At December 31, 2008, we leased office space in various cities throughout the United States under leases expiring between 2009 and 2015 and which required annual rentals of $2.8 million in 2008.
As used below, “we” and “our” refer to MGIC Investment Corporation’s consolidated operations. In the discussion below, we classify, in accordance with industry practice, as “full documentation” loans approved by GSE and other automated underwriting systems under “doc waiver” programs that do not require verification of borrower income. For additional information about such loans, see footnote (3) to the delinquency table under “Results of Consolidated Operations-Losses-Losses Incurred”. The discussion of our business in this document generally does not apply to our Australian operations which are immaterial. The results of our operations in Australia are included in the consolidated results disclosed. For additional information about our Australian operations, see “-Australia” below.
At this time, we are facing two particularly significant challenges, which we believe are shared by the other participants in our industry:
Whether private mortgage insurance will remain a significant credit enhancement alternative for low down payment single family mortgages. This challenge is discussed under “Future of the Domestic Residential Housing Finance System” below.
established for delinquent loans, beginning with our December 31, 2008 calculations.
Some states that regulate us have provisions that limit the risk-to-capital ratio (see “Liquidity and Capital Resources-Risk to Capital”) of a mortgage guaranty insurance company to 25:1. If an insurance company’s risk-to-capital ratio exceeds the limit applicable in a state, it may be prohibited from writing new business in that state until its risk-to-capital ratio falls below the limit. It is also our understanding that certain states have clarified their calculation of risk-to-capital to reduce risk in force for established loss reserves. We have used this methodology beginning with our December 31, 2008 calculations.
At December 31, 2008 MGIC’s risk-to-capital was 12.9:1 and was 14.7:1 on a combined statutory basis.
Under the charters of the GSEs, which are contained in federal statutes subject to amendment by legislation, the GSEs must obtain credit enhancement on single-family mortgages that they purchase when the LTV ratio exceeds 80%. Such low down payment mortgages form the foundation of our business. For decades private mortgage insurance has been the mortgage market’s preferred form of credit enhancement for conforming loans. (For a few years that ended in 2007, piggyback loans, which are loans comprised of both a first and second mortgage, with the LTV ratio of the first mortgage below what investors require for mortgage insurance, took substantial market share from private mortgage insurance. As shown by their recent performance in declining housing markets, we believe piggybacks cannot be fairly viewed as credit enhancements.)
At December 31, 2008, we had approximately $394 million in short-term investments at our holding company. These investments were virtually all of our holding company’s liquid assets. Our holding company’s obligations include $1.090 billion in indebtedness, $400 million of which is scheduled to mature before the end of 2011 and must be serviced pending scheduled maturity. See Notes 6 and 7 to our consolidated financial statements contained in Item 8 for additional information about this indebtedness. See “Liquidity and Capital Resources - Debt at our Holding Company and Holding Company Capital Resources” for information about restrictions on MGIC’s payment of dividends to our holding company and our expectation that we will not be seeking additional dividends that would increase our holding company’s cash resources in 2009. Historically, dividends from MGIC have been the principal source of our holding company’s cash inflow.
Private and Public Efforts to Modify Mortgage Loans and Reduce Foreclosure
Cancellations, which reduce the size of the in force book of insurance that generates premiums. Cancellations due to refinancings are affected by the level of current mortgage interest rates compared to the mortgage coupon rates throughout the in force book. Refinancings are also affected by current home values compared to values when the loans in the in force book became insured and the terms on which mortgage credit is available.
Premiums are generated by the insurance that is in force during all or a portion of the period. Hence, changes in the average insurance in force in the current period compared to an earlier period is a factor that will increase (when the average in force is higher) or reduce (when it is lower) premiums written and earned in the current period, although this effect may be enhanced (or mitigated)
Our investment portfolio is comprised almost entirely of fixed income securities rated “A” or higher. The principal factors that influence investment income are the size of the portfolio and its yield. As measured by amortized cost (which excludes changes in fair market value, such as from changes in interest rates), the size of the investment portfolio is mainly a function of cash generated from (or used in) operations, such as net premiums received, investment earnings, net claim payments and expenses, less cash provided by (or used for) non-operating activities, such as debt or stock issuance or dividend payments. Realized gains and losses are a function of the difference between the amount received on sale of a security and the security’s amortized cost, as well as any “other than temporary” impairments. The amount received on sale of fixed income securities is affected by the coupon rate of the security compared to the yield of comparable securities at the time of sale.
The size of loans insured. Higher average loan amounts tend to increase losses incurred.
The majority of our operating expenses are fixed, with some variability due to contract underwriting volume. Contract underwriting generates fee income included in “Other revenue.”
In 2007, we began providing mortgage insurance to lenders in Australia. At December 31, 2008 the equity value of our Australian operations was approximately $100 million and our risk in force in Australia was approximately $1.0 billion. In Australia, mortgage insurance is a single premium product that covers the entire loan balance. As a result, our Australian risk in force represents the entire amount of the loans that we have insured. However, the mortgage insurance we provide only covers the unpaid loan balance after the sale of the underlying property. In view of our need to dedicate capital to our domestic mortgage insurance operations, we have been exploring alternatives for our Australian activities which may include a sale of our Australian operations. As a result, we have reduced our Australian headcount and suspended writing new business in Australia. We do not expect to write new business in Australia unless required in connection with an agreed upon sale of this business.
Premiums written and earned during 2008 increased compared to 2007. The increase in premiums resulted from the continued increase in the average insurance in force; however the effect of the higher in force has been somewhat offset by lower average premium yields due to a shift in the mix of new writings to loans with lower loan-to-value ratios, higher FICO scores and full documentation, which carry lower premium rates.
Investment income in 2008 was higher when compared to 2007 due to an increase in the average amortized cost of invested assets, offset by a decrease in the pre-tax yield.
Losses incurred for 2008 significantly increased compared to 2007 primarily due to a significant increase in the default inventory, offset by a smaller increase in the estimates regarding how much will be paid on claims, or severity, and a slight decrease in the estimates regarding how many delinquencies will result in a claim, or claim rate, when compared to 2007. The default inventory increased by 75,068 delinquencies in 2008, compared to an increase of 28,492 in 2007. The continued increase in estimated severity was primarily the result of the default inventory containing higher loan exposures with expected higher average claim payments as well as our inability to mitigate losses through the sale of properties due to home price declines. The decrease in estimated claim rate for 2008 was primarily due to an increase in our loss mitigation efforts that resulted in an increased number of rescissions and claim denials for misrepresentation, ineligibility and policy exclusions.
During 2008 the premium deficiency reserve on Wall Street bulk transactions declined by $757 million from $1,211 million, as of December 31, 2007, to $454 million as of December 31, 2008. The $454 million premium deficiency reserve as of December 31, 2008 reflects the present value of expected future losses and expenses that exceeded the present value of expected future premium and already established loss reserves.
Interest expense for 2008 increased when compared to 2007. The increase primarily reflects the issuance of our convertible debentures in March and April of 2008.
The amount of our primary new insurance written during the years ended December 31, 2008, 2007 and 2006 was as follows:
The decrease in new insurance written on a flow basis in 2008, compared to 2007, was primarily due to changes in our underwriting guidelines discussed below, as well as a decrease in the total mortgage origination market and greater usage of FHA insurance programs as an alternative to mortgage insurance. For a discussion of new insurance written through the bulk channel, see “Bulk transactions” below.
We anticipate our flow new insurance written for 2009 will be significantly below the level written in 2008, due to changes in our underwriting guidelines discussed below as well as premium rate increases implemented during 2008, neither of which were fully implemented at the beginning of 2008. We believe our changes in guidelines and premium rates have led to greater usage of FHA insurance programs as an alternative to private mortgage insurance. Additionally, both GSEs have implemented adverse market charges on all loans and credit risk-based loan level price adjustments on loans with certain risk characteristics which include loans that qualify for private mortgage insurance. The application of these loan level price adjustments results in a materially higher monthly payment for the borrower, which we also believe has led to greater usage of FHA insurance programs as an alternative to private mortgage insurance. Our level of new insurance written could also be affected by other items, as noted in our risk factors in Item 1A, which are an integral part of this Management’s Discussion and Analysis.
Percentage of Flow NIW that Qualified with our Underwriting Guidelines in Place as of December 31, 2008
We regularly review our underwriting guidelines. Additional changes to our guidelines, which include further limitations on the types of refinance loans we will insure, have been announced and will be effective in the first quarter of 2009.
New insurance written and cancellations of primary insurance in force during the years ended December 31, 2008, 2007 and 2006 were as follows:
For the nine months ended September 30, 2008, approximately 34.4% of our flow new insurance written was subject to arrangements with captives or risk sharing arrangements with the GSEs compared to 47.7% for the year ended December 31, 2007 and 47.5% for the year ended December 31, 2006. We expect the percentage of new insurance written subject to risk sharing arrangements to continue to decline in 2009 for the reasons discussed below. The percentage of new insurance written covered by these arrangements is shown only for the nine months ended September 30, 2008 because this percentage normally increases after the end of a quarter. Such increases can be caused by, among other things, the transfer of a loan in the secondary market, which can result in a mortgage insured during a quarter becoming part of a risk sharing arrangement in a subsequent quarter. New insurance written through the bulk channel is not subject to risk sharing arrangements. Premiums ceded in these arrangements are reported in the period in which they are ceded regardless of when the mortgage was insured.
In June 2008 we entered into a reinsurance agreement with an affiliate of HCC Insurance Holdings, Inc. The reinsurance agreement is effective on the risk associated with up to $50 billion of qualifying new insurance written each calendar year. The term of the reinsurance agreement began on April 1, 2008 and ends on December 31, 2010, subject to two one-year extensions that may be exercised by HCC. We believe that substantially all of our insurance committed to subsequent to April 1, 2008 will qualify under the reinsurance agreement. The reinsurance agreement is expected to provide additional claims-paying resources when loss ratios exceed 100% for insurance written beginning April 1, 2008.
When our financial strength rating as determined by two rating agencies is in the “A” category or higher the agreement provides for a 20% quota share agreement, but allows us to retain 80% of the ceded premium (“profit commission”). The profit commission is used to cover losses that otherwise would be ceded to the reinsurer until the profit commission is exhausted. The premium ceded to the reinsurer and the brokerage commission paid to an affiliate of the reinsurer, net of a profit commission retained by us, is recorded as reinsurance fee expense on our statement of operations. In loss environments where loss ratios are less than 80% for the insurance covered by this agreement we expect the net expense will be approximately 5% of net premiums earned on business covered by the agreement. Under the terms of the agreement, if our financial strength rating as determined by two rating agencies falls below the “A” category, we are no longer entitled to the profit commission and our net expense will increase to reflect we no longer receive this profit commission, but this increase will be partially offset by an increase of reinsured losses. In February 2009, Moody’s Investors Service reduced MGIC’s financial strength rating to Ba2 with a developing outlook. The financial strength of MGIC is rated A-, with a negative outlook, by both Standard and Poor’s Rating Services and Fitch Ratings. The reinsurance fee for the year ended December 31, 2008 is separately shown in the statements of operations.
was caused both by decreases in prevailing interest rates and a decrease in the average maturity of our investments. The portfolio’s average pre-tax investment yield was 3.87% at December 31, 2008 and 4.69% at December 31, 2007. The portfolio’s average after-tax investment yield was 3.49% at December 31, 2008 and 4.18% at December 31, 2007. Assuming shorter-term yields remain at their current levels, we expect the investment yield on our portfolio as a whole will continue to decline because we are investing available funds in shorter maturities so that they will be available for claim payments without the need to obtain the necessary funds through sales of our fixed income investments.
Investment income for 2007 increased when compared to 2006 due to an increase in the average investment yield, as well as an increase in the average amortized cost of invested assets.
Realized losses for 2008 included “other than temporary” impairments on our investment portfolio of approximately $62.5 million on our fixed income investments including debt instruments issued by Fannie Mae, Freddie Mac, Lehman Brothers and AIG, and realized losses on the sales of investments of approximately $12.8 million, offset by a $62.8 million gain from the sale of our remaining interest in Sherman. Realized gains in 2007 included a $162.9 million pre-tax gain on the sale of a portion our interest in Sherman. There were no “other than temporary” impairments in 2007 or 2006.
As discussed in “-Critical Accounting Policies”, and consistent with industry practices, we establish loss reserves for future claims only for loans that are currently delinquent. The terms “delinquent” and “default” are used interchangeably by us and are defined as an insured loan with a mortgage payment that is 45 days or more past due. Loss reserves are established based on our estimate of the number of loans in our inventory of delinquent loans that will not cure their delinquency and thus result in a claim, which is referred to as
the claim rate (historically, a substantial majority of delinquent loans have eventually cured), and further estimating the amount that we will pay in claims on the loans that do not cure, which is referred to as claim severity.
Our estimates could also be positively affected by government efforts to assist current borrowers in refinancing to new loan instruments, assisting delinquent borrowers and lenders in modifying their mortgage notes into something more affordable, and forestalling foreclosures. In addition private company efforts may have a positive impact on our loss development. However, all of these efforts are in their early stages and therefore we are unsure of their magnitude or the benefit to us or our industry, and as a result are not factored into our current reserving. For additional information about the potential impact that any plans and programs enacted by legislation may have on us, see the risk factor titled “Loan modification and other similar programs may not provide material benefits to us” in Item 1A.
The amount of losses incurred pertaining to current year loss development represents the estimated amount to be ultimately paid on default notices received in the current year. Losses incurred pertaining to the current year increased in 2008, compared to 2007, primarily due to a significant increase in the default inventory offset by a smaller increase in estimated severity, as well as a slight decrease in estimated claim rate, when each are compared to the same period in 2007. The default inventory increased by 75,068 delinquencies in 2008, compared to an increase of 28,492 in 2007. The continued increase in estimated severity was primarily the result of the default inventory containing higher loan exposures with expected higher average claim payments as well as our inability to mitigate losses through the sale of properties due to home price declines. The increase in estimated severity was less substantial than the increase experienced during 2007. The slight decrease in estimated claim rate for 2008 was primarily due to an increase in our loss mitigation efforts that resulted in an increased number of rescissions and claim denials for misrepresentation, ineligibility and policy exclusions. The estimated claim rate is based on recent historical experience and does not take into account any potential benefits of third party and governmental mitigation programs that are in their early stages for which we have no data on historical performance. Losses incurred pertaining to the current year increased in 2007, compared to 2006, primarily due to significant increases in the default inventory and estimated severity and claim rate, when each are compared to 2006.
Our loss estimates are established based upon historical experience. We continue to experience increases in delinquencies in certain markets with higher than average loan balances, such as Florida and California. In California we have experienced an increase in delinquencies, from 6,900 as of December 31, 2007 to 14,960 as of December 31, 2008. Our Florida delinquencies increased from 12,500 as of December 31, 2007 to 29,380 as December 31, 2008. The average claim paid on California loans in 2008 was more than twice as high as the average claim paid for the remainder of the country.
The amount of losses incurred relating to prior year loss development represents actual claim payments that were higher or lower than what was estimated by us at the end of the prior year as well as a re-estimation of amounts to be ultimately paid on defaults remaining in our default inventory from the end of the prior year. This re-estimation is the result of our review of current trends in default inventory, such as defaults that have resulted in a claim, the amount of the claim, the change in relative level of defaults by geography and the change in average loan exposure. The $387 million addition to losses incurred relating to prior years in 2008 was due primarily to the significant increases in severity during the year, as compared to our estimates when originally establishing the reserves at December 31, 2007. The increase in losses incurred in 2008 related to prior years
We believe that the foregoing trends will likely continue into 2009. These trends may also continue beyond 2009.
Under these agreements the captives are required to maintain a separate trust account, of which we are the sole beneficiary. Premiums ceded to a captive are deposited into the applicable trust account to support the captive’s layer of insured risk. These amounts are held in the trust account and are available to pay reinsured losses. The captive’s ultimate liability is limited to the assets in the trust account. When specific time periods are met and the individual trust account balance has reached a required level, then the individual captive may make authorized withdrawals from its applicable trust account. In most cases, the captives are also allowed to withdraw funds from the trust account to pay verifiable federal income taxes and operational expenses. Conversely, if the account balance falls below certain thresholds, the individual captive may be required to contribute funds to the trust account. However, in most cases, our sole remedy if a captive does not contribute such funds is to put the captive into run-off, in which case no new business would be ceded to the captive. In the event that the captives’ incurred but unpaid losses exceed the funds in the trust
In 2008 the captive arrangements reduced our losses incurred by approximately $476 million. We anticipate that the reduction in losses incurred will be lower in 2009, compared to 2008, as some of our captive arrangements have been terminated.
Information about the composition of the primary insurance default inventory at December 31, 2008, 2007 and 2006 appears in the table below.
At December 31, 2008 and 2007, 45,482 and 39,704 loans in default, respectively, related to Wall Street bulk transactions.
The average loan size of our insurance in force at December 31, 2008, 2007 and 2006 for the top 5 states (based on 2008 losses paid) appears in the table below.
During 2008 the premium deficiency reserve on Wall Street bulk transactions declined by $757 million from $1,211 million, as of December 31, 2007, to $454 million as of December 31, 2008. The $454 million premium deficiency reserve as of December 31, 2008 reflects the present value of expected future losses and expenses that exceeded the present value of expected future premium and already established loss reserves. The discount rate used in the calculation of the premium deficiency reserve at December 31, 2008 was 4.0%.
actual loss experience differ from the assumptions used in calculating the premium deficiency reserves, the differences between the actual results and our estimate will affect future period earnings and could be material.
See discussion of our future interest expense as it relates to our convertible debentures in Note 2 to our consolidated financial statements in Item 8.
The effective tax rate credit on our pre-tax loss was (37.3%) in 2007, compared to an effective tax rate on our pre-tax income of 24.8% in 2006. During those periods, the rate reflected the benefits recognized from tax-preferenced investments. Our tax-preferenced investments that impact the effective tax rate consist almost entirely of tax-exempt municipal bonds. The difference in the rate was primarily the result of a pre-tax loss during 2007, compared to pre-tax income during 2006.
Our equity in the earnings from Sherman and C-BASS and certain other joint ventures and investments, accounted for in accordance with the equity method of accounting, is shown separately, net of tax, on our consolidated statement of operations. Income from joint ventures, net of tax, was $24.5 million in 2008 compared to a loss from joint ventures, net of tax, of $269.3 million for 2007. The loss from joint venture in 2007 was due primarily to the impairment of our investment in C-BASS, which is discussed below. In the third quarter of 2008, we
In August 2008 we sold our entire interest in Sherman to Sherman. Our interest sold represented approximately 24.25% of Sherman’s equity. The sale price was paid $124.5 million in cash and by delivery of Sherman’s unsecured promissory note in the principal amount of $85 million. The scheduled maturity of the Note is February 13, 2011 and it bears interest, payable monthly, at the annual rate equal to three-month LIBOR plus 500 basis points. The Note is issued under a Credit Agreement, dated August 13, 2008, between Sherman and MGIC.
At the time of sale the Note had a fair value of $69.5 million (18.25% discount to par). The fair value was determined by comparing the terms of the note to the discounts and yields on comparable bonds. The value was also discounted for illiquidity and lack of ratings. The discount will be amortized to interest income over the life of the note. The gain recognized on the sale was $62.8 million, and is included in realized investment gains on the statement of operations for the year ended December 31, 2008.
The sale of our interest in Sherman was effected as a repurchase of our interest by Sherman. We believe that Sherman will repay the Note in accordance with its terms. If in the future Sherman were to experience financial distress, there is a risk that Sherman would be unable to meet its obligations under the Note or, if Sherman were unable to meet its obligations generally, that creditors of Sherman would seek to set aside the entire transaction and obtain the return to Sherman of the consideration received by us in the transaction. We cannot predict Sherman’s future performance but its business is sensitive to its ability to purchase receivable portfolios on favorable terms and to service those receivables such that it meets its return targets. In addition, the volume of credit
card originations and the related returns on the credit card portfolio are impacted by general economic conditions and consumer behavior. Sherman’s operations are principally financed with debt under credit facilities.
For some time there has been significant tightening in credit markets, which have become even tighter beginning in September 2008 with the onset of the credit crisis, with the result that lenders are generally becoming more restrictive in the amount of credit they are willing to provide and in the terms of credit that is provided. Credit tightening could adversely impact Sherman’s ability to obtain sufficient funding to maintain or expand its business and could increase the cost of funding that is obtained.
Summary Sherman income statements for the periods indicated appear below. The year ended December 31, 2008 only reflects Sherman’s results and our share of income from Sherman through July 31, 2008 as a result of the sale of our interest in August 2008. Prior to the sale of our interest, we did not consolidate Sherman with us for financial reporting purposes, and we did not control Sherman. Sherman’s internal controls over its financial reporting were not part of our internal controls over our financial reporting. However, our internal controls over our financial reporting include processes to assess the effectiveness of our financial reporting as it pertains to Sherman. We believe those processes are effective in the context of our overall internal controls.
In September 2007 we sold a portion of our interest in Sherman to an entity owned by Sherman’s senior management. The interest sold by us represented approximately 16% of Sherman’s equity. We received a cash payment of $240.8 million in the sale and recorded a $162.9 million pre-tax gain, which is reflected in our results of operations for 2007 as a realized gain.
As of December 31, 2008, 81% of our investment portfolio was invested in tax-preferenced securities. In addition, at December 31, 2008, based on book value, approximately 94% of our fixed income securities were invested in ‘A’ rated and above, readily marketable securities, concentrated in maturities of less than 15 years. Approximately 24% of our investment portfolio is covered by the financial
guaranty industry. We evaluate the credit risk of securities through analysis of the underlying fundamentals of each issuer. A breakdown of the portion of our investment portfolio covered by the financial guaranty industry by credit rating, including the rating without the guarantee is shown below.
If all of the companies in the financial guaranty industry lose their ‘AAA’ ratings, the percentage of our fixed income portfolio rated ‘A’ or better will decline by 1% to 93% ‘A’ or better. Our maximum exposure to any individual financial guarantor is 11%.
At December 31, 2008, the investment portfolio had gross unrealized losses of $256.6 million. For those securities in an unrealized loss position, the length of time the securities were in such a position, as measured by their month-end fair values, is as follows:
At December 31, 2008, we also had $390 million principal amount of 9% Convertible Junior Subordinated Debentures due in 2063. At issuance, within the $390 million principal amount was an embedded derivative with a value of $16.9 million. The amount of the derivative is treated as a discount on issuance and is being amortized over the expected life of five years to interest expense. The fair value of the convertible debentures was approximately $145.7 million at December 31, 2008.
the payment of interest as of December 31, 2008. The establishment of this liability required estimates of potential outcomes of various issues and required significant judgment. Although the resolutions of these issues are uncertain, we believe that sufficient provisions for income taxes have been made for potential liabilities that may result. If the resolutions of these matters differ materially from these estimates, it could have a material impact on our effective tax rate, results of operations and cash flows.
amounts, if any, remaining available under our credit facility expiring in March 2010,
the amount outstanding under our credit facility that expires in March 2010,
federal taxes. For further information about tax and loss bonds, see Note 2 to our consolidated financial statements in Item 8.
To increase our capital position, late in the first quarter and early in the second quarter of 2008, we raised net proceeds of approximately $840 million through the sale of our common stock and junior convertible debentures. In the second quarter of 2008, we further enhanced our claims paying resources by entering into the reinsurance agreement with HCC discussed under “Results of Consolidated Operations-Risk sharing arrangements.” In the third quarter of 2008 we sold our remaining interest in Sherman and recognized a gain of $62.8 million. As discussed under “Overview-Outlook-Capital,” we may need additional capital in 2009 to continue to write new business.
For information about debt at our holding company, see Notes 6 and 7 to our consolidated financial statements in Item 8. You should also review “Overview-Debt at our Holding Company and Holding Company Capital Resources” above.
We may from time to time seek to acquire our debt obligations through cash purchases and/or exchanges for other securities. We may do this in open market purchases, privately negotiated acquisitions or other transactions. The amounts involved may be material.
Risk in force - net at December 31, 2008, as shown in the table above, is net of reinsurance and established loss reserves as discussed under “Capital” above. Risk in force - net at December 31, 2007 is net of reinsurance.
The increase in risk-to-capital during 2008 is the result of a decrease in statutory policyholders’ position. Statutory policyholders’ position decreased in 2008, primarily due to losses incurred, offset by a capital contribution to our subsidiary, MGIC, from the proceeds raised by the sale of our common stock and convertible debentures. If our insurance in force continues to grow, our risk in force would also grow. To the extent our statutory policyholders’ position does not increase at the same rate as our growth in risk in force, our risk-to-capital ratio will increase. Similarly, if our statutory policyholders’ position decreases at a greater rate than our risk in force, then our risk-to-capital ratio will increase.
We expect that our risk-to-capital ratio will increase above its level at December 31, 2008. See further discussion under “Overview-Capital” above as well as our risk factor titled “Because our policyholders position could decline and our risk-to-capital could increase beyond the levels necessary to meet regulatory requirements we are considering options to obtain additional capital” in Item 1A.
For further information about the importance of MGIC’s ratings, see our Risk Factor titled “Our financial strength rating has been downgraded below Aa3/AA-, which could reduce the volume of our new business writings” in Item 1A.
At December 31, 2008, the approximate future payments under our contractual obligations of the type described in the table below are as follows:
Our long-term debt obligations at December 31, 2008 include our $300 million of 5.375% Senior Notes due in November 2015, $200 million of 5.625% Senior Notes due in September 2011, $200 million outstanding under a credit facility expiring in March 2010 and $390 million in convertible debentures due in 2063, including related interest, as discussed in Notes 6 and 7 to our consolidated financial statements in Item 8 and under “-Liquidity and Capital Resources” above. For discussions related to our debt covenants see “-Liquidity and Capital Resources” and our risk factor titled “The amounts that we owe under our revolving credit facility and Senior Notes could be accelerated” In Item 1A. Our operating lease obligations include operating leases on certain office space, data processing equipment and autos, as discussed in Note 14 to our consolidated financial statements in Item 8. See Note 11 to our consolidated financial statement in Item 8 for discussion of expected benefit payments under our benefit plans.
Reserves are established for reported insurance losses and loss adjustment expenses based on when notices of default on insured mortgage loans are received. A default is defined as an insured loan with a mortgage payment that is 45 days or more past due. Reserves are also established for estimated losses
The claims rate and claim amounts are likely to be affected by external events, including actual economic conditions such as changes in unemployment rate, interest rate or housing value. Our estimation process does not include a correlation between claims rate and claims amounts to projected economic conditions such as changes in unemployment rate, interest rate or housing value. Our experience is that analysis of that nature would not produce reliable results. The results would not be reliable as the change in one economic condition can not be isolated to determine its sole effect on our ultimate paid losses as our ultimate paid losses are also influenced at the same time by other economic conditions. Additionally, the changes and interaction of these economic conditions are not likely homogeneous throughout the regions in which we conduct business. Each economic environment influences our ultimate paid losses differently, even if apparently similar in nature. Furthermore, changes in economic conditions may not necessarily be reflected in our loss development in the quarter or year in which the changes occur. Typically, actual claim results often lag changes in economic conditions by at least nine to twelve months.
In considering the potential sensitivity of the factors underlying our best estimate of loss reserves, it is possible that even a relatively small change in estimated claim rate or a relatively small percentage change in estimated claim amount could have a significant impact on reserves and, correspondingly, on results of operations. For example, a $1,000 change in the average severity reserve factor combined with a 1% change in the average claim rate reserve factor would change the reserve amount by approximately $184 million as of December 31, 2008. Historically, it has not been uncommon for us to experience variability in the development of the loss reserves through the end of the following year at this level or higher, as shown by the historical development of our loss reserves in the table below:
Estimation of losses that we will pay in the future is inherently judgmental. The conditions that affect the claim rate and claim severity include the current and future state of the domestic economy and the current and future strength of local housing markets. Current conditions in the housing and mortgage industries make these assumptions more volatile than they would otherwise be. The actual amount of the claim payments may be substantially different than our loss reserve estimates. Our estimates could be adversely affected by several factors, including a deterioration of regional or national economic conditions leading to a reduction in borrowers’ income and thus their ability to make mortgage payments, and a drop in housing values that could materially reduce our ability to mitigate potential losses through property acquisition and resale or expose us to greater losses on resale of properties obtained through the claim settlement process. Changes to our estimates could result in a material impact to our results of operations, even in a stable economic environment.
Our estimates could also be positively affected by government efforts to assist current borrowers in refinancing to new loan instruments, assisting delinquent borrowers and lenders in modifying their mortgage notes into something more affordable, and forestalling foreclosures. In addition private
Our estimates could also be positively affected by the extent of fraud that we uncover in the loans we have insured; higher rates of fraud should lead to higher rates of rescission, although the relationship may not be linear. Rescissions and denials totaled $85 million in the fourth quarter of 2008 and $171 million for the year ending December 31, 2008. In the fourth quarter of 2007 rescissions and denials totaled only $7 million and totaled only $28 million for the year ended December 31, 2007.
After our reserves are established, we perform premium deficiency calculations using best estimate assumptions as of the testing date. The calculation of premium deficiency reserves requires the use of significant judgments and estimates to determine the present value of future premium and present value of expected losses and expenses on our business. The present value of future premium relies on, among other things, assumptions about persistency and repayment patterns on underlying loans. The present value of expected losses and expenses depends on assumptions relating to severity of claims and claim rates on current defaults, and expected defaults in future periods. Assumptions used in calculating the deficiency reserves can be affected by volatility in the current housing and mortgage lending industries. To the extent premium patterns and actual loss experience differ from the assumptions used in calculating the premium deficiency reserves, the differences between the actual results and our estimate will affect future period earnings.
As is the case with our loss reserves, as discussed above, the severity of claims and claim rates, as well as persistency for the premium deficiency calculation, are likely to be affected by external events, including actual economic conditions. However, our estimation process does not include a correlation between these economic conditions and our assumptions because it is our experience that an analysis of that nature would not produce reliable results. In considering the potential sensitivity of the factors underlying management’s best estimate of premium deficiency reserves, it is possible that even a relatively small change in estimated claim rate or a relatively small percentage change in estimated claim amount could have a significant impact on the premium deficiency reserve and, correspondingly, on our results of operations. For example, a $1,000 change in the average severity combined with a 1% change in the average claim rate could change the Wall Street bulk premium deficiency reserve amount by approximately $125 million. Additionally, a 5% change in the persistency of the underlying loans could change the Wall Street bulk premium deficiency reserve amount by approximately $22 million. We do not anticipate changes in the discount rate will be significant enough as to result in material changes in the calculation.
Because our insurance premiums are earned over time, changes in persistency result in deferred insurance policy acquisition costs being amortized against revenue over a comparable period of time. At December 31, 2008, the persistency rate of our primary mortgage insurance was 84.4%, compared to 76.4% at December 31, 2007. This change did not significantly affect the amortization of deferred insurance policy acquisition costs for the period ended December 31, 2008. A 10% change in persistency would not have a material effect on the amortization of deferred insurance policy acquisition costs in the subsequent year.
To determine the fair value of securities available-for-sale in Level 1 and Level 2 of the fair value hierarchy a variety of inputs are utilized including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two sided markets, benchmark securities, bids, offers and reference data including market research publications. Inputs may be weighted differently for any security, and not all inputs are used for each security evaluation. Market indicators, industry and economic events are also considered. This information is evaluated using a multidimensional pricing model. Quality controls are performed throughout this process which includes reviewing tolerance reports, trading information and data changes, and directional moves compared to market moves. This model combines all inputs to arrive at a value assigned to each security.
based on the use of our multidimensional pricing model are classified in Level 2 and include certain municipal and corporate bonds.
A 1.00% change in the discount rate would change the value of our ARS by approximately $17 million. A two year change to the years to liquidity assumption would change the value of our ARS by approximately $1 million. The remainder of our level 3 securities are valued based on the present value of expected cash flows utilizing data provided by the trustees.
As discussed in Note 7 to our consolidated financial statements in Item 8 the derivative related to the outstanding debentures was valued using the Black-
Scholes model. Remaining derivatives were valued internally, based on the present value of expected cash flows utilizing data provided by the trustees.
Consolidated statements of shareholders’ equity for each of the three years in the period ended December 31, 2008
Historically a significant portion of the mortgage insurance provided by us through the bulk channel has been used as a credit enhancement for securitizations. During the fourth quarter of 2007, the performance of loans included in Wall Street bulk transactions deteriorated materially and this deterioration was materially worse than we experienced for loans insured through the flow channel or loans insured through the remainder of our bulk channel. Therefore, during the fourth quarter of 2007, we decided to stop writing that portion of our bulk business. A Wall Street bulk transaction is any bulk transaction where we had knowledge that the loans would serve as collateral in a home equity securitization. In general, loans included in Wall Street bulk transactions had lower average FICO scores and a higher percentage of ARMs or adjustable rate mortgages, compared to our remaining business. We continue to provide mortgage insurance on bulk transactions with the GSEs or for portfolio transactions where the lender will hold the loans.
The adoption of SFAS No. 157 resulted in no changes to January 1, 2008 retained earnings. (See note 5.)
Home office and equipment is carried at cost net of depreciation. For financial statement reporting purposes, depreciation is determined on a straight-line basis for the home office, equipment and data processing hardware over estimated lives of 45, 5 and 3 years, respectively. For income tax purposes, we use accelerated depreciation methods.
Home office and equipment is shown net of accumulated depreciation of $56.3 million, $51.7 million and $47.6 million at December 31, 2008, 2007 and 2006,
respectively. Depreciation expense for the years ended December 31, 2008, 2007 and 2006 was $4.5 million, $4.4 million and $4.4 million, respectively.
During 2008, 2007 and 2006, we amortized $10.0 million, $12.9 million and $14.2 million, respectively, of deferred insurance policy acquisition costs.
Reserves are established for reported insurance losses and loss adjustment expenses based on when we receive notices of default on insured mortgage loans. A default is defined as an insured loan with a mortgage payment that is 45 days or more past due. Reserves are also established for estimated losses incurred on notices of default not yet reported to us. In accordance with GAAP for the mortgage insurance industry, we do not establish loss reserves for future claims on insured loans which are not currently in default. Loss reserves are established by our estimate of the number of loans in our inventory of delinquent loans that will not cure their delinquency and thus result in a claim, which is referred to as the claim rate, and further estimating the amount that we will pay in claims on the loans that do not cure, which is referred to as claim severity. Our loss estimates are established based upon historical experience. Amounts for salvage recoverable are considered in the determination of the reserve estimates. Adjustments to reserve estimates are reflected in the financial statements in the years in which the adjustments are made. The liability for reinsurance assumed is based on information provided by the ceding companies.
Our insurance subsidiaries write policies which are guaranteed renewable contracts at the insured’s option on a single, annual or monthly premium basis. The insurance subsidiaries have no ability to reunderwrite or reprice these contracts. Premiums written on a single premium basis and an annual premium basis are initially deferred as unearned premium reserve and earned over the policy term. Premiums written on policies covering more than one year are amortized over the policy life in accordance with the expiration of risk which is the anticipated claim payment pattern based on historical experience. Premiums written on annual policies are earned on a monthly pro rata basis. Premiums written on monthly policies are earned as coverage is provided. When a policy is cancelled, all premium that is non-refundable is immediately earned. Any refundable premium is returned to the lender and will have no effect on earned premium. Policy cancellations also lower the persistency rate which is a variable used in calculating the rate of amortization of deferred insurance policy acquisition costs.
We offer both medical and dental benefits for retired domestic employees and their spouses. Under the plan retirees pay a premium for these benefits. In October 2008 we amended our postretirement benefit plan. The amendment, which is effective January 1, 2009, terminates the benefits provided to retirees once they reach the age of 65. This amendment reduces our accumulated postretirement benefit obligation by $59.2 million as of December 31, 2008. The amendment will also reduce our net periodic benefit cost in future periods beginning with calendar year 2009. We accrue the estimated costs of retiree medical and life benefits over the period during which employees render the service that qualifies them for benefits. Historically benefits were generally funded as they were due. The cost to us has not been significant. In 2008, approximately $1.3 million benefits were paid from the fund, and approximately $0.5 million were funded by us. (See note 11.)
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment,” under the modified prospective method. This statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. The fair value recognition provisions of SFAS No. 123 were voluntarily adopted by us in 2003 prospectively to all employee awards granted or modified on or after January 1, 2003. Under SFAS 123R, we are required to record compensation expense for all awards granted after the date of adoption and for all the unvested portion of previously granted awards that remained outstanding at the date of adoption. Under the fair value method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period which generally corresponds to the vesting period. Awards under our plans generally vest over periods ranging from one to five years. (See note 13.)
average number of common shares outstanding. Typically, diluted EPS is based on the weighted average number of common shares outstanding plus common stock equivalents which include stock awards, stock options and the dilutive effect of our convertible debentures. In accordance with SFAS 128, if we report a net loss from continuing operations then our diluted EPS is computed in the same manner as the basic EPS. For the years ended December 31, 2008, 2007 and 2006 our net loss (income) is the same for both basic and diluted EPS. The following is a reconciliation of the weighted average number of shares; however for the years ended December 31, 2008 and 2007 common stock equivalents of 23.1 million and 0.3 million, respectively, were not included because they were anti-dilutive. For 2008 the 23.1 million of common stock equivalents includes 22.7 million share equivalents related to our convertible debentures and 0.4 million related to restricted shares or share units. For 2007 the 0.3 million of common stock equivalents related to restricted shares or share units.
Our total comprehensive income, as calculated per SFAS No. 130, “Reporting Comprehensive Income”, was as follows:
At December 31, 2008, accumulated other comprehensive loss of ($106.8) million included ($51.0) million of net unrealized losses on investments, ($47.9) million relating to defined benefit plans and ($7.9) million related to foreign currency translation adjustment. At December 31, 2007, accumulated other comprehensive income of $70.7 million included $65.9 million of net unrealized gains on investments, ($3.2) million relating to defined benefit plans, $8.5 million related to foreign currency translation adjustment and ($0.5) million relating to the accumulated other comprehensive loss of our joint venture investment. (See notes 4 and 11.)
In December 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) 132R-1 which amends FASB Statement No. 132R, “Employers’ Disclosures about Pensions and Other Postretirement Benefits”, to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. The FSP is effective for fiscal years ending after December 15, 2009. We are currently evaluating the provisions of this statement and the impact, if any, this statement will have on our disclosures.
In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active.” The FSP clarifies the application of FASB Statement No. 157, “Fair Value Measurements” in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial
asset is not active. Our fair value policies are consistent with the guidance in this FSP.
In May 2008, the FASB issued FSP APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement).” FSP APB 14-1 requires the issuer of certain convertible debt instruments that may be settled in cash (or other assets) on conversion to separately account for the liability (debt) and equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. FSP APB 14-1 is effective for fiscal years beginning after December 15, 2008 on a retroactive basis. The adoption will result in a net-of-tax increase to our shareholders’ equity of approximately $63 million on January 1, 2009 and will result in a net-of-tax increase to interest expense of approximately $11 million for the year ended December 31, 2008 and $15 million annually thereafter, through April 1, 2013. These increases result from our Convertible Junior Subordinated Debentures discussed in Note 7.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We are currently evaluating the provisions of this statement and the impact, if any, this statement will have on our disclosures.
Certain reclassifications have been made in the accompanying financial statements to 2007 and 2006 amounts to allow for consistent financial reporting.
We provided certain services to C-BASS and Sherman in 2007 and 2006 in exchange for fees. In addition, C-BASS provided certain services to us during 2008, 2007 and 2006 in exchange for fees. The net impact of these transactions was not material to us.
The amortized cost, gross unrealized gains and losses and fair value of the investment portfolio at December 31, 2008 and 2007 are shown below. Debt securities consist of fixed maturities and short-term investments.
At December 31, 2008 and 2007, the investment portfolio had gross unrealized losses of $256.6 million and $39.4 million, respectively. For those securities in an unrealized loss position, the length of time the securities were in such a position, as measured by their month-end fair values, is as follows:
For the year ended December 31, 2008 we recognized “other than temporary” impairment charges of approximately $63 million on our fixed income investments, including debt instruments issued by Fannie Mae, Freddie Mac, Lehman Brothers and AIG. There were no “other than temporary” asset impairment charges on our investment portfolio for the years ending December 31, 2007 and 2006.
In mid-February 2008, auctions began to fail due to insufficient buyers, as the amount of securities submitted for sale in auctions exceeded the aggregate amount of the bids. For each failed auction, the interest rate on the security moves to a maximum rate specified for each security, and generally resets at a level higher than specified short-term interest rate benchmarks. At December 31, 2008, our entire ARS portfolio, consisting of 47 investments in ARS, was subject to failed auctions; however, we had redeemed at par $16.7 million in ARS from the period when the auctions began to fail through the end of 2008. Subsequent to December 31, 2008, and through January 27, 2009, we redeemed an additional $2.0 million in ARS at par. To date, we have collected all interest due on our ARS and expect to continue to do so in the future.
As a result of the persistent failed auctions, and the uncertainty of when these investments could be liquidated at par, the investment principal associated with failed auctions will not be accessible until successful auctions occur, a buyer is found outside of the auction process, the issuers establish a different form of financing to replace these securities, or final payments come due according to the contractual maturities of the debt issues. We believe that issuers and financial markets are exploring alternatives that may improve liquidity, although it is not yet clear when or if such efforts will be successful. We intend to hold our ARS until we can recover the full principal amount through one of the means described above, and have the ability to do so based on our other sources of liquidity.
The net realized investment gains (losses) and change in net unrealized appreciation (depreciation) of investments are as follows:
events are also considered. This information is evaluated using a multidimensional pricing model. Quality controls are performed throughout this process which includes reviewing tolerance reports, trading information and data changes, and directional moves compared to market moves. This model combines all inputs to arrive at a value assigned to each security.
Securities available-for-sale classified in Level 3 are not readily marketable and are valued using internally developed models based on the present value of expected cash flows. Our Level 3 securities primarily consist of auction rate securities. Our investments in auction rate securities were classified as Level 3 beginning in the fourth quarter of 2008 as quoted prices were unavailable due to events described in Note 4 and as there became increased doubt as to the liquidity of the securities. In particular, announced settlements in the fourth quarter of 2008 specified that re-marketers of the ARS provide liquidity to retail investors prior to providing liquidity to institutional investors and we did not observe a majority of issuers replacing these securities with another form of financing. Due to limited market information, we utilized a discounted cash flow (“DCF”) model to derive an estimate of fair value at December 31, 2008. The assumptions used in preparing the DCF model included estimates with respect to the amount and timing of future interest and principal payments, the probability of full repayment of the principal considering the credit quality and guarantees in place, and the rate of return required by investors to own such securities given the current liquidity risk associated with auction rate securities. The DCF model is based on the following key assumptions.
Fair value measurements for items measured at fair value included the following as of December 31, 2008 (in thousands of dollars):
For assets and liabilities measured at fair value using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances for the year ended December 31, 2008 is as follows (in thousands of dollars):
Short- and long-term debt, excluding convertible debentures discussed in Note 7.
The credit facility requires us to maintain Consolidated Net Worth of no less than $2.00 billion at all times. However, if as of June 30, 2009, Consolidated Net Worth equals or exceeds $2.75 billion, then the minimum Consolidated Net Worth under the facility will be increased to $2.25 billion at all times from and after June 30, 2009. Consolidated Net Worth is generally defined in our credit agreement as the sum of our
At December 31, 2008 and 2007 we had $200 million, 5.625% Senior Notes due in September 2011 and $300 million, 5.375% Senior Notes due in November 2015. Covenants in the Senior Notes include the requirement that there be no liens on the stock of the designated subsidiaries unless the Senior Notes are equally and ratably secured; that there be no disposition of the stock of designated subsidiaries unless all of the stock is disposed of for consideration equal to the fair market value of the stock; and that we and the designated subsidiaries preserve our corporate existence, rights and franchises unless we or such subsidiary determines that such preservation is no longer necessary in the conduct of its business and that the loss thereof is not disadvantageous to the Senior Notes. A designated subsidiary is any of our consolidated subsidiaries which has shareholder’s equity of at least 15% of our consolidated shareholders equity.
If (i) we fail to maintain any of the requirements under the credit facility discussed above, (ii) we fail to make a payment of principal when due under the credit facility or a payment of interest within five days after due under the credit facility or (iii) our payment obligations under our Senior Notes are declared due and payable (including for one of the reasons noted in the following paragraph) and we are not successful in obtaining an agreement from banks holding a majority of the debt outstanding under the facility to change (or waive) the applicable requirement, then banks holding a majority of the debt outstanding under the facility would have the right to declare the entire amount of the outstanding debt due and payable.
If (i) we fail to meet any of the covenants of the Senior Notes discussed above, (ii) we fail to make a payment of principal of the Senior Notes when due or a payment of interest on the Senior Notes within thirty days after due or (iii) the debt under our bank facility is declared due and payable (including for one of the reasons noted in the previous paragraph) and we are not successful in obtaining an agreement from holders of a majority of the applicable series of Senior Notes to change (or waive) the applicable requirement or payment default, then the holders of 25% or more of either series of our Senior Notes each would have the right to accelerate the maturity of that debt. In addition, the Trustee of these two issues of Senior Notes, which is also a lender under our bank credit facility, could, independent of any action by holders of Senior Notes, accelerate the maturity of the Senior Notes.
The debentures rank junior to all of our existing and future senior indebtedness. The net proceeds of the debentures were approximately $377 million. A portion of the net proceeds of the debentures and a concurrent offering of common stock (see Note 13) was used to increase the capital of MGIC, our principal insurance subsidiary, in order to enable us to expand the volume of our new insurance written, and a portion is available for our general corporate purposes. Debt issuance costs are being amortized over the expected life of five years to interest expense.
We may redeem the debentures prior to April 6, 2013, in whole but not in part, only in the event of a specified tax or rating agency event, as defined in the Indenture.
In any such event, the redemption price will be equal to the greater of (1) 100% of the principal amount of the debentures being redeemed and (2) the applicable make-whole amount, as defined in the Indenture, in each case plus any accrued but unpaid interest. On or after April 6, 2013, we may redeem the debentures in whole or in part from time to time, at our option, at a redemption price equal to 100% of the principal amount of the debentures being redeemed plus any accrued and unpaid interest if the closing sale price of our common stock exceeds 130% of the then prevailing conversion price of the debentures for at least 20 of the 30 trading days preceding notice of the redemption. We will not be able to redeem the debentures, other than in the event of a specified tax event or rating agency event, during an optional deferral period.
At issuance approximately $52.8 million in face value of the convertible debentures could not be settled in our common shares without prior shareholder approval and thus required bifurcation of the embedded derivative related to those convertible debentures. The derivative value of $16.9 million was determined using the Black-Scholes model, and is treated as a discount on issuance of the convertible debentures and amortized over the expected life of five years to interest expense. Prior to shareholder approval, changes in the fair value of the derivative were reflected in our results of operations. Since the changes in fair value corresponded
to changes in our stock price, a decrease in our stock price resulted in a decrease in the derivative liability. On the date of shareholder approval, June 27, 2008, the value of the derivative had decreased to $5.9 million. On this date the amount was re-classified from a liability to shareholders’ equity on the consolidated balance sheet, and subsequent changes in the fair value of the derivative will not be reflected on our financial statements. The change in fair value of the derivative from issuance to shareholder approval of approximately $11.0 million is included in other revenue on our statement of operations for the year ended December 31, 2008.
Our estimates could also be positively affected by government efforts to assist current borrowers in refinancing to new loan instruments, assisting delinquent borrowers and lenders in modifying their mortgage notes into something more affordable, and forestalling foreclosures. In addition private company efforts may have a positive impact on our loss development. However, all of these efforts are in their early stages and therefore we are unsure of their magnitude or the benefit to us or our industry, and as a result are not factored into our current reserving.
Our estimates could also be positively affected by the extent of fraud that we uncover in the loans we have insured; higher rates of fraud should lead to higher rates of rescissions, although the relationship may not be linear. Rescissions and denials totaled $85 million in the fourth quarter of 2008 and $171 million for the year ending December 31, 2008. Rescissions and denials totaled only $7 million in the fourth quarter of 2007 and totaled only $28 million for the year ended December 31, 2007.
The following table provides a reconciliation of beginning and ending loss reserves for each of the past three years:
The top portion of the table above shows losses incurred on default notices received in the current year and in prior years, respectively. The amount of losses incurred relating to default notices received in the current year represents the estimated amount to be ultimately paid on such default notices. The amount of losses incurred relating to default notices received in prior years represents actual claim payments that were higher or lower than what we estimated at the end of the prior year, as well as a re-estimation of amounts to be ultimately paid on defaults remaining in inventory from the end of the prior year. This re-estimation is the result of our review of current trends in default inventory, such as percentages of defaults that have resulted in a claim, the amount of the claims, changes in the relative level of defaults by geography and changes in average loan exposure.
experienced during that year, when compared to our estimates when originally establishing the reserves at December 31, 2005.
Information about the composition of the primary insurance default inventory at December 31, 2008 and 2007 appears in the table below.
In accordance with industry practice, loans approved by GSE and other automated underwriting (AU) systems under “doc waiver” programs that do not require verification of borrower income are classified by MGIC as “full documentation.” Based in part on information provided by the GSEs, we estimate full documentation loans of this type were approximately 4% of 2007 NIW. Information
for other periods is not available. We understand these AU systems grant such doc waivers for loans they judge to have higher credit quality. We also understand that the GSEs terminated their “doc waiver” programs, with respect to new commitments, in the second half of 2008.
Each quarter, we re-estimate the premium deficiency reserve on the remaining Wall Street bulk insurance in force. The premium deficiency reserve primarily changes from quarter to quarter as a result of two factors. First, it changes as the actual premiums, losses and expenses that were previously estimated are recognized. Each period such items are reflected in our financial statements as earned premium, losses incurred and expenses. The difference between the amount and timing of actual earned premiums, losses incurred and expenses and our previous estimates used to establish the premium deficiency reserves has an effect (either positive or negative) on that period’s results. Second, the premium deficiency reserve changes as our assumptions relating to the present value of expected future premiums, losses and expenses on the remaining Wall Street bulk insurance in force change. Changes to these assumptions also have an effect on that period’s results. The decrease in the premium deficiency reserve for the year ended December 31, 2008 was $757 million, as shown in the chart below, which represents the net result of actual premiums, losses and expenses offset by $134 million change in assumptions primarily related to higher estimated ultimate losses.
At the end of 2008 we performed a premium deficiency analysis on the portion of our book of business not covered by the premium deficiency described above. That analysis concluded that, as of December 31, 2008, there was no premium deficiency on such portion of our book of business. For the reasons discussed below, our analysis of any potential deficiency reserve is subject to inherent uncertainty and requires significant judgment by management. To the extent, in a future period, expected losses are higher or expected premiums are lower than the assumptions we used in our analysis, we could be required to record a premium deficiency reserve on this portion of our book of business in such period.
Under these agreements the captives are required to maintain a separate trust account, of which we are the sole beneficiary. Premiums ceded to a captive are deposited into the applicable trust account to support the captive’s layer of insured risk. These amounts are held in the trust account and are available to pay reinsured losses. The captive’s ultimate liability is limited to the assets in the trust account. When specific time periods are met and the individual trust account balance has reached a required level, then the individual captive may make authorized withdrawals from its applicable trust account. In most cases, the captives are also allowed to withdraw funds from the trust account to pay verifiable federal income taxes and operational expenses. Conversely, if the account balance falls below certain thresholds, the individual captive may be required to contribute funds to the trust account. However, in most cases, our sole remedy if a captive does not contribute such funds is to put the captive into run-off (in a run-off, no new loans are reinsured by the captive but loans previously reinsured continue to be covered, with premium and losses continuing to be ceded on those loans). In the event that the captives’ incurred but unpaid losses exceed the funds in the trust account, and the captive does not deposit adequate funds, we may also be allowed to terminate the captive agreement, assume the captives’ obligations, transfer the assets in the trust accounts to us, and retain all future premium payments. We intend to exercise this additional remedy when it is available to us. The total fair value of the trust fund assets under these agreements at December 31, 2008 approximated $582 million. During 2008, $265 million of trust fund assets were transferred to us as a result of captive terminations. There were no material captive terminations in 2007. The transferred funds resulted in an increase in our investment portfolio (including cash and cash equivalents) and there was a corresponding decrease in our reinsurance recoverable on loss reserves, which is offset by a decrease in our net losses paid.
Since 2005, we have entered into three separate aggregate excess of loss reinsurance agreements under which we ceded approximately $130 million of risk in force in the aggregate to three special purpose reinsurance companies. In 2008, we terminated one of these excess of loss reinsurance agreements. The remaining amount of ceded risk in force at December 31, 2008 was approximately $50.6 million. Additionally, certain pool polices written by us have been reinsured with one domestic reinsurer. We receive a ceding commission under certain reinsurance agreements.
The agreement is accounted for under deposit accounting rather than reinsurance accounting, because under the guidance of SFAS 113 “Accounting for Reinsurance Contracts”, we concluded that the reinsurance agreement does not result in the reasonable possibility that the reinsurer will suffer a significant loss.
We measured the value of our investment based upon the potential market for the equity interest in C-BASS and expected future cash flows of C-BASS, including a consensual, non-bankruptcy restructuring, which, subsequently occurred on November 16, 2007 through an override agreement with C-BASS’s creditors. The override agreement provides that C-BASS’s assets are to be paid out over time to its secured and unsecured creditors. The information used in our valuation was provided by C-BASS. We believe there is a high degree of uncertainty surrounding the amounts and timing of C-BASS’s cash flows and our analysis of them involved significant management judgment based upon currently available facts and circumstances, which are subject to change. The market analysis as well as our analysis of the cash flow projections reflected little or no value for our equity interest in C-BASS. Based on these analyses our entire equity interest in C-BASS was written down through an impairment charge under the guidance of APB 18 - Equity Method of Accounting.
At the time of sale the note had a fair value of $69.5 million (18.25% discount to par). The fair value was determined by comparing the terms of the Note to the discounts and yields on comparable bonds. The fair value was also discounted for illiquidity and lack of ratings. The discount will be amortized to interest income over the life of the Note. The gain recognized on the sale was $62.8 million, and is included in realized investment gains (losses) on the statement of operations for the year ended December 31, 2008.
purchase of interests in Sherman in which the fair value of the consideration reflects a value of Sherman over $1 billion plus an additional amount. The additional amount was $33 million if a definitive agreement had been entered into by early September 2008 and increases by $11 million for each monthly period that elapses after early September 2008 until a monthly period beginning in early February 2009, when the additional amount is $100 million. A qualifying purchase or sale transaction must close for us to be entitled to an additional payment.
In connection with the sale we waived, effective at the time at which the Note is paid in full, our right to any contingent consideration for the sale of the interests in Sherman that we sold in September 2007 to an entity owned by the management of Sherman. Under that sale, we are entitled to an additional cash payment if the purchaser’s after-tax rate of return on the interests purchased exceeds a threshold that equates to an annual return of 16%.
acceptable to obtain those objectives. To achieve these goals the minimum and maximum allocation ranges for fixed income securities and equity securities are:
We have a profit sharing and 401(k) savings plan for employees. At the discretion of the Board of Directors, we may make a profit sharing contribution of up to 5% of each participant’s eligible compensation. We provide a matching 401(k) savings contribution on employees’ before-tax contributions at a rate of 80% of the first $1,000 contributed and 40% of the next $2,000 contributed. We recognized profit sharing expense and 401(k) savings plan expense of $4.5 million, $2.7 million and $5.6 million in 2008, 2007 and 2006, respectively.
Net deferred tax assets and liabilities as of December 31, 2008 and 2007 are as follows:
The components of the net deferred tax asset as of December 31, 2008 and 2007 are as follows:
We (received) paid ($938.1) million, ($176.3) million and $227.3 million in federal income tax in 2008, 2007 and 2006, respectively. At December 31, 2008, 2007 and 2006, we owned $431.5 million, $1,319.6 million and $1,686.5 million, respectively, of tax and loss bonds.
eliminate the further accrual of interest. Although the resolution of this issue is uncertain, we believe that sufficient provisions for income taxes have been made for potential liabilities that may result. If the resolution of this matter differs materially from our estimates, it could have a material impact on our effective tax rate, results of operations and cash flows.
In February 2009, the Internal Revenue Service informed us that it plans to conduct an examination of our federal income tax returns for 2005 through 2007. We believe that income taxes related to these years have been properly provided for in the financial statements.
Effective January 1, 2007, we adopted FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” The Interpretation seeks to reduce the significant diversity in practice associated with recognition and measurement in the accounting for income taxes. The interpretation applies to all tax positions accounted for in accordance with SFAS No. 109, “Accounting for Income Taxes.” When evaluating a tax position for recognition and measurement, an entity shall presume that the tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information. The interpretation adopts a benefit recognition model with a two-step approach, a more-likely-than-not threshold for recognition and derecognition, and a measurement attribute that is the greatest amount of benefit that is cumulatively greater than 50% likely of being realized. As a result of the adoption, we recognized a decrease of $85.5 million in the liability for unrecognized tax benefits, which was accounted for as an increase to the January 1, 2007 balance of retained earnings. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
In March 2008 we completed the public offering and sale of 42.9 million shares of our common stock at a price of $11.25 per share. We received net proceeds of approximately $460 million, after deducting underwriting discount and offering expenses. Of the 42.9 million shares of common stock sold, 7.1 million were newly issued shares and 35.8 million were common shares issued out of treasury. The cost of the treasury shares issued exceeded the proceeds from the sale by approximately $1.6 billion, which resulted in a deficiency. The deficiency was charged to paid-in capital related to previous treasury share transactions, and the remainder was charged to retained earnings.
company cash inflow, is restricted by insurance regulation. MGIC is the principal source of dividend-paying capacity. During 2008, MGIC paid three quarterly dividends of $15 million each to our holding company, which increased the cash resources of our holding company. As has been the case for the past several years, as a result of extraordinary dividends paid, MGIC cannot currently pay any dividends without regulatory approval. We do not anticipate seeking approval in 2009 for any additional dividends from MGIC that would increase our cash resources at the holding company. Our other insurance subsidiaries can pay $3.6 million of dividends to us without such regulatory approval.
Certain of our non-insurance subsidiaries also have requirements as to maintenance of net worth.
Decreases in contingency reserves in 2007 and 2008 reflect early withdrawals for incurred losses that exceeded 35% of net premiums earned in a calendar year, in accordance with insurance regulations.
Some states that regulate us have provisions that limit the risk-to-capital ratio of a mortgage guaranty insurance company to 25:1. This ratio is computed on a statutory basis for our combined insurance operations and is our net risk in force divided by our policyholders’ position. Policyholders’ position consists primarily of statutory policyholders’ surplus, plus the statutory contingency reserve. The statutory contingency reserve is reported as a liability on the statutory balance sheet. A mortgage insurance company is required to make annual contributions to the contingency reserve of approximately 50% of net earned premiums. These contributions must generally be maintained for a period of ten years. However, with regulatory approval a mortgage insurance company may make early
withdrawals from the contingency reserve when incurred losses exceed 35% of net earned premium in a calendar year. If an insurance company’s risk-to-capital ratio exceeds the limit applicable in a state, it may be prohibited from writing new business in that state until its risk-to-capital ratio falls below the limit.
In February 2009, we received clarification from the OCI regarding the methodology used in calculating the excess of our policyholders position over the MPP. The clarification effectively reduces the required MPP by our reserves established for delinquent loans, beginning with our December 31, 2008 calculations. It is also our understanding that certain states have clarified their calculation of risk-to-capital to reduce risk in force for established loss reserves. We have used this methodology beginning with our December 31, 2008 calculations.
At December 31, 2008, MGIC exceeded MPP by more than $1.5 billion, and we exceeded MPP by $1.6 billion on a combined basis. At December 31, 2008 MGIC’s risk-to-capital was 12.9:1 and was 14.7:1 on a combined basis.
In addition to the uncertainties that could result in increased losses, there are other items that could favorably impact our future losses. For example, our estimated loss reserves reflect loss mitigation from rescissions using only the rate at which we have rescinded claims during recent periods, as discussed in Note 8. In light of the number of claims investigations we are pursuing and our perception that books of insurance we wrote before 2008 contain a significant number of loans involving fraud, we expect our rescission rate during future periods to increase. The insured can dispute our right to rescind coverage, and whether the requirements to rescind are met ultimately would be determined by arbitration or judicial proceedings. Also, our estimated loss reserves do not take account of the effect of potential benefits that might be realized from third party and governmental loan modification programs.
Because the factors that will affect our future losses are subject to significant uncertainty, there is significant uncertainty regarding the level of our future losses. However, if recent loss trends continue MGIC’s policyholders position would decline and its risk-to-capital would increase beyond the levels necessary to meet regulatory requirements. Depending on the level of future losses, this could occur before the end of 2009.
An inability to write new business does not mean that we do not have sufficient resources to pay claims. We believe we have more than adequate resources to pay claims on our insurance in force, even in scenarios in which losses materially exceed those that would result in not meeting MPP and risk-to-capital requirements. Our claims paying resources principally consist of our investment portfolio, captive reinsurance trust funds and future premiums on our insurance in force, net of premiums ceded to captive and other reinsurers.
The compensation cost that has been charged against income for the share-based plans was $17.4 million, $19.3 million and $33.4 million for the years ended December 31, 2008, 2007 and 2006, respectively. The related income tax benefit recognized for the share-based compensation plans was $6.1 million, $6.8 million and $11.7 million for the years ended December 31, 2008, 2007 and 2006, respectively.
A summary of option activity in the stock incentive plans during 2008 is as follows:
The following is a summary of stock options outstanding at December 31, 2008:
The aggregate intrinsic value of options outstanding and options exercisable at December 31, 2008 was zero. The aggregate intrinsic value represents the total pre-tax intrinsic value based on our closing stock price of $3.48 as of December 31, 2008 which would have been received by the option holders had all option holders exercised their options on that date. Because our closing stock price at December 31, 2008 was below all exercise prices, none of the outstanding options had any intrinsic value.
A summary of restricted stock or restricted stock units during 2008 is as follows:
3,004,229 shares were available for future grant under the 2002 stock incentive plan. Of the shares available for future grant, 2,905,609 are available for restricted stock awards. The total fair value of restricted stock vested during 2008, 2007 and 2006 was $3.3 million, $20.7 million and $17.4 million, respectively.
Under terms of our Shareholder Rights Agreement each outstanding share of our Common Stock is accompanied by one Right. The “Distribution Date” occurs ten days after an announcement that a person has become the beneficial owner (as defined in the Agreement) of the Designated Percentage of our Common Stock (the date on which such an acquisition occurs is the “Shares Acquisition Date” and a person who makes such an acquisition is an “Acquiring Person”), or ten business days after a person announces or begins a tender offer in which consummation of such offer would result in ownership by a person of 15 percent or more of the Common Stock. The Designated Percentage is 15% or more, except that for certain investment advisers and investment companies advised by such advisers, the Designated Percentage is 20% or more if certain conditions are met. The Rights are not exercisable until the Distribution Date. Each Right will initially entitle shareholders to buy one-half of one share of our Common Stock at a Purchase Price of $225 per full share (equivalent to $112.50 for each one-half share), subject to adjustment. If there is an Acquiring Person, then each Right (subject to certain limitations) will entitle its holder to purchase, at the Rights’ then-current Purchase Price, a number of our shares of Common Stock (or if after the Shares Acquisition Date, we are acquired in a business combination, common shares of the acquiror) having a market value at the time equal to twice the Purchase Price. The Rights will expire on July 22, 2009, subject to extension. The Rights are redeemable at a price of $0.001 per Right at any time prior to the time a person becomes an Acquiring Person. Other than certain amendments, the Board of Directors may amend the Rights in any respect without the consent of the holders of the Rights.
Consumers are bringing a growing number of lawsuits against home mortgage lenders and settlement service providers. In recent years, seven mortgage insurers, including MGIC, have been involved in litigation alleging violations of the anti-referral fee provisions of the Real Estate Settlement Procedures Act, which is commonly known as RESPA, and the notice provisions of the Fair Credit Reporting Act, which is commonly known as FCRA. MGIC’s settlement of class action
In 2008, complaints in five separate purported stockholder class action lawsuits were filed against us, several of our officers and an officer of C-BASS. The allegations in the complaints are generally that through these individuals we violated the federal securities laws by failing to disclose or misrepresenting C-BASS’s liquidity, the impairment of our investment in C-BASS, the inadequacy of our loss reserves and that we were not adequately capitalized. The collective time period covered by these lawsuits begins on October 12, 2006 and ends on February 12, 2008. The complaints seek damages based on purchases of our stock during this time period at prices that were allegedly inflated as a result of the purported misstatements and omissions. With limited exceptions, our bylaws provide that our officers are entitled to indemnification from us for claims against them of the type alleged in the complaints. We believe, among other things, that the allegations in the complaints are not sufficient to prevent their dismissal and intend to defend against them vigorously. However, we are unable to predict the outcome of these cases or estimate our associated expenses or possible losses.
Other lawsuits alleging violations of the securities laws could be brought against us. In December 2008, a holder of a class of certificates in a publicly offered securitization for which C-BASS was the sponsor brought a purported class action under the federal securities laws against C-BASS; the issuer of such securitization, which was an affiliate of a major Wall Street underwriter; and the underwriters alleging material misstatements in the offering documents. The complaint describes C-BASS as a venture of MGIC, Radian Group and the management of C-BASS and refers to Doe defendants who are unknown to the plaintiff but who the complaint says are legally responsible for the events described in the complaint.
See Note 12 for a description of federal income tax contingencies.
The fourth quarter results included the establishment of premium deficiency reserves related to our Wall Street bulk business. (See Notes 1 and 8.)