As a result of the risks facing MBIA Corp., during the fourth quarter of 2012, MBIA successfully completed a consent solicitation pursuant to which we received the consent of MBIA Inc. senior noteholders to amend the indentures pursuant to which the senior notes were issued to substitute National Public Finance Guarantee Corporation for MBIA Insurance Corporation in the definition of “Restricted Subsidiary” and “Principal Subsidiaries” in the respective indentures, which provide that an insolvency proceeding with respect to a Restricted or Principal Subsidiary, as the case may be, that remains in place for a specified period of time constitutes an event of default, which would likely result in the acceleration of the senior notes. In addition, we repurchased approximately $172 million of the outstanding principal amount of the notes issued under the Senior Indenture, dated as of November 24, 2004, by and between the Company and the Bank of New York (as supplemented by the first Supplemental Indenture, dated as of November 24, 2004, and the Second Supplemental Indenture, dated as of November 21, 2012 (the “Second Supplemental Indenture”) (collectively, the “2004 Indenture”)), governing the Company’s $329 million principal amount of notes (the “2004 Notes”), in privately negotiated seller initiated reverse inquiry transactions directly from holders that had consented pursuant to the consent solicitation.
On December 17, 2012, the Company sent the Trustee a letter advising the Trustee that the Purported Notice of Default is meritless and has no force or effect under the 2004 Indenture, directing the Trustee to take no action in furtherance of the Purported Notice of Default, and advising the Trustee that the Company intends to take any and all necessary and appropriate actions to enforce the Second Supplemental Indenture. In addition, on February 7, 2013, the Company filed a complaint for declaratory and injunctive relief seeking, among other things, a declaration that the Purported Notice of Default is invalid. While the Company believes the Purported Notice of Default is meritless, there can be no assurances that the Company will successfully contest its validity, or that the holders of the 1990 Notes will not declare an event of default under the 1990 Indenture on the basis of any purported acceleration of the 2004 Notes prior to resolution of the Company’s action for declaratory and injunctive relief. If the Company is unable to repay the 2004 Notes or the 1990 Notes in the event it is not ultimately successful in contesting the validity of the Purported Notice of Default and any subsequent acceleration, the Trustee or holders of the 2004 Notes or the 1990 Notes would likely exercise their rights as creditors to force repayment and the Company would have an immediate need to pursue other alternatives, including, if the Company is not successful in pursuing out-of-court alternatives, the filing for protection under applicable insolvency laws. For a complete description of the litigation around the Consent Solicitation, see “Note 20: Commitments and Contingencies” in the Notes to Consolidated Financial Statements.
Loss and LAE reserves are established by loss reserve committees in each of our major operating insurance companies (National, MBIA Insurance Corporation, and MBIA UK Insurance Limited) and reviewed by our executive Loss Reserve Committee, which consists of members of senior management. Loss and LAE reserves include case basis reserves and accruals for LAE incurred with respect to non-derivative financial guarantees. Case basis reserves represent our estimate of expected losses to be paid under insurance contracts, net of potential recoveries, on insured obligations that have defaulted or are expected to default. These reserves require the use of judgment and estimates with respect to the occurrence, timing and amount of paid losses and recoveries on insured obligations. Given that the reserves are based on such estimates and assumptions, there can be no assurance that the actual ultimate losses will not be greater than or less than such estimates resulting in the Company recognizing additional or reversing excess loss and LAE reserves through earnings.
During the fourth quarter of 2012, we completed an analysis of our deferred income tax balances, and as a result, identified errors to the current and deferred income tax balances. Accordingly, we recorded the impact of these errors, representing a net benefit for income taxes, of approximately $60 million in the fourth quarter of 2012. Refer to “Note 11: Income Taxes” in the Notes to Consolidated Financial Statements for a discussion of this adjustment.
(4)-The discount rate on insured derivative installment revenue and impairments was 5% as of December 31, 2012 and 2011.
ADJUSTED PRE-TAX INCOME (LOSS) In addition to the above results, we also analyze the operating performance of our structured finance and international insurance segment using adjusted pre-tax income (loss), a non-GAAP measure. We believe adjusted pre-tax income (loss), as used by management, is useful for an understanding of the results of operations of our structured finance and international insurance segment. Adjusted pre-tax income (loss) is not a substitute for pre-tax income (loss) determined in accordance with GAAP, and our definition of adjusted pre-tax income (loss) may differ from that used by other companies.
Adjusted pre-tax loss for the year ended December 31, 2012 increased compared with 2011 principally due to a decrease in premiums earned, an increase in insurance losses and LAE, an increase in interest expense from the National Secured Loan that was established in December of 2011 and a decrease on net gains from asset sales, partially offset by decreased impairments on insured credit derivatives.
Structured finance and international net premiums earned decreased in 2012 and 2011 due to the maturity and early settlement of insured transactions with no new material insurance writings.
The following tables present the aggregate loss and LAE reserves and insurance loss recoverables as of December 31, 2012 and 2011, and the aggregate change in the discounted values of net payments expected to be made on all insurance contracts for the years ended December 31, 2012, 2011 and 2010:
MBIA Corp. insures mortgage-backed securities (“MBS”) backed by residential mortgage loans, including second-lien residential mortgage securitizations (revolving HELOC loans and CES). For the year ended December 31, 2012, we recorded losses and LAE of $13 million related to insured second-lien RMBS transactions, before the elimination of $164 million of losses incurred as a result of consolidating VIEs. The $151 million benefit was due to gross recoveries of actual and expected payments of $371 million offset by gross losses and LAE related to actual and expected payments of $220 million.
Our high yield corporate CDO portfolio, totaling $5.7 billion of gross par exposure, largely comprises middle-market/special-opportunity corporate loan transactions and broadly syndicated CLOs. Our gross par exposure to high yield corporate CDOs represents 11% of MBIA Corp.’s CDO exposure and 5% of MBIA Corp.’s total gross par insured as of December 31, 2012.
For the year ended December 31, 2011, the favorable change in pre-tax income (loss) compared with 2010 was primarily driven by decreases in operating expenses related to a reversal of accrued long-term compensation costs. Decreases in fees due to declines in asset balances managed for our other segments and for third parties were largely offset by a $7 million performance fee received from our corporate segment for advisory-related services provided in 2011.
OTHER NET REALIZED GAINS (LOSSES) Other net realized gains (losses) for the years ended December 31, 2012 and 2011 relate to insurance recoveries received from our directors’ and officers’ insurance policy. These insurance recoveries reimbursed the Company for a portion of the expenses incurred by the Company related to private securities litigation. No recoveries were received in 2010.
NET GAINS (LOSSES) ON FINANCIAL INSTRUMENTS AT FAIR VALUE AND FOREIGN EXCHANGE The favorable change in net gains (losses) on financial instruments at fair value and foreign exchange for the year ended December 31, 2012 compared with 2011 was primarily due to a decline in losses on derivatives and financial instruments, partially offset by adverse foreign currency exchange rates on the U.S. dollar. The unfavorable change in net gains (losses) on financial instruments at fair value and foreign exchange for the year ended December 31, 2011 compared with 2010 was primarily due to net losses from fair valuing financial instruments, mostly a result of adverse movements in interest rates, and realized losses from asset sales.
For the year ended December 31, 2012, total revenues increased compared with 2011 as a result of net gains on the repurchase of debt issued by Meridian, and total expenses increased compared with 2011 as a result of $95 million in fees paid to our corporate segment for administrative and other services compared with $65 million paid during 2011.
Reductions in the contingency reserve may be recognized based on excessive reserves and under certain stipulated conditions, subject to the approval of the Superintendent of the NYSDFS. As of December 31, 2012, MBIA Insurance Corporation had a deficit of $140 million of qualifying assets required to support its contingency reserves. The deficit was caused by the failure of certain mortgage originators, particularly Bank of America, to honor their contractual obligations to repurchase ineligible mortgage loans from securitizations we insured thus requiring MBIA Insurance Corporation to sell liquid assets in order to make claim payments. Absent a resolution of the disputes with these parties, the deficit is expected to grow as additional commutation and claim payments are made in the future. The Company has reported the deficit and has requested approval from the NYSDFS as of September 30, 2012 and December 31, 2012, but to date has not received approval. For risks associated with MBIA Insurance Corporation’s failure to meet its contingency reserve requirement, see “Risk Factors-Capital, Liquidity and Market Related Risk Factors-If our insurance companies fail to meet regulatory capital requirements they may become subject to regulatory action” in Part I, Item 1A of this Form 10-K.
During the year ended December 31, 2012, pursuant to the tax sharing agreement, National settled its taxes related to the 2010 and 2011 tax years of $1 million and $16 million, respectively, with MBIA Inc. In addition, National paid to MBIA Inc. estimated 2012 taxes of $170 million. Consistent with the tax sharing agreement, these amounts were placed in an escrow account until the expiration of National’s two-year net operating loss (“NOL”) carry-back period under U.S. tax rules. At the expiration of National’s carry-back period, any funds remaining after any reimbursement to National in respect of any NOL carry-backs would be available for general corporate purposes, including to satisfy any other obligations under the tax sharing agreement. As of December 31, 2012, $445 million remained in escrow for the 2010 through 2012 tax years. During the first quarter of 2013, MBIA Inc. received $115 million that was previously held in escrow under the MBIA group tax sharing agreement. The amount represents National’s liability under the tax sharing agreement for the 2010 tax year, and was released pursuant to the terms of the agreement following the expiration of National’s two-year NOL carry-back period under U.S. tax rules.
The insurance policies issued or reinsured by National, the entity from which we conduct our U.S. public finance insurance business, provide unconditional and irrevocable guarantees of payments of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that the insurance company has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon the insurance company’s election to accelerate. In the event of a default in payment of principal, interest or other insured amounts by an issuer, National generally promises to make funds available in the insured amount within one to three business days following notification. In some cases, the amount due can be substantial, particularly if the default occurs on a transaction to which National has a large notional exposure or on a transaction structured with large, bullet-type principal maturities. The fact that the U.S. public finance insurance segment’s financial guarantee contracts generally cannot be accelerated by a party other than the insurer helps to mitigate liquidity risk in this segment.
As of December 31, 2012, based on the actual or estimated underlying ratings of our consolidated investment portfolio, without giving effect to financial guarantees, the weighted average rating of the consolidated investment portfolio would be in the Aa range, the weighted average rating of only the Insured Investments in the investment portfolio would be in the Baa range, and 4% of the total investment portfolio would be rated below investment grade in the Insured Investments.
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2012, 2011 and 2010
While MBIA Inc.’s senior note indentures were amended in November 2012 such that an MBIA Corp. Proceeding would not constitute an event of default, Bank of America has initiated pending litigation regarding the validity of those amendments, and there can be no assurance that the validity of those amendments would be upheld. If the amendments were to be overturned, MBIA Inc.’s senior debt may be accelerated if an MBIA Corp. Proceeding were to occur.
In determining fair value, the Company uses various valuation approaches, including both market and income approaches. The accounting guidance for fair value measurement establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available and reliable. Observable inputs are those the Company believes that market participants would use in pricing the asset or liability developed based on market data.
The Company assesses the financial abilities of the sellers/servicers using external credit ratings and other factors. The impact of such factors on cash flows related to expected recoveries is incorporated into the Company’s probability-weighted scenarios. Accordingly, the Company has not recognized any recoveries related to its IndyMac Bank, F.S.B. insured exposures and has subsequent to the Residential Capital, LLC (“ResCap”) bankruptcy filing reviewed the indicative scenarios and related probabilities assigned to each scenario to develop a distribution of possible outcomes. The Company’s expected recoveries may be discounted in the future based on additional reviews of the creditworthiness of other sellers/servicers.
3. the improvement in the financial strength of certain sellers/servicers due to mergers and acquisitions and/or government assistance, which should facilitate the ability of these sellers/servicers and their successors to comply with required loan repurchase/substitution obligations. The Company is not aware of any provisions that explicitly preclude or limit successors’ obligations to honor the obligations of original sellers/servicers. The Company’s assessment of any credit risk associated with sellers/servicers (or their successors) is reflected in the Company’s probability-weighted potential recovery scenarios;
10. MBIA’s successful motion regarding causation and the right to rescissory damages in the Countrywide litigation, which provides that MBIA is not required to establish a direct causal link between Countrywide’s misrepresentations and MBIA’s claims payments made pursuant to the insurance policies at issue, and that MBIA may seek damages equal to the amount that it has been and will be required to pay under the relevant policies, less premiums received;
The third approach stratifies loans into buckets based on delinquency status (including a “current” bucket) and utilizes recent Roll Rates actually experienced within each of the commercial mortgage-backed index (“CMBX”) series in order to formulate an assumption to predict future delinquencies. Ultimately, this generates losses over a projected time horizon based on the assumption that loss severities will begin to decline from the high levels seen over the past two years. The Company further examines those loans referenced in the CMBX indices which were categorized as 90+ days delinquent or in the process of foreclosure and determines the average monthly balance of such loans which were cured. The Company then applies the most recent rolling six-month average balance of all such cured loans to all underperforming loans in the 90+ day delinquent bucket or in the foreclosure process (and those projected to roll into late stage delinquency from the current and lesser stage levels of delinquency) and assumes all other loans are liquidated. The Company reserves the right to exclude any aberrant data from this analysis and also assumes all loans in the REO category liquidate over the next twelve months.
Based on a review of the data, the Company found property type and the DSCR to be the most significant determinants of a loan’s default probability, with other credit characteristics less influential. As a result, the Company developed a model in which the loans were divided into 168 representative cohorts based on their DSCR and property type. For each of these cohorts, the Company calculated the average annual probability of default, and then ran Monte Carlo simulations to estimate the timing of defaults. In addition, the model incorporated the following logic:
The second-lien RMBS losses and LAE related to actual and expected payments included in the preceding table comprise net increases of previously established reserves. The second-lien RMBS recoveries of actual and expected payments comprise $454 million in recoveries resulting from ineligible mortgage loans included in insured exposures that are subject to contractual obligations by sellers/servicers to repurchase or replace such mortgages, partially offset by an $83 million reduction in excess spread. The first-lien losses and LAE expense primarily resulted from credit deterioration.
This pricing would be based on the expected loss of the exposure. The Company reviews its valuation model results on a quarterly basis to assess the appropriateness of the assumptions and results in light of current market activity and conditions. This review is performed by internal staff with relevant expertise. If live market spreads or securities prices are observable for similar transactions, those spreads are an integral part of the analysis. New insured transactions that resemble existing (previously insured) transactions, if any, would be considered, as well as negotiated settlements of existing transactions.
(1)-Represents unrealized gains or losses on other than temporarily impaired securities recognized in accumulated other comprehensive income (loss), which includes the non-credit component of impairments, as well as all subsequent changes in fair value of such impaired securities reported in accumulated other comprehensive income (loss).
The following table presents the distribution by contractual maturity of AFS and HTM fixed-maturity securities at amortized cost and fair value as of December 31, 2012. Contractual maturity may differ from expected maturity as borrowers may have the right to call or prepay obligations.
Changes in the fair value of the Company’s asset/liability products business derivatives are recorded on the Company’s consolidated statements of operations within “Net gains (losses) on financial instruments at fair value and foreign exchange.”
The fair value of amounts recognized for eligible derivative contracts executed with the same counterparty under a master netting agreement, including any cash collateral that may have been received or posted by the Company, is presented on a net basis in accordance with accounting guidance for the offsetting of fair value amounts related to derivative instruments. Insured CDSs and insured swaps are not subject to master netting agreements. VIE derivative assets and liabilities are not presented net of any master netting agreements.
As of December 31, 2011, the total fair value of the Company’s derivative assets, after counterparty netting of $93 million, was $459 million, of which $452 million was reported within “Other assets” and “Derivative assets-VIEs”. Embedded derivatives of $7 million were reported within “Medium-term notes” on the Company’s consolidated balance sheets.
The following table presents the total fair value of the Company’s derivative assets and liabilities by instrument and balance sheet location, before counterparty netting and posting of cash collateral, as of December 31, 2011:
On April 1, 2010, MBIA Corp. commenced an action in New York State Supreme Court, New York County, against GMAC. The complaint alleges fraud and negligent misrepresentation on the part of GMAC in connection with the procurement of financial guarantee insurance on three RMBS transactions, breach of GMAC’s representations and warranties and its contractual obligation to cure or repurchase ineligible loans and breach of the implied duty of good faith and fair dealing. The case is currently stayed as a result of the Chapter 11 filing of ResCap on May 14, 2012 in the United States Bankruptcy Court for the Southern District of New York.
On September 17, 2012, MBIA Insurance Corp. filed a complaint in Minnesota state court for aiding and abetting fraud and breach of contract against certain Ally Bank companies relating to seven MBIA-insured mortgage-backed securitizations sponsored by RFC and GMAC during 2006-2007. The defendants removed to the United States District Court for the District of Minnesota on October 5, 2012, and filed a notice of motion to dismiss on October 12, 2012. A hearing on the defendants’ motion to dismiss is scheduled for April 25, 2013.
On September 10, 2012, CQS ABS Master Fund Ltd., CQS Select ABS Master Fund Ltd., and CQS ABS Alpha Master Fund Ltd. as holders of MBIA-insured residential mortgage-backed bonds filed suit against MBIA Inc., MBIA Corp. and National. The complaint alleges that certain of the terms of the transactions entered into by MBIA Corp., which were approved by the New York State Department of Insurance, constituted fraudulent conveyances under §§ 273, 274, 276 and 279(c) of New York Debtor and Creditor Law and a breach of the implied covenant of good faith and fair dealing under New York common law. On October 19, 2012, MBIA filed its answer.