MBIA Corp. owns the 273,417 square foot office building on approximately 38 acres of property in Armonk, New York, in which the Company, MBIA Corp. and MBIA Asset Management have their headquarters. MBIA Corp. also has offices with approximately 32,590 square feet of rental space in New York, New York; San Francisco, California; Paris, France; Madrid, Spain; Sydney, Australia; London, England; Tokyo, Japan; and Mexico City, Mexico. MBIA Asset Management has 7,607 square feet of office space in Denver, Colorado. The Company believes that these facilities are adequate and suitable for its current needs.
Net of reinsurance and other reimbursement arrangements not accounted for as reinsurance.
the possibility that we will experience severe losses due to the continued deterioration in the performance of residential mortgage-backed securities (“RMBS”) and collateralized debt obligations (“CDOs”) or unanticipated losses in other sectors of the Company’s insured portfolio due to ongoing financial and economic stress;
The above factors and other factors that could affect our financial performance and business are discussed under “Risk Factors” in Part I, Item 1A of this annual report on Form 10-K. The Company undertakes no obligation to publicly correct or update any forward-looking statements.
MBIA operates the largest financial guarantee insurance business in the industry and a substantial asset/liability management program. MBIA also provides asset management and other specialized financial services. These activities are managed through two principal business operations: insurance and investment management services. Corporate operations include revenues and expenses that arise from general corporate activities. Our insurance and certain investment management services programs have historically relied upon triple-A credit ratings. The loss of those ratings in the second quarter of 2008 resulted in a dramatic reduction in the Company’s business activities.
In February 2008, we announced our intention to reorganize our insurance operations in a manner that would provide public finance and structured finance insurance from separate operating entities. In February 2009, after receiving the required regulatory approvals, we restructured our principal insurance subsidiary, MBIA Insurance Corporation, and established a separate U.S. public finance financial guarantee insurance company using MBIA Insurance Corp. of Illinois (“MBIA Illinois”), an existing public finance financial guarantee insurance company wholly owned by MBIA. Refer to the following “Business Description” section for information about this reorganization.
Severe financial markets dislocation, widening credit spreads and increased defaults have placed pressure on our insurance and investment portfolios.
Current financial strength ratings of MBIA Illinois, MBIA Insurance Corporation and MBIA Inc. are summarized below:
Initiated long-term restructuring initiative to separate MBIA into separate and distinct operating entities for public finance, structured finance and asset management businesses in no later than five years.
Executed insurance portfolio management actions to de-lever risk exposure and improve overall capital adequacy.
Entered into a reinsurance agreement with Financial Guaranty Insurance Company (“FGIC”) whereby MBIA assumed total net par outstanding of $181 billion and deferred premium revenue, net of commissions, of $717 million.
Raised $400 million through the issuance of preferred stock and repurchased $125 million par value at a substantial economic gain.
Our consolidated book value (total shareholders’ equity) was $994 million as of December 31, 2008, down 73% from $3.7 billion as of December 31, 2007. Consolidated book value per share as of December 31, 2008 was $4.78, down 84% from $29.16 as of December 31, 2007. A further discussion of our financial results is presented within the “Results of Operations” section included herein.
In certain cases, the Company may be required to consolidate entities established as part of securitizations when it insures the assets or liabilities of those entities. These entities typically meet the definition of a variable interest entity (“VIE”) under Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 46(R), “Consolidation of Variable Interest Entities-an interpretation of ARB No. 51.” We do not believe there is any difference in the risks and profitability of financial guarantees provided to VIEs compared with other financial guarantees written by the Company. Additional information relating to VIEs is contained in the “Variable Interest Entities” section included herein.
As a result of these actions, MBIA Illinois, which is expected to be renamed National Public Finance Guarantee Corporation, is now a stand-alone, separately capitalized and governed insurance company with $554 billion of net par insured. Its assets are available to service the policies of its domestic public finance insureds. MBIA Insurance Corporation is now a stand-alone, separately capitalized and governed insurance company with $233 billion of net par insured. Its assets are available to service the policies of its structured finance and international infrastructure finance insureds. The major rating agencies have recognized this separation with their ratings decisions on these two companies to date.
MBIA’s investment management services operations include a substantial asset/liability management business, in which it has issued debt and investment agreements, which are insured by MBIA Corp., to capital markets and municipal investors and then initially purchased assets that largely matched the duration of those liabilities. The ratings downgrades of MBIA Corp. have resulted in the termination of certain investment agreements and, together with the cost and availability of funding, have significantly adversely affected this business. Our investment management services operations also provide cash management, discretionary asset management and structured products to the public, not-for-profit, corporate and financial sectors.
securitizations of Capital Asset tax liens, which were consolidated within the Company’s insurance operations in accordance with FIN 46(R).
Loss and loss adjustment expense (“LAE”) reserves are established by the Company’s Loss Reserve Committee, which consists of members of senior management. This estimate requires the use of judgment and estimates with respect to the occurrence, timing and amount of a loss on an insured obligation. Loss and LAE reserves relate only to MBIA’s non-derivative financial guarantees.
As of December 31, 2008, the Company reported total loss reserves, net of reinsurance, of $1.5 billion, representing 0.14% of its outstanding non-derivative net debt service insured of $1.1 trillion. We believe that these reserves are adequate to cover ultimate net losses. Given that the reserves are based on estimates, there can be no assurance that the ultimate liability will not exceed such estimates resulting in the Company recognizing additional loss and LAE in earnings.
While the underlying principles applied to loss reserving are consistent across the financial guarantee industry, differences exist with regard to the methodology and measurement of loss reserves. Alternative methods may produce different estimates than the method used by the Company. Additionally, the accounting for non-derivative financial guarantee loss reserves changed on January 1, 2009 when the Company adopted SFAS 163, “Accounting for Financial Guarantee Insurance Contracts - an interpretation of FASB Statement No. 60.” Under SFAS 163, the Company will no longer record an unallocated loss reserve but instead recognize and measure claim liabilities for each policy equal to the present value of expected net cash outflows using a risk-free rate. Loss reserves will only be recorded in amounts that exceed the unearned premium revenue. Refer to the “Recent Accounting Pronouncements” section included herein for additional information on the adoption of SFAS 163 and refer to “Note 2: Significant Accounting Policies” and “Note 12: Loss and Loss Adjustment Expense Reserves” in the Notes to Consolidated Financial Statements for further information about the Company’s loss and loss adjustment expense and reserves.
the insurance operations included premiums from both our non-derivative insured portfolio and our insured derivative portfolio. Effective January 1, 2008, premiums from insured derivative contracts are no longer included as part of scheduled net earned premium but are rather reported as part of “Realized gains (losses) and other settlements on insured derivatives.” As a result, we have increased our loss factor to 14.5% from 12% in order to maintain a loss and LAE provision consistent with that calculated using historical scheduled net earned premium.
On an annual basis, the Loss Reserve Committee evaluates the appropriateness of the fixed percent loss factor. In performing this evaluation, the Loss Reserve Committee considers the composition of the Company’s insured portfolio by public finance sector, structured asset class, remaining maturity and credit quality, along with the latest industry data, including historical default and recovery experience for the relevant sectors of the fixed-income market. In addition, the Company considers its own historical loss activity and how those losses developed over time. The Loss Reserve Committee reviews the results of its annual evaluation over a period of several years to determine whether any long-term trends are developing that indicate the loss factor should be increased or decreased. Therefore, case basis reserves established in any year may be above or below the loss factor without requiring an increase or decrease to the loss factor. However, if a catastrophic or unusually large loss occurred in a single year or if the Loss Reserve Committee determined that any change to one or more of the variables that influence the loss factor is likely to have an impact on the level of probable losses in its insured portfolio, the Loss Reserve Committee will increase or decrease the loss factor accordingly, which will result in an increase or decrease in the Company’s provision for loss and LAE. Alternatively, the Loss Reserve Committee may establish additional reserves for sectors within the Company’s insured portfolio that it believes have a significantly higher risk of loss relative to the insured portfolio taken as a whole and not increase the loss factor.
Several variables are considered by the Loss Reserve Committee when evaluating the adequacy of the loss factor over an extended period of time. For example, as external and internal statistical data are applied to the various sectors of the Company’s insured portfolio, a shift in business written toward sectors with high default rates would likely increase the loss factor, while a shift toward sectors with low default rates would likely decrease the loss factor. Additionally, increases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or decreases in statistical recovery rates and in the Company’s actual recovery experience would likely increase the Company’s loss factor. Conversely, decreases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or increases in statistical recovery rates and in the Company’s actual recovery experience would likely decrease the Company’s loss factor.
Considering all of the assumptions used in the assessment of the adequacy of the loss factor, including the higher case basis incurred activity and the offsetting effect of observed changes in the variables described above, we believe that our current loss factor of 14.5% continues to represent a reasonable estimate of losses that have occurred or are probable to occur as a result of credit deterioration in our insured portfolio, excluding our RMBS exposure, but which have not yet been specifically identified and applied to specific insured obligations. In addition, we believe that the amount of unallocated loss reserves recorded on our balance sheet at December 31, 2008 are adequate to cover specific losses that may develop from our existing insured portfolio, although a prolonged recession could result in incurred losses within our non-RMBS insured portfolio that exceed our unallocated loss reserve. However, we do not believe that reasonably likely changes in the assumptions used to calculate the loss factor and the unallocated loss reserve would have a material impact on the amount of our unallocated loss reserve. Loss reserving for our RMBS exposure is discussed below.
In determining the RMBS case basis reserves recorded in 2008 which relate to home equity lines of credit (“HELOCs”) and closed-end second mortgages (“CES”) RMBS, the Company employed a multi-step process using a database of loan level information which allowed the Company to determine borrower payment status, including delinquencies and charge-offs. The Company relied upon this database to determine the likelihood of a delinquent loan being charged off. The information was then used in conjunction with a proprietary internal cash flow model and a commercially available model to estimate ultimate cumulative losses to our insured bonds. The Company establishes a case basis reserve for any transaction to the extent that cumulative losses exceed credit support available to its insured bonds and, as such, results in a claim on our financial guarantee policy for which we do not expect a full recovery.
The Company continues to use the general procedure described above. However, based upon our review of the data, in the third quarter of 2008 we made one change related to our methodology for estimating future defaults for loans that are current (not delinquent) by utilizing the “Current to Loss” approach described below, versus the current three-month or derived conditional default rate (“CDR”) approach used in prior quarters. The change for this one component in our methodology was due to the increased unpredictability and volatility of loss timing observed in the third quarter of 2008 under the CDR approach, which rendered future outcomes under that approach increasingly unreliable. The following are the principal assumptions used with respect to the underlying loans to determine the projected performance of our insured RMBS transactions:
The Roll Rate Default Methodology involves reviewing on a transaction-specific basis the percentage of 30-59 and 60-89 day delinquent loans that became 90 days delinquent (“Roll to Loss”). The Company made the assumption that 100% of the 90 or more days delinquent loans would result in a loss. The Roll to Loss was then applied to the amounts in the respective delinquency buckets based upon delinquencies as of August 31, 2008 to eliminate all delinquencies as of the current reporting period.
We assumed that all defaulted loans will result in a total loss of principal after a six-month liquidation period.
We have not reflected any potential recoveries as salvage or subrogation resulting from either (i) the repurchase of defective loans by the originators of the RMBS transactions with respect to which the Company has established case basis reserves, (ii) the potential impact of existing litigation and (iii) impact of future legislative changes. We believe that the existing litigation has the potential to result in recoveries of loss payments, which could
The fair market values of financial instruments held or issued by the Company are determined through the use of observable market data when available. Market data is obtained from a variety of third-party sources, including dealer quotes. If dealer quotes are not available for an instrument that is infrequently traded, we use alternate valuation methods, including either dealer quotes for similar contracts or modeling using market data inputs. Using alternate valuation methods generally requires considerable judgment in the estimates and assumptions used and changes to these variables may produce materially different values.
The Company’s financial assets are primarily debt and equity investments. The majority of these are accounted for in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS 115 requires all debt instruments and certain equity instruments to be classified in the Company’s balance sheet according to their purpose and, depending on that classification, to be carried at either amortized cost or fair value. Most valuations of the Company’s financial assets use observable market-based inputs, including dealer quotes when available. However, since mid 2007, illiquidity in the credit markets has significantly reduced the availability of observable market data. Other financial assets that require fair value reporting or disclosures within the Company’s notes to the financial statements are valued based on the estimated value of the underlying collateral or the Company’s estimate of discounted cash flows.
The Company monitors investments in which fair value is less than amortized cost in order to assess if declines in value are other-than-temporary and should therefore be reflected as a realized loss in net income. Such assessments include identifying the cause of the decline and whether we have the ability and intent to hold the investment to maturity or until the value recovers to at least the amortized cost. It also includes judgment as to whether an investment is impaired based on market conditions, and trends and the availability of relevant data. Refer to “Note 6: Investment Income and Gains and Losses” in the Notes to Consolidated Financial Statements for further information regarding other-than-temporary losses recorded in net income.
Company’s notes to its financial statements are valued based on either estimated value of the underlying collateral, the Company’s or a third-party’s estimate of discounted cash flows or quoted market values for similar transactions.
deductible. The total notional amount and MBIA’s maximum payment obligation under these contracts as of December 31, 2008 was $81.2 billion. The underlying referenced collateral for contracts executed in this manner largely consist of investment grade corporate debt CDOs, structured commercial mortgage-backed securities (“CMBS”) pools and, to a lesser extent, multi-sector CDO-squared transactions.
We have guarantees under principal protection fund programs, which are also accounted for as derivatives. Under these programs we guaranteed the return of principal to investors and are protected by a daily portfolio rebalancing obligation that is designed to minimize the risk of loss to MBIA. As of December 31, 2008, the maximum amount of future payments that the Company would be required to make under these guarantees was $90 million, but we have not made any payments to date relating to these guarantees. The unrealized gains (losses) on these derivatives for the years ended 2006, 2007 and 2008 were $0, reflecting the extremely remote likelihood that MBIA will incur a loss.
The total changes in fair value of the insured derivatives are recorded in “Net change in fair value of insured derivatives.” “Realized gains (losses) and other settlements on insured derivatives” include (i) net premiums received and receivable on written CDS contracts, (ii) net premiums paid and payable to reinsurers in respect of CDS contracts, (iii) net amounts received or paid on reinsurance commutations, (iv) losses paid and payable to CDS contract counterparties due to the occurrence of a credit event or settlement agreement, (v) losses recovered and recoverable on purchased CDS contracts due to the occurrence of a credit event or commutation 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.
MBIA’s insured CDS contracts do not contain typical CDS market standard features as they have been designed to replicate our financial guarantee insurance policies. Our insured CDS instruments provide protection on a pool of securities or CDSs with either a stated deductible or subordination beneath the MBIA-insured tranche. We are not required to post collateral in any circumstances. At default of an underlying reference obligation, payment is only due after the aggregate amount of such losses exceed the deductible or subordination in the transaction. Some contracts also provide for further deferrals of payment at our option. There is usually no requirement for fair value termination payments except for termination events related to MBIA Corp.’s failure to pay or insolvency and, in some cases, other fair value termination payments for events within our control, such as the sale of all or substantially all of the assets of MBIA Corp. An additional difference between our CDS and typical market standard contracts is that our contract, like our financial guarantee contracts, cannot be accelerated by the counterparty in the ordinary course of business, unless we elect to do so. Similar to our financial guarantee insurance, all insured CDS policies are unconditional and irrevocable and cannot be transferred to most other capital market participants unless they are also licensed to write financial guarantee insurance policies. Note that since insured CDS contracts are accounted for as derivatives under SFAS 133, the Company did not defer the charges associated with underwriting the CDS policies and they were expensed at origination.
with respect to the underlying or referenced collateral that would be required to occur before a claim against an MBIA insurance policy can be made.
MBIA had transferred some of the risk of loss on these contracts using reinsurance to other financial guarantee insurance and reinsurance companies. The fair value of the transfer under the reinsurance contract with the reinsurers is accounted for as a derivative asset. These derivative assets are valued consistently with our SFAS 157 valuation policies as described in “Note 2: Significant Accounting Policies” in the Notes to Consolidated Financial Statements.
Approximately 99.6% of the balance sheet fair value of insurance derivatives as of December 31, 2008 is valued using the Binomial Expansion Technique (“BET”), which is a probabilistic approach to calculate expected loss on our exposure based on market variables for underlying referenced collateral. The BET was originally developed by Moody’s to estimate a probability distribution of losses on a diverse pool of assets. We have made modifications to this technique in an effort to incorporate more market information and provide more flexibility in handling pools of dissimilar assets: a) we use market credit spreads to determine default probability instead of using historical loss experience, and b) for collateral pools where the spread distribution is characterized by extremes, we model each segment of the pool individually instead of using an overall pool average.
There are three steps within BET modeling to arrive at fair value for a structured transaction: pool loss estimation, loss allocation to separate tranches of the capital structure and calculation of the change in value.
For example, if the expected total collateral pool loss is 4% and the transaction has an equity tranche and three progressively more senior C, B, and A tranches with corresponding underlying subordination levels of 0%, 3%, 5% and 10%, then the 4% loss will have the greatest impact on the equity tranche. It will have a lower, but significant impact on the C tranche and a lesser impact on the B tranche. MBIA usually insures the Super Triple-A tranche with lowest exposure to collateral losses due to the underlying subordination provided by all junior tranches.
Collateral is generally considered on an average basis rather than modeled separately.
1) The model takes account of transaction structure and key drivers of market value. The transaction structure includes par insured, weighted average life, level of deductible or subordination and composition of collateral.
The actual calculation of pool average spread varies depending on whether we are able to use collateral-specific credit spreads or generic spreads as an input.
If collateral-specific credit spreads are not available, we use generic spread tables based on asset class and average rating of the collateral pool. Average credit rating for the collateral is calculated from the weighted average rating factor (“WARF”) for the collateral portfolio and then mapped to an appropriate spread. WARF is based on a 10,000 point scale designed by Moody’s where lower numbers indicate better credit quality. Ratings are not spaced equally on this scale because the difference in default probability at higher rating quality is much less than at lower rating levels. We obtain WARF from the most recent trustee’s report or we calculate it based on the collateral credit ratings. For a WARF calculation, we identify the credit ratings of all collateral (using, in order of preference as available, Moody’s, S&P or Fitch ratings), then converts those credit ratings into a rating factor on the WARF scale, averages those factors (weighted by par) to create a portfolio WARF, and then maps the portfolio WARF back into an average credit rating for the pool. We then apply this pool rating to a market spread table or index appropriate for the collateral type to determine the generic spread for the pool, which becomes the market-implied default input into the BET model.
When spreads are not available on either a collateral-specific basis or ratings-based generic basis, MBIA uses its hierarchy of spread sources (see below) to identify the most appropriate spread for that asset class to be used in the model.
1) Actual collateral-specific credit spreads. If up-to-date and reliable market-based spreads are available, they are used.
Over time the data inputs change as new sources become available, existing sources are discontinued or are no longer considered to be reliable or the most appropriate. It is always our objective to move to higher levels on the hierarchy, but we sometimes move to lower priority inputs because of discontinued data sources or because we consider higher priority inputs no longer representative of market spreads. This occurs when transaction volume changes such that a previously used spread index is no longer viewed to reflect current market levels, as was the case for CMBS collateral in insured CDSs during 2008. Refer to section “Input Adjustments for Insured CMBS Derivatives in the Current Market” below.
The recovery rate represents the percentage of par expected to be recovered after an asset defaults, indicating the severity of a potential loss. MBIA generally uses rating agency recovery assumptions which may be adjusted to account for differences between the characteristics and performance of the collateral used by the rating agencies and the actual collateral in MBIA-insured transactions. We may also adjust rating agency assumptions based on the performance of the collateral manager and on empirical market data. For example, in the first quarter of 2008, new S&P research used a lower recovery rate for securities backed by Alternative A-paper (“ALT-A”) and subprime real estate collateral and in the same period trading spreads widened materially for these assets, so we adjusted the recovery rates in our mortgage-backed collateral by approximately 10 percentage points. We did this even though the collateral backing MBIA’s transactions is on average a better credit quality than the assets used in S&P’s research. Also in the fourth quarter of 2008 MBIA began using a distribution of potential recovery rates instead of a single point estimate.
Approximately $47 billion gross par of MBIA’s insured derivative transactions include substantial amounts of CMBS and commercial mortgage collateral. In prior years, we had used spreads drawn from CMBX indices and CMBS spread tables as pricing input on the underlying referenced collateral in these transactions. In 2008 as the financial markets became illiquid, we saw a significant disconnect between cumulative loss expectations of market analysts on underlying commercial mortgages, which were based on the continuation of low default and loss rates, and loss expectations implied by the CMBX indices and CMBS spread tables. CMBS collateral in MBIA’s insured credit derivatives has performed in line with the market analysts assessments and continue to be rated triple-A by Moody’s or S&P.
SFAS 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The objective of a fair value measurement is to determine the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
Instruments that trade infrequently and therefore have little or no price transparency are classified within Level 3 of the fair value hierarchy. Also included in Level 3 are financial instruments that have significant unobservable inputs deemed significant to the instrument’s overall fair value. The following table presents the fair values of assets and liabilities recorded on our balance sheet that are classified as Level 3 within the fair value hierarchy, along with a brief description of the valuation technique for each type of asset and liability:
Level 3 assets were $3.8 billion as of December 31, 2008, and represented approximately 21% of total assets measured at fair value. Level 3 liabilities were $6.5 billion as of December 31, 2008, and represented approximately 89% of total liabilities measured at fair value.
Upfront premiums are earned in proportion to the expiration of the related principal balance of an insured obligation. Therefore, for transactions in which the premium is received upfront, premium earnings are greater in the earlier periods when there is a higher amount of principal outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. Accordingly, deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. When an MBIA-insured obligation is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company. Installment premiums are earned on a straight-line basis over each installment period, generally one year or less. As the outstanding principal of an installment-based policy is paid down by the issuer of an MBIA-insured obligation, less premium is collected and recognized by the Company. Both upfront and installment premium recognition methods recognize premiums over the term of an insurance policy in proportion to the remaining outstanding principal balance of the insured obligation.
In performing the impairment test of goodwill of our insurance operations, we determined the best measure of fair value of the insurance reporting segment is its book value calculated under GAAP (shareholders’ equity) adjusted for the after-tax effects of net deferred premium revenue and the present value of future installment premiums less the after-tax effects of deferred acquisition costs and a provision for losses, and by excluding the after-tax effects of cumulative unrealized net gains or losses, net of credit impairments, to arrive at adjusted book value. Adjusted book value is a measure commonly provided by financial guarantee companies, which we believe provides a comprehensive measure of the value of the Company since we expect that the adjustments to book value will affect future results and, in general, do not require any additional future performance on the part of the Company. The assumptions used to estimate the fair value of the insurance operations are (i) its statutory income tax rate of 35%, (ii) the yield-to-maturity of MBIA Insurance Corporation’s fixed-income investment portfolio, excluding investments in money market funds and including intercompany loans under repurchase agreements , of 5.03%, (iii) its 14.5% loss factor to arrive at the provision for losses, and (iv) an estimate of the present value of payments under insured derivatives.
Goodwill within our investment management services operations was related to MBIA Municipal Investors Service Corporation (“MBIA-MISC”). MBIA-MISC’s fair value is estimated by using a multiple of its earnings before interest, income tax, depreciation and amortization (“EBITDA”), which is a common method used to value investment management companies. The assumption used to arrive at MBIA-MISC’s fair value is a multiple of seven times EBITDA as of December 31, 2008 and ten times EBITDA as of December 31, 2007. The change in the earnings multiple is based on current market conditions for investment management companies.
We performed our annual impairment testing of goodwill as of January 1, 2008 and January 1, 2009. On both dates, the fair value of the insurance reporting unit exceeded its carrying value indicating that goodwill was not impaired. As of January 1, 2008, the fair value of MBIA-MISC also exceeded its carrying value indicating that goodwill was not impaired. However, on January 1, 2009, the fair value of MBIA-MISC was less than its carrying value indicating that goodwill was impaired. The impairment of MBIA-MISC’s goodwill resulted from a decrease in EBITDA due to a write-down of a receivable in 2008. As a result, as of December 31, 2008, the Company recorded an impairment loss for the full amount of MBIA-MISC’s goodwill.
Alternate valuation methods used to assess goodwill would have likely produced different fair values. However, we believe that the valuation methods described above provide the best estimates of fair value. Refer to “Note 13: Goodwill” in the Notes to Consolidated Financial Statements for further information about our accounting for goodwill.
Deferred income taxes are recorded with respect to the temporary differences between the tax bases of assets and liabilities and the reported amounts in the Company’s 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. Such temporary differences relate principally to premium revenue recognition, deferred acquisition costs, unrealized appreciation or depreciation of investments and derivatives, and MBIA Corp.’s statutory contingency reserve.
Valuation allowances are established to reduce deferred tax assets to an amount that more likely than not will be realized and the offset is reflected as a provision for income taxes in the statement of operations. Determining whether to establish a valuation allowance and, if so, the amount of the valuation allowance requires management to exercise judgment and make assumptions regarding whether such tax benefits will be realized in future periods. All evidence, both positive and negative, needs to be identified and considered in making the determination. Future realization of the existing deferred tax asset ultimately depends on management’s estimate of the future profitability and existence of sufficient taxable income of appropriate character (for example, ordinary income versus capital gains) within the carry-forward period available under the tax law. In the event that the Company’s estimate of taxable income is less than that required to utilize the full amount of any deferred tax asset, a valuation allowance would be established.
As of December 31, 2008, we reported a net deferred tax asset of $2.4 billion primarily related to the unrealized losses recorded on the Company’s derivative and investment portfolios. With respect to temporary differences related to insured CDS contracts, on a pre-tax basis, the Company estimates that it is more likely than not the entire amount of such benefit will be utilized in future periods as an offset to ordinary income and has not established a valuation allowance. However, since the Federal income tax treatment for CDS contracts is an unsettled area of tax law, in the event that the Internal Revenue Service has a different view than the Company, such that insured CDS losses are considered capital losses, the Company would be required to establish a valuation allowance against substantially all of the deferred tax asset related to these losses. With respect to realized capital losses on the disposal and impairment of investments in the asset/liability products segment’s investment portfolio, the Company established a valuation allowance of $351 million as of December 31, 2008, which is included in the net deferred tax asset of $2.4 billion. Refer to “Note 14: Income Taxes” in the Notes to Consolidated Financial Statements for additional information about the Company’s deferred income taxes.
In December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities,” which requires enhanced disclosures about transfers of financial assets and involvement with variable interest entities. The Company adopted FSP FAS 140-4 and FIN 46(R)-8 for financial statements prepared as of December 31, 2008. Since FSP FAS 140-4 and FIN 46(R)-8 only requires additional disclosures concerning transfers of financial assets and interests in variable interest entities, adoption of FSP FAS 140-4 and FIN 46(R)-8 did not affect the Company’s consolidated balance sheets, results of operations or cash flows. Refer to “Note 8: Variable Interest Entities” in the Notes to Consolidated Financial Statements for disclosures required by FSP FAS 140-4 and FIN 46(R)-8.
In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active: An Amendment of FASB Statement No. 157.” FSP FAS 157-3 clarifies the application of SFAS 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is not active. The provisions are effective upon issuance, including prior periods for which financial statements have not been issued. The adoption of FSP FAS 157-3 did not affect the Company’s consolidated balance sheets, results of operations or cash flows.
In September 2008, the FASB issued FSP FAS 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161.” FSP FAS 133-1 and FIN 45-4 requires enhanced disclosures about credit derivatives and guarantees and amends FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to exclude derivative instruments accounted for at fair value under SFAS 133. The Company adopted FSP FAS 133-1 and FIN 45-4 for financial statements prepared as of December 31, 2008. Since FSP FAS 133-1 and FIN 45-4 only requires additional disclosures concerning credit derivatives and guarantees, adoption of FSP FAS 133-1 and FIN 45-4 did not affect the Company’s consolidated balance sheets, results of operations or cash flows. Refer to “Note 7: Derivative Instruments” in the Notes to Consolidated Financial Statements for disclosures required by FSP FAS 133-1 and FIN 45-4.
permits the fair value option election on an instrument-by-instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. The Company applies the disclosure requirements of SFAS 159 for certain eligible instruments which it previously elected to fair value under SFAS 155. These instruments included certain MTNs and certain available-for-sale securities which contained embedded derivatives requiring bifurcation. The Company did not elect the fair value option under SFAS 159 for any eligible financial instruments.
- Includes a net change in the fair value of insured derivatives of ($2,220), ($3,611) and $76 in 2008, 2007 and 2006, respectively.
- Includes net realized (losses)/gains primarily on investment securities of ($1,719), $3 and $7 in 2008, 2007 and 2006, respectively.
Consolidated expenses from continuing operations increased 3% to $2.9 billion in 2008 from $2.8 billion in 2007. The increase in consolidated expenses was principally due to additional loss and LAE incurred of $1.2 billion related to our insured second-lien RMBS exposure and interest expense on surplus notes issued in the first quarter of 2008 in our insurance operations. The increase in insurance expenses was partially offset by a decrease in interest expense within our investment management services operations resulting from a decline in investment agreement and MTN balances. Corporate interest expense decreased slightly due to the effect of extinguishing debt during 2008.
In addition to book value per share, we also analyze adjusted book value per share (“ABV”) when evaluating the value of the Company. ABV is a non-GAAP measure of book value inclusive of items that are expected to impact shareholders’ equity in future periods and, in general, do not require any additional future performance obligation on the Company’s part. Additionally, ABV excludes gains and losses due to market value changes that have not been realized through sales or impairments of assets or extinguishment of liabilities. While ABV is not a substitute for GAAP book value, we believe it provides a comprehensive measure of the embedded value of the Company and is meaningful to investors and analysts when viewed in conjunction with GAAP book value. As of December 31, 2008, ABV per share was $40.06, down 49% from $77.89 as of December 31, 2007. The following provides a reconciliation of book value per share to ABV per share:
Net of cumulative estimated impairments on insured derivatives of $3.78 and $1.04 as of December 31, 2008 and December 31, 2007, respectively.
In 2008, total revenues from the Company’s insurance operations were a loss of $534 million compared with loss of $2.1 billion in 2007. The decrease in the insurance operations’ loss was principally due to a $1.4 billion reduction in net losses on insured derivatives, an $88 million increase in net gains on financial instruments at fair value and foreign exchange, driven by the change in the fair value of our CPCT facility, and an $140 million increase in premiums earned, primarily due to refunded insured obligations. Total insurance expenses increased 51% to $1.8 billion in 2008 from $1.2 billion in 2007. The increase in insurance expenses was due to approximately $400 million of additional loss and LAE related to our second-lien RMBS exposure. Additionally, operating expenses increased as a result of a decline in deferrable acquisition costs and interest expense increased as a result of the issuance of our surplus notes. Gross operating expenses (expenses before ceding commission income and the deferral and amortization of acquisition costs) decreased 20% to $198 million in 2008 compared with the 2007 as a result of a reversal of prior years’ compensation expenses related to long-term incentive awards and bonuses. The reversal of expenses associated with performance-based long-term incentive awards totaled $45 million in 2008 and related to awards granted in 2007, 2006, and 2005. Gross operating expenses in 2008 were less than operating expenses reported in the preceding table as a result of the reversal of compensation expenses that were previously deferred as acquisition costs.
Gross premiums written (“GPW”), net premiums written (“NPW”) and net premiums earned on non-derivative financial guarantees for the last three years are presented in the following table:
GPW reflects premiums received and accrued for in the period and does not include the present value of future cash receipts expected from installment premium policies originated during the period. NPW represents gross premiums written net of premiums ceded to reinsurers. Net premiums earned include scheduled premium earnings as well as premium earnings from refunded issues.
Global public finance net par insured rated A or above, before giving effect to the Company’s guarantee, represented 94% of global public finance business written by the Company during 2008, compared with 88%
during 2007 and 84% during 2006. These percentages reflect a change in the mix of business written during each year among sectors with varying levels of risk. Additionally, 2008 includes a significant amount of par assumed from FGIC, which comprised high-quality domestic public finance exposure. At December 31, 2008, 88% of the outstanding global public finance net par insured was rated A or above before the Company’s guarantee, up from 84% at December 31, 2007.
GLOBAL STRUCTURED FINANCE MARKET MBIA’s premium writings and premium earnings in both the new issue and secondary global structured finance markets on non-derivative financial guarantees are presented in the following table:
INVESTMENT INCOME The insurance segment’s net investment income for the last three years and ending investment asset balances at amortized cost as of December 31, 2008 and 2007 are presented in the following tables:
-Includes investment income related to VIEs and Northwest Airlines’ enhanced equipment trust certificates and interest received on reimbursed expenses.
In 2007, our insurance segment’s pre-tax net investment income, excluding net realized gains and losses, decreased 1% to $573 million from $581 million in 2006. The decline in pre-tax net investment income reflects a decrease in average invested assets in 2007 compared with 2006, as well as an $11 million decrease in investment income related to Northwest Airlines’ EETCs, which the Company received in connection with a remediation and subsequently sold in the second quarter of 2007. However, pre-tax net investment income benefited from a $16 million increase in VIE interest income. After-tax net investment income decreased 1% in 2007 as the proportion of taxable investments remained relatively consistent with 2006.
In 2007, excluding interest income related to VIEs and the Northwest Airlines’ EETCs and interest received on reimbursed expenses, insurance-related net investment income decreased 1% on a pre-tax and after-tax basis compared with 2006. These decreases were attributable to a decline in average invested assets as a result of dividends paid from MBIA Corp. to MBIA Inc. in December 2006 and April 2007 and claim payments made in the fourth quarter of 2006 to call two MBIA-insured transactions. Average investment yields decreased slightly in 2007 compared with 2006. Ending asset balances at amortized cost, excluding VIE and Northwest Airlines’ EETC assets, were $10.1 billion and $9.6 billion at December 31, 2007 and 2006, respectively. Tax-exempt investments represented 58% and 55% of ending asset balances, excluding VIE and Northwest Airlines’ EETC assets, at December 31, 2007 and 2006, respectively.
NET CHANGE IN FAIR VALUE OF INSURED CREDIT DERIVATIVES MBIA has sold credit protection by insuring derivative contracts with various financial institutions. In certain cases, the Company reinsured these policies thereby purchasing credit protection on a portion of the risk written. Changes in fair value of the insured derivatives are recorded in “Net change in fair value of insured derivatives” in the Consolidated Statements of Operations. The “Realized gains (losses) and other settlements on insured derivatives” include (i) net premiums received and receivable on written CDS contracts, (ii) net premiums paid and payable to reinsurers in respect of CDS contracts, (iii) net amounts received or paid on reinsurance commutations, (iv) losses paid and payable to CDS contract counterparties due to the occurrence of 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 following table presents the net premiums written related to derivatives and the components of the net change in fair value of insured derivatives in 2008, 2007 and 2006:
Realized losses on insured derivatives in 2008 represent net payments related to the settlement of all or a portion of four CDO transactions, in which we reduced our aggregate exposure to these transactions by approximately $2.7 billion.
We estimate that cumulative credit impairments on insured derivatives as of December 31, 2008 were $1.5 billion, consisting of twelve CDO transactions. This estimate is inclusive of the four CDO transactions for which we realized net losses of $558 million through negotiated settlements. Cumulative credit impairments on insured derivatives as of December 31, 2007 were estimated at $200 million and consisted of three CDO transactions. Credit impairments on insured derivatives represent present value of our estimate of expected future claim payments, which may differ from a transaction’s fair value. Insured derivative contracts have similar terms and conditions to the Company’s non-derivative insurance contracts and are evaluated for credit impairment under the same risk monitoring process. The fair value of an insured derivative contract will be influenced by a variety of market and transaction-specific factors that may not result in a claim payment. In the absence of further credit impairment or the termination of derivatives at a loss, the cumulative unrealized losses recorded from fair valuing insured derivatives should reverse at the maturity of these contracts. Additionally, the Company is not required to post collateral to counterparties of these contracts, thereby avoiding liquidity risks typical of standard credit derivative contracts.
The following table estimates the attribution of the unrealized loss for the year ended December 31, 2008 by sector and does not represent actual losses paid due to each attribute:
The “Other” category includes the reversal of the mark-to-market on commuted transactions, as well as eliminations.
The following table estimates the attribution of the unrealized loss for the year ended December 31, 2007 by sector and does not represent actual losses paid due to each attribute:
Refer to the preceding “Critical Accounting Estimates” section included herein for further information about the fair values of our insured derivative instruments.
NET GAINS ON EXTINGUISHMENT OF DEBT During 2008, we repurchased $47 million par value of outstanding surplus notes at a discount to carrying value and recognized a net gain of $10 million. The Company did not have similar activity in 2007 and 2006.
LOSSES AND LOSS ADJUSTMENT EXPENSES MBIA’s Insured Portfolio Management (“IPM”) Division is responsible for monitoring MBIA-insured issues. The level and frequency of MBIA’s monitoring of any insured issue depends on the type, size, rating and performance of the insured issue. If IPM identifies concerns with respect to the performance of an insured issue it may designate such insured issue as “Caution List-Low,” “Caution List-Medium” or “Caution List-High.” The designation of any insured issue as “Caution List-Medium” or “Caution List-High” is based on the nature and extent of these concerns and requires that an increased monitoring and, if needed, a remediation plan be implemented for the related insured issue.
The amounts included within this “Loss and Loss Adjustment Expense” section exclude realized and unrealized gains and losses and estimated credit impairments on insured credit derivatives. Refer to “Net Change in Fair Value of Insured Credit Derivatives” included herein for information about payments we have made or expect to make under insured credit derivative transactions.
Refer to “Recent Accounting Pronouncements” included herein for a discussion on the FASB’s accounting standard regarding accounting for financial guarantee insurance contracts, which modifies the way MBIA establishes claim liabilities effective January 1, 2009. Additionally, a further description of the Company’s loss reserving policy is included in “Note 2: Significant Accounting Policies” in the Notes to Consolidated Financial Statements.
The following table presents the components of the Company’s total loss and LAE reserves, as well as its loss provision and case basis activity, as of and for the years ended December 31, 2008, 2007 and 2006.
In 2008 and 2007, losses and LAE consisted of $92 million and $86 million, respectively, based on our policy of applying a loss factor to our insurance segment’s scheduled net earned premium and $1.2 billion and $814 million, respectively, of additional loss and LAE related to our second-lien RMBS exposure. In 2006, the Company recorded $81 million in losses and LAE based on our loss factor reserving policy. As of December 31, 2008, we had an unallocated loss reserve of $232 million. The decrease in our unallocated loss reserve from 2007 resulted from the transfer of $200 million to case basis reserves during 2008 related to our second-lien RMBS exposure. Refer to “Critical Accounting Estimates-Loss and Loss Adjustment Expenses” included herein for information regarding the Company’s loss reserving methodology.
Included in the Company’s case basis reserves are both loss reserves for insured obligations for which a payment default has occurred and MBIA has already paid a claim and also for which a payment default has not yet
occurred but a claim is probable and estimable in the future. As of December 31, 2008, case basis reserves consisted of the following:
When MBIA becomes entitled to the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment and the recovery of such salvage is probable and reasonably estimable, it records salvage and subrogation as an asset. Such amounts are included within “Other assets” and corresponding salvage and subrogation amounts due to reinsurers are included within “Other liabilities” in the Company’s consolidated balance sheet. As of December 31, 2008 and December 31, 2007, we had salvage and subrogation assets of $459 million and $108 million, respectively. The increase in our salvage and subrogation assets principally resulted from claim payments we made on our RMBS exposure that we expect to recover. The amount the Company records as salvage and subrogation may be influenced by several factors during any period, such as the level of claim payments made for which the Company is entitled to reimbursements, amounts collected and impairment write-downs. As of December 31, 2008 and December 31, 2007, salvage and subrogation due to reinsurers totaled $13 million and $4 million, respectively. Salvage and subrogation recoveries are only paid to reinsurers upon receipt of such amounts by MBIA.
The Company has not reflected any potential recoveries as salvage or subrogation resulting from the obligation of the originators of RMBS transactions to repurchase ineligible loans. MBIA has initiated two lawsuits against mortgage loan originators seeking recoveries for the inclusion of ineligible loans in RMBS transactions and is pursuing other means of recovery. Such recoveries may be substantial. Once we can assess the likelihood and amounts of such recoveries, we will establish salvage and subrogation reserves.
MBIA insures mortgage-backed securities backed by subprime mortgages directly through residential mortgage-backed securities securitizations. MBIA also has indirect exposure to subprime mortgages that are included in CDOs, in which MBIA guaranteed the senior most tranche of such transactions. There has been considerable stress and continued deterioration in the subprime mortgage market throughout 2008 reflected by delinquencies and losses, particularly related to subprime mortgage loans originated during 2005, 2006, and 2007. As of December 31, 2008, the Company had $4.0 billion of net par outstanding from direct exposure to subprime mortgages and $7.3 billion of indirect exposure to subprime mortgages in the form of performing collateral within CDOs. Of the $7.3 billion of indirect exposure, $6.3 billion was related to CDOs executed in derivative form. While
After two consecutive quarters of relatively flat early-stage delinquencies within our insured second-lien residential mortgage securitizations, we observed an increase in delinquencies in the second half of 2008 and a greater than expected level of losses being realized within the individual transactions. Due to a combination of the overall weakening in the economic environment, servicer performance related issues and relatively few successful loan modifications by the loan servicers, MBIA recorded loss and LAE related to its second-lien residential mortgage exposures of $1.2 billion in 2008. This provision primarily reflects additions to previously established reserves on certain deals rather than a material increase in the number of transactions requiring loss reserves. Notably, a very high proportion of loan losses continue to be associated with loans that MBIA believes are in breach of the originators’ representations with respect to such loans and, therefore, should have been excluded from the MBIA-insured securitizations.
The following table presents the net par outstanding of MBIA’s RMBS insured exposure as of December 31, 2008 by S&P credit rating category:
MBIA continues to closely monitor the manufactured housing sector, which has experienced stress during the last several years. MBIA ceased writing business in this sector, other than through certain CDO transactions, in 2000. At December 31, 2008, the Company had $22 million in case basis reserves, net of reinsurance, covering net insured par outstanding of $116 million on three credits within the manufactured housing sector. The Company had additional manufactured housing net insured par outstanding of $1.7 billion as of December 31, 2008, of which approximately 22% has been placed on the Company’s “Caution List-Medium” and “Caution List-High.”
As of December 31, 2008, the aggregate amount of insured par ceded by MBIA to reinsurers under reinsurance agreements was $54.9 billion compared with $79.7 billion as of December 31, 2007. The decrease from 2007 was due to the maturity and termination of insured par and the reinsurance commutations executed during 2008. The following table presents the credit ratings and ratings status, percentage of outstanding par ceded, the reinsurance recoverable, derivative asset, and estimated credit impairments by reinsurer as of December 31, 2008. Estimated credit impairments represent the reinsurers’ portion of amounts we expect to pay on insured derivative contracts.
Several of the Company’s other financial guarantee reinsurers, including Ambac Assurance Corporation, Assured Guaranty Corp., Assured Guaranty Re Ltd., Old Republic Insurance Co., Swiss Reinsurance Company, Syncora Guarantee Re Ltd. and Syncora Guarantee Inc. (formerly known as XL Financial Assurance and XL Capital Assurance), have had their credit ratings either downgraded or put on negative watch by one or more of the major rating agencies between December 2007 and December 2008. Although there was no material impact on the Company for any of the rating agency actions through December 2008 relating to these reinsurers, a further downgrade of one or more of these reinsurers could require the establishment of reserves against any receivables due from the reinsurers.
On an annual basis MBIA reviews its insurance-related expenses to determine if there have been any changes in its business or cost structure that would materially change the amount of costs accounted for as policy acquisition costs. If so, the Company conducts a policy acquisition cost study to determine the amount of insurance costs that relate to acquiring new non-derivative insurance policies and that are deferrable under GAAP. As a result of our temporary moratorium on structured finance business and a decline in our public finance business, we determined that fewer costs were attributable to acquiring new business and thus significantly lowered the rate at which costs are deferred. This resulted in an increase in the amount of operating expenses reported by the Company. We expect to increase the rate at which we defer expenses in the future commensurate with growth in our insurance-related business volume.
Operating expenses increased 56% to $208 million in 2008 from $133 million in 2007. The increase in operating expenses in 2008 was principally due to the decline in the rate at which acquisition costs are deferred. Additionally, insurance operating expenses were greater than insurance gross expenses for 2008 as a portion of the expense reversal of prior year bonus and long-term incentive award accruals reduced deferred acquisition costs not yet amortized as expense. Operating expenses decreased 15% to $133 million in 2007 from $156 million in 2006 due to the aforementioned increase in costs allocated to our investment management services and corporate operations and a decrease in loss prevention efforts.
Financial guarantee insurance companies use the expense ratio (expenses divided by net premiums earned) as a measure of expense management. In 2008, insurance expenses increased at a greater rate than premiums earned resulting in a higher expense ratio, as reported in the preceding table. The decrease in the expense ratio from 2006 to 2007 was principally due to lower operating expenses and higher net premiums earned in 2007 compared with 2006.
MBIA consolidates certain third-party VIEs as a result of financial guarantees provided by our insurance operations. As of December 31, 2008, the assets of these VIEs primarily consisted of fixed rate and floating rate securities and loans and the liabilities of these VIEs primarily consisted of fixed rate and floating rate notes. MBIA eliminates any investment in third-party VIEs against the debt of these VIEs upon consolidation into MBIA’s financial statements. The following table presents MBIA’s carrying value of assets and liabilities related to third-party VIEs, after the aforementioned eliminations, as of December 31, 2008 and 2007 by balance sheet caption:
Refer to “Note 8: Variable Interest Entities” for additional information about the Company’s interest in consolidated and nonconsolidated VIEs.
Does not include multi-sector CDO-Squared transactions totaling $8.3 billion net par.
For the multi-sector CDOs, the next four tables provide breakdowns of the collateral composition and ratings of subprime RMBS collateral, non-subprime RMBS collateral, and CDOs of ABS collateral by vintage year and rating. CDOs of ABS may contain exposure to various types of collateral, including RMBS. The collateral level detail presented for each year insured was calculated using a weighted average of the total collateral as of December 31, 2008 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.
MBIA’s multi-sector CDOs benefit from two sources of credit enhancement. Firstly, the subordination in the underlying securities collateralizing the MBIA wrapped tranche must be fully eroded; secondly, the subordination below MBIA’s insurance coverage in the CDO transaction must be fully eroded before MBIA’s insured interest is subject to a claim. The original subordination levels and those as of December 31, 2008 are detailed in the above table, and these subordination levels may have declined materially since this date. MBIA’s payment obligations after a default vary by deal and by insurance type; there are three types of policy payment types: (i) where MBIA insures Current Interest and Ultimate Principal; (ii) where MBIA insures Ultimate Principal only; and (iii) where MBIA insures payments upon settlement of individual collateral losses as they occur after the complete erosion of deal deductibles, such payment profiles are referred to as Asset Coverage with a Deductible.
Multi-Sector CDO Portfolio: Vintage and Collateral Ratings of CDOs Containing Subprime RMBS
Multi-Sector CDO Portfolio: Vintage and Collateral Ratings of CDOs Containing CDOs of ABS
The table does not provide collateral level detail on 41 CDOs totaling $2.2 billion of net par. Three deals, with $0.8 billion of net par, contain European Mezzanine ABS assets including 53% RMBS, 23% CDO, 18% CMBS and 6% other, and were closed in 2004, 2005 and 2006. In addition, 37 deals represent insurance sold to investors for CDO tranches in their portfolios (secondary market insurance executions). The deals total $1.3 billion of par and all were insured prior to 2005. In addition, all 37 deals were rated triple-A at the time MBIA wrote insurance on them.
collateral referenced or held in the multi-sector CDO transactions, the amount of credit impairments could increase materially.
As of December 31, 2008, the majority of insurance protection provided by MBIA for its Investment Grade Corporate CDO exposure attached at a super senior level. Although several of the Company’s insured Investment Grade Corporate CDOs referenced obligors recently defaulted none experienced any material credit deterioration. The Company’s net par exposure to Investment Grade Corporate CDOs represents 32% of the Company’s CDO exposure and approximately 5% of the Company’s total net par insured. The Company’s Investment Grade Corporate CDO exposure references pools of predominantly investment grade corporate credits; some of these pools may also include limited exposure to other asset classes, including structured finance securities (including RMBS and CDO collateral). Most of MBIA’s Investment Grade Corporate CDO policies guarantee coverage of losses on collateral assets once subordination in the form of a deductible has been eroded, and are generally highly customized structures.
The table does not provide collateral level detail on 15 Investment Grade CDOs totaling $0.5 billion of net par. These deals were insured prior to 2003. In addition, all 15 deals were rated triple-A at the time MBIA wrote insurance on them.
Investment Grade Corporate CDO Portfolio: Vintage and Collateral Ratings of CDOs Containing Non Subprime RMBS
Investment Grade Corporate CDO Portfolio: Vintage and Collateral Ratings of CDOs Containing CDOs of ABS
The following table shows the collateral composition, original and current subordination for the High Yield Corporate CDOs, as well as the net derivative asset/(liability) for each year insured. The collateral level detail for each year insured was calculated using a weighted average of the net par written 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.
CDOs with zero subordination are currently being remediated and have reserves established against them.
The table does not provide collateral level detail on 30 High Yield CDOs totaling $0.7 billion of net par. These deals were insured prior to 2004. In addition, all 31 deals were rated triple-A at the time MBIA wrote insurance on them.
The table includes Emerging Market CDOs totaling $0.2 billion of net par.
The Structured CMBS Pools and CRE CDO portfolio is a diversified global portfolio of highly-rated structured transactions primarily supported by collateral from the commercial real estate sector. The Company did not experience any material credit deterioration to this portfolio during the quarter ended December 31, 2008. This portfolio can be sub-divided into two distinct pools: Structured CMBS pools and CRE CDOs.
The Company’s exposure to Structured CMBS Pools totaling $35.2 billion represents 28% of the Company’s CDO exposure and approximately 4% of the Company’s total net par insured as of December 31, 2008. These transactions are pools of CMBS, Real Estate Investment Trust (“REIT”) debt and CRE CDOs that are structured with a first loss deductible sized to a triple-A (or a multiple of triple-A) level of credit protection before consideration is given to the wrap provided by the Company. The credit protection sizing is a function of the underlying collateral ratings and the structural attributes. MBIA’s guarantee for most structured CMBS pool transactions covers losses on collateral assets once a deductible has been eroded. The securities in the pool are either cash assets or (more typically) securities referenced synthetically. Each pool consists primarily of CMBS securities drawn from a range of different CMBS securitizations, which in turn are backed by a diverse pool of loans secured by commercial real estate properties. The Company’s Structured CMBS Pools are static, meaning that the collateral pool of securitizations cannot be changed.
The following table shows the collateral composition, original and current subordination for Structured CMBS Pools and CRE CDOs, as well as the net derivative asset/(liability) for each year insured. The collateral level detail for each year insured was calculated using a weighted average of the net par written 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 overcollateralization and subordination) and reinsurance.
Structured CMBS Pools and CRE CDOs: Collateral Composition, Subordination, and Net Derivative Asset/Liability
This column represents the net derivative asset/(liability) primarily for CDS deals written in that year. Note that not all insurance contracts are considered derivatives. Please refer to “Note 4: Fair Value of Financial Instruments” and “Note 7: Derivative Instruments” in the Notes to Consolidated Financial Statements for the Company’s accounting treatment of derivatives (including CDS on CDOs).
CRE CDOs: Vintage and Collateral Ratings of CDOs Containing Subprime RMBS
As of December 31, 2008, the Company’s CMBS and CRE CDO portfolios remain protected against loss during the current economic stress due to the diversified nature of the transactions, deal level credit enhancement and low near-term refinancing risk. Our static pooled portfolio comprises over 56,000 loans and is well diversified geographically and by property type in keeping with the industry as a whole. The current weighted average debt service coverage ratio of underlying mortgages in the CMBS pools is 1.58, with a weighted average loan-to-value of 67.7%. The current weighted average maturity of the underlying mortgages is between 6 to 7 years, with over 95% of the collateral in the form of fixed-rate loans. These factors, combined with MBIA deal attachment points ranging from 5% to 80% depending upon collateral composition provide substantial protection against losses. Additionally, underlying bond collateral loss coverage in our pools generally ranging from 2% to 30% provides further protection against losses.
The following table summarizes the results and assets under management of our investment management services operations over the last three years. These results include revenues and expenses from transactions with the Company’s insurance and corporate operations.
In 2008, investment management services’ revenues were a loss of $345 million compared with revenues of $1.8 billion in 2007. Excluding net realized gains and losses from investment securities and net gains on financial instruments at fair value and foreign exchange, revenues were $1.3 billion compared with revenues of $1.6 billion in 2007. The decrease was due to lower assets under management, particularly in the asset/liability products segment, coupled with reduced interest income from lower yielding short-term assets purchased to increase the liquidity of that segment. Decreases in revenues were offset by net gains from the repurchase of MTNs and terminations of investment agreements within our asset/liability products segment, which totaled $341 million during 2008. Total investment management services’ expenses were $1.0 billion, down 33% compared with 2007. The decrease in expenses were primarily driven by a decline in interest expense from lower MTN and investment agreement balances outstanding, as well as lower operating expenses that vary with asset and liability balances and reversal of compensation-related accruals recorded in prior years.
In 2007, investment management services’ revenues of $1.8 billion increased 48% over 2006. Excluding net realized gains from investment securities and net gains on financial instruments at fair value and foreign exchange, revenues of $1.6 billion increased 33% over 2006. The increase in revenues was attributable to growth in the Company’s asset/liability products segment, primarily due to investment agreement and MTN issuance, and the advisory services segment. Advisory services’ revenues were favorable compared with 2006 as a result of growth in managed assets, particularly in municipal investment pool balances where assets under management increased by $1.6 billion due to new clients, and growth in our Customized Asset Management product. Total investment management services’ expenses in 2007 were $1.5 billion, up 36% compared with 2006. This increase was primarily driven by higher interest expense from the growth in asset/liability products segment activity, which was consistent with the growth in revenues.
Net realized losses from investment securities in the investment management services operations were $1.7 billion in 2008 compared with net realized gains of $3 million in 2007 and net realized gains of $7 million in 2006. In 2008, $774 million of net realized losses were generated from sales of securities in the asset/liability products segment principally to raise cash to fund investment agreement terminations and obtain eligible collateral for posting requirements, which were both caused by the Moody’s downgrades of MBIA Corp.’s insurance financial strength rating. Securities were also sold during 2008 to rebalance the asset portfolio to more closely match remaining future liability cash flows. Additionally, $945 million of net realized losses resulted from write-downs of certain available-for-sale investments to their fair value as a result of management’s determination that these assets were other than temporarily impaired. Of the $945 million of net realized losses from impairments, $553 million was due to issuer credit concerns and $392 million related to specific securities that the Company did not intend to hold to maturity or until fair value recovered to amortized cost. Under accounting rules for available-for-sale investments, the Company is required to reduce the cost basis of assets to their current fair value if the fair value is less than amortized cost and the Company does not expect to receive an amount equal to amortized cost from the issuer or cannot conclude that it intends to hold such assets until their fair value recovers to amortized cost.
While losses from securities sales and impairments negatively impacted our statement of operations, a substantial portion of the impact to shareholders’ equity was offset by a change in accumulated other comprehensive income (loss), since the investments sold were already reflected at fair value as of December 31, 2007. Below is a reconciliation of net realized losses recorded in 2008 and the impact these losses had on the statement of operations and balance sheet of the Company. Additionally, these losses on investments were offset by a cumulative $427 million in gains on credit derivatives that economically hedged the change in value of a portion of the investments sold. Changes in the value of credit derivatives were recorded in our statement of operations over time.
Net gains on financial instruments at fair value and foreign exchange in the investment management services operations in 2008 were $55 million compared with net gains of $179 million and net losses of $11 million in 2007 and 2006, respectively. The net gains in 2008 were primarily generated from foreign exchange gains on euro denominated positions and gains on hybrid financial instruments, partially offset by swap losses. The net gains in 2007 were primarily generated from gains on total return swaps used to hedge certain bond positions, for which the Company did not receive hedge accounting treatment under SFAS 133, partially offset by unfavorable foreign exchange on the re-measurement of euro denominated liabilities against British pound sterling and losses on certain hybrid financial instruments. The net gains in 2006 were primarily generated from gains on foreign exchange partially offset by losses on derivative instruments.
As of December 31, 2008, ending assets under management were $43.6 billion, $19.7 billion lower compared with assets under management of $63.3 billion as of December 31, 2007. The decrease in assets under management during 2008 was predominantly due to a reduction in outstanding investment agreements and MTNs within the asset/liability product segment from regular amortization, termination of investment agreements due to ratings downgrades, and repurchases of MTNs by the Company. Conduit ending assets included in assets under management as of December 31, 2008 totaled $2.4 billion compared with $4.2 billion as of December 31, 2007. Conduit assets declined due to the maturity and regular amortization of transactions. Advisory services segment balances, which include assets managed for external clients and our insurance and corporate investment portfolios, declined $0.9 billion. Average assets under management decreased 14% to $56.8 billion in 2008 from $66.0 billion in 2007. As of December 31, 2007, ending assets under management of $63.3 billion were slightly lower compared with the 2006 year-end level, however, average assets under management for 2007 of $66.0 billion were 18% higher than 2006.
The following provides a summary of each of the investment management services’ businesses by segment. Refer to “Note 15: Business Segments” in the Notes to Consolidated Financial Statements for a tabular presentation of the results of the investment management services’ segments.
2008 was $61 million compared with pre-tax income of $97 million in 2007. This decrease was principally due to a significant decline in net interest income in 2008, which resulted from a decrease in interest on assets as we rebalanced the portfolio into cash and short-term investments to meet current and future liquidity needs. In 2007, asset/liability products’ pre-tax income, excluding realized gains from investment securities and gains on financial instruments at fair value and foreign exchange, totaled $97 million, up 4% over 2006.
As of December 31, 2008, principal and accrued interest outstanding on investment agreement and MTN obligations and securities sold under agreements to repurchase totaled $9.7 billion compared with $26.7 billion at December 31, 2007. In addition, as of December 31, 2008, the segment had a repurchase agreement outstanding with MBIA Corp. for $2.0 billion and cash advanced from the Company’s corporate segment of $600 million. Cash and investments supporting the segment’s liabilities, including intercompany liabilities, had market values plus accrued interest of $9.1 billion and $25.9 billion as of December 31, 2008 and December 31, 2007, respectively. These assets comprise high-quality securities with an average credit quality rating of double-A. The fair values of assets declined over the course of 2008 relative to the carrying value of liabilities due to the widening of credit spreads across the fixed-income market generally and for certain specific asset holdings, while the liabilities are not carried at fair value. Additionally, receivables for securities sold net of payables for securities purchased were $64 million and $96 million as of December 31, 2008 and December 31, 2007, respectively. Refer to the “Liquidity” section included herein for a discussion about the liquidity position of the asset/liability products program.
In 2008, conduits reported a pre-tax loss of $6 million compared with a pre-tax loss of $1 million in 2007. Excluding losses on financial instruments at fair value and foreign exchange, Conduits’ pre-tax income was $7 million in 2008 compared with pre-tax income of $14 million in 2007 and $10 million in 2006. The decrease in 2008 and 2007 principally resulted from the maturity and amortization of transactions financed through our conduits. Certain of MBIA’s consolidated subsidiaries have invested in our conduit debt obligations or have received compensation for services provided to our conduits. As such, we have eliminated intercompany transactions with our conduits from our consolidated balance sheet and statement of operations. After the
elimination of such intercompany assets and liabilities, conduit investments (including cash) and conduit debt obligations totaled $2.5 billion at December 31, 2008. The effect of the elimination on the Company’s consolidated balance sheet is a reduction of fixed-maturity investments, representing investments in conduit MTNs by other MBIA subsidiaries, with a corresponding reduction of conduit MTNs.
Under private placement offerings, Triple-A One Funding Corporation (“Triple-A One”) issued commercial paper to fund the purchase of assets from structured finance clients with maturities of up to 270 days. Assets purchased by Triple-A One are insured by MBIA Corp. Historically, Triple-A One has maintained backstop liquidity facilities for each transaction, covering 100% of the face amount of commercial paper outstanding. These liquidity facilities were designed to allow Triple-A One to repay investors in the event of a market disruption in which Triple-A One would be unable to issue new commercial paper to replace maturing commercial paper. The financial guarantee policies issued by MBIA to insure the assets of Triple-A One cannot be accelerated to repay maturing commercial paper or borrowings under liquidity facilities and only guarantee ultimate payments over time relating to the assets.
The objective of East-Fleet is to issue senior commercial paper and invest in term-matched repurchase agreements guaranteed by major banks and broker/dealers rated “A-1/P-1” or better by S&P and Moody’s, respectively, who use the repurchase agreement market to finance assets. As of December 31, 2008, East-Fleet did not have any commercial paper outstanding compared with $1.2 billion as of December 31, 2007. Adverse conditions in the structured finance and asset-backed commercial paper markets beginning in the second half of 2007 reduced demand by clients for financing and increased the cost of East-Fleet’s commercial paper funding, together causing the outstanding balances of repurchase agreements and commercial paper funding to decline to zero. Due to the cash matched funding of assets and liabilities, East-Fleet was not exposed to liquidity risk and was not required to liquidate assets in the market in order to settle its liabilities.
beneficiary and need not consolidate East-Fleet. Had the Company concluded that consolidation was warranted, the impact to its December 31, 2008 balance sheet would have been immaterial.
A subsidiary of MBIA Asset Management is the program manager for six CDOs totaling $1.5 billion in par amount as of December 31, 2008. These CDOs are managed investment vehicles that purchase a portfolio of diversified assets funded by the issuance of debt and equity, the repayment and return of which are linked to the performance of the assets. The CDOs managed by MBIA consist of a variety of asset classes as underlying collateral, including corporate and asset-backed securities. Principal on three of these CDOs, totaling $986 million, are insured by MBIA Corp. As of December 31, 2008, the Company had invested $14 million in the CDOs it manages.
At the inception of each CDO, or upon the adoption of FIN 46(R) in the case of CDOs issued prior to the adoption of FIN 46(R), the Company conducted consolidation analyses and the Company concluded that while the CDOs met the definition of VIEs, MBIA was not the primary beneficiary and, therefore, need not consolidate them. The Company’s variable interest is represented by the management fee it earns from the CDOs and its investment in the CDOs. The Company believes that there are no possible scenarios under which it would consolidate the VIEs given the Company assessment of its variable interest. Had the Company concluded that consolidation was warranted, the impact to its December 31, 2008 balance sheet would have been an increase in assets of $1.5 billion, and a corresponding increase in liabilities and shareholders’ equity. These increases would not have been expected to result in any impact on the Company’s debt covenants, capital ratios or credit ratings.
In 2008, net investment income in our corporate operations increased 119% to $31 million from $14 million in 2007. The increase was primarily due to growth in invested assets driven by $1.1 billion of proceeds from our public offering of MBIA Inc. common stock in February 2008. The impact of the growth in invested assets was partially offset by lower yields on our investments as we have primarily invested in short-term liquid securities. In 2007, net investment income in our corporate operations increased 6% to $14 million from $13 million in 2006. The increase in 2007 was primarily due to higher invested assets driven by dividends paid by MBIA Corp. to MBIA Inc. and higher investment yields, partially offset by losses from several of the Company’s alternative investments.
Corporate operating expenses were $31 million, $29 million and $18 million for the years ended December 31, 2008, 2007 and 2006, respectively. In 2008, corporate operating expenses increased compared with 2007 as a result of legal costs associated with corporate litigation and costs associated with warrants issued to Warburg Pincus. The increase in corporate operating expenses in 2007 compared with 2006 was primarily due to an increase in costs allocated from the insurance operations.
Interest expense in our corporate operations was $75 million, $81 million and $81 million for the years ended December 31, 2008, 2007 and 2006, respectively. Interest expense is primarily generated from debt issued by MBIA Inc. for corporate purposes. The decrease in interest expense in 2008 compared with 2007 resulted from the repurchase of debt during 2008.
The Company’s income taxes and the related effective tax rates for the years ended December 31, 2008, 2007 and 2006 are as follows:
For the years ended December 31, 2008 and 2007, the effective tax rates reflect a tax benefit at a rate of 28.3% and 37.3%, respectively, and for the year ended December 31, 2006, the effective tax rate reflects tax expense of 28.2%. For the year ended December 31, 2008, the effective tax rate was lower than the statutory rate of 35% primarily due to the establishment of a valuation allowance of $351 million against the deferred tax asset attributable to other than temporary impairments and capital loss carryforwards, which offset the benefit of tax-exempt income. For the year ended December 31, 2007, the effective tax rate was slightly higher than the statutory rate of 35% primarily due to the benefit of tax-exempt income. For the year ended December 31, 2006, the effective tax rate was lower than the statutory rate of 35% primarily due to the benefit of tax-exempt income. In general, tax-exempt income lowers our effective tax rate in years in which we report pre-tax income and increases our effective tax rate in years in which we report pre-tax losses.
Section 382 of the Internal Revenue Code of 1986, as amended, imposes annual limitations on the utilization of net operating loss (“NOL”) carryforwards, other tax carryforwards, and certain built-in losses, as defined under that Section, upon an ownership change. In general terms, an ownership change may result from transactions that increase the aggregate ownership of certain stockholders in our stock by more than 50 percentage points over a testing period (generally three years).
Warburg Pincus made an initial investment of $500 million in MBIA through the acquisition of 16.1 million shares of MBIA Inc. common stock at a price of $31.00 per share, which was completed on January 30, 2008. In
On February 13, 2008, the Company completed a public offering of 94.65 million shares of MBIA Inc. common stock at $12.15 per share. Warburg Pincus informed the Company that it purchased $300 million in common stock as part of the offering. The Company did not use the $750 million Warburg Pincus backstop. In addition, Warburg Pincus did not exercise its right to purchase up to $300 million in preferred stock. Pursuant to the amended Warburg Pincus Agreement, Warburg Pincus was granted 4 million of “B2” warrants at a price of $16.20 per share. In addition, under anti-dilution provisions in the Warburg Pincus Agreement, the terms of the warrants issued to Warburg Pincus on January 30, 2008 were amended, which resulted in (a) the 8.7 million of warrants exercisable at $40 per share being revised to 11.5 million warrants exercisable at $30.25 per share and (b) the 7.4 million of “B” warrants exercisable at $40 per share being revised to 9.8 million “B” warrants exercisable at $30.25 per share.
On February 25, 2008, the Company’s Board of Directors approved the elimination of MBIA Inc. shareholder dividends. The elimination of MBIA Inc. shareholder dividends is expected to preserve approximately $174 million of capital on an annualized basis.
On February 1, 2007, our 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. However, due to our decision in the third quarter of 2007 to suspend share repurchases under the program in light of concerns and uncertainties regarding the housing markets, the structured finance sector and the U.S. economy, no shares were repurchased during the first six months of 2008.
In addition to common stock repurchases, MBIA Inc. or its subsidiaries may also repurchase their outstanding equity or debt securities. During 2008, MBIA Inc. repurchased $127 million par value outstanding of its general corporate debt at an average price of 75.81 and our investment management services operations repurchased $1.8 billion par value outstanding of MTNs issued by its asset/liability products segment at an average price of 76.38. Also during 2008, MBIA Insurance Corporation repurchased $125 million par value of its recently issued preferred stock at an average price of 0.10.
MBIA Corp. had access to $400 million through the CPCT facility issued by eight trusts (the “Trusts”), which were created for the primary purpose of issuing CPCT securities and investing the proceeds in high-quality commercial paper or short-term U.S. Government obligations. The Company had a put option to sell to the Trusts the preferred stock of MBIA Corp. in exchange for proceeds of $400 million. In November 2008, MBIA Corp. exercised the put option to sell to the Trusts the perpetual preferred stock issued by MBIA Corp. Upon MBIA exercising the put option, the Trusts transferred proceeds of $400 million to MBIA Corp. in exchange for non-cumulative perpetual preferred stock. The proceeds of the preferred stock will be held by MBIA Corp. in liquid securities in order to enhance its financial flexibility. Subsequent to the sale of the preferred stock to the trusts, MBIA purchased $125 million par value of its preferred stock for $12 million. Payment of dividends on MBIA Corp.’s preferred stock is subject to the same restrictions that apply to dividends on common stock under New York State insurance law. Refer to “Subsidiary Dividends” in the following “Liquidity” section for an explanation of these restrictions.
The carrying value of the preferred stock was $28 million as of December 31, 2008 and is presented as minority interest on the Company’s consolidated balance sheet. The carrying value represents the $400 million of proceeds received reduced by the carrying value of the put option at the time of exercise of $360 million and the carrying value of the shares repurchased of $12 million. Prior to exercise, the put option was reported at fair value within “Other assets” on the Company’s consolidated balance sheet and changes in fair value of the put option was reported within “Net gains (losses) on financial instruments at fair value and foreign exchange” on the Company’s statement of operations. Refer to “Note 24: Common and Preferred Stock” in the Notes to Consolidated Financial Statements for further information relating to the issuance of preferred stock under this facility.
From time to time, MBIA accesses the capital markets to support the growth of its businesses. As such, we filed a registration statement on Form S-3ASR with the SEC in June 2007 for an indeterminate amount which replaced and canceled remaining balances on all prior shelf registration statements filed with the SEC. This shelf registration permits us to issue various debt and equity securities described in the prospectus filed as part of the registration statement. In February 2008, we filed amendments to our Form S-3ASR to allow the issuance of $1.15 billion of common stock as part of our capital strengthening plan.
As a financial services company, we carefully manage liquidity risk, which is the probability that an enterprise will not have sufficient resources to meet contractual payment obligations when due. Management of liquidity risk is of critical importance to financial services companies, and most failures of financial institutions have occurred in large part due to their inability to maintain sufficient liquidity resources under adverse circumstances. Generally, lack of sufficient resources results from an enterprise’s inability to access the capital markets or to sell assets at values necessary to satisfy payment obligations and/or an unexpected acceleration of payments to settle liabilities. We encounter significant liquidity risk in our insurance operations, asset/liability products business and corporate operations.
As part of our liquidity risk management framework, we also evaluate and manage liquidity on both a legal entity basis and a segment basis. Segment liquidity is an important consideration for the Company as we conduct the operations of our corporate segment and certain activities within the asset/liability products segment of our 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 our triple-A insurance financial strength ratings have significantly increased the liquidity needs and decreased the financial flexibility in our segments. The Company has satisfied all of its payment obligations from cash generated from operations, the issuance of equity and debt, and sales of investments. We believe that we have adequate resources to meet our 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.
Liquidity risk arises in our insurance operations when claims on insured exposures result in payment obligations, when operating cash inflows fall due primarily to depressed writings of new insurance or lower investment income, or when assets experience credit defaults or significant declines in fair value. Prior to 2008, loss payments were immaterial relative to the significant operating cash flows of this business.
Following the Moody’s downgrade of MBIA Corp. to Baa1 in November 2008, most outstanding investment agreements were terminated in accordance with their terms. As of December 31, 2008, we had $9.7 billion in remaining liabilities related to our asset/liability products business, of which $4.7 billion were investment agreements. All of the investment agreements were collateralized by cash or high-grade securities. This includes $2.4 billion of investment agreements which could have been terminated at the holders’ option upon the downgrade of MBIA Corp. to Baa1 by Moody’s. The remaining $5.0 billion in liabilities consist of MTNs issued by MBIA Global Funding, LLC and term repurchase agreements, which are not subject to additional collateralization or termination provisions upon a downgrade. Payments and additional collateral requirements on the liabilities in the asset/liability products segment are expected to be met without the need for additional asset sales in the current stressed credit environment but rather from cash flows from investments and the intercompany facilities described above.
We currently believe that the liquidity position of the asset/liability products segment, including the utilization of intercompany resources, is adequate to meet projected payments. Certain events, however, could place further stress on our ability to meet asset/liability segment obligations without additional asset sales or borrowing
facilities, including any further asset impairments, asset or liability cash flow variability, or increased collateral margin requirements due to a reduction in the market value or rating eligibility of assets pledged as collateral. In such events, we may be forced to sell additional assets at potentially substantial losses to meet such obligations. Additionally, the asset/liability products segment may receive further liquidity support from our corporate segment, however, there can be no assurance that such support would be adequate to meet all payment obligations.
During 2009, we currently expect that we will be required to make loss and CDS settlement payments, before reinsurance, of between $900 million and $1.1 billion primarily relating to insured RMBS and multi-sector CDO credits. In addition, we currently estimate that the surplus notes will require interest payments totaling approximately $130 million for 2009.
For the year ended December 31, 2008, net cash used by financing activities was $15.9 billion compared with net cash provided by financing activities of $5.3 billion for the year ended December 31, 2007. Net cash used by financing activities for the year ended December 31, 2008 principally related to withdrawals and terminations of investment agreements and maturities and repurchases of MTNs within our asset/liability products segment,
Under New York State insurance law, without prior approval of the Superintendent of the NYSID, financial guarantee insurance companies can pay dividends from earned surplus subject to retaining a minimum capital requirement. The payment of regular dividends in any 12-month period are limited to the lesser of (i) 10% of policyholders’ surplus as shown on MBIA Corp.’s latest filed statutory financial statements and (ii) 100% of adjusted net investment income. During 2008, MBIA Corp. did not declare or pay any dividends to MBIA Inc. as part of our strategy to conserve and build capital. However, MBIA Corp. may begin paying dividends to MBIA Inc. in future periods. As of December 31, 2008, MBIA Corp.’s dividend capacity under insurance law was approximately $1 million.
MBIA maintained a revolving credit facility totaling $500 million with a group of highly rated global banks, which expires in May 2011. The facility contains certain covenants including, among others, that the consolidated net worth of MBIA Inc. and MBIA Corp. will not fall below $2.8 billion and that the ratio of consolidated debt to equity for MBIA Inc. and MBIA Corp. will not exceed 30%, at any time. In January 2008, the Company amended the credit facility to treat the Surplus Notes as equity in the net worth and leverage calculations. This facility does not include any material credit rating triggers or any provisions that could require the posting of collateral. During 2008, there were no draws upon this facility nor were there any balances outstanding under the facility. The Company has been negotiating an amendment to the terms of the facility to exclude unrealized gains and losses on insured credit derivatives from the calculation of net worth. After consideration of the terms and conditions required to obtain an amendment, MBIA elected to terminate the facility effective February 27, 2009 in accordance with its rights under the credit facility. As of the termination date, neither MBIA Inc. nor MBIA Corp. had outstanding borrowings under the facility, and there were no early termination fees or premiums paid as a result of terminating the facility.
Triple-A One, an MBIA-administered multi-seller conduit consolidated in the Company’s conduit segment, issues commercial paper to fund the purchase of assets from structured finance clients. Assets purchased by Triple-A One are insured by MBIA Corp. Triple-A One maintains backstop liquidity facilities for each transaction, covering 100% of the face amount of commercial paper outstanding, with banks rated A-1/P-1 or better by S&P and Moody’s, respectively. These liquidity facilities are designed to allow Triple-A One to repay investors in the event of a market disruption in which Triple-A One is unable to issue new commercial paper to replace maturing commercial paper. The financial guarantee policies issued by MBIA Corp. to insure the assets of Triple-A One cannot be accelerated to repay maturing commercial paper or borrowings under liquidity facilities and only guarantee ultimate payments over time relating to the assets. During 2008, conditions in the asset-backed commercial paper market deteriorated making it increasingly difficult for Triple-A One to issue new commercial paper at commercially acceptable rates to refund maturing obligations. Accordingly, Triple-A One began borrowing under its liquidity facilities to repay maturing commercial paper. By September 2008, these facilities were drawn in full and Triple-A One ceased issuing commercial paper. All commercial paper holders were repaid in full and borrowings under liquidity facilities, which totaled $345 million as of December 31, 2008, will be repaid as the assets purchased by Triple-A One mature.
Our available-for-sale investment portfolios comprise high-quality fixed-income securities and short-term investments. As of December 31, 2008 and 2007, the fair value of the consolidated available-for-sale investment portfolio was $17.0 billion and $36.5 billion, respectively, as presented in the following table. Additionally, consolidated cash and cash equivalents as of December 31, 2008 and December 31, 2007 were $2.3 billion and $264 million, respectively.
The carrying value of our consolidated investment portfolios decreased 51% to $20.6 billion as of December 31, 2008 from $42.1 billion as of December 31, 2007. The decrease in the amortized cost of the insurance operations’ available-for-sale investments was the result of liquidating investments into cash for purposes of enhancing liquidity, including providing the $2 billion repurchase agreement to our investment management services operations, and paying claims on insurance policies, partially offset by proceeds from debt and equity issuances, proceeds from our reinsurance agreement with FGIC and the consolidation of VIE investments. The decrease in the amortized cost of available-for-sale investments in the investment management services operations principally resulted from the maturity and sale of investments to repay investment agreement and MTN obligations within our asset/liability products segment, as well as the other-than-temporary impairment of securities. Corporate investments decreased as a result of liquidating securities into cash for purposes of enhancing liquidity, including providing the $600 million loan to our investment management services operations, partially offset by proceeds from MBIA Inc.’s common stock offering.
The fair value of the Company’s investments is based on prices which include quoted prices in active markets and prices based on market-based inputs that are either directly or indirectly observable, as well as prices from dealers in relevant markets. Differences between fair value and amortized cost arise primarily as a result of changes in interest rates and general market credit spreads occurring after a fixed-income security is purchased,
although other factors influence fair value, including specific credit-related changes, supply and demand forces and other market factors. When the Company holds an available-for-sale investment to maturity, any unrealized gain or loss currently recorded in accumulated other comprehensive income (loss) in the shareholders’ equity section of the balance sheet is reversed. As a result, the Company would realize a value substantially equal to amortized cost. However, when investments are sold prior to maturity, the Company will realize any difference between amortized cost and the sale price of an investment as a gain or loss within its statement of operations. The Conduit portfolios are considered held-to-maturity, as the Company has the ability and intent to hold these investments to their contractual maturity. Therefore, these portfolios are reported on the Company’s consolidated balance sheet at amortized cost and are not adjusted to reflect unrealized changes in fair value.
The following table presents the fair values and unrealized losses by credit rating category of ABS included in our consolidated investment portfolio as of December 31, 2008 for which fair value was less than amortized cost. Of the total $1.6 billion of fair value and $1.1 billion of unrealized losses, $1.5 billion of fair value and $1.1 billion of unrealized losses relates to ABS included in our asset/liability products investment portfolio. Fair values include the benefit of guarantees provided by financial guarantors, including MBIA. The credit ratings are based on ratings from Moody’s as of December 31, 2008 or an alternate ratings source, such as S&P, when a security is not rated by Moody’s. For insured bonds, the credit rating reflects the greater of the insurer’s rating or the underlying bond’s rating.
ratings, was A and the average underlying credit rating of guaranteed ABS investments, without giving effect to the guarantees, was Ba. Without giving effect to the benefit of guarantees provided by financial guarantors, including MBIA Corp., $373 million or 23% of the securities included in the preceding table were rated below investment grade.
MBIA’s consolidated investment portfolio includes investments that are insured by various financial guarantee insurers (“Insured Investments”), including investments insured by MBIA Corp. (“MBIA Insured Investments”). As of December 31, 2008, Insured Investments at fair value represented $5.5 billion or 27% of consolidated investments, of which $3.5 billion or 17% of consolidated investments were insured by MBIA Corp. This includes conduit investments at fair value of $2.4 billion or 12% of consolidated investments, which were all insured by MBIA Corp.
As of December 31, 2008, 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 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 A range, and 6.3% of the investment portfolio would be rated below investment grade.
The underlying ratings of the MBIA Insured Investments as of December 31, 2008 are reflected in the following table. Amounts represent the fair value of such investments including the benefit of the MBIA guarantee. The ratings in the following table are the lower underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating agency, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment.
Conduit programs involve the use of rating agencies in assessing the quality of asset purchases and in assigning ratings to the various programs funded through the conduits. All transactions currently funded in the conduits had an underlying rating of at least investment grade by Moody’s and S&P prior to funding. The weighted average underlying rating for transactions currently funded in the conduits was A- by S&P and A2 by Moody’s at the time such transactions were funded. MBIA estimates that the current weighted average underlying rating of all outstanding conduit transactions was A- by S&P and A3 by Moody’s at December 31, 2008.
Due to uncertainty with respect to the timing of future cash flows and the ultimate outcome associated with the Company’s unrecognized tax benefits as of December 31, 2008, the Company is unable to make reliable estimates of the periods in which cash settlements will occur with applicable taxing authorities. Therefore, the contractual obligations table presented above does not include any unrecognized tax benefits relating to FIN 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement 109.”
Credit spread sensitivity can be estimated by projecting a hypothetical instantaneous increase or decrease in credit spreads. The following table presents the estimated pre-tax change in fair value of the Company’s financial instruments (including investment securities and investment agreement and MTN obligations) as of December 31, 2008 from instantaneous shifts in credit spread curves. For this table it was assumed that all credit spreads move by the same amount. It is more likely that the actual changes in credit spreads will vary by security. MBIA Corp.’s investment portfolio would generally be expected to experience lower credit spread volatility than the investment portfolio of the asset/liability products segment because of higher credit quality and portfolio composition in sectors that have been less volatile historically. The table shows hypothetical increases and decreases in credit spreads of 50 and 200 basis points. Because downward movements of these amounts in some cases would result in negative spreads, a floor was assumed for minimum spreads. The changes in fair value reflect partially offsetting effects as the value of the investment portfolios generally change in opposite direction from the liability portfolio.
MBIA issued insurance policies insuring payments due on structured credit derivative contracts and directly entered into credit derivative contracts, which are marked-to-market through earnings under the requirements of SFAS 133. All these transactions were insured by the Company’s insurance operations. The majority of these structured CDSs related to structured finance transactions with underlying reference obligations of cash securities and CDSs referencing liabilities of corporations or of other structured finance securitizations. The asset classes of the underlying reference obligations included corporate, asset-backed, residential mortgage-backed and commercial mortgage-backed securities. These transactions were usually underwritten at or above a triple-A credit rating level. As of December 31, 2008, approximately 82% of the tranches insured by the Company were rated triple-A. Additionally, MBIA’s investment management services operations enter into single-name CDSs as part of its asset management activities. During 2008, the value of the Company’s credit derivative contracts were affected predominantly by changes in credit spreads of the underlying reference obligations’ collateral, changes in recovery rate assumptions, erosion of subordination and ratings downgrades of securities backing CDOs. This was significantly offset by the effect of the Company’s own credit risk on the portfolio in accordance with SFAS 157. As those risk factors change, the values of credit derivative contracts will change and the resulting gains or losses will be recorded within net income.
In 2008, we have observed a further extensive widening of market spreads and credit quality deterioration of certain tranches within our insured CDOs. In addition, the Company has observed an extensive widening of its own credit spreads. Predominantly, as a result of the further market spread widening and the deterioration of some credit factors, MBIA suffered additional unrealized losses on the portfolio, however, this was significantly offset by the effect of SFAS 157 due to our own spreads widening. As changes in fair value can be caused by
factors unrelated to the performance of MBIA’s business and credit portfolio, including general market conditions and perceptions of credit risk, as well as market use of credit derivatives for hedging purposes unrelated to the specific referenced credits in addition to events that affect particular credit derivative exposures, the application of fair value accounting may cause the Company’s earnings to be more volatile than would be suggested by the underlying performance of MBIA’s business operations and credit portfolio.
The following tables reflect sensitivities to changes in credit spreads, recovery rates, rating migrations and to changes in our own credit spreads. Each table stands on its own and should be read independently of each other.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of MBIA Inc. and its subsidiaries at December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2), present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
On February 25, 2008, the Company announced that it had ceased insuring new credit derivative contracts except in transactions related to the reduction of existing derivative exposure. In addition, the Company announced that it suspended the writing of all new structured finance business for approximately six months. Currently, the global structured finance market is generating very little new business, and it is uncertain how or when the Company may re-engage this market. The municipal bond market has also seen a drop in the demand for bond insurance, but the Company expects to compete for this business in the future. While the Company has written almost no traditional direct insurance business in the second half of 2008, MBIA Corp. provided reinsurance for a portfolio of United States (“U.S.”) public finance bonds originally insured by Financial Guaranty Insurance Company (“FGIC”) with total assumed par of $181 billion. Refer to “Note 18: Reinsurance” for further details of this transaction.
MBIA’s investment management services operations include a substantial asset/liability management business, in which it has issued debt and investment agreements, which are insured by MBIA Corp., to capital markets and municipal investors and then initially purchased assets that largely matched the duration of those liabilities. The ratings downgrades of MBIA Corp. have resulted in the termination of certain investment agreements and,
As a financial guarantee insurance and investment management services company, MBIA is materially affected by conditions in global financial markets. During 2008, conditions and events in these markets, along with the loss of MBIA Insurance Corporation’s triple-A credit ratings, have created substantial liquidity risk for the Company.
Liquidity risk arises in the Company’s insurance operations when claims on insured exposures result in payment obligations, when operating cash inflows fall primarily due to depressed writings of new insurance or lower investment income, or when assets experience credit defaults or significant declines in fair value. Prior to 2008, loss payments were immaterial relative to the significant operating cash flows of this business.
of MBIA Corp.), thereby mitigating liquidity risk. However, when a default or impairment of an insured obligation occurs, MBIA encounters liquidity risk resulting from its irrevocable pledge to pay principal and interest, or other amounts owing on insured obligations, when due. Additionally, MBIA’s insurance operations require cash for the payment of operating expenses, as well as principal and interest related to its surplus notes and preferred stock issuance. Finally, MBIA Corp. also provides secured lending to the Company’s asset/liability products segment to support its business operations and liquidity position, as described below. These lending arrangements reduce the liquidity position of MBIA Corp.
Beginning in the fourth quarter of 2007 and throughout 2008, MBIA has made a significant amount of payments associated with insured second-lien RMBS securitizations, as well as settlement payments relating to CDS contracts referencing ABS collateralized debt obligations (“CDOs”). Among MBIA’s outstanding insured portfolio, these types of payments exhibit the highest degree of volatility and, therefore, pose material liquidity risk. The level of future loss payments on second-lien RMBS, CDO-squared, and ABS CDO transactions is dependent upon the performance trends of the underlying collateral supporting these insured transactions.
willingness of investors to purchase or lend against even very high-quality assets. In addition, negative net interest spread between asset and liability positions resulted from the need to hold cash as collateral against terminable investment agreement contracts and reduced the cash flow historically provided by net investment income.
In order to monitor liquidity risk and maintain appropriate liquidity resources for near-term cash and collateral requirements within MBIA’s asset/liability products segment, the Company calculates monthly forecasts of asset and liability maturities, as well as collateral posting requirements. Cash availability at the low point of the Company’s 12-month forecasted cash flows is measured against one-week and one-year liquidity needs using stress-scenario testing of each of the potential liquidity needs described above. To the extent there is a shortfall in MBIA’s liquidity coverage, the Company proactively manages its cash position and liquidity resources to maintain an adequate cushion to the stress scenario. These resources include the sale of unpledged assets, the use of free cash at the holding company, and potentially increased borrowings from MBIA Insurance Corporation.
As a result of the increased liquidity needs in MBIA’s investment management services operations, in the fourth quarter of 2008, the Company transferred $600 million from its corporate segment to its 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 New York State Insurance Department (“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.
Liquidity needs in MBIA’s 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 the Company’s 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.
Certain amounts have been reclassified in prior years’ financial statements to conform to the current presentation. This includes the reclassification of premiums from the Company’s insured derivatives portfolio from “Scheduled premiums earned”, “Refunding premiums earned”, “Premiums earned” and “Fees and reimbursements” to “Realized gains (losses) and other settlements on insured derivatives” and the reclassification of unrealized gains and losses on the Company’s insured derivatives portfolio from “Net gains (losses) on financial instruments at fair value and foreign exchange” to “Unrealized gains (losses) on insured derivatives”, both of which had no effect on total revenues and total expenses as previously reported. Additionally, “Gross premiums written”, “Ceded premiums written” and “Net premiums written” exclude premiums from the Company’s insured derivatives portfolio. Amounts reclassified in prior years’ financial statements also include the reclassification of net interest income and expense and net realized gains and losses related to non-hedging derivative instruments from “Net investment income”, “Interest expense”, and “Net realized gains (losses)”, respectively, to “Net gains (losses) on financial instruments at fair value and foreign exchange.”
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, a VIE or a qualifying special-purpose entity (“QSPE”).
Voting interest entities are entities in which (i) the total equity investment at risk is sufficient to enable an entity to finance its activities independently and (ii) the equity holders have the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. Voting interest entities are consolidated in accordance with Accounting Research Bulletin No. (“ARB”) 51, “Consolidated Financial Statements,” as amended. ARB 51 states that the usual condition for a controlling financial interest in an entity is ownership of a majority voting interest. Accordingly, the Company consolidates voting interest entities in which it has a majority voting interest.
VIEs are entities that lack one or more of the characteristics of a voting interest entity. A controlling financial interest in a VIE is present when an enterprise has a variable interest, or a combination of variable interests, that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. In accordance with FIN 46(R), the Company consolidates all VIEs in which it is the primary beneficiary.
Held-to-maturity investments consist mainly of debt securities, loans, lease receivables and trade receivables for which the Company has the ability and intent to hold such investments to maturity. These investments are reported in the consolidated balance sheets at amortized cost. Discounts and premiums are amortized using the effective yield method over the remaining term of the assets. Investment income is recorded as earned.
Short-term investments are carried at fair value, and include all fixed-maturity securities with a remaining effective term to maturity of less than one year, commercial paper and money market securities.
Other investments include the Company’s investment in equity securities. In accordance with SFAS 115, the Company records its share of the unrealized gains and losses on equity investments, net of applicable deferred income taxes, in accumulated other comprehensive income (loss) in shareholders’ equity when it does not have a controlling financial interest in or exert significant influence over an entity (generally a voting interest of less than 20%).
When the Company does not have a controlling financial interest in an entity but exerts significant influence over the entity’s operating and financial policies (generally a voting interest of 20% to 50%) and has an investment in common stock or substance common stock, the Company accounts for its investments in accordance with the equity method of accounting prescribed by Accounting Principles Board Opinion No. (“APB”) 18, “The Equity Method of Accounting for Investments in Common Stock.” The carrying amounts of equity method investments are initially recorded at cost and adjusted to recognize the Company’s share of the profits or losses, net of any intercompany gains and losses, of the investees subsequent to the purchase date. Such profits and losses are recorded within net investment income in the consolidated statements of operations. Dividends are applied as a reduction of the carrying amount of equity method investments.
If any of the above criteria are met, further analysis is performed to determine whether the impairment is other than temporary. In assessing whether a decline in value is other than temporary, the Company considers several factors, including but not limited to (a) the magnitude and duration of the decline, (b) the reasons for the decline, such as general interest rate or credit spread movements, credit rating downgrades, issuer-specific changes in credit spreads, and the financial condition of the issuer, and (c) any guarantees associated with a security such as those provided by investment-grade financial guarantee insurance companies. The recoverability of amortized cost for ABSs and CDOs is assessed using discounted cash flow modeling and the recoverability of amortized cost for corporate obligations is assessed using issuer-specific credit analyses. Based on this assessment, if the Company believes that either (a) the investment’s fair value will not recover to an amount equal to its amortized cost or (b) the Company does not have the ability and intent to hold the investment to maturity or until the fair value recovers to an amount at least equal to amortized cost, it will consider the decline in value to be other than
temporary. If MBIA determines that a decline in the value of an investment is other than temporary, the investment is written down to its fair value and a realized loss is recorded in its statement of operations.
Property and equipment consists of land, buildings, leasehold improvements, furniture, fixtures and computer equipment and software. All property and equipment is recorded at cost and, except for land, is depreciated over the appropriate useful life of the asset using the straight-line method. Leasehold improvements are amortized over the useful life of the improvement or the remaining term of the lease, whichever is shorter. The cost and related accumulated depreciation applicable to assets sold or retired are removed from the accounts and any gain or loss on disposition is recognized as a component of net realized gains (losses). Maintenance and repairs are charged to current earnings as incurred.
Under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” all derivative instruments are required to be recognized on the balance sheet as either assets or liabilities depending on the rights or obligations under the contract and are required to be measured at fair value. The recognition of changes in the fair value of a derivative within the statement of operations will depend on the intended use of the derivative. If the derivative does not qualify as part of a hedging relationship or is not designated as such, the gain or loss on the derivative is recognized in the statement of operations. For derivatives that qualify for hedge accounting, the gain or loss is either recognized in income along with an offsetting adjustment made to the hedged item, or the effective portion of the gain or loss is deferred in other comprehensive income (loss), net of tax, and reclassified into income in the same period(s) that the hedged item affects income. To qualify for hedge accounting, the derivative must qualify as a fair value hedge, a cash flow hedge, or a foreign currency hedge.
The nature of the Company’s business activities requires the management of various financial and market risks, including those related to changes in interest rates and foreign currency exchange rates. The Company uses derivative instruments to mitigate or eliminate certain of those risks. The Company designates derivatives as fair value hedges, cash flow hedges and foreign currency hedges.
Level 3-Valuations based on inputs that are unobservable and supported by little or no market activity and that are significant to the overall fair value measurement. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Assets and liabilities utilizing Level 3 inputs include certain MBS, ABS and CDO securities where observable pricing information was not able to be obtained for a significant portion of the underlying assets; and complex OTC derivatives (including certain foreign currency options; long-dated options and swaps; and certain credit derivatives) and insured derivatives that require significant management judgment and estimation in the valuation.
Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Company’s own assumptions are set to reflect those that it believes market participants would use in pricing the asset or liability at
the measurement date. The Company uses prices and inputs that are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to Level 3. The Company has also taken into account its own nonperformance risk and that of its counterparties when measuring fair value.
is based on the net present value of the expected ultimate losses and loss adjustment expense payments that the Company expects to pay with respect to such policy, net of expected recoveries under salvage and subrogation rights. As of December 31, 2008, the amount of the expected loss, net of expected recoveries, was present valued using a discount rate equal to the yield-to-maturity of MBIA Insurance Corporation’s fixed-income investment portfolio, excluding investments in money market funds and including intercompany loans under repurchase agreements. As of December 31, 2007 and 2006, the discount rate was equal to the yield-to-maturity of the consolidated fixed-income portfolio of the Company’s insurance subsidiaries at the end of the preceding fiscal quarter. The change in the discount rate was made to better align the discount rate with (a) the entity establishing loss reserves and, (b) the current yield profile of the investment portfolio. The Company believes the investment portfolio yield is an appropriate rate of return for present valuing its reserves as it reflects the rate of return on the assets supporting future claim payments by the Company. The discount rate used as of December 31, 2008, 2007 and 2006 was 5.03%, 5.06% and 5.10%, respectively. Once a case basis reserve is established for an insured obligation, the Company continues to record premium revenue to the extent premiums have been or are expected to be collected on that obligation.
Case basis reserves are established in the same manner for policies with respect to which an insured event (i.e., a payment default on the insured obligation) has already occurred and for those policies where the Company expects that an insured event will occur in the future based upon credit deterioration which has already occurred and has been identified. This reserving methodology is different from case basis reserves that are established by traditional property and casualty insurance companies, which determine case basis reserves only upon the occurrence of an insured event when reported. The Company does not establish case basis reserves for all payments due under an insured obligation but rather only those that the Company believes the issuer of the insured obligation will be unable to make. Case basis reserves cover the amount of principal and interest owed that the Company expects to pay on its insured obligations and the costs of settlement and other loss mitigation expenses, net of expected recoveries.
Expected recoveries reduce the amount of case basis reserves established by the Company. When MBIA becomes entitled to the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment, it records salvage and subrogation as an asset. Such amounts are included in the Company’s balance sheet within “Other assets.”
The Company’s loss reserving policy, described above, is based on guidance provided in SFAS 60, SFAS 5, “Accounting for Contingencies” and analogies to Emerging Issues Task Force (“EITF”) 85-20, “Recognition of Fees for Guaranteeing a Loan.” SFAS 60 requires that, for short-duration contracts, a liability for unpaid claim costs relating to insurance contracts, including estimates of costs relating to incurred but not reported claims, be accrued when insured events occur. Additionally, SFAS 5 requires that a loss be recognized where it is probable that one or more future events will occur confirming that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated.
The Company believes its loss reserving policy reflects the requirements of applicable accounting literature, as well as the fact that financial guarantee losses occur over time as a result of credit deterioration, operational difficulties of the insured obligor or fraud, which may not be specifically detected when they occur but which can be generally estimated across a portfolio of insured obligations based on the credit quality and nature of the portfolio and historical default data. The Company does, however, recognize premium revenue and policy acquisition costs in a manner consistent with the guidance provided in SFAS 60 for short-duration contracts.
The accounting for non-derivative financial guarantee loss reserves changed when the Company adopted SFAS 163, “Accounting for Financial Guarantee Insurance Contracts - an interpretation of FASB Statement No. 60,” on its effective date, January 1, 2009. Under SFAS 163, the Company will recognize and measure claim liabilities based on the present value of expected net payments using a risk-free rate in excess of the unearned premium revenue. Refer to “Note 3: Recent Accounting Pronouncements” for additional information on the adoption of SFAS 163.
Deferred income taxes are recorded with respect to the temporary differences between the tax bases of assets and liabilities and the reported amounts in the Company’s 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. Such temporary differences relate principally to premium revenue recognition, deferred acquisition costs, unrealized appreciation or depreciation of investments and derivatives, and MBIA Corp.’s statutory contingency reserve. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized. Deferred tax assets and liabilities are adjusted for the effect of changes in tax laws and rates in the period in which changes are approved by the relevant authority.
obtained from such deductions must be invested in non-interest-bearing U.S. Government tax and loss bonds. The Company records purchases of tax and loss bonds as payments of federal income taxes. The amounts deducted must be restored to taxable income when the contingency reserve is released, at which time the Company may present the tax and loss bonds for redemption to satisfy the additional tax liability.
Refer to “Note 14: Income taxes” for additional information about the Company’s income taxes.
In December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities,” which requires enhanced disclosures about transfers of financial assets and involvement with variable interest entities. The Company adopted FSP FAS 140-4 and FIN 46(R)-8 for financial statements prepared as of December 31, 2008. Since FSP FAS 140-4 and FIN 46(R)-8 only requires additional disclosures concerning transfers of financial assets and interests in variable interest entities, adoption of FSP FAS 140-4 and FIN 46(R)-8 did not affect the Company’s consolidated balance sheets, results of operations or cash flows. Refer to “Note 8: Variable Interest Entities” for disclosures required by FSP FAS 140-4 and FIN 46(R)-8.
In September 2008, the FASB issued FSP FAS 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161.” FSP FAS 133-1 and FIN 45-4 requires enhanced disclosures about credit derivatives and guarantees and amends FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to exclude derivative instruments accounted for at fair value under SFAS 133. The Company adopted FSP FAS 133-1 and FIN 45-4 for financial statements prepared as of December 31, 2008. Since FSP FAS 133-1 and FIN 45-4 only requires additional disclosures concerning credit derivatives and guarantees, adoption of FSP FAS 133-1 and FIN 45-4 did not affect the Company’s consolidated balance sheets, results of operations or cash flows. Refer to “Note 7: Derivative Instruments” for disclosures required by FSP FAS 133-1 and FIN 45-4.
In May 2008, the FASB issued SFAS 163 which requires financial guarantee insurance (and reinsurance) contracts issued by reporting entities considered insurance enterprises under SFAS 60 to recognize and measure premium revenue based on the amount of insurance protection provided and the period in which it is provided and to recognize and measure claim liabilities based on the present value of expected net cash outflows to be paid, using a risk-free rate, in excess of the unearned premium revenue. SFAS 163 does not apply to financial guarantee insurance contracts accounted for as derivative instruments within the scope of SFAS 133. SFAS 163 is effective for the Company prospectively as of January 1, 2009, except for the presentation and disclosure requirements related to claim liabilities effective for financial statements prepared on or after September 30, 2008, as presented and disclosed in “Note 12: Loss and Loss Adjustment Expense Reserves.” The cumulative effect of initially applying SFAS 163 will be recognized as an adjustment to the opening balance of retained earnings for the fiscal year beginning January 1, 2009. The Company expects the adoption of SFAS 163 to have a material impact on the Company’s consolidated balance sheets and results of operations. However, the amount is not known or reasonably estimable at this time as the Company is currently evaluating the required changes to its accounting processes and systems, which are significant.
In March 2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133.” SFAS 161 expands the disclosure requirements about an entity’s derivative instruments and hedging activities. The disclosure provisions of SFAS 161 apply to all entities with derivative instruments subject to SFAS 133 and its related interpretations. The provisions also apply to related hedged items, bifurcated derivatives, and non-derivative instruments that are designated and qualify as hedging instruments. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company will adopt the disclosure provisions of SFAS 161 on January 1, 2009. Since SFAS 161 requires only additional disclosures concerning derivatives and hedging activities, adoption of SFAS 161 will not affect the Company’s consolidated balance sheets, results of operations or cash flows.
repurchase financing that was entered into contemporaneously with or in contemplation of the initial transfer to be evaluated as a linked transaction under SFAS 140 unless certain criteria are met. FSP FAS 140-3 was effective for the Company beginning January 1, 2009, and will be applied to new transactions entered into after the date of adoption. Early adoption is prohibited. The Company does not expect the adoption of FSP FAS 140-3 will have a material impact on the Company’s consolidated balance sheets, results of operations or cash flows.
In December 2007, the FASB issued SFAS 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51.” SFAS 160 requires reporting entities to present noncontrolling (minority) interest as equity (as opposed to liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. The presentation and disclosure requirements are to be applied retrospectively. SFAS 160 is effective January 1, 2009 for the Company and earlier adoption is prohibited. The adoption of SFAS 160 will result in preferred stock issued by a subsidiary to be reclassified from minority interests to a separate component of equity. The Company does not expect the adoption of SFAS 160 will have a material impact on the Company’s consolidated balance sheets, results of operations or cash flows.
Foreign governments-The fair value of foreign government obligations are generally based on observable inputs in active markets. When quoted prices are not available, fair value is determined based on a valuation model that has as inputs interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the bond in terms of issuer, maturity and seniority. These bonds are generally categorized in Level 2 of the fair value hierarchy. Bonds that contain significant inputs that are not observable are categorized as Level 3 while bonds that have quoted prices in an active market are classified as Level 1.
Corporate obligations-The fair value of corporate bonds is obtained using recently executed transactions or market price quotations where observable. When observable price quotations are not available, fair value is determined based on cash flow models with yield curves, bond or single name CDS spreads and diversity scores as key inputs. Corporate bonds are generally categorized in Level 2 of the fair value hierarchy; in instances where significant inputs are unobservable, they are categorized in Level 3 of the hierarchy. Corporate obligations may be classified as Level 1 if quoted prices in an active market are available.
Cash and Cash Equivalents, Receivable for Investments Sold, Short-term Debt and Payable for Investments Purchased
The carrying amounts of these items are reasonable estimates of their fair values as they are short-term in nature.
As of December 31, 2007, the Company had access to Money Market Committed Preferred Custodial Trust (“CPCT”) securities issued in multiple trusts. The Company could put the perpetual preferred stock to the trust on any auction date in exchange for the assets of the trusts. The put option, recorded at fair value, was internally valued using LIBOR/swap rates and the Company’s credit spread. As all significant inputs were market-based and observable, the put option was categorized in Level 2 of the fair value hierarchy. The put option was exercised in December 2008. Refer to “Note 24: Common and Preferred Stock” for additional information about the Company’s put option.
The carrying value of commercial paper is a reasonable estimate of fair value primarily due to the short-term nature of commercial paper or the variability in interest rates.
The fair values of medium-term notes recorded at amortized cost are estimated using discounted cash flow calculations based upon interest rates currently being offered for similar notes with maturities consistent with those remaining for the medium-term notes being valued. Nonperformance risk of the Company is incorporated into the valuation by using the Company’s own credit spreads.
The Company has elected to record at fair value under the provisions of SFAS 155 four medium-term notes. Fair value of such notes is derived using quoted market prices or an internal cash flow model. Significant inputs into the valuation include yield curves and spreads to the swap curve. As these notes are not actively traded, certain significant inputs (e.g. spreads to the swap curve) are unobservable. These investments are categorized as Level 3 of the fair value hierarchy.
VIE notes consist of fixed and floating rate securities and related accrued interest. The carrying value of floating rate securities is a reasonable estimate of fair value due to the term of the applicable interest rates. The collateral in the underlying trust entities serves to sufficiently mitigate the nonperformance risk of the Company. The fair value of fixed rate securities is estimated based on quoted market prices.
The derivative contracts that the Company insures cannot be legally traded and generally do not have observable market prices. In the cases with no active price quote, the Company uses a combination of internal and third-party models to estimate the fair value of these contracts. Most insured CDSs are valued using an enhanced Binomial Expansion Technique (“BET”) model (originally developed by Moody’s). Significant inputs include collateral spreads, diversity scores and recovery rates. For a limited number of other insured derivatives, the Company uses industry standard models as well as proprietary models such as Black-Scholes option models and dual-default models, depending on the type and structure of the contract. All of these derivatives are categorized as Level 3 of the fair value hierarchy as a significant percentage of their value is derived from unobservable inputs. For insured swaps (other than CDSs), the Company uses internally and vendor developed models with market-
based inputs (e.g. interest rate, foreign exchange rate, spreads), and are classified as Level 2 within the fair value hierarchy. Effective January 1, 2008, the Company updated its methodology to include the impact of its own credit standing and the credit standing of its reinsurers.
In most cases, the Company’s insured credit derivatives are measured at fair value as they do not qualify for the financial guarantee scope exception under SFAS 133. Because they are highly customized there is generally no observable market for these derivatives, and as a result the Company estimates their value in a hypothetical market based on internal and third-party models simulating what a bond insurer would charge to guarantee the transaction. This pricing would be based on expected loss of the exposure calculated using the value of the underlying collateral within the transaction structure.
The majority of MBIA’s insured credit derivatives referenced structured pools of cash securities and CDSs. The Company generally insured the most senior liabilities of such transactions, and at transaction closing the Company’s exposure generally had more subordination than needed to achieve triple-A ratings from credit rating agencies (referred to as “Super Triple-A” exposure). The collateral backing the Company’s insured derivatives was cash securities and CDSs referencing primarily corporate, asset-backed, residential mortgage-backed, commercial mortgage-backed (“CMBS”), commercial real estate loans, and CDO securities.
A portion of MBIA’s insured CDS contracts require that MBIA make payments for losses of the principal outstanding under the contracts when losses on the underlying referenced collateral exceed a predetermined deductible. The total notional amount and MBIA’s maximum payment obligation under these contracts as of December 31, 2008 was $81.2 billion. The underlying referenced collateral for contracts executed in this manner largely consist of investment grade corporate debt CDOs, structured CMBS pools and, to a lesser extent, multi-sector CDO-squared transactions.
The Company has guarantees under principal protection fund programs, which are also accounted for as derivatives. Under these programs, MBIA guaranteed the return of principal to investors and is protected by a daily portfolio rebalancing obligation that is designed to minimize the risk of loss to MBIA. As of December 31, 2008, the maximum amount of future payments that the Company would be required to make under these guarantees was $90 million, but the Company has not made any payments to date relating to these guarantees. The unrealized gains (losses) on these derivatives for the years ended 2006, 2007 and 2008 were $0, reflecting the extremely remote likelihood that MBIA will incur a loss.
In determining fair value, the Company’s 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 the Company insures 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.
MBIA’s insured CDS contracts do not contain typical CDS market standard features as they have been designed to replicate its financial guarantee insurance policies. The Company’s insured CDS instruments provide protection on a pool of securities or CDSs with either a stated deductible or subordination beneath the MBIA-insured tranche. The Company is not required to post collateral in any circumstances. At default of an underlying reference obligation, payment is only due after the aggregate amount of such losses exceed the deductible or subordination in the transaction. Some contracts also provide for further deferrals of payment at the Company’s option. There is usually no requirement for fair value termination payments except for termination events related to MBIA Corp.’s failure to pay or insolvency and, in some cases, other fair value termination payments for events within the Company’s control, such as the sale of all or substantially all of the assets of MBIA Corp. An additional difference between the Company’s CDS and typical market standard contracts is that the Company’s contract, like its financial guarantee contracts, cannot be accelerated by the counterparty in the ordinary course of business, unless the Company elects to do so. Similar to the Company’s financial guarantee insurance, all insured CDS policies are unconditional and irrevocable and cannot be transferred to most other capital market participants unless they are also licensed to write financial guarantee insurance policies. Note that since insured CDS contracts are accounted for as derivatives under SFAS 133, the Company did not defer the charges associated with underwriting the CDS policies and they were expensed at origination.
The Company’s payment obligations are structured to prevent large one-time claims upon an event of default of underlying reference obligations and to allow for payments over time (i.e. “pay-as-you-go” basis) or at final maturity. However, the size of payments will ultimately depend on the timing and magnitude of losses. There are three types of payment provisions:
MBIA had transferred some of the risk of loss on these contracts using reinsurance to other financial guarantee insurance and reinsurance companies. The fair value of the transfer under the reinsurance contract with the reinsurers is accounted for as a derivative asset. These derivative assets are valued consistently with the Company’s SFAS 157 valuation policies as described in “Note 2: Significant Accounting Policies.”
As a result of these significant differences between market standard CDS contracts and the CDS contracts insured by MBIA, the Company believes there are no relevant third-party exit value market observations for its insured structured credit derivative contracts, and therefore no principal market as described in SFAS 157. In the absence of a principal market, the Company values these insured credit derivatives in a hypothetical market where market participants are assumed to be other comparably-rated primary financial guarantors. Since there are no observable transactions in the financial guarantee market that could be used to value the Company’s transactions, the Company generally uses internal and third-party models, depending on the type and structure of the contract, to estimate the fair value of its insured derivatives.
collateral is generally considered on an average basis rather than modeled separately; and
The Company reviews the 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 are observable for similar transactions, those spreads are an integral part of the analysis. For example, new insured transactions that resemble existing (previously insured) transactions would be considered, as would negotiated settlements of existing transactions. However, this data has been scarce or non-existent in recent periods. As a result, the Company’s recent reviews have focused more on internal consistency and relativity, as well as the reasonableness of modeled results given current market conditions.
3) The model uses market inputs with the most relevant being credit spreads for underlying referenced collateral, assumed recovery rates specific to the type and rating of referenced collateral, and the diversity score of the entire collateral pool. These are key parameters affecting the fair value of the transaction and all inputs are market-based whenever available and reliable.
1) There is no longer a market in which to test and verify the fair values generated by the Company’s model, and at December 31, 2008, the model inputs were also either unobservable or highly illiquid, adversely impacting their reliability.
The average spread of collateral is a key input as the Company assumes credit spreads reflect the market’s assessment of default probability for each piece of collateral. Spreads are obtained from market data sources published by third parties (e.g. dealer spread tables for assets most closely resembling collateral within the Company’s transactions) as well as collateral-specific spreads on the underlying reference obligations provided by trustees or market sources. Also, when these sources are not available, the Company benchmarks spreads for collateral against market spreads, including in some cases, assumed relationships between the two spreads. This data is reviewed on an ongoing basis for reasonableness and applicability to the Company’s derivative portfolio.
The actual calculation of pool average spread varies depending on whether the Company is able to use collateral-specific credit spreads or generic spreads as an input.
If collateral-specific credit spreads are not available, the Company uses generic spread tables based on asset class and average rating of the collateral pool. Average credit rating for the collateral is calculated from the weighted average rating factor (“WARF”) for the collateral portfolio and then mapped to an appropriate spread. WARF is based on a 10,000 point scale designed by Moody’s where lower numbers indicate better credit quality. Ratings are not spaced equally on this scale because the difference in
default probability at higher rating quality is much less than at lower rating levels. The Company obtains WARF from the most recent trustee’s report or the Company calculates it based on the collateral credit ratings. For a WARF calculation, the Company identifies the credit ratings of all collateral (using, in order of preference as available, Moody’s, S&P or Fitch ratings), then converts those credit ratings into a rating factor on the WARF scale, averages those factors (weighted by par) to create a portfolio WARF, and then maps the portfolio WARF back into an average credit rating for the pool. The Company then applies this pool rating to a market spread table or index appropriate for the collateral type to determine the generic spread for the pool, which becomes the market-implied default input into the BET model.
Over time the data inputs change as new sources become available, existing sources are discontinued or are no longer considered to be reliable or the most appropriate. It is always the Company’s objective to move to higher levels on the hierarchy, but the Company sometimes moves to lower priority inputs because of discontinued data sources or because the Company considers higher priority inputs no longer representative of market spreads. This occurs when transaction volume changes such that a previously used spread index is no longer viewed to reflect current market levels, as was the case for CMBS collateral in insured CDSs during 2008. Refer to section “Input Adjustments for Insured CMBS Derivatives in the Current Market” below.
In addition, due to financial market uncertainty this past year, transaction volume in CMBS and trading activity in the CMBX were both dramatically lower than in prior periods. The Company also considered that the implied loss rates within the CMBX index were much higher than that forecast by fundamental researchers and MBIA’s internal analysis. Also, the implied illiquidity premium on the index was very high and the model assumed that all of this would influence monoline pricing. This has not been the case in other periods of market illiquidity (because
monoline insurers have “buy and hold” portfolios, spread changes that reflect illiquidity versus changes in perceived credit fundamentals are not typically fully reflected in pricing). As a result of these issues, the Company concluded that the CMBX indices and the CMBS spread tables were unreliable model inputs for the purpose of estimating fair value in the Company’s hypothetical market among monoline insurers.
In compliance with the requirements of SFAS 157, effective January 1, 2008, the Company updated its valuation methodology for insured credit derivative liabilities to incorporate the Company’s own nonperformance risk and the nonperformance risk of its reinsurers. The Company calculated this adjustment by discounting the estimated market value loss on insured CDSs at MBIA Corp.’s and the reinsurers’ CDS spreads at December 31, 2008. The calculation resulted in a pre-tax $13.2 billion reduction in the fair value of the derivative liability. Nonperformance risk is a fair value concept and does not contradict the Company’s internal view, based on fundamental credit analysis of its economic condition, that the Company will be able to pay all claims when due.
The Company believes that it is important to consistently apply its valuation techniques. However, the Company may consider making changes in the valuation technique if the change results in a measurement that is equally or more representative of fair value under current circumstances. Prior to the third quarter of 2008, the difference between the MBIA nonperformance credit adjusted value of certain portions of the derivative liability related to collateral defaults in excess of subordination and the unadjusted value of those same portions of the derivative liability was immaterial relative to the Company’s unrealized gains (losses) on insured derivatives reported on the Company’s statement of operations. As a result, the Company made no nonperformance risk adjustment for this portion of the derivative liability. During the third quarter of 2008, the magnitude of the difference between the MBIA nonperformance credit adjusted value of this portion of the derivative liability and the unadjusted value of the same portion of the derivative liability was material relative to the Company’s unrealized gains (losses) on insured derivatives reported on the Company’s statement of operations. The Company recognized that losses related to collateral defaults that exceeded the attachment point in certain transactions could be paid over time as opposed to immediately at MBIA’s option. Therefore, the Company adjusted its estimate of nonperformance risk to reflect the longer exposure period for this portion of the liability. The formula the Company used was the same as what it uses to adjust other unrealized losses for counterparty risk. It takes into account the upfront and annual cost of buying CDS protection in MBIA’s name in the marketplace as well as the average life of the transactions where the losses occurred.
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 dividends data. As all significant inputs are market-based and observable, warrants are categorized in Level 2 of the fair value hierarchy.
Gross Financial Guarantees-The Company estimates the fair value of its gross financial guarantee liability using a discounted cash flow model with significant inputs that include (i) an assumption of expected loss on financial guarantee policies for which case basis reserves have not been established, (ii) the amount of loss expected on financial guarantee policies for which case basis reserves have been established, (iii) the cost of capital reserves required to support the financial guarantee liability, and (iv) the discount rate set at MBIA Insurance Corporation’s cost of capital, as measured by the yield on its surplus notes. The discount rate incorporates the nonperformance risk of the Company and has been applied to the estimated fair values as of December 31, 2008 and 2007 to facilitate comparability. As the Company’s gross financial guarantee liability represents its obligation to pay claims under its insurance policies, the Company’s calculation of fair value does not consider future installment premium receipts or returns on invested upfront premiums as inputs.
The following fair value hierarchy table presents information about the Company’s assets (including short-term investments) and liabilities measured at fair value on a recurring basis as of December 31, 2008:
The following tables present information about changes in Level 3 assets (including short-term investments) and liabilities measured at fair value on a recurring basis for the year ended December 31, 2008:
Gains and losses (realized and unrealized) included in earnings pertaining to Level 3 assets and liabilities for the year ended December 31, 2008 are reported on the consolidated statements of operations as follows:
The Company elected, under SFAS 155, to record at fair value certain financial assets and liabilities that contain embedded derivatives. Changes in fair value of these hybrid financial instruments are reflected in “Net gains (losses) on financial instruments at fair value and foreign exchange” on the Company’s consolidated statement of operations.
The Company’s fixed-maturity portfolio consists of high-quality (average rating double-A) taxable and tax-exempt investments of diversified maturities. Other investments primarily comprise equity investments, including those accounted for under the equity method in accordance with APB 18 and highly rated perpetual securities that bear interest and are callable by the issuer. The following tables present the amortized cost and fair value of available-for-sale fixed-maturity and other investments included in the consolidated investment portfolio of the Company as of December 31, 2008 and 2007:
Fixed-maturity investments carried at fair value of $14 million and $13 million as of December 31, 2008 and 2007, respectively, were on deposit with various regulatory authorities to comply with insurance laws.
The following table presents the distribution by contractual maturity of available-for-sale fixed-maturity investments at amortized cost and fair value as of December 31, 2008. Contractual maturity may differ from expected maturity because borrowers may have the right to call or prepay obligations.
Included in the preceding tables are investments that have been insured by MBIA Corp. (“MBIA Insured Investments”). As of December 31, 2008, MBIA Insured Investments at fair value represented $3.5 billion or 17% of the consolidated investment portfolio. Conduit segment investments represented $2.4 billion or 12% of the consolidated investment portfolio and were all insured by MBIA Corp. Without giving effect to the MBIA guarantee of the MBIA Insured Investments, the underlying ratings (those given to an investment without the benefit of MBIA’s guarantee) of the MBIA Insured Investments as of December 31, 2008 are reflected in the following table. Amounts represent the fair value of such investments including the benefit of MBIA Corp.’s guarantee. The ratings in the following table are the lower underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating agency, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment.
The following tables present the gross unrealized losses of held-to-maturity investments as of December 31, 2008 and 2007. Held-to-maturity investments are reported at amortized cost on the Company’s balance sheet. The table segregates investments that have been in a continuous unrealized loss position for less than twelve months from those that have been in a continuous unrealized loss position for twelve months or longer.
As of December 31, 2008 and 2007, the Company’s available-for-sale fixed-maturity, equity and held-to-maturity investment portfolios’ gross unrealized losses totaled $2.8 billion and $1.3 billion, respectively. The weighted average contractual maturity of securities in an unrealized loss position as of December 31, 2008 and 2007 was 16 years and 18 years, respectively. As of December 31, 2008, there were 570 securities that were in an unrealized loss position for a continuous twelve-month period or longer with aggregate unrealized losses of $1.9 billion. Within the 570 securities, the book value of 486 securities exceeded market value by more than 5% as presented in the following table:
For 2008, net realized losses in other investments of $23 million related to the sales of perpetual equity securities. For 2007, other investment net realized losses of $6 million included a write-down of $11 million for the Bear Stearns High Grade Structured Credit Strategies L.P. Other investment net realized gains of $24 million in 2006 were primarily due to the sale of a common stock investment in RAM Holdings, Inc., the holding company of RAM Reinsurance Company, Ltd., which generated a realized gain of $11 million.
The investment management services operations have entered into derivative transactions primarily consisting of interest rate, cross currency, total return swaps, principal protection guarantees and credit default swaps. Interest rate swaps have been entered into to hedge the risks associated with fluctuations in interest rates or fair values of certain contracts. Cross currency swaps have been entered into to hedge the variability in cash flows resulting from fluctuations in foreign currency rates. Total return swaps are entered into to enable the Company to earn returns on certain obligations without directly owning the underlying obligations. The Company has also provided loss protection on certain MBIA Municipal Investor Service Corporation (“MBIA-MISC”) managed municipal pools that invest in highly rated short-term fixed-income securities. Such protection is accounted for as a derivative under SFAS 133 and is included as part of the Company’s principal protection guarantees. CDSs were 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 investment management business.
Certain interest rate and cross currency swaps qualify as cash flow hedges and fair value hedges under SFAS 133. The cash flow hedges mitigate or offset fluctuations in cash flows arising from variable rate assets or liabilities. The unrealized gains and losses relating to the cash flow hedges are reported in accumulated other comprehensive income (loss) and will be reclassified into earnings as interest revenue and expense are recognized on the hedged assets and liabilities. The fair value hedges are used to protect against changes in the market value of the hedged assets or liabilities. The gains and losses relating to the fair value hedges are recorded directly in earnings. Cash flow and fair value hedges are hedging existing assets, liabilities or forecasted transactions. During 2008, the Company recorded losses of $0.9 million (net of tax) and gains of less than $0.1 million in earnings within net gains (losses) on financial instruments at fair value and foreign exchange due to the ineffectiveness of fair value hedges and cash flow hedges, respectively.
The conduits primarily enter into interest rate and cross currency swaps as economic hedges against interest rate and currency risks. The cross currency swaps qualify as fair value hedges of foreign currency risk under SFAS 133. During 2008, the Company recorded losses of $2 million (net of tax) in earnings due to the ineffectiveness of these hedges. The Company also recorded losses of $3 million (net of tax) on economic hedges that did not qualify for hedge accounting under SFAS 133.
The corporate operations have entered into a cross currency swap to hedge foreign exchange risks related to the issuance of certain MBIA long-term debt in accordance with the Company’s risk management policies. The cross currency swap has been designated as a cash flow hedge and hedges the variability arising from currency exchange rate movements on the foreign denominated fixed rate debt. Changes in the fair value of the cross currency swap are recorded in accumulated other comprehensive income (loss). As the debt is revalued at the spot exchange rate in accordance with SFAS 52, an amount that will offset the related transaction gain or loss arising from the revaluation will migrate each period from accumulated other comprehensive income (loss) into earnings. This cash flow hedge was 100% effective during 2008.
The notional values of all derivative instruments by business operations as of December 31, 2007 are as follows:
The following table presents information about credit derivatives sold (insured) by the Company’s insurance operations that were outstanding as of December 31, 2008. Credit ratings represent the lower of underlying ratings currently assigned by Moody’s, S&P or MBIA.
Referenced credit ratings assigned by MBIA to insured credit derivatives are derived by the Company’s surveillance group in conjunction with representatives from its new business and risk divisions. In assigning an internal rating, current status reports from issuers and trustees, as well as publicly available transaction-specific information, are reviewed. Also, where appropriate, cash flow analyses and collateral valuations are considered. The maximum potential amount of future payments (undiscounted) on CDSs are estimated as the notional value plus any additional debt service costs, such as interest or other amounts owing on CDSs. Refer to “Note 17: Net Insurance in Force” for further information about the Company’s sold credit derivatives, including the maximum potential undiscounted payments, recourse provisions and collateral arrangements. The maximum potential amount of future payments (undiscounted) on insured swaps, total return swaps and credit linked notes sold are estimated as the notional value of such contracts.
The Company manages counterparty credit risk on an individual counterparty basis through master netting agreements covering derivative transactions in the investment management services and corporate operations. These agreements allow the Company to contractually net amounts due from a counterparty with those amounts due to such counterparty when certain triggering events occur. The Company only executes swaps under master netting agreements, which typically contain mutual credit downgrade provisions that generally provide the ability to require assignment or termination in the event either MBIA or the counterparty is downgraded below a specified
As of December 31, 2008 and 2007, the Company reported derivative assets of $1.4 billion and $1.7 billion, respectively, and derivative liabilities of $7.0 billion and $5.0 billion, respectively, which are shown separately on the Company’s consolidated balance sheets. The following tables present the amount of the derivative assets and liabilities by business operations for the years ended December 31, 2008 and 2007. The net changes in derivative assets and derivative liabilities were primarily due to the $1.8 billion loss on insured credit derivatives.
The statement of operations impact for all derivative transactions for 2008 was an after-tax decrease in net income of $1.6 billion. The impact of all derivative transactions for 2007 was an after-tax decrease in net income of $2.2 billion while the impact for 2006 was an after-tax increase in net income of $84 million. The statement of operations impact of derivative activity is broken down into revenues, realized gains (losses) and other settlements on insured derivatives, unrealized gains (losses) on insured derivatives, net realized gains (losses), net gains (losses) on financial instruments at fair value and foreign exchange and expenses. For derivatives that have been designated as qualifying hedges, income and expense are recorded as an adjustment to those of the hedged items. The following tables present the impact described above on the 2008, 2007 and 2006 statements of operations by business operation.
Through MBIA’s insurance operations, the Company provides credit enhancement services to issuers of obligations that may involve issuer-sponsored special purpose entities (“SPEs”). An SPE may be considered a VIE as defined by FIN 46(R) to the extent the SPE’s total equity at risk is not sufficient to permit the SPE to finance its activities without additional subordinated financial support or if its equity investors lack any one of the characteristics of a controlling financial interest including (i) the ability to make significant decisions through voting rights, (ii) the right to receive the expected residual returns of the entity, or (iii) the obligation to absorb the expected losses of the entity. The holder of a variable interest that will absorb the majority of the expected losses of the VIE, receive the majority of the expected returns of the VIE, or both, is required to consolidate the VIE. The variable interest holder required to consolidate a VIE is considered to be the primary beneficiary under FIN 46(R). A variable interest holder determines whether it is the primary beneficiary of the VIE at initial recognition of its variable interest in the VIE and reconsiders its determination if certain events occur in a subsequent reporting period.
The Company generally makes this determination based on a qualitative assessment of the design and purpose of the VIE, the capital structure and other variable interests that will absorb expected losses. If the Company cannot make the determination based on a qualitative analysis, a quantitative analysis is used. The Company generally provided credit protection on the most senior obligations issued by VIEs, and at inception of the contract, its exposure generally had more subordination than necessary to achieve triple-A credit ratings from credit rating agencies. MBIA generally does not absorb the majority of the expected losses and is not the primary beneficiary as the result of its guarantees of insured obligations issued by VIEs. The Company generally considers its guarantee of principal and interest payments of insured obligations, given nonperformance by a nonconsolidated VIE, to be a significant variable interest.
In the fourth quarter of 2008, additional variable interests were acquired in two VIEs which have outstanding obligations insured by MBIA, and a subordinated interest was acquired in a newly formed entity considered to be a VIE. Based on qualitative assessments, the Company determined that it is the primary beneficiary of the aforementioned VIEs and consolidated the assets and liabilities of the entities as of December 31, 2008.
The following table presents the total assets of nonconsolidated VIEs in which the Company holds a significant variable interest as of December 31, 2008. The table also presents the Company’s maximum exposure to loss in comparison to the carrying value of liabilities resulting from financial guarantees and insured CDSs as of December 31, 2008. The Company has aggregated nonconsolidated VIEs based on the underlying credit exposure of the insured obligation. Refer to “Note 7: Derivative Instruments” for information about the Company’s valuation of insured derivatives. Additionally, as the majority of the Company’s loss and LAE reserves relate to guarantees of VIEs, refer to “Note 12: Loss and Loss Adjustment Expense Reserves” for information about the Company’s loss and LAE activity.
The maximum exposure to loss as a result of the Company’s interest in the VIE is represented by net insurance in force. Net insurance in force is the maximum future payments of principal and interest, net of cessions to reinsurers, which may be required under commitments to make payments on insured obligations issued by nonconsolidated VIEs, assuming a full credit event occurs. The maximum exposure to loss presented in the preceding table is included in and not incremental to the net insurance in force presented in “Note 17: Net Insurance in Force.”
In the advisory segment of its investment management services operations, the Company provides collateral management services to six VIEs. Additional variable interests are held in certain of these VIEs in the form of either credit protection provided on VIE obligations or investment in a VIE obligation. The Company evaluates each VIE to determined whether its combined variable interests in each respective VIE will absorb the majority of the expected losses of the VIE, receive the majority of the expected returns of the VIE, or both. The Company is not the primary beneficiary of the aforementioned VIEs. Significant variable interests resulting from credit protection provided on obligations issued by three of the VIEs are presented in table above. The Company does not hold a significant variable interest in any of the remaining three VIEs.
As of December 31, 2008, a Company sponsored nonconsolidated funding conduit held no material assets and had no obligations outstanding, and as of December 31, 2007 had $1.2 billion in commercial paper outstanding. The Company has no liquidity obligation to fund nonconsolidated funding conduits.
In the conduit segment of its investment management services operations, the Company manages and administers two multi-seller conduit SPEs, Triple-A One and Meridian Funding Company, LLC (collectively, the “Conduits”). The Conduits invest in various types of financial instruments, such as debt securities, loans, lease receivables and trade receivables, and obligations issued by SPEs, and funds the investments through the issuance of commercial paper and/or medium-term notes. The assets and liabilities of the Conduits are supported by credit enhancement provided through MBIA Corp. The Conduits are designed to provide issuers an efficient source of funding for issued obligations, and to provide an opportunity for MBIA Corp. to issue financial guarantee insurance policies.
The Conduits are VIEs and are consolidated by the Company as the primary beneficiary. MBIA has included on its balance sheet the assets and liabilities of each Conduit, which consist primarily of various types of investments funded by commercial paper and/or medium-term notes, and has included in its statement of operations the operating revenues and expenses of the Conduits. Certain of MBIA’s consolidated subsidiaries have invested in Conduit debt obligations or have received compensation for services provided to the Conduits. As such, MBIA has eliminated intercompany transactions with the Conduits from its balance sheet and statement of operations. After the elimination of such intercompany assets and liabilities, total assets and liabilities of the Conduits were $2.5 billion and $2.1 billion, respectively, as of December 31, 2008 and $4.4 billion and $4.3 billion, respectively, as of December 31, 2007. Creditors of the Conduits do not have recourse to the general assets of MBIA outside of financial guarantee policies provided on obligations issued by the Conduits.
Under certain non-insurance derivative contracts entered into by the Company, collateral postings are required by either MBIA or the counterparty when the aggregate market value of derivative contracts entered into with the same counterparty exceeds a predefined threshold. Cash or securities may be posted as collateral at the option of the party posting the collateral. As of December 31, 2008, the Company did not hold cash collateral from derivative counterparties but posted cash collateral to derivative counterparties of $92 million. As of December 31, 2008, the Company had securities with a fair value of $284 million posted to derivative counterparties. Refer to “Note 7: Derivative Instruments” for a further discussion on collateralized derivative transactions.
The Company reports cash received or posted in its consolidated statements of cash flows as either operating, investing or financing consistent with the classification of the asset or liability that created the posting requirement.
In the fourth quarter of 2008, the Company terminated its Tender Option Bond (“TOB”) trades bringing its short-term debt to zero. A TOB trade is a repackaging of municipal bonds, effectively providing MBIA with leveraged securitized financing of long-term bonds at short-term tax-exempt rates. At December 31, 2007, floating rate certificates related to the TOB trades included in short-term debt totaled $13 million. The aggregate weighted average interest rate as of December 31, 2007 was 3.52%.
Callable at any time at the greater of 100.00 or the present value of the remaining scheduled payments of principal and interest.
Liquidity loans presented in the preceding table represent borrowings under liquidity facilities. Triple-A One, an MBIA-administered multi-seller conduit consolidated in the Company’s conduit segment, issues commercial paper to fund the purchase of assets from structured finance clients. Assets purchased by Triple-A One are insured by MBIA Corp. Triple-A One maintains backstop liquidity facilities for each transaction, covering 100% of the face amount of commercial paper outstanding, with banks rated A-1/P-1 or better by S&P and Moody’s respectively. These liquidity facilities are designed to allow Triple-A One to repay investors in the event of a market disruption in which Triple-A One is unable to issue new commercial paper to replace maturing commercial paper. The financial guarantee policies issued by MBIA to insure the assets of Triple-A One cannot be accelerated to repay maturing commercial paper or borrowings under liquidity facilities and only guarantee ultimate payments over time relating to the assets. During 2008, conditions in the asset-backed commercial paper market deteriorated making it increasingly difficult for Triple-A One to issue new commercial paper at commercially acceptable rates to refund maturing obligations. Accordingly, Triple-A One began borrowing under its liquidity facilities to repay maturing commercial paper. By September 2008, these facilities were drawn in full and Triple-A One ceased issuing commercial paper. All commercial paper holders were repaid in full and borrowings under liquidity facilities, which totaled $345 million as of December 31, 2008, will be repaid as the assets purchased by Triple-A One mature. The Company expects that the facilities will be fully repaid by 2037. The interest rate applicable to $250 million of borrowings is one-month LIBOR plus 0.75% and the interest rate applicable to $95 million of borrowings is one-month LIBOR plus 0.425%.
Note 10: Short-Term Debt, Long-Term Debt and Other Borrowing Arrangements (continued)
Obligations under investment agreement contracts are recorded as liabilities on the Company’s consolidated balance sheet based upon proceeds received plus unpaid accrued interest at the balance sheet date. Upon the occurrence of certain contractually agreed-upon events, some of these funds may be withdrawn prior to their expected withdrawal dates by the investor. Additionally, certain investment agreements provide for early termination at the option of the investor upon the downgrade of MBIA Corp. to certain credit rating levels. Such terminations significantly reduced outstanding investment agreement balances during 2008.
Investment agreements have been issued with either fixed or floating interest rates in both U.S. dollars and foreign currencies. As of December 31, 2008, the annual interest rates on these agreements ranged from 0.17% to 7.93% and the weighted average interest rate was 4.41%. As of December 31, 2007, the annual interest rates on these agreements ranged from 2.50% to 7.93% and the weighted average interest rate was 4.96%. Principal payments due under these investment agreements in each of the next five years ending December 31 and thereafter, based upon expected withdrawal dates, are as follows:
The Company’s Insured Portfolio Management Division (“IPM”) monitors MBIA’s outstanding insured obligations with the objective of minimizing losses. IPM meets this objective by identifying issuers that, because of deterioration in credit quality or changes in the economic, regulatory or political environment, are at a heightened
risk of defaulting on debt service of obligations insured by MBIA. In such cases, IPM works with the issuer, trustee, bond counsel, servicer, underwriter and other interested parties in an attempt to alleviate or remedy the problem and avoid defaults on debt service payments. IPM works closely with the Company’s Risk Management function and the applicable business unit to analyze insured obligation performance and credit risk parameters, both before and after an obligation is insured.
Insured obligations are monitored periodically. The frequency and extent of such monitoring is based on the criteria and categories described below. Insured obligations that are judged to merit more frequent and extensive monitoring or remediation activities due to a deterioration in the underlying credit quality of the insured obligation or the occurrence of adverse events related to the underlying credit of the issuer are assigned to a surveillance category (“Caution List-Low,” “Caution List-Medium,” “Caution List-High,” or “Classified List”) depending on the extent of credit deterioration or the nature of the adverse events. IPM monitors insured obligations assigned to a surveillance category more frequently and, if needed, develops a remediation plan to address any credit deterioration. The Company does not establish any case basis reserves for insured obligations that are assigned to “Caution List-Low,” “Caution List-Medium,” or “Caution List-High.” In the event MBIA determines that it must pay a claim or that a claim is probable and estimable with respect to an insured transaction, it places the insured transaction on its “Classified List” and establishes a case basis reserve. The following provides a description of each surveillance category:
Reported within “Loss and loss adjustment expense reserves” on MBIA Inc.’s consolidated balance sheets.
Costs associated with remediating insured obligations assigned to “Caution List-Low,” “Caution-List-Medium,” and “Caution List-High” are recorded as loss prevention expenses (“LPE”) as incurred and are included in operating expenses on the Company’s consolidated statements of operations. When the Company is reimbursed for LPE, such reimbursement is recorded as income when received and included in “Fees and reimbursements” on the Company’s consolidated statements of operations. Costs associated with remediating insured obligations assigned to the Company’s “Classified List” are recorded as LAE. LAE is recorded as part of the Company’s provision for its unallocated loss reserve and included in “Losses and loss adjustment” on the Company’s consolidated statement of operations. Case basis reserves related to LAE are established by transferring amounts from the Company’s unallocated loss reserve to specific case basis LAE reserves and are included in “Loss and loss adjustment expense reserves” on the Company’s consolidated balance sheets. The following table provides information about the expenses, reimbursements and reserves net of recoveries (gross and net of reinsurance) related to remedial actions for insured obligations included in the Company’s surveillance categories:
The Company is required to establish a valuation allowance against its deferred tax asset when it is more likely than not that all or a portion of the deferred tax asset will not be realized. All evidence, both positive and negative, needs to be identified and considered in making the determination. Future realization of the existing deferred tax
Approximately $1.7 billion of the net deferred tax asset was a result of the cumulative unrealized losses of $4.8 billion, which excludes credit impairments, primarily related to insured credit derivatives. The Company believes that it is more likely than not that its total $1.7 billion in deferred tax assets associated with the unrealized losses of $4.8 billion will be realized as the Company expects the unrealized losses to substantially reverse over time, at which point the related deferred tax asset will reverse. As such, no valuation allowance with respect to this item was established. In its conclusion, the Company considered the following evidence (both positive and negative):
The Company realized capital losses in 2008. The Company established a valuation allowance against the entire deferred tax asset related to the expected capital loss carryforward (after the allowable three-year carryback and expected capital gains) and substantially all of the deferred tax asset related to other than temporary impairments.
As of December 31, 2008, the Company has not experienced an ownership change under Section 382. However, had one occurred as of December 31, 2008, the ownership change, in itself, would not have had a material impact on the Company’s financial position or results of operations. The Company has already established a full valuation allowance against its capital loss carryforwards and the Company has the ability and intent to hold securities with a built-in loss as of December 31, 2008 to maturity or until such time as the value recovers as not to trigger a built-in loss. Additionally, the Company expects to have sufficient income to utilize its alternative minimum tax credit, which may be carried forward indefinitely. The Company had no NOL carrryforwards as of December 31, 2008.
Treatment of Undistributed Earnings of Certain Foreign Subsidiaries under APB 23, “Accounting for Income Taxes-Special Areas”
connection with the adoption of FIN 48, the Company has elected to classify interest and penalties as components of income taxes. The total amount accrued for interest and penalties was $4 million at the date of adoption, and the amount of interest and penalties during 2008 was not material.
At December 31, 2008 and December 31, 2007, respectively, the total amounts of unrecognized tax benefit were $19 million and $38 million. During 2008, the Company reduced its unrecognized tax benefits by $23 million as a result of changes in judgment and settlements with taxing authorities.
It is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within the next 12 months due to the possibility of the conclusion of all the tax examinations. The range of this possible change in the amount of uncertain tax benefits cannot be estimated at this time.