This annual report of MBIA Inc. (“MBIA”, the “Company” or “we”) includes statements that are not historical or current facts and are “forward-looking statements” made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “believe,” “anticipate,” “project,” “plan,” “expect,” “intend,” “will likely result,” “looking forward” or “will continue,” and similar expressions identify forward-looking statements. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. MBIA cautions readers not to place undue reliance on any such forward-looking statements, which speak only to their respective dates. The following are some of the factors that could affect financial performance or could cause actual results to differ materially from estimates contained in or underlying the Company’s forward-looking statements:
New business opportunities have been significantly limited in the structured finance and international sectors.
Retired $127 million par value of corporate debt and $47 million of surplus notes.
the restructuring, the stock of MBIA Illinois was transferred to a newly established intermediate holding company, which is wholly owned by MBIA Inc. Additionally, MBIA Illinois was further capitalized with approximately $2.1 billion from funds distributed by MBIA Insurance Corporation to MBIA Inc. as a dividend and return of capital, which MBIA Inc. contributed to MBIA Illinois through the intermediate holding company. Our new operating structure will facilitate both transparency of business lines and future capital raising efforts.
In 2008, additions to case basis reserves totaled $1.9 billion, of which $1.8 billion related to our RMBS exposure. Additions to case basis reserves have been partially offset by the establishment of salvage and subrogation receivables and collections totaling $406 million as of December 31, 2008. RMBS case basis reserves, net of salvage and subrogation receivables, have been principally established from the additional loss and LAE provisions recorded in 2008 and 2007. Refer to “Loss and Loss Adjustment Expenses” included in the Results of Operations section herein for further information regarding case basis reserve activity.
In determining fair value, our valuation approach always uses observable market prices when available and reliable. Market prices are generally available for traded securities and market standard CDSs but are less available or accurate for highly customized CDSs. Most of the derivative contracts we insure are the latter as they are non-traded structured credit derivative transactions. In contrast, typical market CDSs are standardized, liquid instruments that reference tradable securities such as corporate bonds that themselves have observable prices. These market standard CDSs also involve collateral posting, and upon a default of the underlying reference obligation, can be settled in cash.
Our primary model for insured CDSs simulates what a bond insurer would charge to guarantee a transaction at the measurement date, based on the market-implied default risk of the underlying collateral and the remaining structural protection in a deductible or subordination. This approach assumes that bond insurers would be willing to accept these contracts from us at a price equal to what they could issue them for in the current market. While the premium charged by financial guarantors is not a direct input into our model, the model estimates such premium and this premium increases as the probability of loss increases, driven by various factors including rising credit spreads, negative credit migration, lower recovery rates, lower diversity score and erosion of deductible or subordination.
In the first quarter of 2008 we modified the spread used for these transactions to reflect a combination of market spread pricing and third-party fundamental analysis of CMBS credit. Our revised spread input is a CMBX index analog that combines expectations for CMBS credit performance (as forecasted by the average of three investment banks’ research departments) together with the illiquidity premium implied by the CMBX indices. The illiquidity premium we use is the senior triple-A tranche spread of the CMBX index that matches the origination vintage of collateral in each transaction. For example, collateral originated in the second half of 2006 uses the triple-A tranche spread of the CMBX series 1 as the illiquidity premium. The sum of the illiquidity premium plus the derived credit spread based on the average cumulative net loss estimates of three investment bank’s research department is used as a CMBX analog index.
Refer to the “Market Risk” section included herein for a further discussion of how the Company manages the risks inherent in valuing financial instruments.
$15.0 billion excluding the effects of MBIA’s and reinsurers’ nonperformance risk. As of December 31, 2008, MBIA Corp’s five-year CDS spread was 46.50% upfront plus 5% per annum compared with 3.3% per annum as of December 31, 2007. MBIA’s nonperformance risk only affected 2008 and was a result of the adoption of SFAS 157. Unrealized losses in 2007 were principally driven by wider credit spreads on CMBS collateral and the ratings downgrades of collateral within multi-sector CDO structures.
Included in our net unrealized losses on insured derivative contracts is the reversal of $288 million of unrealized losses relating to exposure ceded to Channel Re. As a result of our analysis of Channel Re’s claims-paying ability, unrealized losses relating to exposure ceded to Channel Re had been adjusted to reflect Channel Re’s inability to pay amounts due to MBIA if these contracts were to be settled at their current fair value. As of December 31, 2008, MBIA determined that Channel Re did not have the ability to pay all amounts that would be due to MBIA under these contracts. However, there is no requirement to settle amounts due from Channel Re when corresponding amounts have not been realized by MBIA through actual payments. Refer to the “Reinsurance” section included herein for more information on this adjustment.
In the fourth quarter of 2008, the Company took remediation action on an international infrastructure financing. The project’s revenue was below original projections and the issuer’s debt was trading at a significant discount. We purchased 62% of the outstanding debt of the issuer; and as a consequence, the Company is consolidating the issuer as a VIE. An equal amount of assets and liabilities were recorded in the Company’s consolidated balance sheet related to this VIE.
MBIA also insures mortgage-backed securities backed by mortgages that when originally underwritten were deemed to be issued to prime and near prime borrowers, including second-lien residential mortgage securitizations (revolving HELOC loans and CES mortgages). Since the second half of 2007, the performance of our home equity transactions has deteriorated significantly. As of December 31, 2008, MBIA had established cumulative case basis reserves of $2.4 billion for future payments in connection with these transactions, the balance of which was $1.0 billion as of December 31, 2008. During 2008, the Company paid $1.4 billion in claims, net of reinsurance, on 29 credits in this sector. As of December 31, 2008, net par insured of $13.7 billion remained outstanding on these transactions.
MBIA owns a 17.4% equity interest in Channel Re. In August 2008, Moody’s downgraded Channel Re to Baa1 with a negative outlook and in September 2008, S&P downgraded Channel Re to AA- with a negative rating outlook. As of December 31, 2008, the Company expects Channel Re to continue to report negative shareholders’ equity on a GAAP basis primarily due to unrealized losses on its insured credit derivatives based on fair value accounting. As of December 31, 2008, the fair value of the derivative assets related to credit derivatives ceded to Channel Re was $682 million and the reinsurance recoverable from Channel Re was $16 million. In determining the fair value of our derivative assets, we considered the credit risk of Channel Re and, as a result, reversed $288 million of unrealized losses ceded to Channel Re. The amount reported in the preceding table reflects this reversal. After considering the credit risk of Channel Re in fair valuing our derivative assets, we believe Channel Re has sufficient liquidity supporting its business to fund amounts due to MBIA. In performing our assessment, we determined that cash and investments, inclusive of approximately $524 million that Channel Re had on deposit in trust accounts for the benefit of MBIA as of December 31, 2008, and borrowing facilities available to Channel Re were in excess of MBIA’s exposure to Channel Re. Although the trust accounts limit the potential for Channel Re to default on its obligations to MBIA, there can be no assurance that Channel Re will not default on its obligations to MBIA that exceed the amounts already held in the trust accounts.
POLICY ACQUISITION COSTS AND OPERATING EXPENSES Expenses that vary with and are primarily related to the production of the Company’s insurance business (policy acquisition costs) are deferred and recognized over the period in which the related premiums are earned. The Company does not defer costs associated with underwriting CDS policies and expenses such costs immediately. If an insured issue is refunded and the related premium is earned early, the associated acquisition costs previously deferred are also recognized immediately.
INTEREST EXPENSE Interest expense from our insurance operations primarily consists of interest related to MBIA Corp.’s surplus notes issued on January 16, 2008 and debt issued by consolidated VIEs. Interest expense increased to $190 million in 2008 from $82 million in 2007. The increase resulted from interest expense associated with our surplus notes, which totaled $133 million, partially offset by a decline in interest expense associated with VIE debt resulting from a decline in interest rates. Interest expense for 2007 increased to $82 million from $77 million in 2006. The increase in 2007 resulted from an increase in interest expense associated with consolidated VIEs. Interest expense related to consolidated VIEs was $56 million, $74 million and, $58 million in 2008, 2007 and 2006, respectively.
Revenues and expenses related to third-party VIEs are primarily recorded in “Net investment income” and “Interest expense”, respectively, on the Company’s statements of operations and substantially net to zero. Consolidation of such VIEs does not increase our exposure above that which is already committed to in our insurance policies. Additionally, consolidation of VIEs does not affect the capital ratios, debt covenants, dividends or credit ratings of the Company.
The Company’s $124.9 billion CDO portfolio comprised 16% of the Company’s total insured net par of $786.5 billion as of December 31, 2008. The Company’s aggregate CDO book is diversified by vintage and collateral type. Eighty-nine percent of this exposure, or $110.6 billion, was insured via CDS. The distribution of the Company’s insured CDO and related instruments portfolio by collateral type is presented in the following table:
Of the Company’s $39.4 billion net par Investment Grade CDO portfolio at December 31, 2008, the collateral composition, underlying credit ratings of the collateral that support the Subprime RMBS, Non-subprime RMBS, and CDOs of ABS exposures along with their vintage are presented in the following tables. The collateral level detail for each year insured was calculated using a weighted average of the total collateral for deals closed for the insured year. The total collateral amount of the portfolio exceeds the net par written as a result of credit enhancement (such as over collateralization and subordination) and reinsurance.
These years contain deals with allowances for synthetic tranches of leveraged investment grade corporate debt. Collateral contained in referenced Monotranche obligations are classified as Corporate Exposure as they are 100% corporate references.
Delinquencies of underlying commercial mortgages continue to rise, albeit from historically low levels. As of December 31, 2008, 30-day and over delinquencies topped 1% in the CMBS market (1.2%) and in MBIA’s insured portfolio (1.1%). MBIA believes delinquencies will continue to increase over the next 12 to 18 months. Retail bankruptcies will continue to impact loans secured by shopping centers and malls well into 2009, and the deterioration of a large number of financial firms may lead to an office market contraction.
As of December 31, 2008, we had repurchased a total of 40 million shares under the program at an average price of $21.79 per share and $119 million remained available under the buyback program.
During 2008, the Company maintained a line of credit and an equity-based facility, which further supported the claims-paying resources of our insurance operations. In aggregate, we believe our claims-paying resources are more than adequate to support our ongoing business risks.
The Company has instituted a liquidity risk management framework to evaluate its enterprise-wide liquidity position. The primary objective of this risk management system is to monitor potential liquidity constraints and guide the proactive management of liquidity resources to ensure adequate protection against liquidity risk. Our liquidity risk management framework monitors the Company’s cash and liquid asset resources using stress-scenario testing. Members of MBIA’s senior management meet frequently to review liquidity metrics, discuss contingency plans and establish target liquidity cushions on an enterprise-wide basis.
As a result of the increased liquidity needs in our investment management services operations, in the fourth quarter of 2008, we transferred $600 million from our corporate segment to our asset/liability products segment and established an intercompany repurchase agreement between MBIA Inc. and MBIA Insurance Corporation for up to $2 billion to support the projected liquidity needs of the segment. Pursuant to the repurchase agreement, the asset/liability products segment may transfer securities in its portfolio to MBIA Insurance Corporation in exchange for up to $2 billion in cash. In the event that the book value of the transferred securities declines below the amount outstanding under the facility, MBIA Inc. will be required to transfer additional securities or reduce the outstanding amount. The repurchase arrangement was approved by the NYSID and, in connection with the approval, MBIA Inc. agreed to repay amounts transferred under the repurchase agreement before returning the $600 million that the corporate segment transferred to the asset/liability products segment. As of December 31, 2008, including the full $2.6 billion of intercompany resources, the asset/liability products segment had cash and investments of $9.1 billion and receivables for securities sold net of payables for securities purchased of $64 million.
Liquidity needs in our corporate segment are highly predictable and comprise principal and interest payments on corporate debt, operating expenses and dividends to MBIA Inc. shareholders. Liquidity risk is associated primarily with the dividend capacity of MBIA Insurance Corporation, the distributable earnings of the investment management services operations conducted by MBIA Inc., dividends from asset management subsidiaries, investment income and our ability to issue equity and debt. Additionally, the corporate segment maintains excess cash and investments to ensure it is able to meet its ongoing short-term and long-term cash requirements in the event that cash becomes unavailable from one or more sources.
partially offset by proceeds received from our capital issuance and surplus notes transactions. For the year ended December 31, 2007, net cash provided by financing activities principally resulted from the issuance of investment agreements and, to a lesser extent, the issuance of MTNs by our asset/liability products segment, which funded the purchase of the fixed-maturity investments mentioned above.
Investment agreements, commercial paper, MTNs, variable interest entity notes, securities sold under agreements to repurchase and long-term debt include principal and interest and exclude premiums or discounts. Interest payments on floating rate obligations are estimated using applicable forward rates. Principal and interest on callable obligations or obligations that allow investors to withdraw funds prior to legal maturity are based on the expected call or withdrawal dates of such obligations. Gross insurance claim obligations represent the future value of payments MBIA expects to make, before estimated recoveries and reinsurance, under actual or probable insurance policy claims. The discounted value of such actual or estimated claims, after estimated recoveries, is reported as case basis reserves within “Loss and loss adjustment expense reserves” on the Company’s consolidated balance sheet.
MBIA’s insurance of structured credit derivatives typically remain in place until the maturity of the derivative. The Company does, however, periodically establish positions which offset its insurance positions in the reinsurance market, in which contracts also typically remain in place until the maturity of the insurance contract. Any difference between the price of the initial transaction and the offsetting transaction will result in gains or losses. With respect to MBIA’s insured structured credit derivatives, in the absence of credit impairment, the cumulative gains and losses should reverse at maturity. Additionally, in the event of the termination and settlement of a contract prior to maturity, any resulting gain or loss upon settlement will be recorded in the Company’s financial statements. In February 2008, we decided not to insure credit derivatives in the future, except in transactions that are intended to reduce our overall exposure to insured derivatives. This may result in termination of certain existing contracts prior to maturity.
As discussed in Note 3 to the consolidated financial statements, the Company has adopted SFAS No. 157, “Fair Value Measurements” in 2008. As discussed in Note 1 to the consolidated financial statements, in 2008, credit rating downgrades caused a significant reduction in insurance and funding activities and, in February 2009, the Company received regulatory approvals to establish a separate U.S. public finance financial guarantee insurance company.
As part of MBIA’s liquidity risk management framework, the Company also evaluates and manages liquidity on both a legal entity basis and a segment basis. Segment liquidity is an important consideration for the Company as it conducts the operations of its corporate segment and certain activities within the asset/liability products segment of the Company’s investment management services operations from MBIA Inc. During 2008, dislocation in the global financial markets, the overall economic downturn in the U.S., and the loss of MBIA Corp.’s triple-A insurance financial strength ratings have significantly increased the liquidity needs and decreased the financial flexibility in the Company’s segments. MBIA has satisfied all of its payment obligations from cash generated from operations, the issuance of equity and debt, and sales of investments. The Company believes that it has adequate resources to meet its ongoing liquidity needs in both the short-term and the long-term. However, if the current market dislocation and economic conditions persist for an extended period of time or worsen, the Company’s liquidity resources will experience further stress.
The Company classifies its fixed-maturity investments as either available-for-sale or held-to-maturity, as defined by SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” Available-for-sale investments are reported in the consolidated balance sheets at fair value, with unrealized gains and losses, net of deferred taxes, reflected in accumulated other comprehensive income (loss) in shareholders’ equity. Bond discounts and premiums are amortized using the effective yield method over the remaining term of the securities. For bonds purchased at a price above par value that also have call features, premiums are amortized to the call date that produces the lowest yield. For mortgage-backed and asset-backed securities, discounts and premiums are adjusted quarterly for the effects of actual and expected prepayments on a retrospective basis. For pre-refunded bonds, the remaining term is determined based on the contractual refunding date. Investment income is recorded as earned. Realized gains or losses on the sale of investments are determined by utilizing the first-in, first-out method to identify the investments sold and are included as a separate component of revenues.
Although SFAS 60 provides guidance to insurance enterprises, the Company does not believe SFAS 60 comprehensively addresses the unique attributes of financial guarantee insurance contracts, as the standard was developed prior to the maturity of the financial guarantee industry. SFAS 60 provides guidance with respect to insurance contracts that are either short-duration or long-duration in nature. Financial guarantee contracts typically have attributes of both and, therefore, are difficult to classify as either. For instance, financial guarantee
The Company follows the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation,” as revised by SFAS 123(R), “Share-Based Payment.” Under the modified prospective transition method selected by the Company under the provisions of SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” all equity-based awards granted to employees and existing awards modified on or after January 1, 2003 are accounted for at fair value with compensation expense recorded in net income. Refer to “Note 22: Long-term Incentive Plans” for a further discussion regarding the methodology utilized in recognizing employee stock compensation expense.
In February 2008, the FASB issued FSP FAS 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” FSP FAS 140-3 requires an initial transfer of a financial asset and a
Other investments include the Company’s interest in equity securities (including exchange-traded closed-end funds), money market mutual funds and perpetual securities. Fair value of other investments is determined by using quoted prices, live trades, or valuation models that use market-based and observable inputs. Other investments are categorized in Level 1, Level 2 or Level 3 of the fair value hierarchy.
2) Sector-specific spreads (JP Morgan and Merrill Lynch spread tables by asset class and rating).
In the first quarter of 2008 MBIA modified the spread used for these transactions to reflect a combination of market spread pricing and third-party fundamental analysis of CMBS credit. The Company’s revised spread input is a CMBX index analog that combines expectations for CMBS credit performance (as forecasted by the average of three investment banks’ research departments) together with the illiquidity premium implied by the CMBX indices. The illiquidity premium the Company uses is the senior triple-A tranche spread of the CMBX index that matches the origination vintage of collateral in each transaction. For example, collateral originated in the second half of 2006 uses the triple-A tranche spread of the CMBX series 1 as the illiquidity premium. The sum of the illiquidity premium plus the derived credit spread based on the average cumulative net loss estimates of three investment banks’ research department is used as a CMBX analog index.
a credit event or settlement agreement, (v) losses recovered and recoverable on purchased CDS contracts due to the occurrence of a credit event or settlement agreement and (vi) fees relating to CDS contracts. The “Unrealized gains (losses) on insured derivatives” include all other changes in fair value of the derivative contracts.
The Company has entered into derivative transactions that it views as an extension of its core financial guarantee business but which do not qualify for the financial guarantee scope exception under SFAS 133 and, therefore, must be stated at fair value. The insurance operations, which represent the majority of the Company’s notional derivative exposure, have insured derivatives primarily consisting of structured pools of CDSs that the Company intends to hold for the entire term of the contract absent a negotiated settlement with the counterparty. The insurance operations have also provided guarantees on the value of certain structured closed-end funds, which meet the definition of a derivative under SFAS 133. The Company reduces risks embedded in its insured portfolio through the use of reinsurance and by entering into derivative transactions. This includes cessions of insured derivatives under reinsurance agreements and capital markets transactions in which the Company economically hedges a portion of the credit and market risk associated with its insured credit derivative portfolio. Such arrangements are also accounted for as derivatives under SFAS 133 and recorded in the Company’s financial statements at fair value.
The aggregate maturity of long-term debt obligations, excluding accrued interest and premiums or discounts, as of December 31, 2008 for each of the next five years and thereafter commencing in 2009 was:
The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on tax assets and liabilities is recognized in income in the period that includes the enactment date.
At December 31, 2008, the Company has approximately $2.5 billion in unrealized losses, the majority of which are related to fixed-income securities. The Company has approximately $867 million in deferred tax assets related to such unrealized losses. The Company expects, based on its ability and intent, to hold these investments until maturity. As such, the Company expects the recovery of the value of these securities to par and the related deferred tax assets will reverse over the life of the securities.
No U.S. deferred income taxes have been provided on the undistributed earnings of MBIA UK Insurance Ltd., MBIA Euro Asset Acquisitions Ltd., and the remaining earnings of MBIA Assurance, which merged into MBIA UK Insurance Ltd. as of December 31, 2007, because of the Company’s practice and intent to permanently reinvest its earnings. The cumulative amounts of such untaxed earnings were $9 million, $224 million and $206 million at December 31, 2008, 2007 and 2006, respectively.
The U.K. tax matters have been concluded through 2004. The U.K. tax authorities are currently auditing tax years 2005 through 2006, which should be resolved by the end of 2009. The French tax matters have been concluded through 2005. The Company expects to settle, in early 2009, an unrecognized tax benefit that was established in prior years relating to the timing for recognizing earned premium.
MBIA Corp. guarantees the payment of principal of, and interest or other amounts owing on, municipal, asset- /mortgage-backed and other non-municipal securities. Additionally, MBIA Corp. has insured CDSs primarily on pools of collateral, which it previously considered part of its core financial guarantee business. The pools of collateral are primarily made up of corporate obligations, but also include commercial and residential mortgage-backed securities-related assets. MBIA Corp.’s net insurance in force represents the aggregate amount of the insured principal of, and interest or other amounts owing on insured obligations, net of cessions to reinsurers. MBIA Corp.’s ultimate exposure to credit loss in the event of nonperformance by the issuer of the insured obligation is represented by the net insurance in force in the tables that follow.
The financial guarantees issued by MBIA Corp. provide unconditional and irrevocable guarantees of the payment of the principal of, and interest or other amounts owing on, insured obligations when due. The obligations are generally not subject to acceleration, except that MBIA Corp. may have the right, at its discretion, to accelerate insured obligations upon default or otherwise. Certain guaranteed investment contracts written by MBIA Inc. are terminable upon ratings downgrades, and if MBIA Inc. were to have insufficient assets to pay the termination payments, MBIA Corp. would make such payments. These amounts have been excluded in the tables that follow.
Reinsurance enables the Company to cede exposure for purposes of syndicating risk and increasing its capacity to write new business while complying with its single risk and credit guidelines. MBIA Corp. reinsures exposure to other insurance companies under various treaty and facultative reinsurance contracts, both on a proportional and non-proportional basis. In the event that any or all of the reinsurers are unable to meet their obligations, MBIA Corp. would be liable for such defaulted amounts. When a reinsurer is downgraded by one or more of the rating agencies, less capital credit is given to MBIA under rating agency models and the overall value of the reinsurance to MBIA is reduced.
Includes transactions (represented by structured pools of primarily investment grade corporate credit risks or commercial real estate assets) that do not include typical CDO structuring characteristics, such as tranched credit risk, cash flow waterfalls, or interest and over-collateralization coverage tests.
The following is a reconciliation of the consolidated shareholders’ equity of the Company, presented on a GAAP basis, to the statutory capital and surplus of MBIA Corp. and its subsidiaries:
The Company intends to vigorously defend against the aforementioned actions in which it is a defendant and against other potential actions, and the Company does not expect the outcome of these matters to have a materially adverse effect on its business, results of operations or financial condition. The Company cannot provide assurance, however, that the ultimate outcome of these actions will not cause a loss nor have a material adverse effect on its business, results of operations or financial condition.