FSA or its subsidiaries also maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid (Spain), Mexico City (Mexico), Paris (France), Sydney (Australia) and Tokyo (Japan). The Company and its subsidiaries do not own any material real property.
(b)Amounts are statutory data for FSA and therefore differ from comparable GAAP amounts.
The affected competitors are taking a variety of actions to protect policyholders, restore stable Triple-A ratings and recover market confidence. Certain financial guaranty insurers have announced or are considering plans to divide their insurance operations into separate legal operating companies for municipal and non-municipal insurance. Some have raised substantial amounts of new capital.
Beginning in 2005, the Company cut back insurance of RMBS and generally avoided CDOs of ABS. In all, FSA insured two CDOs of ABS: (1) a Double-A rated obligation insured in 2000 with $63 million net par outstanding and less than 3% invested in U.S. subprime and "Alt-A" RMBS collateral, and (2) a $300 million CDS excess-of-loss reinsurance transaction insured in 2005 at four times the original Triple-A attachment point. "Alt-A" refers to borrowers whose credit quality falls between prime and subprime. In contrast, most of the Company's peers have suffered from projected
In 2007, mortgage performance deteriorated rapidly, exceeding the most conservative historical loss expectations. For the first time since the Great Depression, year-over-year home prices declined across the entire United States, not just regionally. As projected losses on subprime and other RMBS increased, some mortgage lenders failed, and rating agencies downgraded many mortgage-related securities. This included a large amount of CDOs of ABS. In the home equity line of credit ("HELOC") market, which generally involves prime borrowers, projected losses also rose to unprecedented levels. The performance of closed-end second-lien mortgage loan securitizations also deteriorated.
The Company's net loss of $65.7 million in 2007 was caused primarily by unrealized negative after-tax fair-value adjustments totaling $417.7 million for insured derivatives, comprising mainly pooled corporate CDS and CDS on funded CLOs. Management believes such fair-value adjustments in 2007 were due principally to the disruption in market liquidity and other technical factors in the CDS market. The fair-value adjustments must be made even if no credit losses are expected on the underlying securities. Based on observed market indicators through February 2008, management expects there will be additional significant negative unrealized mark-to-market adjustments with respect to its insured derivative portfolio in the first quarter of 2008. Absent any claims under the guarantees, any decreases or increases to income due to these marks will sum to zero by the time of each contract's maturity and are therefore one of the elements omitted from the non-GAAP measure operating earnings, which totaled $378.0 million in 2007. See "-Summary Results of Operations and Financial Condition" and "-Non-GAAP Measures."
Widening spreads related to market illiquidity also caused unrealized mark-to-market adjustments in the available-for-sale FP Investment Portfolio totaling negative $964.5 million after taxes in 2007, primarily resulting from changes in fair value of RMBS. The Company has the ability and intent to hold each asset to its maturity, and therefore, absent credit losses, marks should sum to zero when the asset matures. Given the large size of the FP Investment Portfolio ($18.1 billion carrying value), even a small price change can have a material impact on aggregate market value. The FP segment began accumulating cash in the fourth quarter of 2007 to improve its liquidity position.
To reflect accurately how the Company's management evaluates the Company's operations and progress toward long-term goals the Company discloses both GAAP and non-GAAP measures. Although the measures identified as non-GAAP should not be considered substitutes for GAAP measures, management considers them key performance indicators and employs them in determining compensation. Non-GAAP measures therefore provide investors with important information about the way management analyzes its business and rewards performance. The purpose and definition of each
non-GAAP measure are briefly described when the term first appears. For a more complete explanation of these terms, see "-Non-GAAP Measures" below.
In 2007, the Company reported a net loss of $65.7 million, compared with net income of $424.2 million in 2006 and $326.1 million in 2005. Net income reported in accordance with GAAP is volatile because it includes (a) fair-value adjustments for investment-grade insured derivatives and (b) fair-value adjustments for economic interest rate hedges that are not in designated hedging relationships under Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). Operating earnings, a non-GAAP measure that excludes fair-value adjustments for investment-grade insured derivatives and fair-value adjustments for economic interest rate hedges, is reconciled to net income (loss) as follows:
Economic interest rate hedges are defined as hedges that are economically effective but do not meet the criteria necessary to receive hedge accounting treatment under SFAS 133. The majority of the Company's economic hedges relate to interest rate derivatives used to convert the fixed interest rates of certain assets and liabilities to dollar-denominated floating rates based on the London Interbank Offered Rate ("LIBOR"). Without hedge accounting, SFAS 133 requires the marking to fair value of each such derivative in income without the offsetting mark to fair value on the risk it is intended to hedge. These one-sided valuations cause volatility in the consolidated statements of operations and comprehensive income. Management views fair-value adjustments on economically hedged risks together with the fair-value adjustments on the hedging items in order to analyze and manage economic hedge inefficiency, regardless of the prescribed accounting treatment. Under the Company's definition of operating earnings, the economic effect of these hedges is recognized, which, for interest rate swaps, generally results in any cash paid or received being recognized ratably as an expense or revenue over the hedged item's life.
Fair-value adjustments for insured derivatives are excluded from operating earnings because, as discussed above under "-Business Environment and Market Trends-Reduced Liquidity in Capital Markets," management does not expect material realized losses as a result of credit deterioration in the Company's insured derivatives portfolio and expects the negative fair-value adjustments to reverse as these insured obligations approach their maturities. Insured derivatives represent approximately one-fifth of total net par outstanding, consisting mainly of insured CDS on pooled corporate risk. The underlying quality of FSA's total insured CDS portfolio was 96% Triple-A or "Super Triple-A," 3% Double-A and 1% below Double-A at December 31, 2007. "Super Triple-A" indicates a level of first-loss protection generally exceeding 1.3 times the level required by a rating agency for a Triple-A rating.
2007 vs. 2006: Operating earnings increased in both the financial guaranty and FP segments. In the financial guaranty segment, net investment income from the general investment portfolio, and nonrecurring items such as refundings and realized foreign exchange gains were partially offset by higher losses, interest expense and operating expenses. In the FP segment, despite an after-tax OTTI charge of $7.2 million, FP Segment NIM increased. However, this upward trend began to reverse in the fourth quarter of 2007 due to management's decision to build liquidity in the FP segment.
Shareholders' equity under GAAP ("book value") was $1.6 billion in 2007, compared with $2.7 billion in 2006. Shareholders' equity declined $1.1 billion in 2007 primarily as a result of negative mark-to-market adjustments on the FP Investment Portfolio of $964.5 million, negative mark-to-market adjustments on insured derivatives of $417.7 million and dividends paid of $122.0 million, offset partially by operating earnings of $378.0 million. Non-agency RMBS represented 67% of the FP Investment Portfolio and was the primary driver of the negative mark in other comprehensive income. As of December 31, 2007, 92% of these RMBS securities were rated Triple-A, and 8% were rated Double-A. The declines in value recorded at December 31, 2007 were deemed to be temporary.
ABV, after adding back dividends, grew at a compounded annual growth rate of 18% in 2007, driven primarily by the growth of present value ("PV") future net installment premiums ("PV premiums outstanding") and PV of future FP NIM ("PV NIM outstanding"), as well as unearned premium revenue. See "-New Business Production." ABV takes into account future revenue streams from unearned premium revenue recorded on the Company's balance sheet as well as PV premiums
(1)Amounts include the effects of PV future ceding commission and premium taxes. The discount rate varies according to the year of origination. For each year's originations, the Company calculates the discount rate as the average pre-tax yield on its investment portfolio for the previous three years. The rate was 4.86% for 2007 and 5.07% for 2006.
(2)At the beginning of 2007, based on experience, management applied a reduced estimate of transaction and hedging costs to the PV NIM outstanding. This increased December 31, 2007 PV NIM outstanding by approximately $24.7 million net of tax.
PV originations are estimated by the Company for business originated in the period as the sum of:
•the present value of FP NIM originated in a given period in the FP segment ("PV NIM originated"), defined as estimated interest to be received on investments less estimated transaction expenses and interest to be paid on liabilities plus results from derivatives used for hedging purposes, discounted to present value (see "-Financial Products Segment-PV NIM Originated" and "-Non-GAAP Measures-Present Value of Financial Products Net Interest Margin Originated").
PV originations rose to a record level of $1,271.0 million in 2007, an increase of 40% over that of the previous year, primarily due to increased FSA production in the international public infrastructure sector, a growing preference for FSA insurance over guarantees from other monolines in the fourth quarter and wider credit spreads across FSA's financial guaranty markets, partially offset by a decline in FP originations due to the Company's decision to build liquidity in the fourth quarter. In 2006, PV originations declined 10% from those of 2005, due primarily to declines in U.S. public finance and global asset-backed markets in an environment of tight credit spreads, partially offset by increased international public finance and financial products production. The changes in the components of PV originations are discussed in detail in "-Financial Guaranty Segment" and "-Financial Products Segment" below.
Management believes that, by disclosing the components of PV originations in addition to premiums written, the Company provides investors with a more comprehensive description of its new business activity in a given period. The discount rate used to calculate PV originations was 4.86% for 2007, 5.07% for 2006 and 5.30% for 2005.
insure transactions due to unattractive premium rates or credit quality that did not comply with the Company's underwriting guidelines. In 2007, this trend started to reverse as the demand for FSA's financial guaranty increased and pricing provided much higher returns than in previous years. Public finance premiums earned have steadily increased over the past several years.
The Company employs reinsurance to manage single-risk limits and maintain capacity to write new business. Over the past three years, the Company has ceded approximately one-quarter of its gross par insured with a diversified group of reinsurers. The ratio of ceded premiums written to gross premiums written was 34% in 2007, 35% in 2006 and 31% in 2005.
Geographical diversification has always been a risk management strategy for the financial guaranty segment, particularly in the public finance sector. In recent years, the Company's growth area has been in international business, particularly public-private partnership transactions in the infrastructure sector and financings of water and other utility companies. The table below shows the amount of U.S. and international premiums earned based on geography of underlying risks. These types of transactions serve to support the Company's future earnings for extended periods of time due to their long-dated maturities.
(1)Yields are based on amortized cost and stated on a pre-tax basis. The General Investment Portfolio includes the Company's investment in preferred shares of XL Financial Assurance Ltd. ("XLFA"), a subsidiary of Security Capital Assurance Ltd. ("SCA"). The Company's preferred stock investment in XLFA is redeemable beginning in November 2008. Based on information available as of December 31, 2007, management concluded that the $39 million carrying value of its investment in XLFA was recoverable. Subsequent to year-end, XLFA was downgraded by S&P from Triple-A to Single-A with a negative watch and by Moody's from Aaa to A3 with a review for downgrade. Management is closely monitoring developments and will continue to evaluate the carrying value and recoverability of its investment in XLFA preferred shares.
The fair-value adjustments for insured derivatives represent hypothetical replacement value and comprise the majority of the balance in this line item, as shown in the table below. The fair value of an insured CDS contract incorporates all the remaining future premiums to be received over the life of the insured CDS contract, discounted to present value and multiplied by the ratio of the current replacement premium (what a buyer or seller would pay for a similar contract based on current market conditions) to the contractual premium. As the fair value of an insured CDS contract incorporates all the remaining future premium payments to be received over the life of the insured CDS contract, the
The negative fair-value adjustments in 2007 resulted from an unusual and severe widening of credit spreads during the year. Despite the structural protections associated with the Company's CDS, the significant widening of credit spreads on pooled corporate CDS and CDS of funded CDOs and CLOs, as with other structured credit products, during the second half of 2007, resulted in a decline in fair value of these contracts. Funding costs for domestic and European CLOs as well as pooled corporate CDS were at their widest levels during the fourth quarter. As a result, Triple-A spreads to LIBOR continued to widen in the fourth quarter and resulted in the significant adverse mark reflected in the CDS fair-value results.
The Company believes that fair value is potentially misleading unless one understands that the Company's typical insured CDS contract is different from CDS contracts entered into by parties that are not financial guarantors because:
Fair value is defined as the price at which an asset or a liability could be bought or sold in a current transaction between willing parties. Fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is the case with most of the Company's insured CDS contracts because these contracts are not traded, then the determination of fair value is based on internally developed estimates that employ credit-spread algorithms. These algorithms are unique to each insured CDS category and utilize various publicly available indices, depending on the types of assets referenced by the insured CDS contract and the length of the contract. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal credit assessments or rating agency-based shadow ratings, and, for its insured obligations, the level at which the deductible has been set. Estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions. The following is a description of the market pricing information that the Company utilizes in determining the fair value for significant categories of its insured CDS portfolio.
The Company's valuation process for pooled corporate CDS involves stratifying the investment-grade and high-yield contracts by remaining term to maturity, consistent with the reference indexes. Within maturity bands, further distinction is made for contracts that have higher attachment points. As index prices are quoted for standard attachment and detachment points (or tranches), the Company calibrates the quoted index price to the typical attachment points for its individual CDS contracts in order to derive the appropriate value, which is then validated by comparing it with relevant recent market transactions, if available.
In order to estimate the weighted-average market price of an investment-grade pooled corporate CDS contract, the Company primarily utilizes the applicable market prices of the quoted tranches of the published CDX North America IG Index. In order to estimate the weighted-average market price for high yield pooled corporate CDS contracts, the Company obtains dealer prices for the most senior quoted three-year and five-year tranches of the CDX North America High Yield Index and then applies a factor to the quoted prices. The factor depends on (a) the term to maturity of the Company's contract and (b) the attachment point of the Company's pooled corporate CDS contract, and is intended to calibrate the published index price to the Company's pooled corporate CDS contract, which references entities with higher credit quality than those reflected in the published indexes.
Other Structured Obligations Valuation: The Company determines the fair value of insured CDS of European residential mortgage loan portfolios with reference to the recent auction prices of KfW Bankengruppe, the German development bank, when available. For CDS for which observable market value information is not available, management applies its best judgment to estimate the appropriate current fair value.
(4)Amounts include transactions previously wrapped by other monolines. See "-Exposure to Other Monolines."
The upward trend in loss expense results primarily from higher originations in the international project finance sector, which generally comprises larger, lower rated transactions with higher reserve charges based on the Company's non-specific reserving methodology. The increase in 2007 was also a function of applying a higher experience factor. The Company's calculation of its non-specific reserve includes the application of a factor to adjust the statistical loss calculation for Company-specific experience. HELOC transactions in the asset-backed portfolio have experienced some deterioration. Credit support for the HELOC transactions is primarily provided by excess spread. Generally, once the overcollateralization is exhausted, the Company pays a claim if losses in a period exceed excess spread for the period, and to the extent excess spread exceeds losses, the Company is reimbursed for any losses paid to date. As of December 31, 2007, an estimated ultimate loss (discounted to present value) of $65.0 million on HELOC transactions had been transferred from the non-specific reserve to case reserves, which increased the experience factor. Such estimate of loss is net of reinsurance and anticipated recoveries and is re-evaluated on a quarterly basis. In the second half of 2007, the Company paid a total of $47.6 million in HELOC claims, of which $39.5 million represented what the Company deems to be recoverable and is recorded as salvage and subrogation recoverable as of December 31, 2007.
Case and non-specific reserves for losses and loss adjustment expenses are discounted when established using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established. The amount of the discount as of December 31, 2007 for the total gross and net case reserves was $14.5 million and $3.3 million, respectively.
Public Finance: Within the public finance insured portfolio, the potential severity of health care losses is comparatively high in the event of a loss. Hospital facilities are single-purpose assets and a failing health care issuer is likely to be liquidated or acquired. If there is collateral associated with a health care credit, it is generally in the form of a hospital facility, the value of which is primarily driven by the community's need for that facility. The more hospitals competing in a community, the more fragile the value of the hospital collateral is likely to be in a stress scenario. The Company addresses the severity risk in this sector through internal policies that limit exposure to any single credit.
The Company had a reserve as of December 31, 2007 for one insured hospital. The reserve was set assuming the loss would be equal to 64% of net par insured (i.e., at 64% loss severity).
Asset-backed Obligations: The pools of assets backing any given insured transaction are generally of one type (such as automobile loans, residential mortgage loans, corporate loans, etc.). However, they are generally diversified within that asset type. In management's view, the Company's losses incurred to date on insured transactions have been manageable due to characteristically low default frequency despite variability.
Draw rates are a key determinant of loss in some of the more poorly performing HELOC transactions, particularly those sponsored by Countrywide Financial Corporation ("Countrywide"), because once those transactions breach performance thresholds, draws funded by Countrywide effectively support the transactions and reduce the claims that would otherwise be paid by the Company. Although Countrywide has acknowledged its obligation to fund future draws to performing HELOC borrowers, management has assumed a reduction in future draw rates to reflect management's estimation of Countrywide's future curtailment of availability for borrowers who are delinquent or whose homes have declined too much in value. In setting its reserves, management assumed annualized draw rates would decline linearly from 10% to 5% over 12 months, then remain at 5%.
The Alt-A (or near-prime first lien) and Alt-A closed-end second lien ("CES") insured risks may also be at risk for future losses if default rates increase beyond current expectations. Management used a deterministic model to project the performance of FSA-insured mortgage-backed securities backed by closed-end (i.e., not revolving like HELOCs) second lien mortgage loans to Alt-A borrowers and does not currently estimate any losses for these transactions. All outstanding guaranteed Alt-A CES transactions were rated Triple-A when insured by the Company. Of the $1.5 billion net par currently outstanding, $681 million is protected by insurance policies from other monolines. The Company has reduced its internal ratings from Triple-A on four unwrapped Alt-A CES with aggregate net par of $814 million. One unwrapped Alt-A CES with $74 million in net par was downgraded to Single-A, and three unwrapped Alt-A CES with $740 million in net par were downgraded to Triple-B. While the three most troubled transactions have overcollateralization of over 20%, all are experiencing historically high default rates. Management's current deterministic model assumes that current default rates remain at their high levels for six months, then return to their normal range over the next six months. Management's future estimation of Alt-A CES performance could vary from its current estimates and could result in future Alt-A CES estimated losses.
FSA management believes that the liability it carries for losses and loss expenses is adequate to cover the net cost of claims. However, the loss liability is based on assumptions regarding the insured portfolio's probability of default and its severity of loss, and there can be no assurance that the liability for losses will not exceed such estimates.
The Company's insurance policies, including insured derivatives, are generally non-cancelable and remain outstanding for years from date of inception, in some cases 30 years or longer. Accordingly, PV premiums originated, as distinct from earned premiums, represents premiums to be earned in the future. See "-Non-GAAP Measures-Present Value of Premiums Originated" below for a more detailed discussion.
(1)Based on internal ratings at date of origination. As of December 31, 2007, certain transactions had been downgraded.
During the first nine months of 2007, the pricing environment was more competitive, and FSA generally focused on higher quality core sectors, such as general obligations, where more attractive relative returns were available. For the full year 2007, U.S. municipal par insured increased 23%, and PV premiums originated increased 25%. In 2006, U.S. public finance par insured declined 28%, and PV premiums originated declined 36%, as FSA increased its strategic focus on core municipal sectors.
Results in the international public finance sector tend to be irregular because of the timing of large transactions with long development periods.
For the full year, international public finance par originated increased 33% to $12.5 billion, and PV premiums originated increased 27% to a record $404.9 million, driven by a significant number of large transactions in diverse sectors, such as transportation, health care and utilities. While FSA was most active in the United Kingdom and Europe, it also insured issues in Canada, Mexico, Australia, New Zealand, Japan and South Korea.
In 2006, international public finance originations grew 27% in par insured, while PV premiums grew at a higher rate, 71%, because of longer average lives. Originations were strongest in the United Kingdom and Australia, but FSA also guaranteed public finance transactions in Western and Central Europe, Asia and the Americas.
In 2007, FSA increased U.S. asset-backed par originated 41% and PV premiums originated 184%. PV originations grew more rapidly than par originated due to spread widening and longer average lives of transactions. Widening spreads created particularly strong opportunities in Super Triple-A pooled corporate CDS.
In 2006, FSA's U.S. asset-backed par insured increased 17%, and PV premiums originated declined 42%. Throughout 2006, the asset-backed market was characterized by tight credit spreads, excess market liquidity and aggressive uninsured structures, which had a negative impact on pricing. Additionally, originations in 2006 had shorter average lives than those in 2005.
The Company seeks to maintain a diversified portfolio of insured public finance obligations designed to spread its risk across a number of geographic areas. The table below sets forth those jurisdictions in which municipalities issued an aggregate of 2% or more of the total net par amount outstanding of FSA-insured public finance securities:
As of December 31, 2007, the public finance insured portfolio contained three obligations for which the Company estimates an ultimate net loss: an international infrastructure obligation, a healthcare transaction and a waste treatment facility transaction. Estimated net loss as of December 31, 2007 on a present value basis or based on management's best estimate, net of anticipated recoveries and reinsurance was $34.9 million and is included in case reserves. The Company paid $1.1 million in 2007, $1.0 million in 2006 and $0.9 million in 2005 in claims on public finance obligations, net of reinsurance and recoveries. Management continually monitors these obligations and adjusts reserves accordingly.
The Company insures a wide variety of structured finance securities, including insured derivatives, which generally are investment grade at origination, typically with low loss severity in the event of
default and low liquidity demands. See "-Results of Operations-Fair-Value Adjustments for Derivatives" for a discussion of the Company's insured derivative portfolio. In the normal course of business, the Company monitors its exposures in all insured categories. Due to recent events, additional focus has been placed on the mortgage-backed categories. The Company internally rates each insured credit periodically based on criteria similar to those used by the rating agencies. Estimated net loss for the asset-backed insured portfolio as of December 31, 2007, on a present value basis, net of anticipated recoveries and reinsurance, was $63.2 million and was recorded in case reserves. See "-Results of Operations-Losses." During 2007, the Company paid $61.9 million on claims in the asset-backed sector, net of recoveries received as of December 31, 2007, and reinsurance. During 2006 and 2005, the Company recovered $0.7 million and $0.4 million, respectively, on previously paid claims in the asset-backed sector, net of reinsurance and recoveries.
The following discussion summarizes the Company's exposure to various types of mortgage-backed obligations.
Alt-A Closed-End Second Lien Mortgages: Alt-A closed-end second lien mortgages represent 1% of total asset-backed par outstanding. Closed-end second lien mortgage transactions insured by FSA are typically structured with 25-27% of subordination plus excess spread of approximately 8% on a present value basis. At initial underwriting, defaults were expected to equal approximately 11%, with no assumed recovery, providing over three times coverage. Therefore, lifetime default rates would generally need to exceed 33-35% for the Company to suffer a loss. All FSA-insured closed-end second-lien mortgage transactions were rated Triple-A at closing. Six insured 2007 transactions with an aggregate net par of $681 million are rated Triple-A based on wraps provided by other monolines. FSA insured four closed-end second lien mortgage transactions that were not previously wrapped. Their performance has been deteriorating, and FSA downgraded three of these transactions to Triple-B and one to Single-A as of December 31, 2007.
NIM Securitizations: NIM securitizations represent less than 1% of total asset-backed par outstanding. Since 2001, FSA has insured 67 NIM securitizations totaling $5.9 billion. Of this amount,
transactions, with an aggregate net par outstanding of $255 million, were outstanding at December 31, 2007. Twelve of FSA's outstanding insured NIM securitizations benefit from first-loss insurance provided by either Radian Insurance or Bluepoint Re. The performance of one insured NIM securitization, with a net par outstanding of $14.9 million, has deteriorated; Radian Insurance provides first-loss coverage for this NIM securitization, which has grown to 83% of net par outstanding.
Reinsurance does not relieve the Company of its obligations to policyholders. In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company may be unable to recover amounts due. A number of FSA's reinsurers are required to pledge collateral to secure their reinsurance obligations to FSA in an amount equal to their statutory unearned premium loss and contingency reserves associated with the ceded business. FSA requires collateral from reinsurers primarily to (a) receive statutory credit for the reinsurance, (b) provide liquidity to FSA in the event of claims on the reinsured exposures, and (c) enhance rating agency credit for the reinsurance.
(2)Outlook revised downward after December 31, 2007 by one or more of the rating agencies.
(4)Over 97% of risks reinsured to R.V.I. Guaranty Co., Ltd. have underlying ratings of Triple-A.
(5)Downgraded by Moody's (A1/stable) and S&P (A+/negative outlook) in March 2008.
The FP segment includes the results of operations of the GIC Subsidiaries and consolidated variable interest entities ("VIEs"). Management's analysis of the FP segment is primarily based on FP Segment NIM, a non-GAAP measure.
Commencing with the fourth quarter of 2007, the Company has been enhancing the liquidity available in its FP Investment Portfolio by investing newly originated GIC proceeds in short-term investments, in anticipation of earlier than anticipated withdrawals from GICs supporting credit-linked notes referencing CDOs of ABS. As a result, the NIM on new business originations in the FP segment has been eliminated and, in some cases, negative NIM is generated. Overall, NIM remained positive through December 31, 2007. This trend is expected to continue in the near term to the extent that funding costs exceed short-term investment rates.
•the VIE Investment Portfolio, consisting of the investments supporting the VIE liabilities.
In addition to this test, management selected what it believed to be the 20 worst performing investments from each of the Alt-A and subprime investment categories for further analysis. The Alt-A sector was identified because this sector demonstrated the worst relative performance in terms of over-
The Company's effective tax rate benefit was 64% in 2007 and tax rate provisions were 29% in 2006 and 27% in 2005. The 2007 effective tax rate reflects the higher ratio of tax-exempt interest income to year-to-date pre-tax loss, which was caused by mark-to-market losses recorded in income. The 2007 and 2006 rates differ from the statutory rate of 35% due primarily to tax-exempt interest and, in 2006, minority interest. In 2005, the rate differed from the statutory rate of 35% due primarily to tax-exempt interest, minority interest and the Company's reorganization of Financial Security Assurance International Ltd. ("FSA International") together with its intention to begin repatriating FSA International's future earnings.
The American Jobs Creation Act of 2004 (the "Act"), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provided guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International's tax dividend distribution made in the fourth quarter of 2005.
In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%) applicable to certain earnings and profits of offshore subsidiaries repatriated during 2005 and invested in the United States pursuant to a qualifying reinvestment plan in accordance with the Act. In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned subsidiary and declared that it no longer intends to reinvest future earnings of that subsidiary permanently offshore, with the effect that 2005 and future income from FSA International have become subject to an increased effective U.S. tax rate. The effect in 2005 on earnings reflects (a) a tax liability of $15.1 million in respect of earnings of FSA International that have previously been recognized for GAAP but not yet for tax and (b) $14.2 million related to 2005 earnings.
In connection with Dexia's acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. ("WMH"). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment is treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains Insurance Group under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2007.
(2)Represent par balances for the insured portfolios and amortized cost for the investment portfolios.
The Company also bears some of the "risks and rewards" associated with the performance of those special purpose entities' assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given special purpose entity's obligations, the Company bears the risk of asset performance (typically, but not always, after a significant depletion of overcollateralization, excess spread, a deductible or other credit protection).
performance are assumed by FSA. In analyzing special purpose entities described above, the Company considers reinsurance to be an implicit variable interest. Where the Company determines it is required to consolidate the special purpose entity, the outstanding exposure is excluded from outstanding exposure amounts reported in this Annual Report on Form 10-K.
At December 31, 2007, FSA Holdings had cash and investments of $35.7 million available to fund the liquidity needs of its non-insurance operations. Because the majority of the Company's operations are conducted through FSA, the long-term ability of FSA Holdings to service its debt will largely depend on its receipt of dividends from FSA and FSA's repurchase of its own shares from FSA Holdings. In February 2008, Dexia Holdings, Inc. contributed $500.0 million of additional capital to FSA Holdings to provide additional capacity to insure new financial guaranty business. FSA Holdings contributed this amount to FSA, which increased FSA's excess rating agency capital.
At December 31, 2007, FSA repaid its entire surplus note obligation of $108.9 million to FSA Holdings. In addition, FSA Holdings forgave all interest expense for 2007, which totaled $5.0 million, including $3.6 million already paid by FSA and $1.4 million of accrued interest. FSA Holdings then recontributed the proceeds from the repayment of the surplus notes plus the amount of interest expense already paid to FSA. All surplus note transactions were approved by the New York Superintendent. FSA paid interest of $5.4 million and $5.4 million in 2006 and 2005.
FSA Holdings paid dividends of $122.0 million in 2007, $530.0 million in 2006 and $71.1 million in 2005. FSA International paid preferred dividends of $6.9 million in 2005 to XL Capital Ltd, its minority interest owner. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda) Ltd. for a cash purchase price of $39.1 million, in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect wholly owned subsidiary of the Company.
FSA's ability to pay dividends depends, among other things, upon FSA's financial condition, results of operations, cash requirements and compliance with rating agency requirements for maintaining its Triple-A ratings, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the New York Insurance Law, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders' surplus as of its last statement filed with the New York Superintendent or (b) adjusted net investment income during this period. Based on FSA's statutory statements for 2007, and considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2007 is approximately $162.9 million. FSA did not pay dividends in 2007 and paid dividends of $140.0 million in 2006 and $87.0 million in 2005.
to $500.0 million of its shares from FSA Holdings through December 31, 2008. FSA repurchased shares of its common stock from FSA Holdings totaling $180.0 million in 2007 and $100.0 million in 2006, and retired such shares.
Management believes that the Company's expected operating liquidity needs, on both a short- and long-term basis, can be funded from its operating cash flow. In addition, the Company has a number of sources of liquidity available to pay claims on a short- and long-term basis: cash flow from premiums written, FSA's investment portfolio and earnings thereon, reinsurance arrangements with third-party reinsurers, liquidity lines of credit with banks, and capital market transactions.
Downgrades of FSA's Triple-A financial strength ratings could have a material adverse effect on its long-term competitive position and prospects for future business opportunities as well as its results of operations and financial condition. Credit ratings are an important component of a financial institution's ability to compete in the financial guaranty market.
The following is a summary of the Company's contractual obligations at December 31, 2007:
(3)Amounts include principal and interest payments for the minimum contractual period.
(4)Excludes amounts related to FIN 48 liabilities, which are uncertain with respect to amount and timing.
The primary source of the fluctuations in cash flow from operations between 2005, 2006 and 2007 was the purchase of bonds in the trading portfolio in 2007 and 2006, which is included in cash flows from operations. Excluding these trading portfolio purchases, cash flow was $600.0 million in 2007 and
Premiums received were $543.9 million in 2007, $523.4 million in 2006 and $594.4 million in 2005. The decline in premiums received in 2006 from 2005 primarily resulted from a decrease in asset-backed installment premium writings and the 2005 reassumption of a block of health care business. The increase in premiums received in 2007 from 2006 was principally due to the receipt of higher installment premiums in 2007, reflecting increases in both public finance and asset-backed transactions.
(1)Management believes the balances in the VIE Investment Portfolio and assets acquired under refinancing transactions are beyond the reach of the Company and its creditors.
The Company includes, in its long-term bond portfolios, variable rate demand notes ("VRDNs") and auction rate securities ("ARS"). VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest rate reset features and are traded in the marketplace through a bidding process. VRDNs totaled $224.3 million and $214.0 million at December 31, 2007 and 2006. As of December 31, 2007, VRDNs consisted of obligations backed by municipal obligors. ARS totaled $532.5 million at December 31, 2006 and zero at December 31, 2007. For management purposes, VRDN and ARS have been managed as short-term investments, although recent failures in the ARS market have raised questions about the liquidity of ARS and, to a lesser extent, VRDNs.
The following tables set forth certain information concerning securities in the Company's General Investment Portfolio based on amortized cost:
(2)Includes U.S. Treasury obligations, which comprised 2% of the portfolio as of December 31, 2007.
The General Investment Portfolio includes bonds insured by FSA ("FSA-Insured Investments"). Of the bonds included in the General Investment Portfolio, 7.5% were Triple-A by virtue of insurance provided by FSA and 28.1% were insured by other monolines, 100% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA insurance, was in the Double-A range. See "-Exposure to Monolines."
At December 31, 2007, there were 354 investments in fixed-income bonds for which amortized cost exceeded fair value; the aggregate amount of the excess of cost over fair value of securities in the unrealized loss position was $9.0 million, or 1%. Of the 180 investments in an unrealized loss position for 12 months or more, at December 31, 2007, the largest loss on an individual investment was $0.3 million, or 5% of its amortized cost. Of the 121 investments in an unrealized loss position for more than six months but less than 12 months, at December 31, 2007, the largest loss on an individual investment was $0.5 million, or 7% of its amortized cost. Of the 53 securities in an unrealized loss position less than six months, at December 31, 2007, the largest loss on an individual investment was
$0.2 million, or 8% of its amortized cost. At December 31, 2006, there were 451 such investments, for which the aggregate amount of the excess over fair value was $9.8 million, or 1%.
The amortized cost and fair value of fixed-income securities in the General Investment Portfolio as of December 31, 2007 and 2006, by contractual maturity, are shown below. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
(1)Stated maturities for mortgage-backed securities of four to 30 years as of December 31, 2007 and of two to 30 years as of December 31, 2006.
The Company's investments in mortgage-backed securities in its General Investment Portfolio primarily consisted of pass-through certificates and collateralized mortgage obligations ("CMOs"), which are backed by mortgage loans guaranteed or insured by agencies of, or sponsored by, the federal government. These securities are highly liquid with readily determinable market prices. The Company also held in its General Investment Portfolio, as of December 31, 2007, $36.9 million of Triple-A-rated CMOs that are not guaranteed by government agencies. Secondary-market quotations are available for these securities, although they are not as liquid as government agency-backed securities.
These CMOs held as of December 31, 2007 have stated maturities ranging from ten to 30 years and expected average lives ranging from one to 16 years based on anticipated prepayments of principal.
The FP Investment Portfolio includes securities classified as available-for-sale and securities classified as trading. It broadly comprises short-term investments, non-agency RMBS, securities issued or guaranteed by U.S. sponsored agencies, taxable municipal bonds, securities issued by utilities, infrastructure-related securities, CDOs, and other asset-backed securities. Non-agency RMBS constitute the majority of the FP Investment Portfolio and include securities backed by pools of the following types of mortgage loans: home equity loans to non-prime borrowers, commonly referred to as "subprime" loans, Alt-A loans, Option ARMs, CES, HELOCs and prime loans. The FP Investment Portfolio also includes NIM securitizations.
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2007, 2006 and 2005
Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2007, 2006 and 2005
The Company received tax benefits of $1.3 million in 2007 and no tax benefits in 2006 or 2005 from its parent company. See Note 12 for disclosure of non-cash transactions relating to restricted treasury stock transactions.
Financial guaranty insurance written by the Company typically guarantees scheduled payments on financial obligations. Upon a payment default on an insured obligation, FSA is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or may, at its option, pay such amounts on an accelerated basis. FSA's underwriting policy is to insure obligations that would otherwise be investment grade without the benefit of FSA's insurance.
for financial guaranty insurance as well as increases in the requirements for conducting, or restrictions on the types of business conducted by, financial guaranty insurers.
The Company consolidates the results of certain variable interest entities ("VIEs"), which include FSA Global Funding Limited ("FSA Global") and Premier International Funding Co. ("Premier").
FSA Global is a special purpose funding vehicle partially owned by a subsidiary of FSA Holdings. FSA Global issues FSA-insured medium term notes and generally invests the proceeds from the sale of its notes in FSA-insured GICs or other FSA-insured obligations with a view to realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. Premier is principally engaged in debt defeasance for finance lease transactions. The GIC Subsidiaries, FSAM, FSA-PAL, FSA Global and Premier are collectively referred to as the "FP segment."
The Company's management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 23). The preparation of financial statements in conformity with GAAP requires management to make extensive estimates and assumptions that affect the reported amounts of assets and liabilities in the Company's consolidated balance sheets at December 31, 2007 and 2006, the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2007, 2006 and 2005 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments
The consolidated financial statements also include the accounts of certain VIEs and refinancing vehicles. Intercompany accounts and transactions have been eliminated. Certain prior year balances have been reclassified to conform to the current year presentation.
•the FP Investment Portfolio, consisting of the investments supporting the GIC liabilities, which are primarily designated as available-for-sale but in some cases are classified as trading; and
Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged with derivatives or are economically hedged but do not qualify for hedge accounting is reflected as a separate component of shareholders' equity, net of tax. The unrealized gain or loss attributable to the hedged risk on investments that
Investments in debt and equity securities designated as trading are carried at fair value. The unrealized gain or loss on trading investments is recognized in the consolidated statements of operations and comprehensive income in other income.
Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at fair value. Changes in fair value of short-term investments are due to changes in foreign exchange rates. Amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less are included in short-term investments.
Mortgage loans are carried at the lower of cost or market on an aggregate basis.
Other-than-temporary impairments ("OTTI") are reflected in earnings as a realized loss.
The Company also has a portfolio of insured derivatives (primarily CDS) that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal part of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement effect of these derivatives is to record earned premiums over the installment period, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in either other assets or other liabilities, as appropriate.
Gross and ceded premiums received at inception of an insurance contract (i.e., upfront premiums) are earned in proportion to the expiration of the related risk. For upfront payouts, premium earnings are greater in the earlier periods, when there is a higher amount of exposure outstanding. The amount of risk outstanding is equal to the sum of the par amount of debt insured over the expected period of coverage. Deferred premium revenue and prepaid reinsurance premiums represent the portions of gross and ceded premium, respectively, that are applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized.
For premiums received on an installment basis, the Company earns the premium over the installment period, typically less than one year, throughout the period of coverage. Typically, installment premiums are applicable to insured transactions that involve CDS or special purpose entities ("SPEs") structured to finance pools of assets such as auto loans or mortgage loans. Premiums on such transactions are typically paid in installments, as the nature of the assets financed can have uncertain debt service schedules due to prepayments. When the Company, through its ongoing credit review process, identifies transactions where premiums are paid on an installment basis and certain default triggers have been breached, the Company ceases to earn premiums on such transactions. Premium revenue recognition is subject to change as a result of the Financial Accounting Standards Board ("FASB") project described in "-Financial Guaranty Insurance-Proposed Guidance."
The Company establishes loss and loss adjustment expense ("LAE") liabilities based on its estimate of specific and non-specific losses. LAE consists of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process.
The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. The non-specific and case reserves together represent the Company's estimate of total reserves. The establishment of a non-specific reserve for credits that have not yet defaulted is a common practice in the financial guaranty industry, although there are differences in the specific methodologies applied by other financial guarantors in establishing and measuring these reserves.
establishment of the reserve is a systematic process that considers this quantitative, statistical information obtained primarily from Moody's and S&P, together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount with the incurred losses as represented by case reserve activity to develop an experience factor that is updated and applied to current-year originations. The process results in management's best estimate of inherent losses associated with providing credit protection at each balance sheet date.
The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by loss frequency and severity factors, with the resulting amounts discounted at the risk-free rates using the treasury yield curve (the "statistical calculation"). The discount rate does not change and is used to accrete the loss for the life of each policy. The loss factors used for the calculation are the product of default frequency rates obtained from Moody's and severity factors obtained from S&P. Moody's is chosen for default frequency rates due to its credibility, large population, statistical format and reliability of future update. The Moody's default information is applied to all credit sectors or asset classes as described below. In its publication of default rates for bonds issued from 1970-2006, Moody's tracks bonds over a 20-year horizon by credit rating at time of issuance. For the purpose of establishing appropriate severity factors, the Company's methodology segregates the portfolio into asset classes, including health care transactions, all other public finance transactions, pooled corporate transactions, commercial real estate, and all other asset-backed transactions. The severity factors are derived from capital charge assessments provided by S&P. S&P capital charges project loss levels by asset class and are incorporated into their capital adequacy stress scenario analysis.
The Company does not defer origination costs relating to GICs issued by the GIC Subsidiaries, except for GIC commissions paid to third parties, which are included in other assets. The amortization of these commissions is recorded in net interest expense from the FP segment.
FP segment debt is recorded at amortized cost. The Company may enter into transactions in order to reduce the Company's exposure to fluctuations in interest rates and foreign exchange rates. For FP
segment debt in a qualifying fair-value hedging relationship, the change in the fair value of debt adjusts the carrying amount of the debt and is recognized in income currently. VIE debt may include hybrid debt instruments that contain embedded derivatives. Under certain conditions, GAAP requires that embedded derivatives be separated from the debt instrument and accounted for at fair value, with all changes in fair value reflected through earnings. Changes in fair value of embedded derivatives in VIE debt are recorded in realized and unrealized gain (loss) on derivative instruments.
The provision for income taxes consists of an amount for taxes currently payable and an amount for deferred taxes arising from temporary differences between the tax bases of assets and liabilities and the amounts reported in the financial statements. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
Asset-backed and, to a lesser extent, public finance transactions insured by FSA may employ SPEs for a variety of purposes. A typical asset-backed transaction, for example, employs an SPE as the purchaser of the securitized assets and as the issuer of the insured obligations. FSA's participation is typically requested by the sponsor of the SPE or the underwriter, either via a bid process or on a sole-source basis. SPEs are typically owned by transaction sponsors, although FSA may have an ownership interest in some cases. FSA maintains certain contractual rights and exercises varying degrees of influence over SPE issuers of FSA-insured obligations. FSA also bears some of the "risks and rewards" associated with the performance of those SPEs' assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given SPE's obligations, FSA bears the risk of asset performance (typically, but not always, after a significant depletion of overcollateralization, excess spread, a deductible or other credit protection). FSA's underwriting policy is to insure only obligations that are otherwise investment grade. In addition, the SPE typically pays a periodic premium to FSA in
The degree of influence exercised by FSA over these special purpose entities varies from transaction to transaction, as does the degree to which "risks and rewards" associated with asset performance are assumed by FSA.
The Company records a liability in other liabilities related to the vested portion of employees' outstanding "performance shares" under the Company's 2004 Equity Participation Plan and 1993 Equity Participation Plan (the "Equity Plans"). The expense is recognized ratably over specified performance cycles. The Company also records prepaid assets for Dexia restricted share awards made under the Company's Equity Plans and amortize these amounts over the employees' vesting periods. For more information regarding the Equity Plans, see Note 12.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which addresses how companies should measure fair value when required to use fair-value measures for recognition or disclosure purposes under GAAP. SFAS 157 adopted an "exit price" approach to determining fair value and established a three-level fair-value hierarchy to prioritize the inputs used in valuation techniques. Level 1 is the highest priority and is defined as observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 is defined as inputs other than quoted prices included in Level 1 that are observable for the asset or liability through corroboration with observable market data. Level 3 is the lowest priority and is defined as a valuation based on unobservable inputs such as a company's own data. Prioritization of inputs, as well as other considerations, determines the level of disclosure required. SFAS 157 is applicable to financial statements issued for fiscal years beginning after November 15, 2007 and for interim periods within those fiscal years. The Company believes that the transition adjustment to retained earnings will not have a material effect on its financial statements. The Company is currently evaluating the prospective impact of SFAS 157 on its results and disclosures for the first quarter of 2008.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"). SFAS 159 permits
(1)Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2007.
(2)Includes U.S. Treasury obligations which comprised 2% of the portfolio as of December 31, 2007.
At December 31, 2007, there were 354 investments in fixed-income bonds for which amortized cost exceeded fair value; the aggregate amount of the excess of cost over fair value of the securities in the unrealized loss position was $9.0 million, or 1.4%. Of the 180 investments in an unrealized loss position for 12 months or more, at December 31, 2007, the largest loss on an individual investment was $0.3 million, or 4.5% of its amortized cost. Of the 121 investments in an unrealized loss position for more than six months but less than 12 months, at December 31, 2007, the largest loss on an individual investment was $0.5 million, or 6.9% of its amortized cost. Of the 53 securities in an unrealized loss position less than six months, at December 31, 2007, the largest loss on an individual investment was $0.2 million, or 7.7% of its amortized cost. At December 31, 2006, there were 451 such investments, for which the aggregate amount of the excess over fair value was $9.8 million, or 1.5%.
Management has determined that the unrealized losses in fixed-income securities at December 31, 2007 are primarily attributable to the current interest rate environment and has concluded that these unrealized losses are temporary in nature based upon (a) the lack of principal or interest payment defaults on these securities, (b) the creditworthiness of the issuers, and (c) the Company's ability and current intent to hold these securities until a recovery in fair value or maturity. As of December 31, 2007 and 2006, 100% of the securities that were in a gross unrealized loss position were rated investment grade.
(2)Stated maturities for asset-backed securities of one to 15 years as of December 31, 2007 and of one to 28 years as of December 31, 2006. Proceeds from sales of bonds from the General Investment Portfolio during 2007, 2006 and 2005 were $3,568.2 million, $1,637.3 million and $1,757.6 million, respectively. Proceeds from maturities of bonds for the General Investment Portfolio during 2007, 2006 and 2005 were $189.2 million, $163.3 million and $130.9 million, respectively. Gross gains of $5.6 million, $0.9 million and $10.9 million and gross losses of $7.5 million, $5.8 million and $6.1 million were realized on sales in 2007, 2006 and 2005, respectively.
Bonds and short-term investments at an amortized cost of $10.1 million and cash of $1.8 million at December 31, 2007 and bonds and short-term investments at an amortized cost of $12.2 million at December 31, 2006, were on deposit with regulatory authorities as required by insurance regulations.
In October 2005, the Company sold its 34.1% interest in SPS Holding Corp. ("SPS") to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expected to receive additional amounts from time to time through March 31, 2008, out of income
The Company's investment in preferred shares of XL Financial Assurance Ltd ("XLFA"), a financial guaranty insurance company and subsidiary of Security Capital Assurance Ltd. ("SCA"), is redeemable starting November 3, 2008.
The Company's carrying value for XLFA preferred shares represents redemption value. In March 2006, the XLFA Board of Directors approved a by-law amendment changing the coupon on XLFA's preferred shares from a participating dividend based on an internal rate of return up to 19% to a fixed rate dividend of 8.25% per annum, effective January 1, 2006. In March 2007, there was a return of capital of $15.0 million.
Amounts recorded by the Company in connection with XLFA are as follows:
Based on information available as of December 31, 2007, management concluded that the $39 million carrying value of its investment in XLFA was recoverable. Subsequent to year-end, XLFA was downgraded by S&P from Triple-A to Single-A with a negative watch and by Moody's from Aaa to A3 with a review for downgrade. Management is closely monitoring developments and will continue to evaluate the carrying value and recoverability of its investment in XLFA preferred shares.
At December 31, 2007, the FP Investment Portfolio held 795 available-for-sale fixed-income bonds for which amortized cost exceeded fair value. The aggregate amount of the excess of amortized cost over fair value of securities in the unrealized loss position was $1,459.7 million, or 10.3%. At December 31, 2007, there were 39 investments in unrealized loss positions for 12 months or more. The largest loss as of December 31, 2007 on an individual investment was $6.3 million, or 22.0% of its amortized cost. At September 30, 2007 the loss on this security was $3.3 million, or 10% of its amortized cost. Of the 223 investments in an unrealized loss position for more than six months but less than 12 months, the largest loss on an individual investment was $21.3 million, or 47.4% of its amortized cost. At September 30, 2007, the loss on this security was $2.6 million, or 5.8% of its amortized cost. Of the 533 securities in an unrealized loss position less than six months at December 31, 2007, the largest loss on an individual investment was $32.2 million, or 43.0% of its amortized cost. At September 30, 2007, the loss was $3.5 million, or 4.7% of its amortized cost. At December 31, 2006, there were 109 such investments, for which the aggregate amount of the excess of amortized cost over fair value was $11.8 million, or 0.7%.
The FP Investment Portfolio has 67% of its portfolio in non-agency RMBS. After analysis of the credit quality and credit protections in the portfolio, and based on management's ability and intent to hold the FP assets to maturity, management did not take OTTI charges in 2007, with the exception of a $11.1 million pre-tax charge related to three NIM securitizations recorded in the third quarter of 2007. At December 31, 2007, over 90% of the assets in the FP Investment Portfolio were Triple-A and 7% were Double-A. Rating agencies continue to monitor the ratings on the residential mortgage-backed securities closely, and adverse rating actions on these securities may occur in 2008.
Management uses judgment in reviewing the specific facts and circumstances of individual securities. It uses estimates and assumptions of expected default rates, loss severity and prepayment speeds to determine expected loss in its evaluation of OTTI. It uses both proprietary and third-party models to analyze the underlying collateral of ABS and the cash flows generated by the collateral to determine whether a security's performance is consistent with the view that all payments of principal and interest will be made as contractually required. Each mortgage-backed security in the FP Investment Portfolio was evaluated for OTTI as of December 31, 2007 by applying projected default assumptions to various delinquency categories, starting with 30 days past due, in order to create a measure of loss coverage. Once default rate assumptions were applied by delinquency category, management applied a 50% severity rate to projected gross losses. The result of this calculation was then compared with the hard credit enhancement embedded in each asset. As of December 31, 2007, all assets in the FP Investment Portfolio passed this test.
(1)Stated maturities for mortgage-backed securities of two to 39 years as of December 31, 2007 and of four to 39 years as of December 31, 2006.
of $13.0 million and $0.1 million, respectively. Gross gains of $0.4 million and gross losses of $7.9 million were realized on sales in 2005.
All the investments supporting VIE liabilities are insured by FSA. The credit quality of the available-for-sale securities in the VIE Investment Portfolio, without the benefit of FSA's insurance, was as follows:
(1)Asset-backed securities consist of floating rate assets, which are valued using readily available quoted market prices or at amortized cost if there is no readily available valuation.
The Company periodically monitors its investment portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2007 and 2006, there were no securities in an unrealized loss position.
As of December 31, 2007, the Company had received $48.5 million of collateral from counterparties to reduce its net derivative exposure to such parties.
The fixed-income assets within the refinanced asset portfolio all have contractual maturities of less than five years. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
In the portfolio of assets acquired in refinancing transactions at December 31, 2007 and 2006, there were no securities in an unrealized loss position for a continuous 12-month period or longer. In 2007, the Company determined that there were no securities considered other-than-temporarily impaired. In 2006, the Company determined that there were three securities considered other-than-temporarily impaired, and a $2.5 million pre-tax impairment charge was recorded in the consolidated statements of operations and comprehensive income.
Activity in the liability for losses and loss adjustment expense reserve, which consists of the case and non-specific reserves, is summarized as follows:
The amount of the discount as of December 31, 2007 for the total gross and net case reserves was $14.5 million and $3.3 million, respectively.
During 2006, the Company charged $23.3 million to loss expense, consisting of $17.8 million for originations of new business and $5.5 million related to accretion on the reserve for in-force business.
Net case reserves decreased $0.7 million due primarily to loss payments and some improvement in CBO transactions, offset in part by the establishment of a new case reserve for a municipal health care transaction.
•Category V reflects transactions where losses are probable. This category includes (1) risks where claim payments have been made and where additional payments, net of recoveries, are expected, and (2) risks where claim payments are probable but none have yet been made. Category IV and Category V transactions are subject to intense monitoring and intervention.
The table below presents the gross and net par outstanding and the gross and net reserves for risks classified as described above:
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption or, if greater, the make-whole redemption price. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, FSA Holdings entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of FSA Holdings long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by FSA Holdings or any of its subsidiaries on or before the date that is 20 years prior to the final repayment date, except to the extent that FSA Holdings has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings. The Junior Subordinated Debentures were issued at a discount of $1.2 million.
The Company's policies insure the scheduled payments of principal and interest on public finance and asset-backed (including FSA-insured CDS) obligations. The gross amount of financial guarantees in force (principal and interest) was $833.2 billion at December 31, 2007 and $743.9 billion at December 31, 2006. The amount of financial guarantees in force, net of reinsurance, was $598.3 billion at December 31, 2007 and $531.4 billion at December 31, 2006. As of December 31, 2007, net par outstanding included $12.5 billion related to policies previously insured by other financial guarantors. Beginning in the fourth quarter of 2007, such amounts were classified based on the underlying risks insured. Prior-year amounts were reclassified to conform to the current-year presentation in the tables below.
Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. The expected maturities for asset-backed obligations are, in general, considerably shorter than the contractual maturities for such
obligations. For asset-backed obligations, the full par outstanding for each insured risk is shown in the maturity category that corresponds to the final legal maturity of such risk:
Contractual Terms to Maturity of Ceded Par Outstanding of Insured Obligations
The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on asset-backed obligations, as well as through reinsurance. The gross, ceded and net par outstanding of insured obligations in the asset-backed insured portfolio includes the following amounts by type of collateral:
states in which municipalities located therein issued an aggregate of 2% or more of the Company's net par amount outstanding of insured public finance securities:
Dexia Holdings, FSA Holdings and its Subsidiaries, except FSA International, file a consolidated U.S. federal income tax return. Prior to 2006, a tax-sharing agreement among the Subsidiaries provided that each member's tax benefit or expense was calculated on a separate-return basis and that any credits or losses available to the Company was allocated among the members based on each member's taxable income. Effective January 1, 2006, the tax-sharing agreement was amended so that Dexia Holdings' credits are no longer available to the members. For the 2007 and 2006 tax years, the Company and its Subsidiaries did not receive any such benefits from utilizing Dexia Holdings' credits.
The 2007, 2006 and 2005 effective tax rates differ from the statutory rate of 35% due primarily to tax-exempt interest income. The current-year effective tax rate reflects the higher ratio of tax-exempt interest income to year-to-date pre-tax loss due to the significant negative fair value adjustments
The Company believes that within the next 12 months, it is reasonably possible that unrecognized tax benefits for positions taken on previously filed tax returns will become recognized as a result of the expiration of statute of limitations for the 2004 tax year, which absent any extension, will close in September 2008.
Through 2004, performance shares were awarded under the 1993 Equity Participation Plan (the "1993 Equity Plan"). The 1993 Equity Plan authorized the discretionary grant of performance shares by the Human Resources Committee to key employees. The amount earned for each performance share depends on the attainment of certain growth rates of adjusted book value and book value per outstanding share over specified three-year performance cycles.
In 2004, the Company adopted the 2004 Equity Participation Plan (the "2004 Equity Plan"), which continues the incentive compensation program formerly provided under the Company's 1993 Equity Participation Plan. The 2004 Equity Plan provides for performance share units comprised 90% of performance shares (which provide for payment based upon the Company's performance over two specified three-year performance cycles) and 10% of shares of Dexia restricted stock. Performance shares have generally been awarded on the basis of two sequential three-year performance cycle, with one-third of each award allocated to the first cycle, which commences on the date of grant, and two-thirds of each award allocated to the second cycle, which commences one year after the date of grant. The Company recognizes expense ratably over the course of each three-year performance cycle. The total number of performance shares authorized under this plan was 3.3 million. At December 31, 2007, 2.4 million performance shares remained available for distribution.
Awards of Dexia restricted stock remain restricted for an additional six months after the end of each vesting period. Shares of Dexia restricted stock purchased under the 2004 Equity Plan are as follows:
Summary of Net Realized and Unrealized Gains (Losses) on Derivative Instruments
(1)As of January 1, 2007, the Company implemented SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS 155"), which resulted in a mark-to-market loss of $2.7 million in 2007 related to insured NIM securitizations originated in 2007. The change in fair value was largely a function of the market's adverse perception of RMBS products.
The fair-value adjustments on insured derivatives represent hypothetical replacement value and comprise the majority of the balance in this line item, as shown in the table below. The fair value of an insured CDS contract incorporates all the remaining future premiums to be received over the life of the insured CDS contract, discounted to present value and multiplied by the ratio of the current replacement premium (what a buyer or seller would pay for a similar contract based on current market conditions) to the contractual premium. As the fair value of an insured CDS contract incorporates all the remaining future premium payments to be received over the life of the insured CDS contract, the fair value of that contract will change, in part, solely from the passage of time as premiums are received. Absent any claims under the Company's guaranty, any "losses" recorded in marking a guaranty to fair value will be reversed by an equivalent "gain" at or prior to the expiration of the guaranty, and any "gain" recorded will be reversed by an equivalent "loss" over the remaining life of
•FSA is not entitled to terminate insured CDS and realize a profit on a position that is "in the money," nor is a counterparty to an insured CDS contract generally able to force FSA to terminate an insured CDS that is "out of the money."
over time, and (b) FSA is not required to post collateral to secure its obligation under the insured CDS contract.
Insured derivatives in the asset-backed portfolio represent 67% of total asset-backed par outstanding. The tables below summarize the credit rating, net par outstanding and remaining average lives for the primary components of the Company's insured CDS portfolio. While most of the Company's insured CDS are pooled corporate exposures, there are also some insured CDS in other sectors, including $76.2 million in U.S. RMBS categories.
(1)Triple-A*, also referred to as "Super Triple-A," indicates a level of first-loss protection generally exceeding 1.3 times the level required by a rating agency for a Triple-A rating.
The Company obtains reinsurance to increase its policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Company reinsures portions of its risks with affiliated (see Note 21) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis.
Reinsurance does not relieve the Company of its obligations to policyholders. In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company may be unable to recover amounts due. A number of FSA's reinsurers are required to pledge collateral to secure their reinsurance obligations to FSA in an amount equal to their statutory unearned premium, loss and contingency reserves associated with the ceded business. FSA requires collateral from reinsurers primarily to (a) receive statutory credit for the reinsurance, (b) provide liquidity to FSA in the event of claims on the reinsured exposures, and (c) enhance rating agency credit for the reinsurance.
The Company cedes approximately 25% of its gross par insured to a diversified group of reinsurers, including other monolines. As of December 31, 2007, 93% of FSA's reinsurers were rated Double-A or higher, but many are still under review by rating agencies. The Company's reinsurance contracts generally allow the Company to recapture ceded business after certain triggering events, such as reinsurer downgrades. Included in the table below is $15,697 million in ceded par outstanding related to insured CDS.
Effective June 2004, the Company entered into a 21-year sublease agreement with Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York, to be used as the Company's new headquarters. The Company moved to this new space in June 2005. The lease contains scheduled rent increases every five years after a 19-month rent-free period, as well as lease incentives for initial construction costs of up to $6.0 million, as defined in the sublease. The lease contains provisions for rent increases related to increases in the building's operating expenses. The lease also contains a renewal option for an additional ten-year period and an option to rent additional office space at various points in the future, in each case at then-current market rents. In addition, the Company and its Subsidiaries lease additional office space under non-cancelable operating leases, which expire at various dates through 2013.
In the ordinary course of business, the Company and certain subsidiaries are parties to litigation.
FSA's ability to pay dividends or repurchase shares depends on FSA's financial condition, results of operations, cash requirements, rating agency capital adequacy and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders' surplus as of its last statement filed with the Superintendent of Insurance of the State of New York (the "New York Superintendent") or (b) adjusted net investment income during this period. FSA paid no dividends in
As of December 31, 2007, FSA repaid its entire surplus note obligation of $108.9 million to FSA Holdings. In addition, FSA Holdings forgave all interest expense for 2007, which totaled $5.0 million, including $3.6 million already paid by FSA and $1.4 million of accrued interest. FSA Holdings recontributed to FSA the proceeds from the repayment of the surplus note plus the amount of interest expense already paid. All surplus note transactions were approved by the Superintendent of Insurance of the State of New York. FSA paid interest of $5.4 million and $5.4 million in 2006 and 2005.
FSA may repurchase shares of its common stock from shareholders, subject to the New York Superintendent's approval. The New York Superintendent has approved the repurchase by FSA of up to $500.0 million of its shares from FSA Holdings through December 31, 2008. In 2007 and 2006, FSA repurchased $180.0 million and $100.0 million of shares of its common stock, respectively, from FSA Holdings and retired such shares.
FSA Holdings paid dividends of $122.0 million in 2007, $530.0 million in 2006 and $71.1 million in 2005.
FSA has a credit arrangement aggregating $150.0 million that is provided by commercial banks and intended for general application to insured transactions. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment, and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At December 31, 2007, there were no borrowings under this arrangement, which expires on April 21, 2011, if not extended.
FSAM has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 5, 2008, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by the GIC Subsidiaries. There were no borrowings under this agreement at December 31, 2007. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either Moody's or S&P, and on neither Moody's nor S&P having issued a rating to FSA below Aa1 or AA+, respectively.
In June 2003, $200.0 million of money market committed preferred trust securities (the "CPS") were issued by trusts created for the primary purpose of issuing the CPS, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the "Preferred Stock") of FSA. There are four trusts, each with an initial aggregate face amount of $50 million. These trusts hold auctions every 28 days at which time investors submit bid orders to purchase CPS. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received
upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts, which represents the difference between the commercial paper yield and the winning auction rate (plus all fees and expenses of the trust). If an auction does not attract sufficient clearing bids, however, the auction rate will be subject to a maximum rate of 150 basis points above LIBOR for the next succeeding distribution period. Beginning in August 2007, the CPS required the maximum rate for each of the relevant trusts. FSA continues to have the ability to exercise its put option and cause the related trusts to purchase FSA preferred stock. The cost of the facility was $1.8 million, $1.0 million, and $1.3 million for 2007, 2006 and 2005, respectively, and was recorded within other operating expenses. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts because it does not retain the majority of the residual benefits or expected losses.
The intersegment assets consist primarily of intercompany notes issued by FSA and held within the FP Investment Portfolio. The intersegment revenues and expenses relate to interest income and interest expense on intercompany notes and premiums paid by FSA Global on FSA-insured notes.
•The Company reimburses Dexia Crédit Local for the portion of director Bruno Deletré's Dexia Crédit Local compensation that relates to his work as liaison with the Company on behalf of Dexia.
The Company determines fair value using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair-value amounts.
•For the bonds in the General Investment Portfolio and the FP Segment Investment Portfolio, the carrying amount represents fair value. The fair value is generally based on prices obtained from an independent pricing service. If quoted market prices are not available, the independent pricing service bases its valuation on pricing models that use as inputs: dealer price quotations, price activity for traded securities with similar attributes and other relevant market factors, including security type, rating, vintage, tenor and its position in the capital structure of the issuer. In the case of the Company's equity investment in XLFA, fair value is based on redemption value. See Note 2 for more discussion.
•For assets acquired under refinancing transactions, each asset's fair value is either the present value of expected cash flows or a quoted market price as of the reporting date.
•For prepaid reinsurance premiums, the fair value is based on estimated proceeds of entering into an assumption of the entire portfolio with third-party reinsurers under current market conditions.
•For FP segment debt, the fair value is the present value of the expected cash flows as of the reporting date.
The table below shows the carrying amount and fair value of the Company's financial instruments:
•acquisition costs are charged to operations as incurred rather than over the period that related premiums are earned;
•deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carryback;
•insured CDS are accounted for as insurance contracts rather than as derivative contracts recorded at fair value;
Consolidated statutory net income was $312.9 million for 2007, $339.6 million for 2006 and $293.0 million for 2005. Statutory surplus totaled $1,608.8 million for 2007 and $1,543.1 million for 2006. Statutory contingency reserves totaled $1,094.3 million for 2007 and $1,011.0 million for 2006.
Net loss reported in the fourth quarter of 2007 was primarily due to negative fair-value adjustments related to insured CDS.
(1)Represents transactions with second-to-pay FSA-insurance that were previously insured by other monolines. Based on net par outstanding.
(2)Represents par balances for the insured portfolios and amortized cost for the investment portfolios.
On February 4, 2008, the Company received a "Wells Notice" from the staff of the Philadelphia Regional Office of the SEC relating to the SEC's investigation concerning the bidding of municipal GICs. The Wells Notice indicates that the SEC staff is considering recommending that the SEC authorize the staff to bring a civil injunctive action and/or institute administrative proceedings against the Company, alleging violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and Section 17(a) of the Securities Act. The Company understands that it will have an opportunity to respond to the Wells Notice and to discuss the matter with the staff before any recommendation is made to the Commission.
In March 2008, two purported class action lawsuits were commenced seeking damages for alleged violations of antitrust laws in connection with the bidding of municipal GICs and derivatives. The suits name as plaintiffs various named and unnamed states and municipalities and name as defendants a large number of major financial institutions, including the Company and FSA. The lawsuits make reference to the ongoing investigations by the DOJ Antitrust Division and the SEC regarding such activities, with respect to which the Company and FSA received subpoenas in November 2006.
In the first two months of 2008, management observed continuing deterioration in the U.S. residential mortgage market. Unless conditions improve, management may need to allocate additional amounts from its non-specific loss reserve to its case reserves, or add to its non-specific reserve, to cover the projected performance of HELOCs or Alt-A closed-end second lien mortgages ("CES").