At our corporate headquarters in Philadelphia, Pennsylvania, we lease approximately 163,031 square feet of office space under a lease that expires in August 2017. In addition, we also lease the following:
Approximately 121,000 square feet of office space (approximately 55,000 square feet of which we sublease to others, including 28,386 square feet subleased to C-BASS and 2,616 square feet subleased to Sherman) for our financial guaranty operations in New York City. The lease for this space expires in 2015;
Approximately 500 square feet of office space for our Australian operations in Sydney, Australia. The lease for this space expires in March 2008, and we have no present plans to renew this lease;
4,786 square feet of office space in Boca Raton, Florida for other operations. The lease for this space expires in 2012; and
15,269 square feet and 27,360 square feet of office space for our data centers in Philadelphia, Pennsylvania and Dayton, Ohio, respectively. The leases for these offices expire in August 2015 (Philadelphia) and September 2012 (Dayton). Under the Dayton lease, we have an early termination option that can be exercised anytime after April 2007, upon 90 days notice.
Our business segments are mortgage insurance, financial guaranty and financial services. The following table shows the percentage of our equity allocated to each business segment at December 31, 2007:
Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions located throughout the U.S. and select countries outside the U.S. We provide these products and services primarily through our wholly-owned subsidiaries, Radian Guaranty Inc., Amerin Guaranty Corporation, and Radian Insurance Inc. (which we refer to as “Radian Guaranty,” “Amerin Guaranty,” and “Radian Insurance,” respectively). Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made mostly to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to Freddie Mac and Federal National Mortgage Association (“Fannie Mae”). We sometimes refer to Freddie Mac and Fannie Mae as “Government Sponsored Enterprises” or “GSEs”.
Traditional Mortgage Insurance. Our mortgage insurance segment, through Radian Guaranty, offers primary and pool mortgage insurance coverage on residential first-lien mortgages. At December 31, 2007, primary insurance on domestic first-lien mortgages made up approximately 91% of our total domestic first-lien mortgage insurance risk in force, and pool insurance on domestic first-lien mortgages made up approximately 9% of our total domestic first-lien mortgage insurance risk in force.
Non-traditional Mortgage Credit Enhancement. We used Radian Insurance to provide credit enhancement for mortgage-related capital market transactions and to write credit insurance on mortgage-related assets, including net interest margin securities (“NIMS”), international insurance and reinsurance transactions, second-lien mortgages, home equity loans and credit default swaps (collectively, we refer to the risk associated with these transactions as “other risk”). We also insured second-lien mortgages through Amerin Guaranty. We are no longer writing insurance on NIMS, second-lien mortgages or credit default swap business.
International Mortgage Insurance. We recently cancelled the authorization of Radian Europe Limited (“Radian Europe”) to engage in the business of insurance in the United Kingdom and other European Union member states. No business had been written by Radian Europe. The capital held by Radian Europe was distributed back to Radian Guaranty in the fourth quarter of 2007. We have written our existing international mortgage insurance business through Radian Insurance. On February 26, 2008, S&P downgraded Radian Insurance from AA- to A-. Radian Insurance had eight active international transactions at the time of the S&P downgrade. Of these transactions, five have early termination clauses that were triggered as a result of the downgrade which allow our counterparties to terminate these transactions. On March 4, 2008, Standard Chartered Bank in Hong Kong informed us that they wished to terminate their contract with Radian Insurance, effective immediately. While we still are in the process of assessing the validity of the notice and the potential impact of termination, there is a possibility that Radian Insurance could be required to return to Standard Chartered Bank, or to transfer to another insurer, unearned premium related to this transaction. Unless extended, this transaction was expected to expire at the end of 2009. If the remaining four transactions also are terminated, we could be required to return or transfer to another insurer additional unearned premiums. We believe the S&P downgrade will make it difficult for us to continue to write international mortgage insurance business through Radian Insurance, and we are in the process of exploring other alternatives for writing such business.
Structured Finance. Insurance of structured finance obligations, including collateralized debt obligations (“CDOs”) and asset-backed securities (“ABS”), consisting of funded and non-funded (“synthetic”) obligations that are payable from or tied to the performance of a specific pool of assets. Examples of the pools of assets that underlie structured finance obligations include corporate loans and bonds, residential and commercial mortgages, a variety of consumer loans, equipment receivables and real and personal property leases. The structured finance obligations we insure are generally rated investment-grade at the time we issue our insurance policy, without the benefit of our insurance;
Financial Solutions. Financial solutions products (which we include as part of our structured finance business), including guaranties of securities exchange clearinghouses, excess-Securities Investor Protection Corporation (“SIPC”) insurance for customers of brokerage firms and excess-Federal Deposit Insurance Corporation (“FDIC”) insurance for customers of banks; and
In October 2005, we exited the trade credit reinsurance line of business. Accordingly, this line of business has been placed into run-off and we have ceased initiating new trade credit reinsurance contracts.
International Financial Guaranty Insurance. RAAL accounted for $14.4 million (or 12.0%) of financial guaranty’s direct premiums written in 2007, compared to $9.2 million (or 5.8%) of financial guaranty’s direct premiums written in 2006.
Our financial services segment includes the credit-based businesses conducted through our affiliates, Credit-Based Asset Servicing and Securitization LLC (“C-BASS”) and Sherman Financial Group LLC (“Sherman”). We currently hold a 46% equity interest in C-BASS and a 21.8% equity interest in Sherman.
Third Quarter Impairment. During the third quarter there were several events that significantly impacted C-BASS. Those events included the following:
On July 26 and 27, 2007, C-BASS received approximately $200 million in margin calls bringing the total margin calls for the month to $362.7 million. As of the close of business on July 27th, C-BASS had paid only $263.5 million of the $362.7 million in outstanding margin calls. As a result of margin calls from lenders that C-BASS had not been able to meet, C-BASS’s purchases of mortgages and mortgage securities and its securitization activities ceased.
On July 29, 2007, we concluded that there were indicators that a material charge for impairment of our investment in C-BASS was required under accounting principles generally accepted in the United States of America (“GAAP”); however, we could not determine the amount, or range of amounts, of the potential impairment until financial information was received from C-BASS. In November 2007, we received financial statements from C-BASS as of September 30, 2007, at which point we made a final determination with respect to impairment.
On September 19, 2007, in connection with the sale of a portion of our equity interests in Sherman, we entered into an Option Agreement with Meeting Street Investments LLC (“MS LLC”), an entity owned by Sherman’s management. Under the Option Agreement, we granted to MS LLC an irrevocable option (the “Call Option”) to require us to sell to MS LLC all of our remaining interests in Sherman at any time during the one year period following September 19, 2007. The purchase price under the Call Option, if exercised, will be equal to: (1) the product of (a) our ownership percentage in Sherman as of the date of sale under the Option Agreement and (b) $1.5 billion, minus (2) 50% of all future distributions made by Sherman with respect to our remaining interests in Sherman through the date of sale under the Option Agreement. We estimated that this call option had a fair value of $0 at December 31, 2007.
On September 4, 2007, facing market conditions that had made combining the companies significantly more challenging, we and MGIC entered into a Termination and Release Agreement relating to the Agreement and Plan of Merger. As a result of this agreement, we and MGIC terminated the Agreement and Plan of Merger, abandoned the merger contemplated by the merger agreement and released each other from related claims. Neither party made a payment to the other in connection with the termination.
As a holder of credit risk, our results are subject to macroeconomic conditions and specific events that impact the production environment and credit performance of our underlying insured assets. The current mortgage cycle, characterized by declining home prices in certain markets, deteriorating credit performance of mortgage assets-particularly Alternative A (“Alt-A”) and subprime-and reduced liquidity for many participants in the mortgage industry, has had, and we believe will continue to have, a significant impact on the results of operations for each of our business segments.
During 2007, the current housing and credit cycle resulted in significant losses in our traditional mortgage insurance business, as well as in certain non-traditional mortgage insurance products-NIMS, second-lien mortgages and mortgage-backed securities-that we insure.
Traditional Mortgage Insurance. Our traditional mortgage insurance business experienced increasingly poor financial results during the second half of 2007. We experienced an accelerating trend of higher delinquencies in
the second half of 2007, primarily driven by the poor performance of the late 2005 through 2007 vintage books of business, a lack of refinance capacity in the current mortgage market, which has been forcing many borrowers, in particular those with adjustable rate mortgages (“ARMs”), into default, and from home price depreciation in many parts of the U.S. While losses generally have increased across all mortgage insurance product lines, a disproportionate percentage of our increased losses are attributable to Alt-A mortgages. Markets in California and Florida, where the Alt-A product and ARMs are prevalent, continue to have a significant negative impact on our mortgage insurance business results. Approximately 37% of the total increase in our mortgage insurance loss reserves during 2007 was attributable to these states, which together represent approximately 18% of our mortgage insurance risk in force.
In addition to the increase in new delinquencies during 2007, our mortgage insurance loss provision at December 31, 2007, when compared to December 31, 2006, was negatively impacted by higher loan balances on delinquent loans, higher rates of delinquencies moving into claim status (referred to as the “claim rate”), a decrease in the cure rate of defaults and an increase in claims paid. During 2007, an increase in both the claim rate and the amount that we will pay if a default becomes a claim (referred to as “claim severity”) resulted in incremental increases in our mortgage insurance loss reserves throughout the year. In addition, we refined our loss reserving methodology in the fourth quarter of 2007 to assume that the deteriorating trends in mortgage insurance claim rates will continue for the next three successive quarters. We believe this assumption is necessary to further align our claim rate expectations with our expectations for continuing home price depreciation, a lack of available credit for many borrowers seeking to refinance and a deficiency in underwriting standards on a portion of the 2005 through 2007 vintage mortgage production, each of which will make it more likely that existing defaults will ultimately result in a claim. This change increased our loss reserves for first-lien mortgages by an additional $136.4 million in the fourth quarter of 2007.
It is likely that ultimate losses on our traditional mortgage insurance portfolio will continue to be driven mainly by declining home prices over the next three years in most of the U.S. In light of continuing declines, we expect incurred losses from our traditional mortgage insurance portfolio will be over 200% of earned premiums in 2008. Beyond 2008, given the current uncertainty in the credit and housing markets and the overall economy, we cannot predict with any degree of certainty what our ultimate losses on our traditional mortgage insurance portfolio will be. We have reviewed a number of stress scenarios that we believe are potentially reasonable, and in each of these cases we believe that our claims paying resources will be sufficient. In some of these scenarios, however, we may require additional capital, if not to support our capital position or ratings, then to ensure greater market confidence among our lending customers and others.
We have protected against some of the losses that may occur in excess of our expectations on some of the risk associated with non-prime and riskier products by reinsuring it through Smart Home transactions. In 2004, we developed Smart Home as a way to effectively transfer risk from our portfolio to investors in the capital markets. Smart Home mitigates our risk against catastrophic loss in extremely adverse conditions, concentrated positions and riskier products such as subprime mortgages. Approximately 5% and 10% of our primary mortgage insurance risk in force was included in Smart Home arrangements at December 31, 2007 and 2006, respectively. In these transactions, we reinsure the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions.
Since August 2004, we have completed four Smart Home arrangements. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2007 are as follows:
Ceded premiums written for the years ended December 31, 2007, 2006 and 2005 were $11.0 million, $12.0 million and $3.5 million, respectively, related to the Smart Home transactions. Ceded premiums earned for 2007, 2006 and 2005 were $11.4 million, $12.3 million and $3.0 million, respectively, related to the Smart Home transactions. Ceded losses in 2007 were $9.8 million as a result of the Smart Home transactions. There were no ceded losses in 2006 or 2005.
The persistency rate, which is defined as the percentage of insurance in force that remains on our books after any 12-month period was 75.4% for the twelve months ended December 31, 2007, compared to 67.3% for the
In the fourth quarter of 2005, we wrote $7.3 billion in notional value of credit protection in credit default swap form on two large AAA tranches of mortgage-backed securities, one in Germany and one in Denmark. As of December 31, 2007, we had incurred an approximate $2 million cumulative unrealized loss on these transactions. Despite the large notional exposure to this business, our remaining subordination for these transactions is substantial, and we do not currently foresee any reasonable scenario under which we would be liable for credit losses with respect to such exposures. With respect to one of these transactions, which has been outstanding almost five years, has incurred aggregate losses as of December 31, 2007 of approximately .002%, and has a weighted average LTV of 50%, we would not be liable for paying losses until cumulative losses reached 6.12%. With respect to the second transaction, which has been outstanding over three years, has incurred aggregate losses as of December 31, 2007 of .001% and has a weighted average LTV of 62%, we would not be liable for paying losses until cumulative losses reached 4.0%. In both of these transactions, our attachment point for losses remains over ten times current expected losses.
2007 presented a difficult business production environment for the financial guaranty industry and Radian Asset Assurance in particular. Due to losses incurred by several of our financial guarantor competitors on their RMBS, CDOs of asset-backed securities and other credit positions, uncertainty as to the extent of future losses among all financial guarantors, including us, and perceived instability in the franchise values and ratings of many of the financial guarantors, credit spreads for all financial guarantors, including us, have widened significantly. This resulted in a material reduction in the financial benefit that our credit protection provides to issuers of both public and structured finance transactions that we insure and a reduced perceived benefit to holders of insured debt from the financial guaranty insurance we provide. Many transactions that would normally have been marketed with some form of financial guaranty insurance protection are either not going to market or are being sold without the benefit of financial guaranty insurance. As a result, there is significant reduction in the volume of transactions for which financial guaranty insurance is a viable option, which makes it more difficult for us to write new business in the current credit environment, and reduces the volume of transactions written by companies that cede business to us.
Our financial guaranty business has exposure to RMBS and CMBS. We retain this exposure through our insurance of CDOs that include asset classes of RMBS or CMBS (referred to as “CDO RMBS” and “CDO CMBS”) and through our insurance of asset-backed securities of RMBS outside of CDOs (referred to as “Non-CDO RMBS”). We do not have any exposure to CMBS outside of CDOs that we insure. Our exposure to RMBS and CMBS is both through our direct insurance and through our reinsurance of business assumed from other financial guarantors.
The third transaction, representing the remaining $100 million of CDO of ABS net par outstanding, is rated BBB by S&P. At December 31, 2007, we had established a $100 million reserve for this transaction, representing our entire exposure. We began paying claims on this transaction in January 2008, and have paid claims totaling our entire $100 million exposure. For more information regarding this credit see “Results of Operations-Financial Guaranty-Year Ended December 31, 2007 Compared to Year Ended December 31, 2006-Provision for Losses.”
The loan collateral pool supporting the CMBS Obligations consists of 15,000 loans with a balance of approximately $200 billion. The underlying loan collateral is well diversified both geographically and by property type.
Sherman increased collection revenues from portfolios owned and experienced continued growth in its banking segment during 2007, compared to 2006. These increases were offset by higher amortization and interest expense, as well as expenses related to joint venture operations. Sherman’s results for 2008 are expected to continue to be profitable, although less profitable when compared to Sherman’s results for 2007. As discussed above, as a result of the rapid deterioration of the subprime mortgage market, C-BASS’s liquidity position became materially stressed in late July 2007 due to excess margin calls from its lenders, resulting in our concluding that our investment had been materially impaired. See “Business Summary-Financial Services- C-BASS” above.
The following table summarizes our consolidated results of operations for 2007, 2006 and 2005 (in millions):
Provision for Losses. The provision for losses for 2007 was $1,299.4 million, up from $369.3 million for 2006. This increase was driven mainly by the deteriorating credit performance in our mortgage insurance business, but also reflects credit deterioration in our financial guaranty portfolio. Our mortgage insurance segment experienced a significant increase in delinquencies compared to 2006, as well as an increase in delinquent loan sizes, a continuation of the aging on existing delinquencies, an increase in the projected claim rates and an increase in severity, all of which require a higher reserve. See “Results of Operations-Mortgage Insurance-Year Ended December 31, 2007 Compared to Year Ended December 31, 2006-Provision for Losses” below. The provision for losses in our financial guaranty segment also increased in 2007 compared to 2006, mainly as a result of a $100 million reserve established for the one direct market-value transaction remaining in our financial guaranty portfolio as discussed above. This was partially offset by a reduction of reserves on our trade credit reinsurance business.
Provision for Second-Lien Premium Deficiency. A provision for second-lien premium deficiency of $195.6 million was established in 2007. See “Critical Accounting Policies-Reserve for Second-Lien Premium Deficiency” below.
Policy Acquisition Costs. Policy acquisition costs were $113.2 million for 2007, an increase of $1.6 million or 1.4% from $111.6 million reported for 2006. In our mortgage insurance segment, estimates of expected gross profit, which are driven in part by persistency and loss development for each underwriting year and product type, are used as a basis for amortization and are evaluated regularly. The total amortization recorded to date is adjusted by a charge or credit to our consolidated statements of income if actual experience or other evidence suggests that earlier estimates should be revised. During 2007, amortization expense was impacted by both an increase in persistency rates and updates to our loss ratio assumptions. In addition, a decrease in net premiums earned from our trade credit reinsurance business offset some of the overall increase in policy acquisition costs in 2007.
Equity in Net (Loss) Income of Affiliates. Equity in net loss of affiliates was $416.5 million for 2007, compared to equity in net income of affiliates of $257.0 million for 2006. The decrease in 2007 was driven by the impairment of our total equity investment in C-BASS and the write-down of the $50 million credit facility with C-BASS. While Sherman’s earnings remained relatively stable, our equity in net income of affiliates for the second half of 2007 reflects our reduced holdings in Sherman, effective September 1, 2007, as a result of our sale during the third quarter of 2007 of a portion of our interests in Sherman. Included in equity in net loss of affiliates for 2007 is $451.4 million of losses related to C-BASS, compared to income of $133.9 million for 2006. Sherman contributed $84.8 million of equity in net income of affiliates for 2007 compared to $123.8 million for 2006. For more information, see “Results of Operations-Financial Services” below.
Net Premiums Written and Earned. Consolidated net premiums written for 2006 were $1,112.0 million, an $11.3 million or 1.0% increase from $1,100.7 million for 2005. Consolidated net premiums earned for 2006 were $1,015.8 million, a $2.9 million or 0.3% decrease from $1,018.7 million earned for 2005. Premiums earned in our mortgage insurance segment increased year over year, in part, due to an increase in premiums earned from the significant amount of non-traditional products, in particular international mortgage insurance, which we
wrote in 2005. Our financial guaranty segment experienced a decrease in premiums earned during 2006 due mostly to the run-off of the trade credit reinsurance business, offset in part by earned premiums on structured direct products. The amount reported for net premiums written in 2005 reflects a reduction of $54.7 million in financial guaranty written premiums related to the 2005 recapture, which also reduced earned premiums by $4.5 million.
Other Income. Other income decreased to $20.9 million for 2006 from $25.3 million for 2005, mainly due to a lower level of income from contract underwriting.
Provision for Losses. The provision for losses for 2006 was $369.3 million, down from $390.6 million for 2005. This was due to a decrease in both the mortgage insurance provision, due mostly to lower primary defaults and claims and the incorporation of new assumptions into our loss reserve model, and the financial guaranty provision, related mostly to the run-off of the trade credit reinsurance business.
Policy Acquisition Costs. Policy acquisition costs were $111.6 million for 2006, a decrease of $4.3 million or 3.7% from $115.9 million reported for 2005. The amount reported in 2006 reflects a $4.7 million acceleration of deferred policy acquisition cost amortization in the mortgage insurance segment and commissions related to international deals. In the fourth quarter of 2006, we updated our product mix assumptions and corresponding amortization periods based upon the latest available information. The changes resulted in a reduced amortization period for deferred costs related to our second-lien business and structured transactions compared to the amortization period for our first-lien business, due to the difference in credit quality of the underlying loans. The amount reported for 2005 includes a $5.1 million acceleration of deferred policy acquisition costs, which decreased the balance of the asset to be amortized in the future. A decrease in net premiums earned from our trade credit reinsurance business caused a decrease in policy acquisition costs in 2006.
Other Operating Expenses. Other operating expenses were $242.6 million for 2006 compared to $226.0 million for 2005. The 2006 amount includes $7.0 million related to compensation expense (net of $3.8 million deferred as policy acquisition costs) recognized in accordance with SFAS No. 123R, “Share-Based Payment” (“SFAS No. 123R”). Other increases in 2006 related to higher employee costs, software expense and outside consulting and a $6.0 million write-down of capitalized software that was deemed impaired.
Interest Expense. Interest expense of $48.1 million for 2006 increased $5.1 million or 11.9% from $43.0 million for 2005, mainly due to a full year of interest on debt issued at a higher interest rate in June 2005 and a negative impact from interest rate swaps that we entered into in 2004.
Income Tax (Benefit) Provision. The consolidated effective tax rate was 28.4% for 2006, compared to 29.4% for 2005. During the quarter ended June 30, 2006, we determined that certain liabilities to taxing authorities were no longer probable due to the expiration of the statute of limitations on the related tax positions. As a result, approximately $10 million in tax liabilities were reversed through the provision for income taxes in the second quarter of 2006. In addition, the lower tax rate reflects an overall increase in the ratio of income generated from tax-advantaged securities compared to income generated from operations.
The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2007, 2006 and 2005 (in millions):
Net (Loss) Income. Our mortgage insurance segment’s net loss for 2007 was $695.4 million, compared to $282.8 million of net income for 2006. The 2007 loss was mainly due to the significant disruptions in the housing and mortgage credit markets during 2007, which resulted in a significant increase in our mortgage insurance provision for losses, a significant mark-to-market loss reserve related to NIMS and credit default swaps, and a provision for second-lien premium deficiency. Partially offsetting these losses was an income tax benefit due to the losses incurred in 2007 and a decrease in operating expenses.
Net Investment Income. Net investment income attributable to our mortgage insurance business for 2007 was $148.3 million, an increase of $10.0 million or 7.2%, compared to $138.3 million for 2006. Investment income for 2007 reflects an increase in investable assets and higher interest rates.
Other Income. Other income for 2007 was $11.3 million, a $1.8 million or 13.0% decrease from $13.1 million in 2006. Other income, which mostly includes income related to contract underwriting services, decreased in 2007 as a result of lower contract underwriting volume.
Provision for Losses. The provision for losses for 2007 was $1,201.3 million, compared to $348.6 million for 2006. The increase in 2007 was mainly attributable to increases in delinquencies and claims paid, the aging of existing delinquencies, larger loan balances, a higher ratio at which delinquencies are moving to claim and increased severity. Following a seasonal decrease in delinquencies in the first quarter of 2007, rising interest rates and home price declines resulted in a significant increase in delinquencies during the third and fourth quarters of 2007, particularly among Alt-A and 2005 through 2007 vintage subprime loans, with primary areas of deteriorating performance in California, Florida and several Midwestern states. The ARM portion of our portfolio also contributed to the rise in delinquencies in 2007 as resets forced many homeowners into default without the ability to refinance.
Other Operating Expenses. Other operating expenses were $143.9 million for 2007, a decrease of $28.1 million or 16.3%, compared to $172.0 million for 2006. Included in 2007, was $13.4 million of expense related to our terminated merger with MGIC. Excluding these expenses for 2007, other operating expenses decreased due to foreign currency gains and lower employee costs and office and computer equipment depreciation. The amount reported for 2006 included a $6.0 million write-off of software that was deemed impaired. Contract underwriting expenses for 2007 and 2006, including the impact of reserves for remedies, were $22.6 million and $28.1 million, respectively.
Net Premiums Written and Earned. Net premiums written for 2006 were $849.1 million, a $28.5 million or 3.2% decrease from $877.6 million for 2005. Net premiums earned for 2006 were $812.0 million, a $5.1 million or 0.6% increase compared to $806.9 million for 2005. The decrease in net premiums written in 2006 was mainly due to a decrease in premiums written from the primary business and from NIMS, partially offset by an increase in premiums written from domestic credit default swaps. The increase in premiums earned mainly related to an increase of $7.3 million from international transactions, partially offset by a decrease in premiums earned related to our NIMS transactions.
Provision for Losses. The provision for losses for 2006 was $348.6 million, compared to $359.1 million for 2005. This decrease was mostly due to a decrease in primary delinquencies and claims received year over year, as well as the incorporation into our loss reserve model of positive results from our heightened loss management efforts throughout 2006 on both first- and second-lien delinquencies. Despite a decrease in delinquencies, there was a shift in existing delinquencies to the later stages of delinquencies, which requires a higher reserve as these delinquencies are closer to a claim payment or foreclosure. In addition, we experienced a significant increase in filed claims during 2006 related to a second-lien structured transaction in which we split losses with our counterparty on a 50-50 basis. This transaction is discussed above under “Overview of Business Results-Mortgage Insurance-Second-Liens”.
Other Operating Expenses. Other operating expenses were $172.0 million for 2006, an increase of $19.3 million or 12.6% compared to $152.7 million for 2005. For 2006, other operating expenses included increases in employee costs due to the implementation of SFAS No. 123R, consulting costs, office equipment, software depreciation and a $6.0 million write-off of capitalized software that was deemed impaired, partially offset by a decrease in contract underwriting expenses and reserves for remedies. Contract underwriting expenses for 2006 and 2005, including the impact of reserves for remedies, were $28.1 million and $35.7 million, respectively.
During 2006, loans underwritten via contract underwriting for flow business accounted for 12.6% of applications, 12.3% of commitments for insurance and 11.4% of insurance certificates issued, compared to 16.6%, 16.3% and 15.7%, respectively, for 2005.
Income Tax (Benefit) Provision. The effective tax rate for 2006 was 26.6% compared to 28.8% in 2005. The tax rate for 2006 reflects an allocation of the reversal of prior years’ reserves for uncertain tax positions that expired June 30, 2006. In addition the lower tax rate reflects an overall increase in the ratio of income generated from tax-advantaged securities compared to income generated from operations.
(b) Loan-to-value ratios: The ratio of the original loan amount to the original value of the property.
In the last three years, we wrote a significant amount of pool risk where we are in a second-loss position. In these transactions, we will only pay claims if pool losses are greater than any applicable deductible.
Other risk in force was $10.5 billion at December 31, 2007, compared to $10.3 billion at December 31, 2006 and $9.7 billion at December 31, 2005. Each of these years included a higher level of risk in force related to credit default swaps, resulting from two large international mortgage securitizations completed in 2005, comprising a total of $8.2 billion of risk in force at December 31, 2007, $7.9 billion of risk in force at December 31, 2006, and $7.5 billion of risk in force at December 31, 2005, in which we provided credit enhancement at a AAA level. Due to foreign currency changes since we underwrote such risk, the current U.S. dollar-denominated risk has increased. See “Overview of Business Results-Mortgage Insurance-Credit Default Swaps” above.
Approximately 39% or $234 million of the total NIMS risk in force at December 31, 2007 was written in the first half of 2007. Almost all of our 2007 NIMS business was with large national lenders as we continued to diversify away from doing NIMS with monoline subprime lenders. In addition, the 2007 NIMS bonds and the mortgage securitizations underlying the NIMS bonds, have been structured with more over-collateralization to meet adjustments to the ratings methodologies employed by the major ratings agencies. Despite these positive characteristics, NIMS performance has been volatile, particularly in the current housing market downturn. As a result, we cannot be certain that the 2007 vintage NIMS bonds will perform any better or worse than earlier vintages. We ceased writing new NIMS business during the second quarter of 2007. See “Overview of Business Results-Mortgage Insurance-NIMS” for a discussion of our ultimate loss projections with respect to NIMS.
Claim activity is not spread evenly throughout the coverage period of a book of business. Historically, relatively few claims on prime business are received during the first two years following issuance of a policy and on non-prime business during the first year. Claim activity on prime loans has historically reached its highest level in the third through fifth years after the year of policy origination, and on non-prime loans this level is expected to be reached in the second through fourth years. Based on these trends, approximately 67.2% of our primary risk in force and approximately 37.1% of our pool risk in force at December 31, 2007 had not yet reached its highest claim frequency years. The late 2005 through 2007 business has experienced default and claim activity sooner than has been the case for historical books of business. Because it is difficult to predict both the timing of originating new business and the cancellation rate of existing business, it is also difficult to predict, at any given time, the percentage of risk in force that will reach its highest claim frequency years on any future date. Direct claims paid for 2007 were $509.4 million compared to $313.4 million for 2006 and $320.3 million for 2005.
A higher level of claims exists in the auto states of Ohio and Michigan as problems with the domestic auto industry and related industries have depressed economic growth, employment and house prices in these states. In Colorado, the high level of claims is a result of property value declines in Denver and areas north of Denver.
In the mortgage insurance segment, the highest state concentration of primary risk in force at December 31, 2007 was Florida at 9.0% compared to 9.2% at December 31, 2006 and 9.5% at December 31, 2005. California accounted for 15.8% of the mortgage insurance segment’s direct primary new insurance written for the year ended December 31, 2007 compared to 12.8% and 13.8% for the years ended December 31, 2006 and 2005.
(2) Related to ceded losses on captive transactions and Smart Home.
The loss reserve as a percentage of risk in force was 3.0% at December 31, 2007, compared to 1.7% at December 31, 2006 and 1.6% at December 31, 2005.
The following table reconciles our mortgage insurance segment’s beginning and ending reserves for losses and loss adjustment expenses (“LAE”) for 2006 and 2007 (in thousands):
The following table summarizes the results of operations for our financial guaranty segment for the years ended December 31, 2007, 2006 and 2005 (in millions):
The following table shows net premiums written and earned by our financial guaranty segment’s various product lines for 2007, 2006 and 2005:
The financial guaranty segment derives a substantial portion of its premiums written from a small number of direct primary insurers. In 2007, three primary insurers accounted for $90.6 million or 39.3% of the financial guaranty segment’s gross written premiums. In 2006, three primary insurers accounted for $91.3 million or 34.7% of the financial guaranty segment’s gross written premiums. Excluding the 2005 recapture, two primary insurers accounted for $74.9 million or 26.8% of the financial guaranty segment’s gross written premiums in 2005. No other primary insurer accounted for more than 10% of the financial guaranty segment’s gross written premiums in 2007, 2006 or 2005.
Change in Fair Value of Derivative Instruments. Change in the fair value of derivative instruments was a loss of $808.9 million for 2007, compared to a gain of $12.4 million for 2006. The decrease in the change in fair value of derivative instruments for 2007 was mainly a result of spread widening related to direct corporate
CDOs, CDO subprime RMBS and CDO CMBS exposures for which unrealized losses in the amount of $549.7 million, $146.5 million and $56.0, respectively, were recorded. We determine fair value of our derivative financial guaranty contracts as discussed in “Critical Accounting Policies-Derivative Instruments and Hedging Activity” in this Item 7 below. The 2007 amount includes a $35.2 million increase in the fair value of derivative instruments related to the value of the put options on CPS. On March 2, 2006, Radian Asset Assurance and its counterparty to a derivative transaction agreed to terminate one transaction and to amend the one other derivative financial guaranty contract that we had with this same counterparty. As a result, included in the change in the fair value of derivative instruments for 2006, was a $17.2 million charge in connection with the termination of this derivative contract. On February 14, 2007, the counterparty also terminated the transaction amended in March 2006, at no cost to either party. As a result of this termination, we had a $10.2 million gain in the fair value of derivative instruments in 2007. See discussion below in “Provision for Losses” for our policy on intensified surveillance credits.
Provision for Losses. The provision for losses was $98.0 million for 2007, compared to $20.7 million for 2006. The provision for losses reported for 2007 includes a $100 million allocated non-specific reserve (which represents 100% of the principal exposure) on one BBB-rated credit as discussed below. The increase in the provision for losses in 2007 was partially offset by favorable loss development on trade credit reinsurance. The provision for losses in 2007 represented 50.2% of net premiums earned for 2007, compared to 10.1% for 2006. Our financial guaranty business paid $11.4 million in insurance claims for 2007 and $15.8 million in claims for 2006 related to a single manufactured housing transaction with Conseco Finance Corp. that was fully reserved for in 2003. We expect that losses related to this transaction will continue to be paid out over the next few years.
We established loss reserves on our non-derivative financial guaranty contracts as discussed in “Critical Accounting Policies-Reserve for Losses” in this Item 7 and in Note 2 of Notes to Consolidated Financial Statements. We have allocated non-specific reserves of $141.3 million on 16 intensified surveillance credits (representing an aggregate par amount of $362.3 million) at December 31, 2007, compared to $26.2 million on three credits at December 31, 2006 and $27.8 million on one credit at December 31, 2005.
There were no direct derivative financial guaranty contracts with $25 million or greater in exposure identified as an intensified surveillance credit at December 31, 2007 or 2006. Two of the six intensified surveillance credits with $25 million or greater in exposure identified at December 31, 2005 were derivative financial guaranty contracts. One of these credits, representing $248 million in exposure, was terminated in March, 2006. The second credit expired in November 2006, without claim. In accordance with GAAP, we do not establish loss reserves on our derivative financial guaranty contracts. Instead, gains and losses on derivative financial guaranty contracts are derived from internally generated models that take into account both credit and market spreads.
Policy Acquisition Costs. Policy acquisition costs were $45.4 million for 2007, compared to $46.6 million for 2006. The year over year decrease was largely the result of the continued run-off in our trade credit reinsurance line of business. Included in policy acquisition costs for 2007 were $12.0 million of origination costs related to derivative financial guaranty contracts, compared to $11.9 million for 2006.
Other Operating Expenses. Other operating expenses were $49.3 million for 2007, compared to $59.8 million for 2006. The year over year decrease resulted primarily from a decrease in employee costs and depreciation. The expense ratio (which includes other operating expenses and policy acquisition costs) of 48.2% for 2007 was down from 52.2% for 2006.
Other Operating Expenses. Other operating expenses were $59.8 million for 2006, compared to $65.0 million for 2005. The year over year decrease resulted primarily from a decrease in consulting costs allocated
Interest Expense. Interest expense was $16.6 million for 2006, compared to $15.1 million for 2005. Both periods include interest on our long-term debt, including the impact of interest-rate swaps, which was allocated to the financial guaranty segment.
Our financial services segment has been significantly affected by the on-going disruption in the housing and mortgage credit markets during 2007. As discussed above under “Business Summary-Financial Services,” the rapid decline in the subprime mortgage market during July 2007 was largely responsible for the impairment of our interest in C-BASS. As a result of the $468 million write-off of our investment in C-BASS during the third quarter and the write-off of the $50 million credit facility with C-BASS during the fourth quarter, our financial services segment incurred a net loss for 2007 of $154.7 million, compared to net income of $163.3 million for 2006 and $136.2 million for 2005. Equity in net loss of affiliates was $416.5 million for 2007, compared to equity in net income of affiliates of $257.0 million for 2006 and $217.7 million for 2005. Sherman accounted for $84.8 million of the total equity in net income of affiliates for 2007, compared to $123.1 million in 2006 and $110.3 million in 2005. While Sherman’s earnings remained relatively stable year over year, our 2007 equity in net income of affiliates reflects our reduced holdings in Sherman, effective September 1, 2007, as a result of our sale during the third quarter of 2007 of a portion of our interest in Sherman. We recorded a pre-tax gain of $181.7 million on that transaction.
C-BASS accounted for $501.4 million of the equity in net loss of affiliates for 2007, compared to equity in net income of affiliates of $133.9 million for 2006 and $107.8 million for 2005.
(1) Our reserve for losses and loss adjustment expenses reflects the application of accounting policies described below in “Critical Accounting Policies-Reserve for Losses.” As of December 31, 2007, we have financial guaranty non-specific reserves of $190.5 million, including allocated non-specific reserves of $141.3 million and unallocated non-specific reserves of $49.2 million. The payments due by period are management’s estimates and assume that all of the loss reserves included in the table will result in claim payments.
liability for unrecognized tax benefits in 2007 associated with the provisions of FIN No. 48. However, due to the high degree of uncertainty regarding the timing of future cash outflows associated with some of our FIN No. 48 liabilities, we cannot make a reasonably reliable estimate of the period of cash settlement for the remaining $74.2 million of liability for unrecognized tax benefits.
Radian Group has agreed to perform, up to a maximum amount of $300 million, Radian Guaranty’s obligations to Radian Insurance under the Net Worth and Liquidity Maintenance Agreement discussed above, in the event that Radian Guaranty is not able to or permitted by the Pennsylvania Insurance Department to perform under the agreement.
Prior to our acquisition of Enhance Financial Services Group (“EFSG”) in 2001, EFSG issued a guaranty of payment of the liabilities and obligations of its subsidiary, Enhance Reinsurance (Bermuda) Limited, deriving from any insurance or reinsurance contract (the “Enhance Guaranty”), for the purpose of maintaining certain regulatory solvency and liquidity margin requirements of the Bermuda Monetary Authority. Following our acquisition of EFSG, Radian Group issued a guaranty for the benefit of EFSG to make funds available to EFSG for its performance of the Enhance Guaranty, to the extent that EFSG is unable to satisfy those obligations.
When an SPE does not meet the QSPE criteria, consolidation is assessed pursuant to FIN No. 46R. Under FIN No. 46R, a VIE is defined as an entity that: (1) lacks enough equity investment at risk to permit the entity to finance its activities without additional subordinated financial support from other parties; (2) has equity owners that lack the right to make significant decisions affecting the entity’s operations; and/or (3) has equity owners that do not have an obligation to absorb the entity’s losses or the right to receive the entity’s returns. FIN No. 46R requires a variable interest holder (i.e., a counterparty to a VIE) to consolidate the VIE if that party will receive the majority of the expected residual returns of the VIE, absorb a majority of the expected losses of the VIE, or both. This party is considered the primary beneficiary.
A determination of whether we have a controlling financial interest in an entity is initially made at the time we become involved with the entity. In those instances where we are the primary beneficiary, the assets and liabilities of the VIE are consolidated on our balance sheet. Certain reconsideration events may occur which cause us to re-assess our initial determination of whether an entity is a VIE or non-VIE. If the entity becomes a VIE, we perform an assessment of consolidation of that entity. Those reconsideration events generally are:
Smart Home-In 2004, we developed a program referred to as “Smart Home,” for reinsuring risk associated with non-prime mortgages and riskier products. These arrangements, through the use of SPE structures, effectively transfer risk from our portfolio to investors in the capital markets. Since August 2004, we have completed four Smart Home arrangements. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2007 are as follows:
Financial guaranty contracts written with SPEs may be written directly with the SPE or indirectly through a credit default swap done with a primary credit enhancer who issues a financial guaranty to the beneficial interest holders in the SPE. These SPEs are commonly employed in CDO transactions where portfolio managers are permitted to buy and sell assets.
Included in “Collateralized Debt Obligations” above is exposure to a commercial paper conduit currently in liquidation. Our maximum exposure is fully reserved and is discussed further in “Results of Operations-Financial Guaranty-Year Ended December 31, 2007 Compared to December 31, 2006-Provision for Losses.”
for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) our ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost; (vii) unfavorable changes in forecasted cash flows on asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies.
The unrealized losses of 12 months or greater duration as of December 31, 2007 on the majority of the securities in this category were caused by market interest rate movement. Certain securities, mainly those issued by financial firms with exposure to subprime residential mortgages, experienced spread widening during 2007. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities had been in a continuous unrealized loss position, at December 31, 2006.
During the third quarter of 2007, we sold a portion of our interest in Sherman for approximately $278 million in cash, which helped our capital and liquidity position in our mortgage insurance business. In December 2007, Radian Guaranty contributed its remaining ownership interest in Sherman of $104 million to Radian Group. Our insurance subsidiaries may be limited in the amount that they may pay in dividends to us during the next 12 months without first obtaining insurance department approval.
C-BASS did not pay dividends to us during 2007 compared to dividends of $46.9 million paid to us during 2006. We do not expect to receive any future dividends from C-BASS. Sherman paid $51.5 million and $103.7 million of dividends to us during 2007 and 2006, respectively. All dividends from C-BASS and Sherman have been initially distributed to our insurance subsidiaries, and therefore, are subject to regulatory limitations, as discussed above. In the fourth quarter 2007, we received regulatory approval for Sherman to be owned by us rather than Radian Guaranty. Therefore, any future dividends from Sherman would be received at the holding company and would not be subject to insurance regulatory approval.
We cancelled the authorization of Radian Europe to engage in the business of insurance in the United Kingdom and other European Union member states. The capital held by Radian Europe, which was approximately $62 million, net of expenses, was distributed back to Radian Guaranty in the fourth quarter of 2007.
Our sources of working capital consist mostly of premiums written by our insurance operating subsidiaries and investment income at both the parent company and operating subsidiary levels. Working capital is applied mainly to the payment of our insurance operating subsidiaries’ claims and operating expenses. Cash flows from operating activities for 2007 were $301.8 million, compared to $488.5 million for 2006. Positive cash flows are invested pending future payments of claims and other expenses.
Our most significant need for liquidity beyond the next twelve months is the repayment of the principal amount of our outstanding long-term debt and other borrowings, a portion of which is due in 2011. We expect to meet our long-term liquidity needs using excess working capital, sales of investments, additional borrowings under our credit facility, if necessary, or through the private or public issuance of debt or equity securities. The current turmoil in the mortgage market has created a situation where we would likely not be able to refinance our long-term debt if it were due currently. We expect that the market cycle will improve by 2011, but cannot be certain this will happen.
On December 13, 2006, we entered into a $400 million unsecured revolving credit facility that is scheduled to expire on December 13, 2011. This new facility includes an additional $100 million uncommitted line that we may exercise at our option, subject to our obtaining necessary commitments from lenders.
Since September 2002, our board of directors has authorized five separate repurchase programs, including the current 6.0 million share program, for the repurchase, in the aggregate, of up to 21.5 million shares of our common stock on the open market. At December 31, 2007, we had repurchased approximately 20.4 million shares under these programs for a total cost of approximately $1.0 billion, including 0.4 million shares during 2007 at a cost of approximately $22.8 million. All share repurchases made to date were funded from available working capital, and were made from time to time depending on market conditions, share price and other factors.
Stockholders’ equity was $2.7 billion at December 31, 2007 compared to $4.1 billion at December 31, 2006. Stockholders’ equity decreased as a result of: (1) a net loss of $1.3 billion, (2) a decrease in the market value of securities available for sale of $55.5 million, net of tax, (3) our repurchase of approximately 400 thousand shares
We establish reserves to provide for losses and the estimated costs of settling claims in both our mortgage insurance and financial guaranty segments. Setting loss reserves in both businesses involves significant use of estimates with regard to the likelihood, magnitude and timing of a loss.
In the mortgage insurance segment, reserves for losses generally are not established until we are notified that a borrower has missed two consecutive payments. We also establish reserves for associated LAE, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” (“SFAS No. 60”) specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses. We maintain an extensive database of claim payment history and use models, based on a variety of loan characteristics, including the status of the loan as reported by its servicer, and macroeconomic factors such as regional economic conditions that involve significant variability over time, as well as more static factors such as the estimated foreclosure period in the area where the default exists, to help determine the likelihood that a default will result in a claim, the amount that we will pay if a default becomes a claim and based on these estimates, the appropriate loss reserve at any point in time.
With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for delinquent loans in the early stage of delinquency are more volatile in nature than for loans that are in the later stage of delinquency, which generally require a larger reserve. As the delinquency proceeds toward foreclosure, there is more certainty around these estimates as a result of the aged status of the delinquent loan, and adjustments are made to loss reserves to reflect this updated information. If a default cures, historically, a large percentage of defaulted loans have cured before going to claim, although this rate has fallen significantly in the current deteriorating housing environment, the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. As a result of changes in estimates of losses on prior years defaults, the mortgage insurance provision for losses increased by $74.3 million in 2007 and decreased by $117.2 million and $86.8 million in 2006 and 2005, respectively. In the mortgage insurance segment, we do not specifically reserve for defaults that we believe to have occurred but that have not been reported to us on a timely basis by lending institutions or for loans that we believe have cured but that have not been reported to us on a timely basis. We believe this number would not be material. All estimates are continually reviewed and adjustments are made as they become necessary.
We generally do not establish reserves for loans that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second-loss position, we calculate what the reserve would have been if there had been no deductible. If the existing deductible is greater than the reserve amount for any given default, we do not establish a reserve for the default. We generally do not establish loss reserves for expected future claims on insured mortgages that are not in default or believed to be in default. See “Reserve for Second-Lien Premium Deficiency” below for an exception to this general principle.
We considered the sensitivity on loss reserve estimates at December 31, 2007, by assessing the potential changes resulting from a hypothetical parallel shift in severity and claim rate. For example, assuming all other factors remain constant, for every 1% change in claim severity or claim rate, we estimated a $12.1 million change in our loss reserves at December 31, 2007.
In the financial guaranty segment, we establish loss reserves on our non-derivative financial guaranty contracts. We establish case reserves for specifically identified impaired credits that have defaulted and allocated non-specific reserves for specific credits that we expect to default. In addition, we establish unallocated non-specific reserves for our entire portfolio based on estimated statistical loss probabilities. As discussed below, the reserving policies used by the financial guaranty industry are continuing to evolve and are subject to change.
Our unallocated non-specific reserves are established over time by applying expected default factors to the premiums earned during each reporting period. The expected lifetime losses for each credit are determined by multiplying the expected frequency of losses on that credit by the expected severity of losses on that credit and multiplying this number, the loss factor, by that credit’s outstanding par amount. The expected frequency and severity of losses for each credit is generated from three sources-two that are published by major rating agencies and one that is generated by a proprietary internal model-based on the product class, published rating and term to maturity for each credit. We set the expected lifetime losses for each credit at a point in the range between the highest and lowest expected lifetime loss factors generated by the rating agency and internally generated models. The default rates published by rating agencies tend to be very low because we mostly insure investment-grade obligations that, historically, have a very low probability of default. Although the default rate is low, the amount of losses upon default can be very high because we tend to insure large financial obligations. Because of the low incidence of losses on financial guaranty obligations, it is also very difficult to estimate the timing of losses on our insured obligations for which we have not yet established a case reserve or allocated non-specific reserve. The default factors for 2007 approximated 10% of earned premiums on public finance credits and 15% of earned premiums on structured finance credits. The default factors for the years ended December 31, 2006 and 2005 approximated 10% of earned premiums on public finance credits and 20% of earned premiums on structured finance credits. As a result of favorable loss development, we were able to lower the default factor for structured finance credits in 2007.
The gains and losses on direct derivative financial guaranty contracts are derived from internally generated models. Estimated fair value amounts are determined by using market information to the extent available, and in most cases, observable market information must be combined with unobservable market inputs in order to estimate fair value. These unobservable market inputs are required to consider differences that exist in the collateral underlying our contracts and the collateral underlying market indices as well as the structural features of our contracts. For corporate pool CDOs, credit spreads on individual names in our collateral pool are used to derive an equivalent risk tranche on an industry standard credit default swap index. When credit spreads on individual names are not available, the average credit spread of similar companies is used. For certain of our non-corporate CDOs, dealer quotes on similar structured transactions are used. In determining our December 31, 2007 valuations, generally market indices are used to estimate fair value on these deals. In determining gains and losses on RMBS and CMBS CDOs, we utilize a generic spread from ABX and CMBX. The generic spread utilized is based on the nature of the underlying collateral in each deal. The gains and losses on Trust Preferred securities deals are derived from internally generated models utilizing observable CDS spreads of a group of investment grade and high-yield financial institutions. Because our collateral does not directly track market indices that are available, adjustments to account for differences in term, credit quality, and diversification of underlying collateral are made in our internal models. In addition, our internal models are adjusted to account for differences between our financial guaranty contracts and similar derivative contracts executed by other primary market participants, the primary difference being the lack of a requirement to post collateral with our counterparties when our contracts are in a liability position. In instances where dealer quotes are not available and market indices are not appropriate, we consider the reinsurance market to be the principal market for purposes of determining fair value, therefore, we utilize an internal model, similar to those used by reinsurers, to estimate fair value. Prior to 2007, many of our non-corporate CDOs were valued using this methodology as the reinsurance market for these products was much more robust than the current environment. Significant differences may exist with respect to the available market information and assumptions used to determine gains and losses on derivative financial guaranty contracts. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of amounts we
A summary of our derivative information and its components as of the periods indicated is as follows:
(1) The fair value of the put options on CPS. Prior to 2007, this amount was immaterial to our consolidated financial statements.
The application of SFAS No. 133, as amended, could result in volatility from period to period in gains and losses as reported on our consolidated statements of income. These gains and losses often result from changes in corporate credit or asset-backed spreads and changes in the creditworthiness of underlying corporate entities or the credit performance of the assets underlying an asset-backed security. Any incurred gains or losses on such contracts would be recognized as a change in the fair value of derivative instruments. We are unable to predict the effect this volatility may have on our financial position or results of operations.
As noted under “Reserve for Losses” above, the FASB is considering the accounting model used by the financial guaranty industry for deferred policy acquisition costs.
In April 2006, the FASB issued FASB Staff Position (“FSP”) FIN No. 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)” (“FSP FIN No. 46(R)-6”), which addresses how a reporting enterprise should determine the variability to be considered in applying FASB Interpretation No. 46(R) (“FIN No. 46R”). The variability that is considered in applying FIN No. 46R affects the determination of (i) whether the entity is a variable interest entity, (ii) which interests are variable interests in the entity and (iii) which party, if any, is the primary beneficiary of the variable interest entity. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP FIN No. 46(R)-6 became effective July 1, 2006. The adoption of this FSP has not had a material impact on our consolidated financial statements. We continue to monitor our variable interest entities for possible consolidation.
In September 2006, the SEC released Staff Accounting Bulletin (“SAB”) No. 108 (“SAB No. 108”). This release expresses the staff’s views regarding the process of quantifying financial statement misstatements and
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure financial instruments and certain other items at fair value. Items eligible for fair value measurement option established by this statement are (i) recognized financial assets and financial liabilities (with some exceptions), (ii) firm commitments that would otherwise not be recognized at inception and that involve only financial instruments, (iii) nonfinancial insurance contracts and warranties that the insurer can settle by paying a third party to provide those goods or services, and (iv) host financial instruments resulting from separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. We adopted SFAS No. 159 effective January 1, 2008 and are currently evaluating the impact of the adoption of SFAS No. 159.
In April 2007, the FASB issued FASB Staff Position (“FSP”) FIN No. 39-1, an amendment of FASB Interpretation No. 39, “Offsetting of Amounts Related to Certain Contracts” (“FSP FIN No. 39-1”). FSP FIN No. 39-1 replaces the terms “conditional contracts” and “exchange contracts” with the term “derivative instruments” and permits a reporting entity to offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement that have been offset in the statement of financial position. FSP FIN No. 39-1 is effective for fiscal years beginning after
November 15, 2007, with early adoption permitted. Management currently is considering the impact, if any, that may result from the adoption of FSP FIN No. 39-1. We will adopt FSP FIN No. 39-1 in the first quarter of 2008.
The Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 06-4, “The Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (“EITF No. 06-4”). EITF No. 06-4 addresses whether the postretirement benefit associated with an endorsement split-dollar life insurance arrangement is effectively settled in accordance with SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and APB Opinion No. 12, “Omnibus Opinion-1967”, upon entering into such an arrangement. EITF No. 06-4 is effective for fiscal years beginning after December 15, 2007. We will adopt EITF No. 06-4 in the first quarter of 2008.
The EITF reached a consensus on EITF Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF No. 06-11”). EITF No. 06-11 addresses how an entity should recognize the income tax benefit received on dividends that are (a) paid to employees holding equity-classified nonvested shares, equity-classified nonvested share units, or equity-classified outstanding share options and (b) charged to retained earnings under SFAS No 123R. EITF No. 06-11 is effective for fiscal years beginning after December 15, 2007. Management is considering the impact that may result from the adoption of EITF No. 06-11.
Management is responsible for the preparation, integrity and objectivity of the Consolidated Financial Statements and other financial information presented in this annual report. The accompanying Consolidated Financial Statements were prepared in accordance with accounting principles generally accepted in the U.S. of America, applying certain estimations and judgments as required.
The board of directors exercises its responsibility for the financial statements through its Audit and Risk Committee, which consists entirely of independent non-management board members. The Audit and Risk Committee meets periodically with management and with the independent registered public accounting firm, both privately and with management present, to review accounting, auditing, internal control and financial reporting matters.
As discussed in Note 2 and 9 and to the consolidated financial statements, as of January 1, 2007, the Company changed its method of accounting for certain investments and income taxes, respectively.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made
In our opinion, based on our audits and (as to the amounts included for Sherman Financial Group LLC for the year ended December 31, 2006) the report of the other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of Radian Group Inc. and subsidiaries at December 31, 2006, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, based on our audits and (as to the amounts included for Sherman Financial Group LLC for the year ended December 31, 2006) the report of the other auditors, such financial statement schedules as of December 31, 2006 and for each of the two years in the period ended December 31, 2006 , when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
March 1, 2007 (March 14, 2008, as to the last paragraph of Note 2 and Note 17, and Note A of Schedule II of Item 15)
We have audited the consolidated balance sheet of Sherman Financial Group LLC and subsidiaries (a Delaware limited liability company) as of December 31, 2006, and the related consolidated statements of income, members’ equity and cash flows for the year then ended (not presented separately herein). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Sherman Financial Group LLC as of and for the year ended December 31, 2005, were audited by other auditors. Those auditors expressed an unqualified opinion on those financial statements in their report dated February 9, 2006. As discussed in Note B (not presented separately herein), the Company has restated its 2005 financial statements to correct certain classifications in conformity with accounting principles generally accepted in the United States of America. The other auditors reported on the 2005 financial statements before the restatement.
As discussed above, the financial statements of Sherman Financial Group LLC as of and for the year ended December 31, 2005, were audited by other auditors. As described in Note B (not presented separately herein), these financial statements have been restated. We have audited the adjustments described in Note B to the financial statements that were applied to restate the 2005 financial statements. In our opinion, such adjustments are appropriate and have been properly applied. However, we were not engaged to audit, review or apply any procedures to the 2005 financial statements of the Company other than with respect to such adjustments and, accordingly, we do not express an opinion or any other form of assurance on the 2005 financial statements taken as a whole.
Private mortgage insurance and risk management services are provided to mortgage lending institutions located throughout the U.S. and select countries outside the U.S. through our principal mortgage guaranty subsidiaries, Radian Guaranty Inc. (“Radian Guaranty”), Amerin Guaranty Corporation (“Amerin Guaranty”) and Radian Insurance Inc. (“Radian Insurance”). Private mortgage insurance generally protects lenders from all or a portion of default-related losses on residential mortgage loans made to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgages in the secondary market, most of which are sold to Freddie Mac and Federal National Mortgage Association (“Fannie Mae”), collectively referred to as Government Sponsored Enterprises (“GSEs”). Radian Guaranty currently offers two principal types of private mortgage insurance coverage: primary and pool. At December 31, 2007, primary insurance on domestic first-lien mortgages comprised approximately 91% of domestic first-lien mortgage insurance risk in force and pool insurance comprised approximately 9% of domestic first-lien mortgage insurance risk in force. Amerin Guaranty offers mortgage insurance on second-lien mortgages, and Radian Insurance provides credit enhancement on mortgage-related assets that our monoline mortgage insurer Radian Guaranty, is not permitted to insure such as second-lien mortgages, home equity loans, net interest margin securities (“NIMS”), international insurance and reinsurance transactions and credit default swaps (collectively, we refer to the risk associated with these transactions as “other risk”).
In 2007, we cancelled the authorization of Radian Europe Limited (“Radian Europe”) to engage in the business of insurance in the United Kingdom and other European Union member states. No business was written by Radian Europe. The $62 million in capital held by Radian Europe, net of expenses related to the closure, was distributed back to Radian Guaranty in the fourth quarter of 2007.
We have written our existing international mortgage insurance business through Radian Insurance. On February 26, 2008, S&P downgraded Radian Insurance from AA- to A-. Radian Insurance had eight active international transactions at the time of the S&P downgrade. Of these transactions, five have early termination clauses that were triggered as a result of the downgrade which allow our counterparties to terminate these transactions. On March 4, 2008, Standard Chartered Bank in Hong Kong informed us that they wished to terminate their contract with Radian Insurance, effective immediately. While we still are in the process of assessing the validity of the notice and the potential impact of termination, there is a possibility that Radian Insurance could be required to return to Standard Chartered Bank, or to transfer to another insurer, unearned premium related to this transaction. Unless extended, this transaction was expected to expire at the end of 2009. If the remaining four transactions also are terminated, we could be required to return, or transfer to another insurer, additional unearned premiums.
On February 28, 2001, we acquired the financial guaranty insurance and other businesses of Enhance Financial Services Group Inc. (“EFSG”), a New York-based insurance holding company that mainly insures and reinsures credit-based risks. We acquired an ownership interest in two credit-based asset businesses (see Note 4) as part of the acquisition of EFSG. The excess of purchase price over fair value of net assets acquired of $56.7 million represents the future value of insurance profits, which is being amortized over a period that approximates the future life of the insurance book of business. At December 31, 2007, $26.5 million of this amount remained on our consolidated balance sheets. During both 2007 and 2006, we amortized $1.8 million related to this transaction.
Our financial services segment includes the credit-based businesses conducted through our affiliates, Credit-Based Asset Servicing and Securitization LLC (“C-BASS”) and Sherman Financial Group LLC (“Sherman”). We currently hold a 46% equity interest in C-BASS and a 21.8% equity interest in Sherman. See Note 4 below.
The credit ratings of Radian Group Inc. and the insurance financial strength ratings assigned to our subsidiaries may be downgraded by one or more of S&P, Moody’s or Fitch if they believe that Radian Group Inc. or such subsidiary has experienced adverse developments in its business, financial condition or operating results. The rating agencies have indicated that they are engaged in on-going monitoring of the mortgage insurance and financial guaranty industries and the mortgage-backed securities market to assess the adequacy of, and where necessary refine, their capital models. The rating agencies could take action, including by downgrading or warning of the strong possibility of downgrade with respect to one or more companies in a specific industry, upon the conclusion of their respective reviews. Although we remain in frequent contact with the rating agencies and have prepared action plans to address any rating agency actions, we are generally not provided with much advance notice of an impending rating decision, which could come at any time.
Our ratings are critical to our ability to market our products and to maintain our competitive position and customer confidence in our products. A downgrade in these ratings, or the announcement of the potential for a downgrade or any other concern relating to the on-going financial strength of our insurance subsidiaries, could have a material adverse effect on our business, financial condition and operating results. In addition, we may be required to raise capital in the event of a downgrade or the likelihood of a downgrade, which we may not be able to do on terms acceptable to us or in an amount that would be sufficient to restore or stabilize our ratings. Additional capital could dilute our existing stockholders and reduce our per-share earnings.
(3) Each S&P rating for our mortgage insurance subsidiaries is currently on CreditWatch with negative implications.
represent that portion of premiums that will be earned over the remainder of the contract period. Assumed premiums are based on information reported by ceding companies. When insured obligations are refunded or called, the remaining premiums are generally earned at that time.
We establish reserves to provide for losses and LAE in both the mortgage insurance and financial guaranty segments. Setting loss reserves in both businesses involves significant use of estimates with regard to the likelihood, magnitude and timing of a loss. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses.
Our reserve model differentiates between prime and other products and takes into account the different loss development patterns and borrower behavior that is inherent in these products, whether we are in a first- or second-loss position and whether there are deductibles on the loan. We use actuarial projection methodologies to produce a range of reserves by product and a midpoint for each product based on historical factors such as ultimate claim rates and claim severity.
On April 18, 2007, the FASB issued an exposure draft, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60” (“Exposure Draft”). The Exposure Draft clarifies how SFAS No. 60 applies to financial guaranty insurance contracts and provides guidance with respect to the timing of claim liability recognition, premium recognition and the related amortization of deferred policy acquisition costs, specifically for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS No. 133. The goal of the proposed statement is to reduce diversity in accounting by financial guaranty insurers, thereby enabling users to better understand and more readily compare insurers’ financial statements. Final guidance from the FASB regarding accounting for financial guaranty insurance is expected to be issued in 2008. If the Exposure Draft is issued as proposed, the effect on the consolidated financial statements, particularly with respect to revenue recognition and claims liability, could be material.
We record case reserves for losses and related LAE when a guaranteed obligation defaults. In the case of direct financial guaranty contracts, we determine the existence of payment default and record case reserves when we determine that a default has occurred, based on a report from the insured party or based on our surveillance efforts. In the case of financial guaranty reinsurance, we rely mostly on information provided by the primary insurer as confirmed by us, as well as specific knowledge of the claim, in recording related case reserves.
At each balance sheet date, we also evaluate both the model-generated default factors and our unallocated non-specific reserves against management’s subjective view of qualitative factors to ensure that the default factors and the unallocated non-specific reserves represent management’s best estimate of the expected losses on our portfolio of credits for which we have not established a case reserve or an allocated non-specific reserve. These qualitative factors include existing economic and business conditions, overall credit quality trends resulting from industry, geographic, economic and political conditions, recent loss experience in particular segments of the portfolio, changes in underwriting policies and procedures and seasoning of the book of business. The macroeconomic factors that we evaluate are outside of our control and are subject to considerable variability. The company specific factors that we evaluate also require that we make subjective judgments. In addition, a significant change in the size of the portfolio underlying our unallocated non-specific reserves, such as through the expiration of policies or the refunding or recapture of insured exposures, could require an adjustment to the default factors or our level of unallocated non-specific reserves.
Once a case reserve is established with respect to an insured credit, an offsetting adjustment typically is made to the non-specific reserve. This offsetting adjustment may or may not be on a dollar-for-dollar basis,
Real estate is acquired in our mortgage insurance business segment to mitigate losses. The real estate acquired is included in other assets on our consolidated balance sheets at the lower of cost or net realizable value. At December 31, 2007 and 2006, we held $3.3 million and $4.6 million, respectively, of real estate acquired to mitigate losses.
Other restructurings in our financial guaranty business segment may consist of purchasing insured debt securities to mitigate losses. Insured debt securities purchased to mitigate losses are included in other assets on our consolidated balance sheets at the lower of cost or net realizable value. Gains or losses from the holding or disposition of the securities acquired are recorded as net gains and losses on securities and derivative instruments. At December 31, 2007 and 2006, we held $1.6 million and $3.3 million, respectively, of insured debt securities purchased to mitigate losses.
We account for derivatives under SFAS No. 133, as amended and interpreted. In general, SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their respective fair values and changes in fair value recorded in net income unless the derivatives qualify as hedges. If the derivatives qualify as hedges, depending on the nature of the hedge, changes in the fair value of the derivatives are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings, or are recognized in accumulated other comprehensive income (loss) until the hedged item is recognized in earnings.
All our derivative instruments are recognized in our consolidated balance sheets as either assets or derivative liabilities, depending on the rights or obligations under the contracts. The interest-rate swaps that we have entered into qualify as hedges and are accounted for as fair value hedges. Our forward foreign currency contracts, credit protection in the form of credit default swaps within both our mortgage insurance and financial guaranty segments and NIMS do not qualify as hedges under SFAS No. 133, so changes in their fair value are included in current earnings in our consolidated statements of income. Net unrealized gains and losses on credit default swaps and certain other derivative contracts are included in either other assets or derivative liabilities on our consolidated balance sheets. See Note 16 for further discussion of our derivative instruments.
$4.9 million and $5.1 million, respectively, of policy acquisition costs in our mortgage insurance segment. Total deferred acquisition costs for mortgage insurance amortized during 2007, 2006 and 2005 was $67.8 million, $65.0 million and $62.9 million, respectively.
We provide for income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). As required under SFAS No. 109, our deferred tax assets and liabilities are recognized under the liability method, which recognizes the future tax effect of temporary differences between the amounts recorded in our consolidated financial statements and the tax bases of these amounts. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled.
In June 2006, the FASB issued FASB Interpretation 48 (“FIN No. 48”), “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109”. FIN No. 48 is effective for fiscal years beginning after December 15, 2006, and clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.
income. Amortization and accretion are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method. See Note 15 for further discussion on the fair value of investments.
Our evaluation of market declines for other-than-temporary impairment is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors regarding the issuer of the security and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by us in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) our ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost; (vii) unfavorable changes in forecasted cash flows on asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies.
Effective January 1, 2007, we began classifying securities previously classified as available for sale and the derivative component previously classified as trading securities as hybrid securities. Hybrid securities generally combine both debt and equity characteristics. Prior to 2007, the changes in fair value of the fixed-maturity component of these securities were recorded in our consolidated statements of changes in common stockholders’ equity through accumulated other comprehensive income or loss (net of tax) and the changes in fair value of the derivative component of these securities were recorded as a gain or loss in our consolidated statements of income. In accordance with SFAS No. 155, effective January 1, 2007, all changes in the fair value of the entire convertible security are now recorded as net gains or losses on securities in our consolidated statements of income. Our transition adjustment related to the adoption of SFAS No. 155 increased retained earnings at January 1, 2007 by $9.8 million, and reduced accumulated other comprehensive income by the same amount. The transition amount includes unrealized gains of $14.1 million (net of tax) and unrealized losses of $4.3 million (net of tax) related to convertible securities at December 31, 2006.
Based Compensation” and supersedes Accounting Principles Board (“APB”) Opinion No. 25. Before the adoption of SFAS No. 123R, we applied APB No. 25 to account for our stock-based compensation.
The sum of the above adjustments related to this recapture, (the “2005 recapture”) is summarized as follows:
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 (i) defines fair value, (ii) establishes a framework for measuring fair value in GAAP and (iii) expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007. We adopted SFAS No. 157 effective January 1, 2008 and are currently evaluating the impact of adoption, which could be material, on our consolidated financial statements. In accordance with SFAS No. 157, we will be required to incorporate into the fair value of our derivative instruments an adjustment that reflects the credit quality of Radian Group Inc. When valuing debt and derivative liabilities, a widening of the obligor’s credit spread results in a reduction of the fair value of the liabilities. Radian’s credit spread has widened substantially since the beginning of 2007. Between January 1, 2007 and February 29, 2008, Radian’s 5-year credit default swap spreads increased by 998 basis points, from 37 basis points to 1,035 basis points. In accordance with FSP SFAS No. 157-2, we have elected to defer the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities until January 1, 2009.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure financial instruments and certain other items at fair value. Items eligible for fair value measurement by this statement are (i) recognized financial assets and financial liabilities (with some exceptions), (ii) firm commitments that would otherwise not be recognized at inception and that involve only financial instruments, (iii) nonfinancial insurance contracts and warranties that an insurer can settle by paying a third party to provide those goods or services, and (iv) host financial instruments resulting from separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument. We adopted SFAS No. 159 effective January 1, 2008 and are currently evaluating the impact of adoption on our consolidated financial statements.
The EITF reached a consensus on EITF Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF No. 06-11”). EITF No. 06-11 addresses how an entity should recognize the income tax benefit received on dividends that are (a) paid to employees holding equity-classified nonvested shares, equity-classified nonvested share units, or equity-classified outstanding share options and (b) charged to retained earnings under SFAS No 123R. EITF No. 06-11 is effective for fiscal years beginning after December 15, 2007. Management is considering the impact, if any, that may result from the adoption of EITF No. 06-11.
Our investment portfolio consisted of the following at December 31, 2007 and 2006 (in thousands):
The contractual maturities of fixed-maturity investments are as follows (in thousands):
If a security’s fair value is below its cost basis, and it is judged to be an other-than-temporary decline, the cost basis of the security is written down to fair value through earnings as a realized loss, and the fair value becomes the new basis for the security. During 2007 and 2006, we recorded approximately $9.4 million and $10.6 million of charges, respectively, related to declines in fair value of securities (primarily small cap value stocks, convertible securities and an investment in a fund co-managed by C-BASS) considered to be other-than-temporary, which are included in the net gains on securities and derivative instruments table above. There were no such charges in 2005. At December 31, 2007, 2006, and 2005, there were no other investments held in the portfolio that were determined to be other-than-temporarily impaired. Realized gains and losses are determined on a specific identification method and are included in income.
The unrealized losses of 12 months or greater duration as of December 31, 2007 on our investments in U.S. Treasury obligations were caused by interest rate movement. The contractual terms of these investments do not
The unrealized losses of 12 months or greater duration as of December 31, 2007 on our investments in tax-exempt state and municipal securities were caused primarily by interest rate movement. Certain securities, mainly those insured by monoline insurance companies, experience credit spread widening during 2007 as a result of recent events in the subprime residential mortgage market. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
For all investment categories, unrealized losses of less than 12 months duration were generally attributable to interest rate movement. In addition, certain securities experienced spread widening due to issuers’ exposure to subprime residential mortgages. All securities were evaluated in accordance with our impairment recognition policy covering various time and price decline scenarios. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at December 31, 2007.
The following table shows our top ten investment portfolio risk concentrations at December 31, 2007:
Securities on deposit with various state insurance commissioners amounted to $17.3 million at December 31, 2007 and $10.1 million at December 31, 2006. We also had $77.0 million on deposit at December 31, 2007 and $71.6 million at December 31, 2006, for the benefit of reinsurers.
We have a 46.0% equity interest in C-BASS and a 21.8% equity interest in Sherman.
On July 29, 2007, we concluded that there were indicators that a material charge for impairment of our investment in C-BASS was required under GAAP. In November 2007, we received financial statements from C-BASS as of September 30, 2007, at which point we made a final determination with respect to impairment.
Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets that it generally purchases at deep discounts from national financial institutions and major retail corporations and subsequently seeks to collect. In addition, Sherman originates credit card receivables through its subsidiary CreditOne and has a variety of other similar ventures related to consumer assets.
2005 Restructuring of Ownership Interest. On June 24, 2005, we entered into agreements to restructure our ownership interest in Sherman. Before this restructuring, we owned 41.5% of Sherman. As part of the restructuring, we agreed to sell a 6.92% interest in Sherman to a new entity controlled by Sherman’s management team, thereby reducing our ownership interest to 34.58%. In return, the new entity controlled by Sherman’s management team paid approximately $15.65 million (which resulted in a $3.3 million loss) to us. Regulatory approval for this transaction was received in August 2005, and our ownership interest was reduced to 34.58%, retroactive to May 1, 2005. Effective June 15, 2005, Sherman’s employees were transferred to this new entity controlled by Sherman’s management team, and this entity agreed to provide management services to Sherman. Sherman’s management team also agreed to reduce significantly its maximum incentive payout under its annual incentive plan for periods beginning on or after May 1, 2005. In connection with the restructuring, we paid $1 million to have the right, in the future, to purchase an additional 6.92% interest in Sherman from the new entity controlled by Sherman’s management team for a price intended to approximate current fair market value.
2006 Restructuring of Option. On September 14, 2006, we agreed to restructure our option. In order to accommodate this restructuring, the equity interests of Sherman were reclassified, effective July 1, 2006, from a single class of equity interests into Class A Common Units and a combination of Preferred Units and Class B Common Units. As part of the reclassification, all of the authorized Class B Common Units were granted to an entity controlled by Sherman’s management. The Class B Common Units entitle Sherman’s management to 3% of Sherman’s earnings above $200 million (on an annual basis) and a right in liquidation of up to 6% of any amounts after satisfaction of a liquidation preference on the Preferred Units. The actual percentage received by the holders of Class B Common Units upon a liquidation or sale of Sherman will depend on when the sale or liquidation occurs and the value of Sherman at that time.
Three percent of the first $200 million of Sherman’s annual earnings, which amount shall be allocated to the Preferred Units on a cumulative basis before any amounts are allocated to the Class B Common Units, and 1.5% of Sherman’s annual earnings above $200 million; and
A preference in the proceeds received upon a liquidation or sale of Sherman equal to the tax basis in the preferred equity.
2007 Option Granted to Sherman’s Management. On September 19, 2007, in connection with the sale of a portion of our equity interests in Sherman, we entered into an Option Agreement with Meeting Street Investments LLC (“MS LLC”), an entity owned by Sherman’s management. Under the Option Agreement, we granted to MS LLC an irrevocable option (the “Call Option”) to require us to sell to MS LLC all of our interests in Sherman at any time during the one year period following September 19, 2007. The purchase price under the Call Option, if exercised, will be equal to: (1) the product of (a) our ownership percentage in Sherman as of the date of sale under the Option Agreement and (b) $1.5 billion, minus (2) 50% of all future distributions made by Sherman with respect to our remaining interests in Sherman through the date of sale under the Option Agreement. The Option Agreement terminates one year from September 19, 2007. We estimated that this call option had a fair value of $0 at December 31, 2007.
Our purchase of an additional interest in the common equity of Sherman in September 2006 resulted in $37.9 million of purchase accounting premium on receivables and approximately $4.0 million in goodwill and other intangibles. The amortization period of the premium on receivables is approximately three years with a higher amount of amortization recognized in the first year and declining over the life of the receivables. As a result of the sale of a portion of our equity interest in Sherman on September 19, 2007, we amortized approximately $9.4 million of premium and we wrote down $1.7 million of goodwill for the portion sold. Included in the equity in net income of affiliates for 2007 is $10.5 million of premium amortization. The remaining goodwill is evaluated annually for impairment.
The following table shows the components of the investment in affiliates balance:
We utilize reinsurance as a risk management tool, to reduce our net risk in force to manage regulatory risk-to-capital requirements and, with respect to mortgage insurance, to comply with the insurance regulations of states that require us to limit our coverage percentage of any single risk to 25%. Although the use of reinsurance does not discharge an insurer from its primary liability to the insured, the reinsuring company assumes the related liability under these arrangements. Included in other assets are unearned premiums (prepaid reinsurance) of $5.9 million and $1.0 million at December 31, 2007 and 2006, respectively.
Ceded premiums written in 2007, 2006 and 2005 include $11.0 million, $12.0 million and $3.5 million, respectively, related to the Smart Home transactions. Ceded premiums earned were $11.4 million, $12.3 million and $3.0 million in 2007, 2006 and 2005, respectively. Ceded losses in 2007 were $9.8 million as a result of the Smart Home transactions. There were no ceded losses in 2006 or 2005.
and in the loss reserve overall, which included an upward revision of the overall loss reserve on many delinquencies that existed.
Reserves for our mortgage insurance business are set at the exact point of our modeled output for loss and LAE reserves. In light of the regular adjustments made to the underlying assumptions in our model as discussed above, we believe the amount generated by our model at December 31, 2007 best represents the most accurate estimate of our future losses and LAE. We believe the high and low amounts highlighted in the table above represent a reasonable estimate of the range of possible outcomes around our recorded reserve point for the period indicated.
(1) Includes a $100.0 million increase for one credit that is a CDO of ABS for which claims have been paid equal to such reserves in the first quarter of 2008.
At December 31, 2007, 16 credits were included in our allocated non-specific reserves of $141.3 million, including a $100.0 million reserve established in 2007 related to a BBB-rated credit that is a collateralized debt obligation (“CDO”) of an asset-backed security (“ABS”). These credits have a par amount of $362.3 million. We expect that we will suffer losses with respect to these insured obligations equal to the amount reserved.
As potential losses migrate through our surveillance process toward actual defaults, we reclassify and update loss estimates among these three reserve categories. These transfers are highlighted in the table below.
In February 2003, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.625% per annum, payable semi-annually on February 15 and August 15 beginning August 15, 2003. These notes mature in February 2013. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed. We used a portion of the proceeds from the offering to repay $75.0 million in principal outstanding on 6.75% debentures issued by EFSG. The remainder was used for general corporate purposes. In April 2004, we entered into interest-rate swap contracts that effectively converted the interest rate on this fixed-rate debt to a variable rate based on a spread over LIBOR. We terminated these swaps in January, 2008.
In September 2003, Radian Asset Assurance completed a transaction for $150 million of money market committed preferred custodial trust securities (“CPS”), pursuant to which it entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), our wholly-owned subsidiary. Radian Asset Securities in turn entered into a series of three perpetual put options on its own preferred stock (on substantially identical terms to the Radian Asset Assurance preferred stock). The counterparties to the Radian Asset Securities put options are three trusts established by two major investment banks. The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more of the put options and the corresponding exercise of one or more corresponding Radian Asset Securities put options.
associated tax benefits of these items. We are contesting all such proposed adjustments relating to the IRS’s opposition of the tax benefits in question and are working with tax counsel in our defense efforts. When an examination has not been settled at the local examination division level, the IRS will usually issue a “30-day” letter which contains details of the proposed adjustments and the taxpayer’s rights to appeal. Upon receipt of the IRS’s 30-day letter, we may make a payment with the U.S. Department of the Treasury to avoid the accrual of the above-market-rate interest associated with our estimate of the potentially unsettled adjustment. We anticipate receiving the 30-day letter related to this matter and making the payment on account during the first or second quarter of 2008. The cash requirement for the payment on account is anticipated to be approximately $75.0 million to $80.0 million. Any ultimate overpayment associated with the payment on account would be recovered through a formal claim for refund process.
(2) Arizona, California, Florida, Georgia, New York, Ohio, Pennsylvania, Texas and New York City.
We act principally as a holding company for our insurance subsidiaries and do not have any significant operations of our own. Dividends from our subsidiaries, which include amounts received from our affiliates (C-BASS and Sherman), and regulated permitted payments to us under our tax-and expense-sharing arrangements with our subsidiaries, along with income from our investment portfolio, are our principal sources of cash to pay stockholder dividends and to meet our obligations. These obligations include our operating expenses, taxes and interest and principal payments on our long-term debt and other borrowings. The payment of dividends and other distributions to us by our insurance subsidiaries are limited by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In addition, although we have expense-sharing arrangements in place with our principal operating subsidiaries that require those subsidiaries to pay their share of holding company-level expenses, including interest expense on long-term debt and other borrowings, these expense-sharing arrangements may be changed at any time by the applicable state insurance departments. In addition, our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the rating agencies for us to maintain our ratings. If the cash we receive from our subsidiaries pursuant to tax- and expense-sharing arrangements is insufficient for us to fund our obligations, we may be required to seek capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all.
Radian Guaranty’s and Radian Insurance’s ability to pay dividends on their common stock is restricted by certain provisions of the insurance laws of Pennsylvania. Under Pennsylvania’s insurance laws, dividends and other distributions may only be paid out of an insurer’s unassigned surplus unless the Pennsylvania Insurance Commissioner approves additional dividends. Radian Guaranty and Radian Insurance had negative unassigned
Radian Asset Assurance Limited’s (“RAAL’s”) ability to pay dividends to Radian Asset Assurance is restricted by legal provisions in the United Kingdom whereby it may only distribute by way of dividend its accumulated realized profits (not previously distributed) less accumulated realized losses, and such dividends may not be paid out of capital. In accordance with these restrictions, $16.4 million would be available to be paid as dividends in 2008.
Under Illinois insurance regulations, Amerin Guaranty is required to maintain statutory-basis capital and surplus of $1.5 million. Amerin Guaranty’s statutory net (loss) income and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
(a) Under STAT, mortgage guaranty insurance companies are required to establish each year a contingency reserve equal to 50% of premiums earned in such year. Such amount must be maintained in the contingency reserve for 10 years after which time it is released to unassigned surplus. Prior to 10 years, the contingency
reserve may be reduced with regulatory approval to the extent that losses in any calendar year exceed 35% of earned premiums for such year.
(d) STAT financial statements only include a provision for current income taxes as a component of net income. Deferred taxes, subject to certain limitations set forth in Statutory Accounting Principles (“SAP”) 10, are recorded in the STAT Balance Sheets with any changes thereto recognized via a change in statutory surplus. Purchases of tax and loss bonds are accounted for as investments under STAT. GAAP financial statements provide for current and deferred income taxes in our consolidated statements of income, and purchases of tax and loss bonds are recorded as prepaid federal income taxes in our consolidated balance sheets.
For the years ended December 31, 2007 and 2006, the adoption of SFAS No. 123R resulted in incremental stock-based compensation of $9.8 million and $10.8 million, respectively, of which $3.4 million and $3.8 million was deferred as policy acquisition costs. The incremental stock-based compensation expense for the year ended December 31, 2007 caused loss before income taxes and net loss to increase by $6.4 million and $4.2 million, respectively, and both basic and diluted earnings per share to decrease by $0.05 per share. The incremental stock-based compensation expense for the year ended December 31, 2006 caused income before income taxes and net income to decrease by $7.0 million and $4.6 million, respectively, and both basic and diluted earnings per share to decrease by $0.06 per share. In computing the pro-forma expense in prior years, there was no assumption that any compensation expense related to stock options would be deferred, and therefore, pro-forma adjustments in prior periods do not include adjustments related to acquisition costs. Cash provided by operating activities decreased and cash provided by financing activities for the years ended December 31, 2007 and 2006 increased by $5.5 million and $4.8 million, respectively, related to excess tax benefits from stock-based payment arrangements.
If any third party were to acquire beneficial ownership of 20% or more of our outstanding common stock, a significant portion of the equity issued under the Plan, including performance shares granted to executive officers, would become fully vested and transferable. We estimate that this would result in a pre-tax accounting charge to us of approximately $25 million to $35 million, representing an acceleration of compensation expense under SFAS No. 123R.
Unless otherwise specified, each option vests ratably over three to four years, beginning one year after the date of grant. As long as the grantee is still with Radian, if not sooner vested by its terms, each option fully vests upon the earliest of:
date of exercise, during the year ended December 31, 2007 and 2006, was $18.9 million and $18.3 million, respectively. The total intrinsic value of options outstanding at December 31, 2007 was immaterial.
We granted, under the Plan, 41,300 shares of restricted stock during 2006 and 605,970 shares of restricted stock during 2007, in the case of each grant, vesting over three to four years.
additional paid-in capital. The amount recorded as stock-based compensation expense related to restricted stock for the years ended December 31, 2007, 2006 and 2005 was $7.0 million, $1.4 million and $0.5 million, respectively. The amount recorded in 2007, is net of $3.6 million deferred as policy acquisition costs. There were no amounts deferred for 2006 or 2005.
We have an Employee Stock Purchase Plan (the “ESPP”). A total of 400,000 shares of our authorized unissued common stock have been made available under the ESPP. The ESPP allows eligible employees to purchase shares of our stock at a discount of 15% of the beginning-of-period or end-of-period (each period being the first and second six calendar months in a calendar year) fair market value of the stock, whichever is lower. Under the ESPP, we sold 16,324 and 15,362 shares to employees during the years ended December 31, 2007 and 2006, respectively. Beginning in 2006, we applied SFAS No. 123R in accounting for the ESPP. The effect of the
issuance of shares under the ESPP on our net income and earnings per share was immaterial in 2005. The amount recorded as stock-based compensation related to the ESPP for the years ended December 31, 2007 and 2006 was $0.1 million and $0.2 million, respectively. No stock-based compensation expense related to the ESPP was recorded for 2005.
On May 8, 2007, our board of directors amended the ESPP: (1) to extend the expiration date of the plan from July 15, 2007 to July 15, 2009; and (2) notwithstanding the extension, in anticipation of our proposed merger with MGIC, to suspend the ESPP effective upon the consummation of the purchase of shares of common stock in connection with the expiration of the current offering and purchase periods under the plan on June 30, 2007.
On November 6, 2007, our board of directors: (1) re-started the ESPP by declaring two new six month offering periods commencing on January 1 and July 1, 2008; (2) amended the eligibility criteria of the ESPP to eliminate an 18-month waiting period previously imposed on new employees; and (3) approved certain administrative amendments to the ESPP to allow for the maximum annual contributions by participants under the ESPP to be equal to the maximum amount permitted from time to time by the Internal Revenue Service.
Each performance share award becomes payable at the target amount multiplied by a factor (between 0% and 200%) depending on our growth in earnings per share, growth in adjusted book value and return on equity over the performance period. For the first and second performance periods, one third of each award is based on each of the three metrics, and each metric is measured both on an absolute basis and relative to a group of our peers.
We maintain a noncontributory defined benefit pension plan (the “Pension Plan”) covering substantially all of our full-time employees. Effective December 31, 2006, we (1) froze all benefits accruing under the Pension Plan and (2) suspended all forms of participation under the Pension Plan. Prior to the suspension, all salaried and hourly employees of Radian and its participating subsidiaries were eligible to participate in the Pension Plan upon attaining 20-1/2 years of age and one year of eligible service. We recorded a curtailment loss of approximately $370,000 in the fourth quarter of 2006 as a result of the freezing of the Pension Plan.
The Pension Plan suspension was aimed at preparing for the future termination of the Pension Plan, and reflects a broader reliance on the Radian Group Inc. Savings Incentive Plan (the “Savings Plan”) as the primary retirement vehicle for our employees. On February 5, 2007, our board of directors approved the termination of the Pension Plan, effective June 1, 2007. We expect to record an immaterial settlement loss upon termination of the Pension Plan, which remains subject to regulatory approval and is expected to occur during 2008.
In the first quarter of 2007, we amended the Pension Plan to (1) accelerate the vesting of accrued benefits under the Pension Plan for all participants in the plan who are employees of Radian or its affiliates at any time between December 31, 2006 and the termination date of June 1, 2007; and (2) enhance the distribution options under the Pension Plan to offer an immediate annuity option and an immediate lump sum option in connection with the June 1, 2007 termination date. On November 7, 2007, the Pension Plan was further amended to extend the lump sum distribution right to terminated vested participants who did not commence receiving benefits prior to January 1, 2007.
We terminated the Radian Group Inc. Supplemental Executive Retirement Plan (the “SERP”) effective December 31, 2006, and adopted a new nonqualified restoration plan (the “Benefit Restoration Plan” or “BRP”), effective January 1, 2007. The BRP is intended to provide additional retirement benefits to Radian employees that are eligible to participate in the Savings Plan and whose benefits under the Savings Plan are limited by applicable IRS limits on eligible compensation.
In addition, we surrendered some of the split-dollar life insurance policies used to finance the SERP. Each participant in the SERP received an initial balance in the BRP equal to the present value of the participant’s SERP benefit as of January 1, 2007. We currently have $9.7 million of split-dollar life insurance policies that are still outstanding.
On November 6, 2007, the BRP was amended and restated: (1) to mandate a lump sum form of payment (rather than offering an annuity election) for participants who separate from service after 2007; (2) to delink discretionary contributions under the BRP from discretionary contributions under the Savings Plan; (3) to provide us with flexibility to waive the eligibility requirements for discretionary contributions under the BRP to allow otherwise ineligible employees, such as those involuntarily terminated during the year, to participate in such contributions; and (4) to conform the BRP to the final regulations under Section 409A of the Internal Revenue Code.
The Savings Plan covers substantially all our full-time and all our part-time employees employed for a minimum of 90 consecutive days. Participants can contribute up to 25% of their base earnings as pretax contributions. We will match at least 100% of the first 6% of base earnings contributed in any given year. Our expense for matching funds for the years ended December 31, 2007, 2006 and 2005 was $5.0 million, $2.9 million and $2.6 million, respectively.
The board approved changes to the Savings Plan, effective January 1, 2007, including among other things, to:
provide for quarterly matching contributions by Radian equal to 100% of employee contributions (up to 6% of eligible pay). Matching contributions may be made in cash or in shares of Radian common stock, at Radian’s election;
The implementation of SFAS No. 158 did not have a significant impact on our financial statements due to the curtailment of the Pension Plan and the SERP. Under SFAS No. 158 we are required to recognize net periodic cost in accumulated other comprehensive income; however, the curtailment impact offset most of our other comprehensive income adjustment. The following table shows the effect of SFAS No. 158 on our consolidated balance sheets as of the periods specified (in thousands):
The accumulated benefit obligation at December 31, 2007 and 2006 for the Radian Pension Plan/SERP was $36.6 million and $33.2 million, respectively, and the unfunded amount is recorded in accounts payable and accrued expenses for the periods indicated.
The components of the Pension Plan/SERP benefit and net periodic postretirement benefit costs are as follows (in thousands):
We expect to contribute $10.0 million to our pension plan in 2008. We expect to contribute nominal amounts to Radian’s and EFSG’s other postretirement benefit plans in 2008.
On October 3, 2007, we received a letter from the staff of the Chicago Regional Office of the Securities Exchange Commission stating that the staff is conducting an investigation involving Radian Group and requesting production of certain documents. We believe that the investigation generally relates to our proposed merger with MGIC and our investment in C-BASS. We are cooperating with the requests of the SEC. The SEC staff has informed us that this investigation should not be construed as an indication by the Commission or its staff that any violation of the securities laws has occurred, or as a reflection upon any person, entity or security.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of asset-backed (including mortgage-backed) securities. To allow our customers to comply with these regulations, we typically are required, depending on the amount of credit enhancement we are providing, to provide (1) audited financial statements for the insurance subsidiary participating in the transaction or (2) a full and unconditional holding-company-level guarantee for our insurance subsidiaries’ obligations in such transactions. To date, Radian Group has guaranteed two structured transactions for Radian Guaranty involving approximately $363.3 million of remaining credit exposure.
As part of the non-investment-grade allocation component of our investment program, we have committed to invest $55 million in alternative investments ($24.5 million of unfunded commitment at December 31, 2007) that are primarily private equity structures, including $10 million in an investment co-managed by C-BASS. These commitments have capital calls over a period of at least six years, and certain fixed expiration dates or other termination clauses.
We lease office space for use in our operations. The lease agreements, which expire periodically through August 2017, contain provisions for scheduled periodic rent increases. Net rental expense in connection with these leases totaled $8,375,000, $9,888,000 and $8,673,000 in 2007, 2006 and 2005, respectively. The commitment for non-cancelable operating leases in future years is as follows (in thousands):
(2) Net (loss) income per share is computed independently for each period presented. Consequently, the sum of the quarters may not equal the total net (loss) income per share for the year.
(3) The third quarter results include a write-off of our investment in C-BASS of $468 million, a $181.7 million gain on the sale of a partial interest in Sherman and a $155.2 million premium deficiency reserve on our second-lien portfolio.
(5) The fourth quarter results reflect a significant increase in provision for losses primarily driven by the deteriorating credit performance in our mortgage insurance business and credit deterioration in our financial guaranty portfolio.
In February 2006, the FASB issued SFAS No. 155, an amendment of SFAS Nos. 133 and 140 which we adopted on January 1, 2007. Accordingly, securities that were previously classified as available for sale and trading securities on our consolidated balance sheets were reclassified to hybrid securities on our consolidated balance sheets on the date of adoption and in accordance with SFAS No. 155, we elected to record convertible securities at fair value. Changes in the fair value are recorded as net gains or losses on securities.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 (i) defines fair value, (ii) establishes a framework for measuring fair value in GAAP and (iii) expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007. We adopted SFAS No. 157 effective January 1, 2008 and are currently evaluating the impact to our consolidated financial statements.
Trading Securities-The fair values of trading securities are obtained from independent pricing services that use observed market transactions, including broker-dealer quotes and actual trade activity as a basis for valuation.
Other Invested Assets-The fair value of other invested assets (residential mortgage-backed securities) is based on the present value of the estimated net future cash flows, including annual distributions. The carrying value of equity-method investments and cost-method investments approximates fair value.
Hybrid Securities-The fair value of hybrid securities is obtained from independent pricing services that use observed market transactions, including broker-dealer quotes and actual trade activity as a basis for valuation.
Derivative Assets and Liabilities-The fair value of derivative assets and liabilities is primarily derived from internally generated models as described in Note 16.
A summary of our derivative information as of the periods indicated is as follows:
NIMS-The gains and losses on derivative mortgage insurance contracts are derived from internally generated models. As a result of the severe disruption in the subprime mortgage market, we refined our methodology for valuing NIMS in the third quarter of 2007 consistent with our increased loss expectations for this product. Prior to the third quarter of 2007, we valued our NIMS bonds by evaluating recent premium levels and the present value of future estimated cash flows. When we determined that a NIMS bond was not performing in accordance with our expectations, we estimated a claim amount that we would be required to pay on each bond. Refinement to our model addresses the potential vulnerability of all NIMS bonds under current market conditions, including those performing within our expectations. Our refined methodology uses market-based roll rates and internally developed loss assumptions and, we estimate losses in each securitization underlying a NIMS bond. We then project prepayment fees on the underlying collateral in each securitization, incorporating actual and historical prepayment experience. The estimated loss and prepayment speeds are used to estimate the cash flows for each underlying securitization and NIMS bond, and ultimately, to produce the projected credit losses for each NIMS bond at legal maturity. In addition to expected credit losses, the fair value for each NIMS bond is approximated by incorporating further loss stresses, future expected premiums from the NIMS bond, and an estimated rate of return that a counterparty would require in assuming the exposure from us. Changes in our estimated fair value marks are recorded as a gain/loss on derivatives. Because NIMS guarantees are not market traded instruments, considerable judgment is required in estimating fair value. Changes in our estimated fair value marks are recorded as a change in fair value of derivatives.
Financial Guaranty Contracts-The gains and losses on direct derivative financial guaranty contracts are derived from internally generated models. Estimated fair value amounts are determined by using market information to the extent available, and in most cases, observable market information must be combined with unobservable market inputs in order to estimate fair value. These unobservable market inputs are required to consider differences that exist in the collateral underlying our contracts and the collateral underlying market indices as well as the structural features of our contracts. For corporate pooled CDOs, credit spreads on individual names in our collateral pool are used to derive an equivalent risk tranche on an industry standard credit default swap index (“CDX”). When credit spreads on individual names are not available, the average credit spread of similar companies is used. For certain of our non-corporate CDOs, dealer quotes on similar structured transactions are used. In determining our December 31, 2007 valuations, generally market indices are used to estimate fair value on these deals. In determining gains and losses on RMBS and CMBS CDOs,
we utilize a generic spread from ABX and CMBX. The generic spread utilized is based on the nature of the underlying collateral in each deal. The gains and losses on Trust Preferred Securities deals are derived from internally generated models utilizing observable CDS spreads of a group of investment grade and high-yield financial institutions. Because our collateral does not directly track market indices that are available, adjustments to account for differences in term, credit quality, and diversification of underlying collateral are made in our internal models. In addition, our internal models are adjusted to account for differences between our financial guaranty contracts and similar derivative contracts executed by other primary market participants, the primary difference being the lack of a requirement to post collateral with our counterparties when our contracts are in a liability position. In instances where dealer quotes are not available and market indices are not appropriate, we consider the reinsurance market to be the principal market for purposes of determining fair value, therefore, we utilize an internal model, similar to those used by reinsurers, to estimate fair value. Prior to 2007, many of our non-corporate CDOs were valued using this methodology as the reinsurance market for these products was much more robust than the current environment. Significant differences may exist with respect to the available market information and assumptions used to determine gains and losses on derivative financial guaranty contracts. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of amounts we could realize in a current market exchange due to the lack of a liquid market. The use of different market assumptions and/or estimation methodologies may have a significant effect on the estimated fair value amounts.
In accordance with our risk management policies, we may enter into derivatives to hedge the interest rate risk related to our long-term debt. As of December 31, 2007, we were a party to two interest rate swap contracts relating to our 5.625% unsecured senior notes due 2013. These interest rate swaps are designed as fair value hedges that hedge the change in fair value of our long-term debt arising from interest rate increases. During 2007, 2006 and 2005, the fair value hedges were 100% effective. Therefore, the change in the fair value of the derivative instruments in our consolidated statements of income was offset by the change in the fair value of the hedged debt.
As a provider of credit enhancement, we periodically transact with entities that may be variable interest entities (“VIEs”). VIEs are corporations, trusts or partnerships that are established for a limited purpose. Special purpose entities (“SPEs”), by their nature, are generally not controlled by their equity owners, as the establishing documents govern all material decisions. We follow the guidance in Financial Accounting Standards Board (“FASB”) Interpretation, Consolidation of Variable Interest Entities (revised)-an interpretation of ARB No. 51 (“FIN No. 46R”) and consolidate VIEs in which we are the primary beneficiary of the variable interests, or a
Mortgage Insurance-We guaranty the payment of principal and interest on our NIMS which are structured as qualifying special purpose entities. There are certain circumstances and triggers, that are outside of our control, that give us the ability to call the NIMS. Under these circumstances, the VIE would not be exempt from consolidation considerations under FIN No. 46R. At December 31, 2007, there were six such transactions requiring consolidation, but such consolidation had an immaterial impact to our consolidated balance sheets.
We have committed to invest $10 million in a fund sponsored and co-managed by C-BASS. The fund invests in real estate related securities and had total assets of $173.8 million and $361.0 million at December 31, 2007 and 2006, respectively. C-BASS is also a co-investor in the fund. These commitments have capital calls over a period of at least six years, and certain fixed expiration dates or other termination clauses. We had $7.6 million invested in the fund at December 31, 2007 and $7.3 million at December 31, 2006.
In the mortgage insurance segment, the highest state concentration of primary risk in force at December 31, 2007, was Florida at 9.0%, compared to 9.2% at December 31, 2006. At December 31, 2007, California accounted for 11.6% of the mortgage insurance segment’s primary insurance in force, compared to 12.8% at December 31, 2006, and 17.8% of the mortgage insurance segment’s pool risk in force, compared to 11.3% for 2006. California also accounted for 15.8% of the mortgage insurance segment’s primary new insurance written for 2007 compared to 12.8% for 2006. The percentage of risk in California has been falling due to the high cancellation rate as compared to new business written.
The largest single customer of our mortgage insurance segment (including branches and affiliates of such customer), measured by primary new insurance written, accounted for 19.4% of primary new insurance written in 2007 compared to 18.6% in 2006 and 10.6% in 2005.
The financial guaranty segment derives a substantial portion of its premiums written from a small number of direct primary insurers. In 2007, three primary insurers accounted for approximately $90.6 million or 39.3% of the financial guaranty segment’s gross written premiums. In 2006, three primary insurers accounted for approximately $91.3 million or 34.7% of the financial guaranty segment’s gross written premiums. No other primary insurers accounted for more than 10% of the financial guaranty segment’s gross written premiums during 2007 or 2006. Gross written premiums and net written premiums are not materially different because we do not cede a material amount of business to reinsurers.