December 31, 2011, 2010 and 2009:
As of December 31, 2011, total structured finance and international gross par outstanding rated A or above, before giving effect to MBIA’s guarantee, was 57% compared with 60% as of December 31, 2010. Additionally, as of December 31, 2011 and 2010, 20% and 18%, respectively, of gross par outstanding was rated below investment grade.
The significant erosion of Insured Tranche Subordination in our multi-sector CDO transactions principally resulted from the underperformance of RMBS and CDO collateral. As discussed above, the erosion of Insured Tranche Subordination in these transactions increases the likelihood that MBIA Corp. will pay claims. As of December 31, 2011, our credit impairment estimates for 28 classified multi-sector CDO transactions for which MBIA Corp. expects to incur actual net claims in the future (15 of which are insured in the secondary market), representing 49% of all MBIA Corp.-insured multi-sector CDO transactions (including both CDS and non-CDS contracts), aggregated $729 million. Of the remaining transactions, 18% are on our Caution List and 33% continue to perform at or close to our original expectations. In the event of further performance deterioration of the collateral referenced or held in our multi-sector CDO transactions, the amount of credit impairments could increase materially.
(1)-All ratings are current. Ratings are derived using the most conservative rating among Moody’s, S&P or internal ratings.
The following table presents the collateral as a percent of the performing pool balances for all MBIA Corp.-insured investment grade corporate CDOs and structured corporate credit pool transactions:
There have been some declines in Insured Tranche Subordination levels as a result of defaults in underlying collateral, as well as sales of underlying collateral at discounted prices. Insured Tranche Subordination for CDOs insured in earlier years have experienced, on average, more deterioration than those insured in later years. Insured Tranche Subordination within CDOs may decline over time as a result of collateral deterioration. The risk of lower Insured Tranche Subordination levels is typically offset by the amortization of outstanding insured debt and a decrease in the time to maturity. There are currently no significant losses on MBIA Corp.’s insured high yield corporate CDO tranches at this time. However, there can be no assurance that the Company will not incur significant losses as a result of deterioration in Insured Tranche Subordination.
As of December 31, 2011, our gross par exposure to structured CMBS pools totaled approximately $19.3 billion and represented approximately 14% of MBIA Corp.’s total gross par insured. Since the end of 2007 through December 31, 2011, our structured CMBS pools gross par exposure has decreased by approximately $21.4 billion, primarily from negotiated commutations and early settlements. Our structured CMBS pool insured transactions are pools of CMBS bonds, Real Estate Investment Trust (“REIT”) debt and other CRE CDOs structured with first loss deductibles such that MBIA Corp.’s obligation attached at a minimum of a triple-A level when the policies were issued. The deductible sizing was a function of the underlying collateral ratings and certain structural attributes. MBIA Corp.’s guarantees for most structured CMBS pool transactions cover losses on collateral assets once the deductibles have been eroded. These deductibles provide credit enhancement and subordination to MBIA’s insured position.
In order to address these liquidity risks and efficiently manage liquidity across the entire enterprise, certain of our subsidiaries which are less liquidity constrained have entered into intercompany agreements that provide resources to subsidiaries that are more liquidity constrained. These resources include intercompany agreements described further below between the Company’s primary insurance subsidiaries and between these insurance subsidiaries and the asset/liability products business (through MBIA Inc.), which in each case were approved by the NYSDFS and are subject to ongoing monitoring by the NYSDFS.
During 2011, MBIA Inc. experienced deterioration in the market values of some of its assets, resulting in increased collateral requirements. During the fourth quarter of 2011, the Company extended the maturity date of the MBIA Corp. Secured Loan, with NYSDFS approval, to May 2012 for a maximum outstanding amount of $450 million, to provide additional liquidity in the event of future declines in asset values.
As of December 31, 2011, the notional amount utilized under the Asset Swap was $1.3 billion and the fair value of collateral pledged by National under the agreement was $1.4 billion. The Asset Swap provides yield enhancement to the Company’s U.S. public finance insurance investment portfolio as a result of increased net interest earnings from the agreement. The net average interest rate on this transaction was 0.34%, 0.35% and 1.70% for the years ended December 31, 2011, 2010 and 2009, respectively.
The following discussion of investments, including references to consolidated investments, excludes cash and investments reported under “Assets of consolidated variable interest entities” on our consolidated balance sheets. Cash and investments of VIEs support the repayment of VIE obligations and are not available to settle obligations of MBIA.
During the fourth quarter of 2010, MBIA Inc. entered into a repurchase agreement with Meridian Funding Company, LLC (“Conduit Repurchase Agreement”), under which $1.0 billion notional amount may be utilized, subject to a pledge of collateral. The Conduit Repurchase Agreement had an average interest rate during 2011 of 2.41%. As of December 31, 2011, the notional amount utilized by MBIA Inc. under this agreement was $80 million.
MBIA Corp. also insures third party holders of the Company’s asset/liability products segment’s obligations. If the Company was unable to meet payment or collateral requirements associated with these obligations, the holders thereof could make claims under the MBIA Corp. insurance policies. In 2008, to provide additional liquidity to the asset/liability products business, MBIA Corp. lent $2.0 billion to the segment on a secured basis under the MBIA Corp. Secured Loan, the outstanding balance of which loan was $300 million as of December 31, 2011. The MBIA Corp. Secured Loan was originally scheduled to mature in the fourth quarter of 2011, but has been extended with the approval of the NYSDFS to May 2012 with a maximum outstanding amount of $450 million. During the year ended December 31, 2011, a total of $675 million was repaid.
The consolidated financial statements include the accounts of MBIA Inc., its wholly-owned subsidiaries and all other entities in which the Company has a controlling financial interest. All material intercompany balances and transactions have been eliminated. The Company determines whether it has a controlling financial interest in an entity by first evaluating whether an entity is a voting interest entity or a VIE.
payments are required based on changes in the creditworthiness of a referenced credit, rather than failure of that debtor to pay when due (i.e., default);
In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820)-Improving Disclosures about Fair Value Measurements,” to require additional disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. The standard also clarifies existing disclosures about the level of disaggregation, valuation techniques and inputs to fair value measurements. The Company adopted this standard as of the first quarter of 2010 except for the requirement to provide the Level 3 activity of purchases, sales issuances and settlements on a gross basis, which the Company adopted in the first quarter of 2011. As this standard only affects disclosures related to fair value, the adoption of this standard did not affect the Company’s consolidated balance sheets, results of operations, or cash flows. Refer to “Note 7: Fair Value of Financial Instruments” for these disclosures.
The following table summarizes the adjustments made to the Company’s consolidated assets, liabilities and equity by transition method of consolidation as of January 1, 2010:
Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (ASU 2010-26)
In October 2010, the FASB issued ASU 2010-26, “Financial Services-Insurance (Topic 944)-Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts.” This amendment specifies which costs incurred in the acquisition of new and renewal insurance contracts should be capitalized. The new guidance is effective for the Company beginning January 1, 2012 with early adoption as of January 1, 2011 permitted. The Company did not early adopt the guidance as of January 1, 2011. The adoption of this standard will not have a material effect on the Company’s consolidated balance sheets, results of operations, or cash flows.
The Company’s second-lien RMBS case basis reserves as of December 31, 2011 relate to RMBS backed by home equity lines of credit (“HELOCs”) and closed-end second mortgages (“CES”).
As of December 31, 2011, the Company recorded estimated recoveries of $3.1 billion, gross of income taxes, related to second-lien RMBS put-back claims on ineligible loans, consisting of $2.0 billion included in “Insurance loss recoverable” and $1.1 billion included in “Loan repurchase commitments” presented under the heading “Assets of consolidated variable interest entities” on the Company’s consolidated balance sheets. As of December 31, 2011 and 2010, the Company’s estimated recoveries after income taxes calculated at the federal statutory rate of 35%, were $2.0 billion and $1.6 billion, respectively, which was 119% and 58% of the consolidated total shareholders’ equity of MBIA, excluding preferred stock of subsidiaries and noncontrolling interests. The percentage increase of recoveries relative to shareholders’ equity was principally driven by losses on insured derivatives as a result of MBIA’s nonperformance risk on the derivative liabilities and an increase in recorded estimated recoveries related to put-back claims of ineligible loans. These estimated recoveries relate to the Company’s put-back claims of ineligible loans, which have been disputed by the loan sellers/servicers and are currently subject to litigation initiated by the Company to pursue recovery. While the Company believes that it will prevail in enforcing its contractual rights, there is uncertainty with respect to the ultimate outcome. Furthermore, there is a risk that sellers/servicers or other responsible parties might not be able to satisfy their put-back obligations.
10. loan repurchase reserves and/or settlements which have been publicly disclosed by certain sellers/servicers to cover such obligations.
Valuation techniques for financial instruments measured at fair value and included in the preceding table are described below. The Company’s assets and liabilities measured at fair value have been categorized according to the fair value hierarchy based on the lowest level input that is significant to the fair value measurement in its entirety.
Mortgage-backed securities and asset-backed securities-MBS and ABS are valued using recently executed transaction prices. When position-specific quoted prices are not available, MBS and ABS are valued based on quoted prices for similar securities. If quoted prices are not available, MBS and ABS are valued using a valuation model based on observable inputs including interest rate yield curves, spreads, prepayments and volatilities, and categorized in Level 2 of the fair value hierarchy. MBS and ABS are categorized in Level 3 of the fair value hierarchy when significant inputs are unobservable.
The fair values of investments held-to-maturity are determined using recently executed transaction prices or quoted prices when available. When position-specific quoted prices are not available, fair values of investments held-to-maturity are based on quoted prices of similar securities. When quoted prices for similar investments are not available, fair values are based on valuation models using observable inputs including interest rate yield curves, and bond spreads of similar securities.
As of December 31, 2011, some of the model inputs were either unobservable or derived from illiquid markets which might adversely impact the model’s reliability.
The Direct Price Model was developed internally to address weaknesses in the Company’s BET Model specific to valuing insured multi-sector CDOs, as previously discussed. There are three significant model inputs used in determining fair value using the Direct Price Model. Significant inputs include market prices obtained or estimated for all collateral within a transaction, the present value of the market-implied potential losses calculated for the transaction, and the impact of nonperformance risk.
Stock warrants issued by the Company are recorded at fair value based on a modified Black-Scholes model. Inputs into the warrant valuation include interest rates, stock volatilities and dividend data. As all significant inputs are market-based and observable, warrants are categorized in Level 2 of the fair value hierarchy.
Transfers into and out of Level 3 were $390 million and $562 million, respectively, for the year ended December 31, 2010. Transfers into and out of Level 2 were $562 million and $390 million, respectively, for the year ended December 31, 2010. These transfers were principally for available-for-sale securities where inputs, which are significant to their valuation, became observable or unobservable during the year. These inputs included spreads, prepayment speeds, default speeds, default severities, yield curves observable at commonly quoted intervals, and market corroborated inputs. CDOs, corporate obligations, RMBS non-agency and other asset-backed comprised the majority of the transferred instruments. There were no transfers into or out of Level 1. For the year ended December 31, 2010, the net unrealized losses related to the transfers into Level 3 was $10 million and the net unrealized gains related to the transfers out of Level 3 was $120 million.
The Company’s derivative exposure within its U.S. public finance insurance operations primarily consists of insured interest rate and inflation-linked swaps related to insured U.S. public finance debt issues. These derivatives do not qualify for the financial guarantee scope exception. The Company has also purchased certain investments containing embedded derivatives. All derivatives are recorded at fair value on the Company’s balance sheet with the changes in fair value recorded in current earnings within “Unrealized gains (losses) on insured derivatives”, for the insured derivatives, or “Net gains (losses) on financial instruments at fair value and foreign exchange” for the embedded derivatives.
The Company’s asset/liability products business has entered into derivative transactions primarily consisting of interest rate swaps, cross currency swaps, and CDS contracts. Interest rate swaps are entered into to hedge the risks associated with fluctuations in interest rates or fair values of certain contracts. Cross currency swaps are entered into to hedge the variability in cash flows resulting from fluctuations in foreign currency rates. CDS contracts are entered into to hedge credit risk or to replicate investments in cash assets consistent with the Company’s risk objectives and credit guidelines for its asset management business.
The Company enters into securities borrowing and lending contracts in connection with MBIA’s collateralized investment agreement and repurchase agreement activities and to invest short-term cash balances or to provide liquidity to the Company’s asset/liability programs. Such contracts are only transacted with high-quality dealer firms. It is the Company’s policy to take possession of securities borrowed under these contracts. The Company minimizes the credit risk of counterparties to transactions that might be unable to fulfill their contractual obligations by monitoring customer credit exposure and collateral values and requiring additional collateral to be deposited with the Company when deemed necessary.
The Company has $10 million of outstanding letters of credit for Cutwater-ISC that is intended to support the net asset value of certain investment pools managed by Cutwater-ISC. These letters of credit can be drawn upon in the event that the liquidation of such assets is required and the proceeds are less than the cost.
VIE notes are variable interest rate debt instruments denominated in U.S. dollars issued by consolidated VIEs within the Company’s structured finance and international insurance and conduit segments. VIE notes within the structured finance and international insurance segment consist of debt instruments issued by issuer-sponsored consolidated VIEs collateralized by assets held by those consolidated VIEs. VIE notes related to the conduit segment consist of floating rate MTN obligations issued by a Company-sponsored conduit collateralized by assets held by the conduit. As of December 31, 2011, the interest rates of the MTNs ranged from 0.64% to 1.78% and the weighted average interest rate was 1.41%. As of December 31, 2010, the interest rates of the MTNs ranged from 0.52% to 1.76% and the weighted average interest rate was 1.37%. The maturity of VIE notes, by segment, as of December 31, 2011 is presented in the following table:
As of January 1, 2012, the fair value of the Company’s U.S. public finance reporting unit did not exceed its carrying value, indicating that goodwill was potentially impaired. The fair value as of January 1, 2012 reflected the prolonged delay on the resolution of the litigation challenging the establishment of National, which adversely impacted the timing of writing new business, a key trigger for assessing goodwill impairment. As a result, in 2011, the Company recorded an impairment loss of $31 million, representing the full amount of goodwill, within “Other net realized gains (losses)” in its consolidated statements of operations. In performing this evaluation, the Company calculated the fair value of its U.S. public finance reporting unit utilizing discounted cash flow modeling. The inputs to the Company’s valuation model included its estimates of market participant assumptions.
The Company performed taxable income projections over a fifteen and twenty year period to determine whether it will have sufficient income to offset its deferred tax asset that will generate future ordinary deductions. In this analysis, the Company concluded that premium earnings, even without regard to any new business, combined with investment income, less deductible expenses, will be sufficient to recover its net deferred tax asset. The Company’s taxable income projections used to assess the recoverability of its deferred tax asset include an estimate of future loss and LAE equal to the present value discount of loss reserves already recognized on the balance sheet and an estimate of loss adjustment expense which is generally insignificant. The Company does not assume additional losses, with the exception of the accretion of its existing present value loss reserves, because the Company establishes case basis reserves on a present value basis based on an estimate of probable losses on specifically identified credits that have defaulted or are expected to default.
No U.S. deferred income taxes have been provided on the differences in the book and tax basis in the Company’s carrying value of MBIA UK and other entities because of the Company’s practice and intent to permanently reinvest these earnings. The cumulative amounts of such differences were $15 million, $3 million and $57 million as of December 31, 2011, 2010 and 2009, respectively. The estimated tax liability with respect to this difference was $5 million as of December 31, 2011.
The total amount of UTB is expected to decrease within the next 12 months due to finalizing adjustments and concluding all significant tax examinations. The range of this possible change to the amount of the unrecognized tax benefit is $20 million to $25 million.
MBIA guarantees the payment of principal of, and interest or other amounts owing on, municipal, asset-backed, mortgage-backed and other non-municipal securities. Additionally, MBIA Corp. has insured CDS primarily on pools of collateral, which it previously considered part of its core financial guarantee business. The pools of collateral are made up of corporate obligations, but also include commercial and RMBS-related assets. MBIA’s insurance in force represents the aggregate amount of the insured principal of, and interest or other amounts owing on, insured obligations. MBIA’s ultimate exposure to credit loss in the event of nonperformance by the issuer of the insured obligation is represented by the insurance in force in the tables that follow.
On February 1, 2007, the Company’s Board of Directors authorized the repurchase of common stock up to $1 billion under a new share repurchase program, which superseded the previously authorized program. As of December 31, 2011, the Company repurchased 56.7 million shares of MBIA Inc. under the share repurchase program at a cost of $977 million and an average price of $17.24 per share, and $23 million remained available under the program. During 2011, MBIA repurchased 6.5 million shares at an average price of $7.64 per share.
During 2011 and 2010, 102,578 and 16,984 shares, respectively, were purchased by the Company for settling awards under the Company’s long-term incentive plans.
On October 14, 2008, June 17, 2009 and August 25, 2009, MBIA Corp. submitted proofs of claim to the Federal Deposit Insurance Corporation (“FDIC”) with respect to the resolution of IndyMac Bank, F.S.B. for both pre- and post-receivership amounts owed to MBIA Corp. as a result of IndyMac’s contractual breaches and fraud in connection with financial guarantee insurance issued by MBIA Corp. on securitizations of home equity lines of credit. The proofs of claim were subsequently denied by the FDIC. MBIA Corp. has appealed the FDIC’s denial of its proofs of claim via a complaint, filed on May 29, 2009, against IndyMac Bank, F.S.B. and the FDIC, as receiver, in the United States District Court for the District of Columbia and alleges that IndyMac fraudulently induced MBIA Corp. to provide financial guarantee insurance on securitizations of home equity lines of credit by breaching contractual representations and warranties as well as negligently and fraudulently misrepresenting the nature of the loans in the securitization pools and IndyMac’s adherence to its strict underwriting standards and guidelines. On February 8, 2010, MBIA Corp. filed its amended complaint against the FDIC both in its corporate capacity and as conservator/receiver of IndyMac Federal Bank, F.S.B. for breach of its contractual obligations as servicer and seller for the IndyMac transactions at issue and for unlawful disposition of IndyMac Federal Bank, F.S.B.’s assets in connection with the FDIC’s resolution of IndyMac Bank, F.S.B. On October 6, 2011, the court issued a ruling granting the FDIC’s motion to dismiss. On November 4, 2011, MBIA Corp. filed a Notice of Appeal.