The credit crisis that began in 2007 followed several years of seemingly benign credit conditions, during which delinquency and default rates were comparatively low across the residential mortgage, consumer finance and corporate finance credit markets. Beginning in 2005, credit spreads were tight, indicating that investors were relatively undiscriminating about risk, and structures of some asset-backed securities were based on loss assumptions that have proven to be too optimistic. This was particularly true in the residential mortgage-backed securities sector and in CDOs of ABS that contain a high percentage of RMBS. During these years, FSA maintained its underwriting and pricing standards, even though this meant declining to insure certain transactions.
Management expects the credit environment to continue to be difficult through 2008. Although structures and pricing in the asset-backed market appear more attractive than at any time in recent years, the Company remains highly selective because credit performance remains unpredictable.
2006 vs. 2005: Operating earnings increased primarily due to increased contributions from the FP segment. In the financial guaranty segment, higher net investment income from general investment portfolio was partially offset by lower refundings (net of amortization and taxes) and premium earnings excluding refundings. 2006 after-tax realized gains were $4.9 million lower than in 2005, and operating expenses increased, due primarily to lower deferral rates and increased personnel costs.
Non-GAAP adjusted book value ("ABV") was $4.5 billion at December 31, 2007 and $3.9 billion at December 31, 2006. Management uses ABV as a measure of performance and to calculate a portion of employee compensation. An investor attempting to evaluate the Company using GAAP measures alone would not have the benefit of this information. The ABV calculation relies on estimates of the amount and timing of installment premiums and NIM and applies discount factors to determine the present value. Actual values may vary from the estimates. For performance reporting purposes, the calculation of ABV includes adjustments to reflect International Financial Reporting Standards ("IFRS") results that the Company reports to its parent, Dexia S.A. ("Dexia") in order to better align the interests of employees with the interests of Dexia, whose accounts are maintained under IFRS. The IFRS adjustments relate primarily to accounting for foreign exchange, contingencies and fair-value adjustments.
During 2007, the Company charged $31.6 million to loss expense, consisting of $25.8 million for originations of new business and $5.8 million related to accretion on the reserve for in-force business. Net case reserves increased $45.1 million in 2007 due primarily to the establishment of new case reserves for HELOC and public finance transactions, offset in part by the settlement of several pooled corporate CBO transactions.
Outside the United States, FSA's international asset-backed par originations were flat in 2007, while PV premiums originated grew 38%. As in the U.S., the increase in PV premiums relative to par originated was primarily due to spread widening.
In 2006, while credit spreads were narrow in international asset-backed markets, FSA increased international asset-backed par originations by 40%, while PV premiums originated declined 13%. Ninety percent or more of the net par volume of 2006 originations was of Triple-A or Super Triple-A quality.
On July 31, 2003, FSA Holdings issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
I. Condensed Financial Statements of Financial Security Assurance Holdings Ltd. as of December 31, 2007 and 2006 and for the Years Ended December 31, 2007, 2006 and 2005
•the General Investment Portfolio, consisting of the investments held by FSA, FSA Holdings and other subsidiaries not included in the portfolios above, which are designated as available-for-sale.
In order to estimate the weighted-average market price of an investment-grade pooled corporate CDS contract, the Company utilizes the applicable market prices of the quoted tranches of the published CDX North America IG Index. In order to estimate the weighted-average market price for high-yield pooled corporate CDS contracts, the Company obtains dealer prices for the most senior quoted three-year and five-year tranches of the CDX North America High Yield Index and then applies a factor to the quoted prices. The factor depends on (a) the term to maturity of the Company's contract and (b) the attachment point of the Company's pooled corporate CDS contract, and is intended to calibrate the published index price to the Company's pooled corporate CDS contract, which references entities with higher credit quality than those reflected in the published indexes.
Contingencies" ("SFAS 5") and Emerging Issues Task Force Issue 85-20, "Recognition of fees for guaranteeing a loan" ("EITF 85-20").
As of December 31, 2007, the primary source of the Company's unrealized losses recorded in other comprehensive income was from the FP Investment Portfolio. The FP Investment Portfolio is broadly composed of short-term investments, non-agency residential mortgage-backed securities ("RMBS"), securities issued or guaranteed by U.S. sponsored agencies, taxable municipal bonds, securities issued by utilities, infrastructure-related securities, CDOs, and other asset-backed securities. The following tables present the amortized cost and fair value of available-for-sale bonds and short-term investments held in the FP Investment Portfolio:
Management has determined that the unrealized losses in fixed-income bonds at December 31, 2007 are attributable primarily to the current market environment for mortgage-backed securities, including securities backed by subprime mortgage loans, and has concluded that these unrealized losses are temporary in nature on the basis of (a) the lack of principal or interest payment defaults on these securities; (b) its analysis of the creditworthiness of the issuers; and (c) the Company's ability and current intent to hold these securities until a recovery in fair value or maturity. As of December 31, 2007 and 2006, all of the securities in a gross unrealized loss position were rated investment grade. In the third quarter of 2007, management deemed that certain investments in NIM securities had an unrealized loss in fair value that was other than temporary. Accordingly, the Company recorded $11.1 million in net realized gains (losses) from financial products segment in the consolidated statement of operations and comprehensive income. See Note 26 for discussion of changes in market conditions subsequent to December 31, 2007.
In the normal course of business, the Company may hold securities purchased under agreements to resell. A portion of these securities may be pledged to the Company's investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). However, such securities generally may not be rehypothecated by the investment agreement counterparty. The Company also pledges investments held in the FP Investment Portfolio to investment agreement counterparties. At December 31, 2007, $5,700 million of the assets held in its FP Investment Portfolio and related accrued interest were pledged as collateral to investment agreement counterparties. In addition, substantially all the assets of FSA Global are pledged to secure the repayment, on a pro rata basis, of FSA Global's notes and its other obligations.
The Company seeks to maintain a diversified portfolio of insured public finance obligations designed to spread its risk across a number of geographic areas. The following table sets forth those
The Company maintains both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $7.7 million, $7.5 million and $7.0 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company enters into derivative contracts to manage interest rate and foreign currency exposure in its FP Segment Investment Portfolio and FP segment debt. All gains and losses from changes in the fair value of derivatives are recognized in the consolidated statements of operations and comprehensive income. These derivatives generally include futures, interest rate and currency swap agreements, which are primarily utilized to convert fixed-rate debt and investments into U.S.-dollar floating rate debt and investments. Hedge accounting is applied to fair-value hedges provided certain criteria are met.
The Company enters into various other derivative contracts that do not qualify for hedge accounting treatment. These derivatives include swaptions, caps and other derivatives, which are used principally as protection against large interest rate movements. Gains and losses on these derivatives are reflected in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income.
Rent expense was $10.2 million in 2007, $10.7 million in 2006 and $10.1 million in 2005. Rent expense in 2005 included a $1.2 million lease termination fee related to the Company's former headquarters.
The Company has also received various regulatory inquiries and requests for information. These include subpoenas duces tecum and interrogatories from the State of Connecticut Attorney General related to antitrust concerns associated with the municipal rating scales employed by Moody's and a proposal by Moody's to assign corporate equivalent ratings to municipal obligations.