The Company's telephone number at its principal executive offices is (212) 826-0100.
(c)Total claims-paying resources is used by Moody's to evaluate adequacy of capital resources and credit ratings. Moody's uses its judgment in making adjustments to some of the measures. This term represents the sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and money market committed preferred trust securities.
After a careful strategic analysis, the Company decided, in August 2008, to cease issuing financial guaranty insurance contracts of asset-backed obligations in order to devote its resources to expanding its position in the global public finance and infrastructure markets. This decision was based on weighing the risks and volatility embedded in the asset-backed security business, in particular residential mortgage-backed securities ("RMBS"), versus the opportunities available in lower-risk sectors of the public finance markets. The change in strategic focus resulted in a staff reduction of 29 positions in 2008. The continuation of the lack of market opportunities led to a further reduction of 32 positions in the first quarter of 2009. The amortizing asset-backed portfolio is expected to generate in excess of $583.7 million of earned revenue over the remaining life of the policies. In November 2008, the Company ceased issuing GICs. While the Company has ceased new originations in its asset-backed financial guaranty business and of GICs, a substantial portfolio of such obligations remains outstanding.
Although the economy is faced with an unprecedented crisis, the Company believes that the current U.S. municipal operating environment remains favorable for highly rated bond insurers. While the insured penetration of bond insurance in the U.S. municipal market decreased to approximately 17% in 2008 compared with 47% in 2007, the Company believes that it will normalize to a higher level as financial markets stabilize, provided that there are highly rated financially stable bond insurers available to service market demand.
The Company's principal insurance company subsidiary is Financial Security Assurance Inc. ("FSA"), a wholly owned New York insurance company. The Company is a subsidiary of Dexia Holdings Inc. ("Dexia Holdings"), which, in turn, is owned 90% by Dexia Crédit Local S.A. ("Dexia Crédit Local") and 10% by Dexia S.A. ("Dexia"). Dexia is a Belgian corporation primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia.
Under the Purchase Agreement described below, Dexia agreed to segregate or separate the Company's FP operations from the financial guaranty operations and retain the FP segment. Consequently, the Company no longer has the intent to hold these assets to maturity and was required to record an OTTI for all securities in a loss position at December 31, 2008. The magnitude of the amount of the OTTI was a result of declines in fair value of RMBS securities in the portfolio. During 2008, the Company has relied on liquidity resources available under agreements with Dexia to meet the GIC withdrawal and collateralization requirements. Further deterioration in the market value of the FP Investment Portfolio or ratings downgrades could result in the FP business having inadequate market value of securities eligible to be pledged as collateral in the event of an FSA downgrade. For more information regarding the liquidity risks inherent to the FP business and the liquidity resources available to it, see "-Liquidity and Capital Resources-FP Segment Liquidity."
monitoring the consumer and corporate sectors for signs of deepening economic stress. See Note 3 to the consolidated financial statements in Item 8.
In November 2008, Dexia and Assured entered into a purchase agreement (the "Purchase Agreement") providing for the purchase by Assured of all Company shares owned by Dexia (the "Acquisition"), subject to the satisfaction of specified closing conditions. Purchase Agreement closing conditions include (1) receipt of regulatory and Assured shareholder approvals; (2) confirmation from Standard & Poor's Ratings Services ("S&P"), Moody's Investors Service, Inc. ("Moody's") and Fitch Ratings ("Fitch") that the acquisition of the Company would not result in a downgrade of the financial strength ratings of the insurance company subsidiaries of Assured or of the Company; and (3) segregation or separation of the Company's FP business such that the credit and liquidity risk of the FP business resides with Dexia, with FSA protected against any future Dexia credit impairment. In February 2009, the Company's ultimate parent, Dexia, entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia, which resulted in the "deconsolidation" of FSAM from the Company (the "FSAM Risk Transfer Transaction").
The Company cannot estimate whether or when the remaining closing conditions will be satisfied or relevant agreements negotiated, whether the Acquisition will be completed and, if completed, whether it will be structured as currently contemplated, or what the effects of the change in control or removal of the FP business will be on the Company and its results of operations. If the Acquisition is not carried out, Dexia may explore other options with respect to the Company, including selling the Company or some of its operations to a third party or ceasing to write new business, which may have a material adverse effect on the Company.
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. The Purchase Agreement provides that Dexia will provide guarantees with respect to the FP business' assets and liabilities, including derivative contracts, and anticipates that some of its guarantees will benefit from guarantees provided by the French and Belgian states. Dexia Holdings, the Company's parent, agreed that if such sovereign guarantees are provided, it will cause FSA Holdings to transfer the ownership interests of certain of the subsidiaries that conduct the FP business, or all the assets and liabilities of such subsidiaries, to Dexia Holdings or one of its affiliates in form reasonably acceptable to Assured.
As a result of the significant decline in asset value and the November 2008 cessation of issuing GICs, the GIC business changed from a business model managed by the Company focused on attaining positive net interest margin, to a run-off business managed by Dexia seeking to minimize liquidity risk and optimize asset recovery values. As a result, the FSAM Risk Transfer Transaction was deemed a reconsideration event for FSAM under FASB Interpretation 46 (R), "Consolidation of Variable Interest Entities" ("FIN 46"). There was no reconsideration event for any of the GIC Subsidiaries.
Upon the reconsideration event, management determined that Dexia is now absorbing the majority of the variability of expected losses of FSAM, which resulted in deconsolidation of FSAM as of February 24, 2009, the effective date of the FSAM Risk Transfer Transaction.
The GIC subsidiaries, unlike FSAM, remain part of the Company's consolidated financial statements notwithstanding the FSAM Risk Transfer Transaction, which means that the GICs issued to third parties and the note receivable from FSAM will represent the primary liabilities and assets of the FP business in the Company's consolidated financial statements. Since some of the GICs were designated as fair value option, they will continue to be marked to market; however, derivatives are maintained within FSAM, so contracts meant to hedge the interest rate risk of those GICs will no longer be included in the Company's consolidated financial statements, increasing the volatility of the Company's net income (loss).
The following table shows the effect of deconsolidation of FSAM had the FSAM Risk Transfer Transaction been executed at December 31, 2008.
Given the rapidly deteriorating state of the U.S. economy, it is difficult to project the future for the Company. Unemployment rates are likely to continue to rise, fueling more residential mortgage delinquencies and putting further pressure on home prices. Loss reserves would grow if these trends continue beyond current assumptions. Consumer and corporate credits are also under pressure, although the Company's consumer and corporate portfolios are holding up relatively well. Commercial mortgage securitizations may be a future source of pain in the economy, however the Company is not exposed to this category of risk. The current environment represents a stress-case worse than any of the models had projected. In the public finance sector, the combination of falling property values and reduced commercial activity, which drive local tax revenues, are putting increasing pressure on municipal budgets at a time when the population is putting increasing pressure on municipal services. The closing of the proposed business combination with Assured is an important component of the Company's survival and, ultimately, return to success.
In addition to FSA, a number of the Company's competitors in the financial guaranty industry have incurred unprecedented increases in projected losses on insured RMBS transactions in 2008 and subsequently were downgraded or placed on credit watch, negative outlook or review for further downgrade by the major securities rating agencies. Several guarantors had significant exposure to CDOs of ABS, which include CDOs of CDOs (also referred to as "CDO squared").
FSA was the U.S. municipal market leader in 2008, achieving a 54% share of market. However, most of its business was originated in the first half of 2008, after which the rating agency actions decreased demand for FSA guarantees. In international public finance markets, where liquidity was constrained all year, FSA's 2008 production decreased significantly in comparison to full year 2007.
The Company has direct exposure to other financial guaranty insurers through secondary guaranties of previously insured securities, reinsurance and investments. Downgrades of other monolines could cause incurred loss in the insured and investment portfolios. Additionally, such downgrades could reduce the credit for reinsurance and for previously wrapped insured transactions that rating agencies assign in their capital adequacy models, increasing the capital charges in those models. At this stage, management cannot predict how the situation will be resolved for the Company or its competitors, or what competitive, regulatory and rating agency environments may emerge.
In 2008, the market turmoil resulted in disruptions in the domestic public finance market, evidenced by auction failures for auction rate municipal bonds, higher rates on variable rate demand notes and historic high yields for tax-exempt municipal bonds compared with U.S. government treasury securities. If these conditions persist for an extended period of time, the Company's own insured obligations could experience increased losses because, in extreme cases, higher borrowing costs could put financial stress on municipal issuers, leading to defaults of FSA-insured securities.
The Company generally avoided insurance of CDOs of ABS. In all, FSA insured two CDOs of ABS with a total net par outstanding of $339 million: (1) a Double-A rated obligation insured in 2000 with $47 million net par outstanding and less than 3% invested in U.S. subprime and "Alt-A" RMBS collateral, and (2) a Triple-B rated CDS excess-of-loss reinsurance transaction insured in 2005 at four times the original Triple-A attachment point with $292 million net par outstanding at December 31, 2008. "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 losses and market concerns related to their exposure to CDOs of ABS that contain a high percentage of mezzanine tranches of subprime RMBS, with most credit concerns focused on 2006 and 2007 originations.
Additionally, in 2008 the Company recorded pre-tax OTTI charges in the FP Investment Portfolio of $8,397.9 million, of which $797.5 million was considered economic credit impairment. In the fourth quarter of 2008, $236.2 million was recorded in OTTI in the VIE Investment Portfolio, none of which was deemed to be economic. The fourth quarter OTTI charge reflects the Company's lack of intent to hold the securities as a result of the Purchase Agreement, which requires immediate recognition in income of all unrealized losses that had been previously recorded in other comprehensive income because the Company no longer intends to hold these assets to maturity or recovery of the losses. At December 31, 2008, approximately 56.6% of the available-for-sale FP Investment Portfolio based on amortized cost was invested in non-agency RMBS, of which 38.8% were rated Triple-A, with 17.2% rated Double-A, 7.0% rated Single-A, 10.0% rated Triple-B and 27.0% below investment grade.
Adverse loss developments surrounding subprime RMBS may lead to earlier than anticipated withdrawals on GICs issued in connection with CDOs of ABS. At December 31, 2008, $983.6 million of CDO of ABS GICs had been terminated due to an event of default in the underlying collateral of the CDOs of ABS and a subsequent liquidation of the CDO portfolio. Between January 1, 2009 and March 2, 2009, no additional CDO of ABS GICs were terminated. Also in 2008, $852.0 million of pooled corporate CDO GICs were terminated due to an event of default caused by the bankruptcy of Lehman Brothers Holdings Inc. ("Lehman Brothers"), which was the guarantor of the CDS protection buyer in those transactions. The Company expects further GIC withdrawals and is regularly evaluating general market conditions, as well as specific transactions.
The full extent of credit losses in the mortgage sector, and the extent to which they may affect the Company, will not be known for several years.
Credit problems expanded beyond the mortgage market to constrain liquidity across the capital markets in 2008. This had a negative impact on new-issue volume in the public finance and structured finance markets. Credit spreads trended wider throughout 2008. Wider spreads generally necessitate unrealized negative fair-value (mark-to-market) adjustments for credit derivatives in the insured portfolio and for certain FP investments. On the other hand, wider spreads generally mean that a financial guarantor has more opportunities to sell insurance at higher premium rates. This was true for the first half of 2008 in the primary U.S. municipal business, where FSA's business production was
In 2008, the Company reported a net loss of $8,443.2 million, compared with a net loss of $65.7 million in 2007 and net income of $424.2 million in 2006. Net income is volatile primarily because it includes (a) where applicable, OTTI charges that are not indicative of estimated economic loss, (b) fair-value adjustments for credit derivatives in the insured portfolio in excess of estimated economic loss, (c) beginning January 1, 2008, fair-value adjustments related to the Company's own credit risk, and (d) fair-value adjustments for instruments with economically hedged risks that are not in designated hedging relationships under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), and adjustments related to non-economic changes in fair value related to the trading portfolio.
The fair-value adjustments that have an impact on net income (loss) are shown in the table below:
(1)Includes the unhedged component of the fair-value adjustment, such as credit risk.
Fair-value adjustments attributable to impairment charges: OTTI securities must be written down to fair value through the income statement, regardless of management's estimate of economic loss. Economic loss is determined by the Company using cash flow models that project the present value of future expected shortfalls in principal and interest. Management views the economic component of impairment charges separate from the full negative fair-value adjustments. For 2008, on a pre-tax basis, the Company recorded $8,397.9 million in OTTI charges in the FP Investment Portfolio, of which $797.5 million represented estimated economic loss. In addition, the Company recorded $236.2 million in non-economic OTTI charges in the VIE Investments Portfolio. The 2008 FP and VIE Investment Portfolio OTTI charges were recognized to reflect Dexia's Purchase Agreement covenant to segregate or separate the Company's FP operations from the Company's financial guaranty operations and retain the FP segment, resulting in the Company's inability to hold the securities to maturity. At December 31, 2008, 72.2% of the FP Segment Investment Portfolio was categorized as Level 3 in the SFAS 157 fair value hierarchy, indicating the significance of unobservable inputs in determining fair value.
Fair-value adjustments attributable to the Company's own credit risk: Fair value measurement rules under SFAS No. 157, "Fair Value Measurements" ("SFAS 157") require the consideration of the Company's own credit risk. The effect of fair-value adjustments attributable to the Company's own credit risk is included in net income. In 2008, the Company's credit spread widened, leading to material unrealized gains on the FP segment debt and on the Company's committed preferred trust securities ("CPS"). At December 31, 2008, all FP segment debt at fair value and the CPS were categorized as Level 3 in the SFAS 157 fair value hierarchy.
Prior to January 1, 2008, the Company elected to comply with the SFAS 133 documentation and testing requirements for certain liability hedging relationships and for none of the asset hedging relationships. Effective January 1, 2008, the Company elected the fair value option under SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"), for
The GAAP measure "gross premiums written" captures financial guaranty premiums collected or accrued in a given period, whether collected for business originated in the period or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a portion of the Company's premiums are collected in installments. Therefore, management calculates the non-GAAP measure PV financial guaranty originations as a measure of current-period premium production. To do so, management combines the following for business closed in the reporting period: (1) gross present value of premium and credit derivative fee installments and (2) premiums received upfront.
Installment premiums and credit derivative fees are not recorded in the financial statements until due, which is a function of the terms of each insurance policy. Future installment premiums and credit derivative fees are not captured in current-period premiums earned or premiums written, the most comparable GAAP measures. Management therefore uses PV premiums and credit derivative fees originated to measure current business production.
In 2008, the disruption of credit markets and the bond insurance industry reduced FSA's opportunities in the global asset-backed and public infrastructure sectors and, in the second half, the U.S. public finance market, resulting in declines from 2007 to 2008 of 57.2% in gross par originated
and 47.8% in PV originations. FSA withdrew from the asset-backed business after the first half of 2008. Additionally, FSA's domestic public finance production fell significantly in the second half due to the negative impact of rating agency actions. PV NIM was negative in 2008 primarily due to the Company curtailing FP asset acquisitions throughout the year to build liquidity. The Company also curtailed the issuance of new GICs in the asset-backed market in August 2008, and ceased issuing GICs in November 2008, in contemplation of the sale of the Company to Assured.
In 2007, PV originations rose to a record level of $1,271.0 million, an increase of 39.6% over that of the previous year, primarily due to increased FSA production in the international public infrastructure sector, a preference for FSA insurance over guarantees from other monolines in the fourth quarter of 2007 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.
(1)The primary components of the GAAP income to segment operating earnings adjustments were non-economic fair-value adjustments on credit derivatives in the insured portfolio and fair-value adjustments on the CPS.
2007 vs. 2006: In the financial guaranty segment, higher invested assets in the General Investment Portfolio, resulting partially from record premiums received in 2007, produced higher net investment income. New business originations also contributed to earned premiums. Refundings (net of amortization) were up 14%. Non-recurring realized foreign exchange gains accounted for a $10.6 million pre-tax increase year over year. These increases were offset, in part, by increased interest expense, loss expense and other operating expenses. Interest expense increased due to the issuance of $300 million in hybrid debt in the fourth quarter of 2006. Loss expense rose primarily due to an increase in the experience factor used in calculating the non-specific reserve and higher originations in the international public finance sector, which attract higher charges in the non-specific reserving methodology. Higher operating expenses were caused by higher compensation expenses, which vary with production and growth in the non-GAAP adjusted book value ("ABV"), and lower deferral rates.
The Company ceased issuing financial guaranties on asset-backed securities in August 2008. For several years prior to then, the Company had limited its originations of asset-backed securities, primarily because tightening credit spreads and the competitive market environment had resulted in unattractive premium rates or credit quality that did not comply with the Company's underwriting guidelines. As transactions originated in earlier years matured, they were not replaced with the same volume of new originations, resulting in a decline in asset-backed earnings. At December 31, 2008, the asset-backed transactions in FSA's insured portfolio had an average life of approximately 4.0 years. As the Company has ceased insuring such transactions, premium earnings from insured asset-backed transactions will continue for several years, but will decline as the insured par runs off.
Geographic diversification has always been a risk management strategy for the financial guaranty segment, particularly in the public finance sector. Through 2007, the Company's growth area had been in international business, particularly public-private partnership transactions in the infrastructure sector and financings of water and other utility companies. These types of transactions serve to support the Company's future earnings for extended periods of time due to their long-dated maturities. The table below shows the amount of U.S. and international premiums earned based on geography of underlying risks.
Net Investment Income and Realized Gains (Losses) from General Investment Portfolio
As the fair value of a CDS contract incorporates all the remaining future payments to be received over the life of the CDS contract, the fair value of that contract will change, in part, solely from the passage of time as fees are received. Absent any claims under the contract, any "losses" recorded in marking the contract to fair value will be reversed by an equivalent "gain" at or prior to the expiration of the contract, and any "gain" recorded will be reversed by an equivalent "loss" over the remaining life of the transaction, with the cumulative changes in the fair value of the CDS summing to zero by the time of each contract's maturity. Unrealized fair-value adjustments for credit derivatives, except for estimates of economic losses, have no effect on operations, liquidity or capital resources.
•The liquidity risk present in most CDS contracts sold outside the financial guaranty industry (i.e., the risk that the CDS writer would be required to make cash payments) is not present in a CDS contract sold by a financial guarantor. Terms of the CDS contracts are designed to replicate the payment provisions of financial guaranty contracts in that (a) losses, if any, are generally paid over time subject to market value termination payments generally due in the event of insurer insolvency, and (b) the financial guarantor is not required to post collateral to secure its obligation under the CDS contract.
I. Condensed Financial Statements of Financial Security Assurance Holdings Ltd. as of December 31, 2008 and 2007 and for the Years Ended December 31, 2008, 2007 and 2006
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries (the "Company") at December 31, 2008 and December 31, 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, in November 2008, Dexia S.A. ("Dexia"), the Company's ultimate parent, entered into an agreement to sell the Company. In February 2009, Dexia assumed significant credit and liquidity risk arising from the Company's Financial Products operations. As discussed in Notes 3 and 4 to the consolidated financial statements, the Company has adopted SFAS No. 157, "Fair Value Measurements" and SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" in 2008.
The Company received tax benefits of $4.7 million in 2008, $1.3 million in 2007 and no tax benefits in 2006 from its parent company. See Note 14 for disclosure of non-cash transactions relating to restricted treasury stock transactions.
Financial Security Assurance Holdings Ltd. ("FSA Holdings") is a holding company incorporated in the State of New York. The Company, through its insurance company subsidiaries, engages in providing financial guaranty insurance on public finance obligations in domestic and international markets. The Company's principal insurance company subsidiary is Financial Security Assurance Inc. ("FSA"), a wholly owned New York insurance company. Historically, the Company also provided financial guaranty insurance on asset-backed obligations. In August 2008, the Company announced that it would cease insuring asset-backed obligations and instead participate exclusively in the global public finance financial guaranty business. References to the "Company" are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.
In addition to its financial guaranty business, the Company historically offered FSA-insured guaranteed investment contracts and other investment agreements ("GICs") as well as medium-term notes to municipalities and other market participants through consolidated entities in its financial products ("FP") segment. In November 2008, the Company ceased issuing GICs in contemplation of the sale of the Company to Assured Guaranty Ltd. ("Assured"). While the Company has ceased new originations of asset-backed financial guaranty business and GICs, a substantial portfolio of such obligations remains outstanding.
In November 2008, Dexia Holdings entered into a purchase agreement (the "Purchase Agreement") providing for the sale of all Company shares owned by Dexia to Assured (the "Acquisition"), subject to the consummation of specified closing conditions, including regulatory approvals, absence of rating impairment and segregation or separation of the Company's FP operations from the Company's financial guaranty operations.
Satisfying all three rating agencies that the necessary steps have or will be taken to transfer the FP segment credit and liquidity risk to Dexia is one of the last conditions to the Purchase Agreement closing. Rating agency confirmation that the Acquisition will not have a negative impact on the financial strength ratings of Assured's insurance company subsidiaries or the Company's insurance company subsidiaries is a condition for closing, and is beyond the Company's control.
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. The Purchase Agreement provides that Dexia will provide guarantees with respect to the FP business' assets and liabilities, including derivative contracts and anticipates that some of its guarantees will benefit from guarantees provided by the French and Belgian states. Dexia Holdings, the Company's parent, agreed that if such sovereign guarantees are provided, it will cause FSA Holdings to transfer the ownership interests of certain of the subsidiaries that conduct the FP business, or all the assets and liabilities of such subsidiaries, to Dexia Holdings or one of its affiliates in form reasonably acceptable to Assured.
with a significant number of GICs subject to redemption or collateralization should FSA be downgraded below Aa3 by Moody's Investors Service, Inc. ("Moody's") (FSA's current Moody's rating) or below AA- by Standard & Poor's Ratings Service ("S&P"). Dexia had previously announced its intention to assume the credit and liquidity risk associated with the Company's FP business, and provided significant support to the FP business in the course of 2008.
As a result, the FSAM Risk Transfer Transaction was deemed a reconsideration event for FSAM under FASB Interpretation 46 (R), "Consolidation of Variable Interest Entities" ("FIN 46"). There was no reconsideration event for any of the GIC Subsidiaries. Upon the reconsideration event, management determined that Dexia is now absorbing the majority of the variability of expected losses of FSAM, which resulted in deconsolidation of FSAM as of February 24, 2009, the effective date of the FSAM Risk Transfer Transaction.
The GIC subsidiaries, unlike FSAM, remain part of the Company's consolidated financial statements, notwithstanding the FSAM Risk Transfer Transaction, which means that the GICs issued to third parties and the note receivable from FSAM will represent the primary liabilities and assets of the FP business in the Company's consolidated financial statements. Since some of the GICs were designated as fair value option, they will continue to be marked to market; however, derivatives are maintained within FSAM, so contracts meant to hedge the interest rate risk of those GICs will no longer be included in the Company's consolidated financial statements, increasing the volatility of the Company's net income (loss).
See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-FP Segment Liquidity-Sources of Liquidity" for more information on the FSAM Risk Transfer Transaction.
Financial guaranty insurance generally provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Upon a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or, at its option, to pay such amounts on an accelerated basis.
the Company's insurance company subsidiaries, as well as the obligations they insured, had been awarded Triple-A ratings by the three major rating agencies.
Asset-backed obligations insured by the Company were generally issued in structured transactions and are backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. The Company insured synthetic asset-backed obligations that generally took the form of credit default swap ("CDS") obligations or credit-linked notes that reference asset-backed securities ("ABS") or pools of securities or other obligations, with a defined deductible to cover credit risks associated with the referenced securities or loans.
Significant accounting policies under GAAP are described below. To the extent the accounting policy calls for fair value measurement, see Note 3 for a discussion of how fair value is measured for each financial instrument.
•the assets acquired in refinancing transactions, which are designated as available-for-sale, fair-value option or lower of cost or market; and
Variable rate demand notes ("VRDNs") are included in bonds in the General Investment Portfolio.
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. 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.
The financial guaranty industry has emerged over the past 35 years. Management believes that accounting literature in effect for 2008, including insurance accounting under SFAS No. 60, "Accounting and Reporting by Insurance Enterprises" ("SFAS 60"), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing literature, including sections of SFAS 60, SFAS No. 5, "Accounting for Contingencies" ("SFAS 5") and Emerging Issues Task Force Issue 85-20, "Recognition of fees for guaranteeing a loan" ("EITF 85-20").
Case reserves for financial guaranty insurance companies differ from those of traditional property and casualty insurance companies. The primary difference is that traditional property and casualty case reserves include only claims that have been incurred and reported to the insurance company. In a traditional property and casualty company, claims are incurred when defined events occur such as an automobile accident, home fire or storm. Unlike traditional property and casualty claims, financial guaranty losses arise from the extension of credit protection and occur as the result of the credit deterioration of the issuer or underlying assets of the insured obligations over the lives of those insured obligations. Such deterioration and ultimate loss amounts can be projected based on historical experience in order to estimate probable loss, if any. Accordingly, specific loss events that require case reserves include (1) policies under which claim payments have been made and additional claim payments are expected and (2) policies under which claim payments are probable and reasonably estimable, but have not yet been made.
The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be statistically estimated using data such as that published by rating agencies. The 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. Management's best estimate of inherent losses associated with providing credit protection at each balance sheet date is evaluated by applying the Moody's expected loss algorithm as an estimate of the reserve required for non-investment grade risks not requiring a core reserve. If such amount is greater than 10% of the statistical product then an additional contribution to the non-specific reserve is made.
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 1970-2007, 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 product of the current-year statistical calculation multiplied by the current-year experience factor represents the present value of loss amounts calculated for current-year originations. The present value of loss amounts calculated for the current-year originations is established at inception of each policy, and there is no subsequent change unless significant adverse or favorable loss experience is observed. The experience factor is based on the Company's cumulative-to-date historical losses starting from 1993, when the Company established the non-specific reserve methodology. The experience factor is calculated by dividing cumulative-to-date actual losses incurred by the Company by the cumulative-to-date losses determined by the statistical calculation. The experience factor is reviewed and, where appropriate, updated periodically, but no less than annually.
•FSA sector assigned (default rate and severity are defined by sector)
In 2008, management recorded additional non-specific reserves as a result of such analysis.
Management believes that accounting literature in effect for 2008 does not address the unique attributes of financial guaranty insurance. As an insurance enterprise, the Company initially refers to the accounting and financial reporting guidance in SFAS 60. In establishing loss liabilities, the Company relies principally on SFAS 60, which prescribes differing treatment depending on whether a contract is a short-duration contract or a long-duration contract. Financial guaranty insurance does not fall clearly within the definition of either short-duration or long-duration contracts. Therefore, the Company does not believe that SFAS 60 alone provides sufficient guidance for financial guaranty claim liability recognition.
As a result, the Company also analogizes to SFAS 5, which requires the establishment of liabilities when a loss is both probable and reasonably estimable. The Company also relies by analogy on EITF 85-20, which provides general guidance on the recognition of losses related to guaranteeing a loan. In the absence of a comprehensive accounting model provided by SFAS 60, industry participants, including the Company, have looked to such other guidance referred to above to develop their accounting policies for the establishment and measurement of loss liabilities. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that a portfolio of credit-based insurance, comprising irrevocable contracts that cannot be unilaterally changed by the insurer and that match the maturity terms of the underlying insured obligations, contains probable and reasonably estimable losses.
Effective January 1, 2009, the Company's measurement and recognition of claims liabilities will change due to the adoption of SFAS 163, as described in "-Recently Issued Accounting Standards."
The gains and losses relating to derivatives not designated as fair-value hedges are included in "net realized and unrealized gains (losses) on derivative instruments" in the consolidated statements of operations and comprehensive income. The gains and losses related to derivatives designated as fair-value hedges are included in either "net interest income from financial products segment" or "net interest expense from financial products segment," as appropriate, along with the offsetting change in the fair value of the risk being hedged. Hedge accounting is applied to fair value hedges provided certain criteria are met. See Note 16 for more information. All cash flows from derivative instruments are classified as "financial products segment net derivative receipts (payments)" on the statement of cash flows, regardless of their designation as fair-value hedges.
The Company also has a portfolio of insured derivatives (primarily CDS). It considers these agreements to be a normal part of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. It ceased issuing asset-backed guarantees in August 2008. These agreements are recorded at fair value. Changes in fair value are recorded in "net change in fair value of credit derivatives."
In consultation with the Securities and Exchange Commission (the "SEC"), members of the financial guaranty industry have collaborated to develop a presentation of credit derivatives issued by financial guaranty insurers that is more consistent with that of non-insurers. Prior-period balances have been reclassified to conform to the current presentation. The reclassifications do not affect net income or equity, although they do affect various revenue, asset and liability line items. Changes in fair value are recorded in "net change in fair value of credit derivatives" in the consolidated statements of operations and comprehensive income. The "realized gains (losses) and other settlements" component of this income statement line includes premiums received and receivable on written CDS contracts and premiums paid and payable on purchased contracts. If a credit event occurred that required a payment under the contract terms, this line item would also include losses paid and payable to CDS contract counterparties due to the credit event and losses recovered and recoverable on purchased contracts.
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized transactions and recorded at contract value plus accrued interest. It is the Company's policy to take possession of securities borrowed under agreements to resell.
FP segment debt is recorded at amortized cost or fair value, if the fair value option was elected. Certain VIE liabilities include embedded derivatives. Prior to the adoption of SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159") on January 1, 2008, changes in fair value of embedded derivatives in VIE debt were recorded in "net realized and unrealized gains (losses) on derivative instruments." In 2008, the fair value option was elected for all VIE liabilities containing embedded derivatives and the change in fair value of the entire debt instrument is recorded in "net unrealized gains (losses) on financial instruments at fair value."
denominated in foreign currencies are recorded in accumulated other comprehensive income unless the security is deemed OTTI. Gains and losses from transactions in foreign currencies are recorded in "other income."
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. Deferred tax assets are evaluated for recoverability and a valuation allowance is established if a deferred tax asset is determined to be non-recoverable.
Non-interest-bearing tax and loss bonds are purchased to prepay the tax benefit that results from deducting contingency reserves as provided under Internal Revenue Code Section 832(e). The Company records the purchase of tax and loss bonds in other assets.
The Company also bears some of the "risks and rewards" associated with the performance of those SPE's assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given SPE'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).
The Company's underwriting guidelines for public finance obligations generally require that a transaction be rated investment grade when FSA's insurance is applied. The Company's underwriting guidelines for asset-backed obligations, which it followed prior to its August 2008 decision to cease insuring such obligations, varied by obligation type in order to reflect different structures and types of credit support. The Company sought to insure asset-backed obligations that generally provided for one or more forms of overcollateralization or third-party protection. In addition, the SPE typically pays a periodic premium to the Company in consideration of the issuance by the Company of its insurance policy, with the SPE's assets typically serving as the source of payment of such premium, thereby providing some of the "rewards" of the SPE's assets to the Company. SPEs are also employed by the Company in connection with secondary market transactions and with refinancing underperforming, non-investment-grade transactions insured by FSA. See Note 7 for more information.
The degree of influence exercised by FSA over these SPEs varies from transaction to transaction, as does the degree to which "risks and rewards" associated with asset 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 determining whether the Company is the Primary Beneficiary of a particular VIE, a number of factors are considered. The significant factors considered are: the design of the entity and the risks it was created to pass-along to variable interest holders; the extent of credit risk absorbed by the Company through its insurance contract and the extent to which credit protection provided by other variable interest holders reduces this exposure; the exposure that the Company cedes to third party reinsurers, to reduce the extent of expected loss which the Company absorbs; and the portion of the VIE's total notional exposure covered by the Company's insurance policy. The Company's accounting policy is to first conduct a qualitative analysis based on the design of the VIE in order to identify whether it is the primary beneficiary. Should the qualitative analysis not provide a basis for conclusion, the Company will perform a quantitative analysis in order to determine if it is the primary beneficiary of the VIE under review.
In May 2008, the FASB issued SFAS 163. This statement addresses accounting standards applicable to existing and future financial guaranty insurance and reinsurance contracts issued by insurance companies, including accounting for claims liability measurement and recognition and premium recognition and related disclosures. SFAS 163 requires the Company to recognize a claim liability when there is an expectation that a claim loss will exceed the unearned premium revenue (liability) on a policy basis based on the present value of expected net cash flows. The premium earnings methodology under SFAS 163 will be based on a constant rate methodology. SFAS 163 does not apply to financial guarantee insurance contracts accounted for as derivatives within the scope of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 163 also requires the Company to provide expanded disclosures relating to factors affecting the recognition and measurement of financial guaranty contracts. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, except for the presentation and disclosure requirements related to claim liabilities which were effective for financial statements prepared as of September 30, 2008. The cumulative effect of initially applying SFAS 163 is required to be recognized as an adjustment to the opening balance of retained earnings. The Company is currently assessing the impact of SFAS 163 on the Company's consolidated financial position and results of operations.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities, an amendment of SFAS 133" ("SFAS 161"). This statement amends and expands the disclosure requirements for derivative instruments and hedging activities by requiring companies to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. This statement is effective for fiscal years and interim periods beginning after November 15, 2008. Since SFAS 161 only requires additional disclosures concerning derivatives and hedging activities, adoption of SFAS 161 will not affect the Company's consolidated financial position and results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements" ("SFAS 160"). SFAS 160 will change the accounting for minority interests, which will be recharacterized as noncontrolling interests and classified by the parent company as a component of equity. SFAS 160 also addresses the accounting for deconsolidations of certain subsidiaries. This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. Upon adoption, SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests and prospective adoption for all other requirements. The Company is currently assessing the impact of SFAS 160 on the Company's consolidated financial position, results of operations and cash flows.
•establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date;
•nullifies the guidance in Emerging Issues Task Force Issue No. 02-03, "Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities" ("EITF 02-03"), which required the deferral of profit at inception of a transaction involving a derivative financial instrument in the absence of observable data supporting the valuation technique;
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 would 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.
SFAS 157 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
At December 31, 2008, the Company's equity securities were comprised of common stock of Dexia. The fair value of the common stock is based upon quoted prices and is categorized as Level 1. At December 31, 2007, the fair value of the Company's equity investment in Syncora Guarantee Re Ltd. ("SGR") was based on redemption value and other inputs.
The FP Segment Investment Portfolio is comprised of investments made with the proceeds of FSA-insured GICs. Together with the VIE Investment Portfolio, it forms the FP Segment Investment Portfolio. The available-for-sale FP Investment Portfolio is broadly comprised of short-term investments, non-agency RMBS, securities issued or guaranteed by U.S. government sponsored agencies, taxable municipal bonds, securities issued by utilities, infrastructure-related securities, collateralized debt obligations ("CDOs"), and other asset backed securities. In addition to its available-for-sale portfolio, the FP Investment Portfolio includes foreign currency denominated securities classified as "trading."
For short-term investments in the FP Segment Investment Portfolio, which are those investments with a maturity of less than one year at time of purchase, the carrying amount is fair value. These short-term investments include overnight federal funds and money market funds, which are categorized as Level 1 on the valuation hierarchy.
For certain assets acquired in refinancing transactions, fair value is either the present value of expected cash flows or a quoted market price as of the reporting date. This portfolio is comprised primarily of bonds, securitized loans, common stock, mortgage loans, real estate and short term investments, of which bonds, common stocks and certain securitized loans are carried at fair value. Mortgage loans are accounted for at fair value when lower than cost. The majority of the assets in this portfolio are categorized as Level 3 in the valuation hierarchy, except for the short-term investments, which are categorized as Level 2.
•CDS contracts in which the Company sells protection to various financial credit institutions, and in certain cases, purchases back-to-back credit protection on all or a portion of the risk written, primarily from reinsurance companies,
•insured interest rate ("IR") swaps entered into by the issuer in connection with the issuance of certain public finance obligations, which guaranty the municipality's performance under the IR swap to the IR swap counterparty,
•insured net interest margin ("NIM") securitizations and other financial guaranty contracts that guarantee risks other than credit risk, such as interest rate basis risk ("FG contracts with embedded derivatives") issued after January 1, 2007.
In the case of CDS contracts, a trust that is consolidated by the Company writes a derivative contract that provides for payments to be made if certain credit events occur related to certain specified reference obligations, in exchange for a fee. The need to interpose a trust is a regulatory requirement imposed by the New York State Insurance Department as an exception to its general rule, in order to allow the financial guarantors to sell credit protection by entering into credit derivative contracts (albeit indirectly by guaranteeing the trust), while other types of insurance enterprises may neither directly enter into such credit derivative contracts, nor provide such guarantees to a trust. The trust's obligation on the CDS contracts it writes are guaranteed by a financial guaranty contract written by FSA that provides payments to the insured if the trust defaults on its payments under the derivative
contract. In these transactions, FSA is considered the counterparty to a financial guaranty contract that is defined as a derivative. The credit event is typically based upon failure to pay or the insolvency of a referenced obligation. In such cases, the claim represents payment for the shortfall amount.
Market perceptions of credit deterioration of the underlying referenced obligation would result in an increase in the expected exit value (the amount required to be paid to exit the transaction due to wider credit spreads).
Fair Value of CDS Contracts in which the Company Sells Protection
Determination of Current Exit Value Premium: The estimation of the current exit value premium is derived using a unique credit-spread algorithm for each defined CDS category that utilizes various publicly available credit indices, depending on the types of assets referenced by the CDS contract and the duration of the contract. The "exit price" derived is technically an "entry price" and not an "exit price" (i.e., the price that would be received to sell an asset or paid to transfer a liability that is required under SFAS 157). This is because a monoline insurer cannot observe "exit prices" for the CDS contract that it writes in a principal market since these contracts are not transferable. While SFAS 157 provides that the transaction (entry) price and the exit price may not be equal if the transaction price includes transaction costs, the Company believes those transaction costs would be the same in an "entry" market and a hypothetical "exit" market and thus it would be inappropriate to record a day one gain when using the estimated "entry price" to determine the exit value premium.
In a financial guaranty insurance policy, a deductible is the portion of a loss under that policy that is not covered by the policy, or in other words, the amount of the loss for which the insurer is not responsible. In a CDS contract, the deductible is quoted as a percentage of the contract's notional amount, and is also referred to as the contract's attachment point. For example, for a CDS with a $1 billion notional amount and a 15% deductible, the Company would only be obligated to make a claim payment after the insured incurred more than $150 million (15% of $1 billion) of losses (net of
The underlying securities of the Company's CDS contracts are predominantly corporate obligations, specifically investment grade pooled corporate CDS, high yield pooled corporate CDS and collateralized loan obligations ("CLOs"). The Company's exposure to underlying securities such as those backed by domestic RMBS and CDOs of ABS was less than one percent of the total CDS par outstanding as of December 31, 2008.
Below is an explanation of how the Company determines the current exit value for each of the following types of CDS contracts:
and iTraxx for European corporate CDS ("iTraxx"). The mid-market price is a practical expedient for the fair-value measurement within a bid-ask spread. For those pooled corporate CDS contracts that include both domestic and foreign reference entities, the Company applies the iTraxx price in proportion to the pool of applicable foreign reference entities comprising the pool by calculating a weighted average of the DJ CDX and iTraxx quoted prices.
The Company's valuation process for pooled corporate CDS involves stratifying the pools into either investment grade credits or high-yield credits and then by remaining term to maturity, consistent with the reference indexes. Within maturity bands, further distinction is made for contracts that have higher attachment points. Both the DJ CDX and iTraxx indices provide quoted prices for standard attachment and detachment points (or "tranches") for contracts with maturities of three, five, seven and ten years.
The Company calibrates the quoted index price to the approximate attachment points for its IG CDS contracts by calculating the weighted average of the given quoted tranche prices for IG CDS of a given maturity using the CDX IG Index and iTraxx quoted tranche widths. The relevant widths of the quoted tranches used by the two indices differ. DJ CDX uses tranches of 10 to 15%, 15 to 30%, and 30 to 100%, resulting in tranche widths of five, 15 and 70 percentage points, whereas iTraxx uses tranches of 9 to 12%, 12 to 22% and 22 to 100%, resulting in tranche widths of three, 10 and 78 percentage points.
The Company applies a factor to the quoted prices (the "IG calibration factor"). The calibration factor is intended to calibrate the index price to each of the Company's pooled corporate investment grade CDS contracts, which reference pools of entities that are typically of lower average credit quality than those reflected in the CDX IG Index. The IG calibration factor is determined for each IG CDS contract by calibrating the WARF of the index so that it approximately equals the WARF of each IG CDS contract. To do so, the Company recalculates the index price after removing from the index the reference obligations that have the highest ratings. This recalculated index price is then divided by the unadjusted index to arrive at the IG calibration factor. As of December 31, 2008, the IG calibration factor applied to the Company's IG CDS contracts ranged from 112% to 530% of the WARF of the index.
To arrive at the exit value premium applied to each of the Company's IG CDS contracts, the Company:
(b)applies the IG calibration factor and non-collateral posting factor to the weighted-average market price determined for each maturity band.
High-Yield Pooled Corporate CDS Contracts: In order to estimate the market price for high-yield pooled corporate CDS contracts ("HY CDS"), the Company uses the average of the dealer mid-market prices obtained for the most senior quoted of the respective three-year, five-year and seven-year tranches of the CDX North America High Yield Index ("CDX HY Index"). The CDX HY Index is comprised of prices sourced from 100 of the most liquid North American high yield CDS quoted (each, an "Index CDS") and is supported by more than 10 of the largest CDS dealers. In addition to the full capital structure, the CDX HY Index also provides price quotes for various tranches delineated by attachment and detachment points: 0 to 10%; 10 to 15%; 15 to 25%; 25 to 35%; and 35 to 100%. The Company uses an average of the dealer mid-market quotes of the index because the Company believes that dealer price quotes have historically been indicative of where trades have been executed in the high-yield market.
closely relates to the credit characteristics, mainly with reference to the WARF, of the Company's HY CDS contracts, and then uses the average of dealer quotes of that series. The Company also remodels each of its contracts to determine if the credit quality remains Super Triple-A and compares the WARF of the index to the WARF of each of the Company's HY CDS contracts.
•For purposes of this calculation, the Company's HY CDS contracts are stratified into three maturity bands: less than 3.5 years; 3.5 to 5.5 years; and 5.5 to 7.5 years.
•The appropriate HY calibration factor and a 70% non-collateral posting factor adjustment are applied to the average of the quotes received at December 31, 2008.
Below is an example of the pricing algorithm that is applied to the Company's domestic HY CDS contracts with durations of 3.5 to 5.5 years, assuming an average HY calibration factor of 100% to determine the exit premium value as of December 31, 2008:
CDS of Funded CDOs and CLOs: Prior to August 2008, the Company sold protection to financial institutions in a principal-to-principal market in which transactions are highly customized and negotiated independently. The Company therefore cannot observe "exit" prices for the CDS contracts it writes in this market since these contracts are not transferable. In the absence of a principal exit market, the Company determines the fair value of a CDS contract it writes by using an internally-developed estimate of an "exit price" that a hypothetical market participant (i.e., a similarly rated monoline financial guarantee insurer, or "monoline insurer") would accept to assume the risk from the CDS writer on the measurement date, on terms identical to the contract written by the CDS writer. The Company believes this approach is reasonable because the hypothetical exit market has been defined as other monoline insurers. In essence, the exit market participants are the same as the monoline participants competing in the entry market.
The CDS protection of a CLO provided by the Company is priced to capture only the credit spread component, as the CDS writer is not providing funding for the CLO, only credit protection. The contracts on which the Company has provided credit protection are regularly evaluated to ascertain whether or not the original Triple-A credit rating is still considered appropriate. The Company determines the exit value premium for all these CDS of CLO contracts in its portfolio that are rated Triple-A with reference to the Triple-A CLO Funded Rate, which is currently the only regularly and frequently quoted rate observable in the market. The Triple-A CLO Funded Rate was 500 bps as of
December 31, 2008. The Company applies a credit component factor to the Triple-A CLO Funded Rate as a means of estimating the fair value of its Triple-A rated contract, which only refers to the credit component. The credit and funding components were 50% each as of December 31, 2008. The components are determined judgmentally and can vary based on estimates provided to the Company by external market participants, specifically purchasers of CDS protection on Triple-A CLO risk and investors in Triple-A CLO bonds.
To arrive at the exit value premium that is applied to each of the Company' CDO and CLO CDS contracts, the non-collateral posting factor is applied to the weighted-average market price determined for each maturity band.
Other Structured Obligations Valuation: For CDS for which observable market value information is not available, management applies its best judgment to estimate the appropriate current exit value premium, and takes into consideration the Company's estimation of the price at which the Company would currently charge to provide similar protection, and other factors such as the nature of the underlying reference credit, the Company's attachment point, and the tenor of the CDS contract.
Fair Value of CDS Contracts in which the Company Purchases Protection
The Company generally utilizes reinsurance to purchase protection for CDS contracts it writes in the same way that it employs reinsurance in respect of other financial guaranty insurance policies. The Company's uses of reinsurance to mitigate risk exposures for CDS contracts and financial guaranty insurance policies are nearly identical as they involve the same reinsurers, the same underwriting process evaluating the reinsurers and the same credit risk management and surveillance processes supporting the reinsurance function. The Company enters into reinsurance agreements on CDS contracts primarily on a quota share basis. Under a quota share reinsurance agreement with a reinsurer, the Company cedes to the assuming reinsurer a proportionate share of the risk and premium.
The determination of the hypothetical exit market is a key factor in determining the fair value of protection purchased (the "ceded" or "reinsurance" contract) with respect to a CDS contract written by a financial guarantor (the "direct contract"). SFAS 157 requires that the valuation premise, used to measure the fair value of an asset, must consider the asset's "highest and best use" from the perspective of market participants. Generally, the valuation premise used for a financial asset is "in-exchange" since this type of asset provides maximum value to market participants on a stand-alone basis. The maximum value of a ceded contract to the CDS writer's exit market participants is in combination with the CDS writer's direct contract. Therefore the appropriate valuation premise to use for a ceded contract is the "in-use" premise.
The Company determines the fair value of a CDS contract in which it purchases protection from a reinsurer (the "ceded CDS contract") as the proportionate percentage of the fair value of the related written CDS contracts, adjusted for any ceding commission and consideration of counterparty risk. In quota share reinsurance agreements, the assuming reinsurer typically pays a ceding commission periodically over the life of the CDS contract to the ceding company that is intended to defray the ceding company's costs for the services it provides to the reinsurer, such as risk selection, underwriting activities and ongoing servicing and reporting. As an element of the fair value of the ceded CDS contract, the ceding commission paid to the ceding company represents the ceding company's profit on the ceded CDS contract after considering counterparty credit risk, (i.e., the difference between (a) the price of the protection the ceding company purchased from the reinsurer, which is net of the ceding commission, and (b) the price that the ceding company would receive to exit the ceded CDS contract
in its principal market, which is comprised of other ceding insurers of comparable credit standing). The Company applies a credit valuation adjustment to the fair value of a ceded CDS contract due from a reinsurer if the reinsurer's credit quality (as determined by CDS price if available, or if not, its credit rating) is less than that of the Company's based upon the premise that the exit market for these contracts would be another monoline financial guarantee insurer that has similar credit rating or spread as the Company.
Insured Interest Rate Swaps and Financial Guarantee Contracts Deemed to be Derivatives
The Company insures IR swaps entered into in connection with the issuance of certain public finance obligations. Because the financial guaranty contract insures a derivative, the financial guaranty contract is deemed to be a derivative. Therefore, the contract is required to be carried at fair value, with the change in fair value being recorded in the determination of net income (loss). As there is no observable market for these policies, the fair value of these contracts is determined by using an internally-developed model and, therefore, they are classified as Level 3 in the valuation hierarchy.
Insured NIM securitizations issued in connection with certain mortgage-backed security financings and financial guaranty contracts with embedded derivatives are deemed to be hybrid instruments that contain an embedded derivative if they were issued after January 1, 2007. The Company elected to record these financial instruments at fair value under SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments." Changes in the fair value of these contracts are recorded in the consolidated statements of operations and comprehensive income. As there is no observable market for these policies, the fair value of these contracts is based on internally-derived estimates and they are, therefore, classified as Level 3 in the valuation hierarchy.
Other assets primarily include receivables for securities sold, deferred compensation plans ("DCP"), supplemental executive retirement plans ("SERP"), and committed preferred trust securities ("CPS"). As there is no observable market for the Company's CPS, fair value of the CPS is based on internally-derived estimates and, therefore, is categorized as Level 3 in the fair value hierarchy.
The fair value of the FP segment debt is determined based on a discounted cash flow model. Fair value calculated by these models includes assumptions for interest rate curves based on selected
The fair value of net financial guarantees written is based on the estimated cost to the Company of transferring the outstanding insured portfolio to another financial guarantor of comparable credit standing, under current market conditions. The fair value of net financial guarantees written incorporates (i) deferred premium revenue, (ii) amounts recoverable from reinsurers on unpaid losses, (iii) estimated future installment premiums receivable, and (iv) losses and loss adjustment expenses. These fair values are based on inputs observable in the market, where available, as well as inputs which are not readily observable in the market. SFAS 157 requires the risk of nonperformance to be included in the estimation of fair value of financial liabilities. The Company's credit risk, as measured by the credit spread on its CDS, has been factored into the fair value of the financial guarantees written in order to account for the risk of nonperformance.
The following table presents the financial instruments carried at fair value at December 31, 2008, by caption on the consolidated balance sheet and SFAS 157 valuation hierarchy.
(1)As permitted by FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39," the Company has elected to net derivative receivables and payables and the related cash collateral received under a master netting agreement.
(2)At December 31, 2008, approximately 97% or $278.1 million of the credit derivative asset in the "assets: credit derivatives" line item above represents the fair value of derivative contracts where the Company purchases protection on its CDS exposure. The remaining 3% or approximately $9.3 million relates to the fair value of certain of the Company's primary contracts (i.e., sold protection), where the fair value is in an asset position because the cash flows necessary to exit such a contract, including the effect of the Company's creditworthiness as determined by CDS referencing the Company's principal insurance subsidiary, would be less than the contractual cash flows to be received. Reinsurance and direct derivative contracts, which call for contractual fees below (reinsurance) or in excess of (direct contracts) the current market price, represent a benefit to the Company and, accordingly, are accounted for as credit derivative assets. Non-Recurring Fair Value Measurements
(2)Transfers are assumed to be made at the beginning of the period.
(5)Reported in net unrealized gains (losses) on financial instruments at fair value.
(6)Reported in net unrealized gains (losses) on financial instruments at fair value.
(7)Unrealized gains are reported in net unrealized gains (losses) on financial instruments at fair value and interest expense is recorded in net interest expense from financial products segment.
(8)Represents net position of derivatives. The consolidated balance sheet presents gross assets and liabilities based on net counterparty exposure.
On January 1, 2008, the Company elected to record the following at fair value:
•Certain FP segment debt instruments including fixed-rate GICs and VIE liabilities for which interest rate risk is hedged using interest rate derivatives in accordance with the Company's risk management strategies. The fair value election enabled the Company to record GICs hedged with IR swaps and/or foreign exchange rate swaps at fair value without having to designate them in a fair value hedge relationship under SFAS 133, as it had previously.
•Certain fixed-rate assets in the portfolio of assets acquired in refinancing transactions. The fair value election enabled the Company to record those assets that are economically hedged with derivatives at fair value without having to designate them in a fair value hedge relationship under SFAS 133.
(1)The majority of foreign securities are government issues and corporate securities that are denominated primarily in U.K. pounds sterling.
(3)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $0.3 million, or 4.5% of its amortized cost. In 2008, the Company had realized gains for sales of bonds, offset in part by an OTTI charge of $6.0 million for several municipal bonds. There were no OTTI charges in the General Investment Portfolio in 2007 and 2006.
Management has determined that the remaining unrealized losses in fixed-income securities at December 31, 2008 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, 2008 and 2007, 100% of the securities that were in a gross unrealized loss position were rated investment grade. Management has based its conclusions on current facts and circumstances. Events could occur in the future that could change management conclusions about its ability and intent to hold such securities.
The amortized cost and fair value of fixed-income securities in the General Investment Portfolio at December 31, 2008 and 2007, 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.
In 2008, the Company sold its investment in SGR Redeemable Preferred Shares. Amounts recorded by the Company in connection with SGR are as follows:
Within the FP Investment Portfolio, the Company classifies all securities as available-for-sale, except for securities owned by FSA-PAL which are classified as trading securities. The assets in the trading portfolio are bonds denominated in foreign currencies. The VIE Investment Portfolio is classified as available-for-sale at December 31, 2008.
The FP Investment Portfolio includes FSA-Insured Investments bought in the ordinary course of business. Of the bonds included in the available-for-sale FP Investment Portfolio at December 31, 2008, 4.5% were insured by FSA. At that date, 98.1% 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 guaranty, was in the Triple-B range. Of the bonds included in the FP Investment Portfolio at December 31, 2008, 15.7% were insured by other monoline guarantors. These assets are included in the Company's surveillance process and, at December 31, 2008, no loss reserves were anticipated on any or these assets. See Note 26.
During 2008, the Company recorded unrealized losses of $202.6 million in income related to the assets in the trading portfolio, compared with unrealized gains of $14.0 million in 2007 and $3.6 million in 2006.
The following tables present the amortized cost and fair value of available-for-sale bonds and short-term investments held in the FP Investment Portfolio:
(2)All securities in an unrealized loss position at December 31, 2008 were recorded in the statement of operations and comprehensive income as OTTI in net realized gains (losses) from financial products segment. See "-Review of FP Investment Portfolio for Other-than-Temporary Impairments."
(3)Includes primarily asset-backed, U.S. agency debentures and treasury securities. The following table shows the gross unrealized losses recorded in accumulated other comprehensive income and fair values of the available-for-sale bonds in the FP Investment Portfolio as of December 31, 2007, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position. There were no unrealized losses recorded in 2008. All securities in an unrealized loss position as of December 31, 2008, were recorded in OTTI.
Aging of Unrealized Losses of Available-for-Sale Bonds in the FP Investment Portfolio
The table below provides the composition of the OTTI charge by asset class.
(1)Amortized cost includes fair-value adjustments recorded as OTTI and hedge accounting adjustments.
(3)Stated maturities for asset-backed and other securities of three to 44 years as of December 31, 2008 and of four to 44 years as of December 31, 2007.
Proceeds from sales of available-for-sale bonds held in the FP Investment Portfolio during 2007 and 2006 were $2,971.7 million and $4,512.5 million, respectively. Sales were de minimus in 2008. Proceeds from maturities of bonds for the FP Investment Portfolio during 2008, 2007 and 2006 were $1,777.9 million, $3,299.0 million and $4,485.1 million, respectively. Gross losses were realized on sales during 2008 of $0.7 million. Gross gains were realized on sales during 2007 and 2006 of $13.0 million and $0.1 million, respectively.
The amortized cost and fair value of available-for-sale bonds and short-term investments in the VIE Investment Portfolio were as follows:
Historically, the Company had the ability and intent to hold the FP Segment Investment Portfolio to maturity. However, the Company no longer has the intent to hold such securities to maturity, due to Dexia's agreement under the Purchase Agreement to retain the FP operations and segregate or separate the Company's FP operations from the Company's financial guaranty operations. As a result, the Company was required to record an OTTI charge for all assets in the portfolio in an unrealized loss position at December 31, 2008.
With respect to transactions governed by ISDA master agreements, FP Risk Management monitors net counterparty credit exposure and, when the exposure exceeds an agreed to limit, demands collateral from the counterparty in accordance with the relevant master agreement.
Securities purchased under agreements to resell are eligible to be pledged to certain interest rate swap counterparties. In general, under the terms of each of these counterparty-specific derivative agreements, the Company and its counterparty may be required to pledge collateral or transfer assets as a result of changes in the fair value of those derivative agreements. The timing and amount are generally dependent on which entity is exposed, as well as the credit rating of the party in the payable position. The Company and the counterparty typically have identical rights and obligations to pledge and rehypothecate collateral according to the terms included within each of the counterparty-specific derivative agreements. At December 31, 2008, $18.2 million of the assets held in the FP Investment Portfolio and related accrued interest were pledged as collateral to margin accounts. FSA Global, under the terms of its derivative agreements, is not required to pledge collateral. Its counterparties, however, may be required to pledge collateral or transfer assets to FSA Global.
The accretable yield on the securitized loans at December 31, 2008, 2007 and 2006 was $7.5 million, $148.8 million and $157.3 million, respectively.
Activity in the liability for losses and loss adjustment expenses, which consist of the case and non-specific reserves, is summarized below. Adjustments to reserves represent management's estimate of the amount required to cover the present value of the net cost of claims based on statistical provisions for new originations.
During 2007, the Company charged $31.6 million to loss expense, consisting of $25.8 million for originations of new business and $5.8 million related to accretion on the reserve for in-force business. Net case reserves increased $45.1 million in 2007 due primarily to the establishment of new case reserves for HELOC and public finance transactions, offset in part by the settlement of several pooled corporate collateralized bond obligations ("CBOs"), which were accrued for in prior years. 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 reevaluated 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 deemed to be recoverable and was recorded as salvage and subrogation ("S&S") recoverable as of December 31, 2007.
•Categories I and II represent fundamentally sound transactions requiring routine monitoring, with Category II indicating that routine monitoring is more frequent, due, for example, to the sector or a need to monitor triggers.
•Category III represents transactions with some deterioration in asset performance, financial health of the issuer or other factors, but for which losses are deemed unlikely. Active monitoring and intervention is employed for Category III transactions.
•Category V reflects transactions where losses are probable. This category includes (1) risks where claim payments have been made and where ultimate losses, net of recoveries, are expected, and (2) risks where claim payments are probable but none have yet been made and ultimate losses, net of recoveries, are expected. Category IV and Category V transactions are subject to intense monitoring and intervention.
FP segment debt consists of GIC and VIE debt. The obligations under GICs issued by the GIC Subsidiaries may be called at various times prior to maturity based on certain agreed-upon events. As of December 31, 2008, interest rates were between 1.18% and 8.71% per annum on outstanding GICs and between 1.98% and 6.22% per annum on VIE debt. Payments due under GICs are based on expected withdrawal dates, which are subject to change, and include accretion of $825.7 million. VIE debt includes $692.2 million of future interest accretion on zero-coupon obligations. The following table presents the combined principal amounts due under FP segment debt for 2009 and each of the next four years ending December 31, and thereafter:
The Company seeks to limit 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.
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:
The par outstanding of insured obligations in the public finance insured portfolio includes the following amounts by type of issue:
Dexia Holdings, FSA Holdings and its Subsidiaries, except FSA International, file a consolidated U.S. federal income tax return. Under the terms of a tax-sharing agreement, each company pays taxes on a separate return basis.
In addition, the Company and its subsidiaries or branches file separate tax returns in various states and local and foreign jurisdictions, including the United Kingdom, Japan, Mexico and Australia. With limited exceptions, the Company and its subsidiaries are no longer subject to income tax examinations for its 2004 and prior tax years for U.S. federal, state and local, or non-U.S. jurisdictions.
addition, the Company shared 50% of the tax benefit with White Mountains when the required circumstances were satisfied in the third quarter of 2008.
The net deferred tax asset of $3.3 billion at December 31, 2008 consists primarily of unrealized capital losses and foreign exchange losses of $3.0 billion, $368 million related to loss reserves, and $453 million related to mark to market on CDS, offset by other net liabilities. The unrealized losses were primarily generated from OTTI losses recognized in the FP investment portfolio. The Company's
management has concluded that a valuation allowance of $2.5 billion is required based on the following factors:
In 2008 and 2007, the Company recognized a tax benefit of $5.6 million and $4.2 million respectively, which include the benefit of $1.4 million and $0.7 million of interest, respectively, from the expiration of the statute of limitations for the 2004 and 2003 tax years.
A reconciliation of the effective tax rate (before minority interest and equity in earnings of unconsolidated affiliates) with the federal statutory rate follows:
The 2008 effective tax rate reflects a lower than expected benefit of 35% due to the establishment of valuation allowance of $2.5 billion, offset by benefits from tax-exempt interest income and the tax-exempt fair value adjustments related to the Company's committed preferred securities. The 2007 and 2006 rates differ from the statutory rate of 35% due primarily to tax-exempt interest. The 2007 rate reflects an unusually high benefit due to the disproportionately low amount of pre-tax income to tax-exempt interest.
The total amount of unrecognized tax benefits at December 31, 2008 and December 31, 2007 was $15.1 million and $19.2 million, respectively. If recognized, the entire amount would favorably affect the effective tax rate. The Company recognizes interest and penalties related to unrecognized tax benefits as part of income taxes. For the year ended December 31, 2008 and 2007, the Company recognized a benefit of $0.9 million and an expense of approximately $0.4 million, respectively, related to interest and penalties. Cumulative interest and penalties of approximately $1.4 million and $2.3 million have been accrued on the Company's balance sheet at December 31, 2008 and December 31, 2007, respectively. A reconciliation of the beginning to ending unrecognized tax benefits follows:
The Company maintains both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of
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 as defined by the 1993 Equity Plan, and book value per outstanding share over specified three-year performance cycles.
At December 31, 2008, 276,842 outstanding performance shares were fully vested, with a value of $0. At December 31, 2008, the total compensation cost related to non-vested performance shares (not yet recognized) was $0.
At December 31, 2007, 349,533 outstanding performance shares were fully vested, with a value of $46.6 million. These amounts were paid in the first quarter of 2008. At December 31, 2007, the total compensation cost related to non-vested performance shares not yet recognized was $130.2 million.
In the fourth quarter of 2000, the Company purchased 304,757 shares of its common stock from Dexia Holdings for $24.0 million. Additional purchases are intended to fund obligations relating to the Company's Director Share Purchase Program ("DSPP"), which enables its participants to make deemed investments in the Company's common stock under the Deferred Compensation Plan and Supplemental Executive Retirement Plan. Under the DSPP, the deemed investments in the Company's stock are irrevocable, settlement of the deemed investments must be in stock and, after receipt, the participants must generally hold the stock for at least six months. Restricted treasury stock is distributed to a director as a DSPP payout at the end of applicable restriction periods.
Prior to the adoption of SFAS 157 on January 1, 2008 (the "Adoption Date"), the Company followed EITF 02-03. Under EITF 02-03, the Company was prohibited from recognizing a profit at the inception of its CDS contracts (referred to as "day one" gains) because the fair value of those derivatives is based on a valuation technique that incorporated unobservable inputs. Accordingly, the Company deferred approximately $40.9 million pre-tax of day one gains related to the fair value of CDS contracts purchased that were not permitted to be recognized under EITF 02-03. As SFAS 157 nullified the guidance in EITF 02-03, the Company recognized a transition adjustment totaling $40.9 million of previously deferred day one gains (pre-tax) in beginning retained earnings on the Adoption Date. See Note 3 for further discussion of the Company's adoption of SFAS 157.
The negative fair-value adjustments for the year ended December 31, 2008 were a result of continued widening of credit spreads in the insured CDS portfolio, offset in part by the positive income effects of the Company's own credit spread widening. Despite the structural protections associated with CDS contracts written by FSA, the significant widening of credit spreads on pooled corporate CDS and funded CDOs and CLOs, as with other structured credit products, resulted in a decline in the fair value of these contracts compared with December 31, 2007.
As the fair value of a CDS contract incorporates all the remaining future payments to be received over the life of the CDS contract, the fair value of that contract will change, in part, solely from the passage of time as fees are received.
•CDS contracts written by FSA are neither held for trading purposes (i.e., a short-term duration contract written for the purpose of generating trading gains) nor used as hedging instruments. Instead, they are written with the intent to provide protection for the stated duration of the contract, similar to the Company's intent with regard to a financial guaranty contract.
(3)Amount includes two CDS contracts with Triple-C underlying ratings. These two risks incurred economic losses at December 31, 2008.
(6)Primarily infrastructure obligations and European mortgage-backed securities. Also includes $375.2 million and $421.4 million at December 31, 2008 and 2007, respectively, in U.S. RMBS net par outstanding. All U.S. RMBS exposures were rated Triple-B or higher. Includes certain pooled corporate obligations. 16. FINANCIAL PRODUCTS SEGMENT DERIVATIVE INSTRUMENTS AND HEDGE ACCOUNTING
The Company enters into derivative contracts to manage interest rate and foreign currency exposure in its FP Segment Investment Portfolio and FP segment debt.
As a result of market interest rate fluctuations, fixed-rate assets and liabilities appreciate or depreciate in market value. Gains or losses on the derivative instruments that are linked to the fixed-rate assets and liabilities being hedged are expected to substantially offset this unrealized appreciation or depreciation relating to the risk being hedged.
The net gain related to the ineffective portion of the Company's fair-value hedges including changes in fair value of hedging instruments related to the passage of time, which was excluded from the assessment of hedge ineffectiveness, was $2.8 million in 2007 and $9.3 million in 2006. For 2008, this measure is not meaningful as substantially all assets in fair value hedging relationships have been recorded in the statement of operations and comprehensive income as OTTI.
In 2007, the Company designated certain IR swaps, which economically hedged FP segment GIC liabilities, as being in fair value hedging relationships. All derivative income, expense and fair value adjustments were reflected in the caption "Net interest expense from financial products segment" in order to offset interest expense and fair value adjustments on the hedged interest rate risk of the GICs, which were also recorded in that caption. With the adoption of SFAS 159 on January 1, 2008, the Company elected to discontinue hedge accounting for these GICs and elected the fair value option for certain liabilities in the FP segment debt portfolio, as described in Note 4. The fair value option allows the fair value adjustment on these liabilities to be recorded in earnings without hedge documentation and effectiveness testing requirements prescribed under SFAS 133. However, when the fair value option is elected, the fair value adjustment of liabilities must incorporate all components of fair value, including valuation adjustments related to the reporting entity's own credit risk. Under hedge accounting, only the component of fair value attributable to the hedged risk (i.e., market interest rate risk) was recorded in earnings.
As of January 1, 2008, fixed-rate assets in the available-for-sale FP Segment Investment Portfolio that were economically hedged with interest rate swaps were designated in fair value hedging relationships. Prior to January 1, 2008, changes in the fair value of these economically hedged assets
The Company enters into various other derivative contracts that do not qualify for hedge accounting treatment. These derivatives may include swaptions, caps and other derivatives, which are used principally as protection against large interest rate movements. Gains and losses on these derivatives are reflected in "net realized and unrealized gains (losses) on other derivative instruments" in the consolidated statements of operations and comprehensive income.
On April 28, 2006, the Company increased its ownership of the ordinary shares of FSA Global from 29% to 49% through an acquisition of shares from an unaffiliated third party. Immediately thereafter, FSA Global's charter documents were amended to create a new class of nonvoting preference shares, which was issued to the Company. Holders of such preference shares have exclusive rights to any future dividends and, upon any winding up of FSA Global, all net assets available for distribution to shareholders (after a distribution of $250,000 to the ordinary shareholder). As a result of the issuance of such preference shares, (a) a substantive sale and purchase of an interest took place between the ordinary shareholders of FSA Global and the Company, resulting in an assessment and recording of the fair value of the assets and liabilities sold and purchased at the time of such transaction, and (b) the Company's minority interest liability associated with FSA Global was eliminated. In the second quarter of 2006, the Company realized a pre-tax gain of $1.8 million as a result of this transaction. Prior to this transaction, the Company recorded minority interest for the 71% of FSA Global common equity not owned by the Company.
(2)Includes a credit-linked note issuer that is fair valued as part of the Company's credit derivative portfolio. In 2008, $28.5 million of net premiums earned resulted from commutations or cancellations of reinsurance contracts. The largest such transactions were with SGR and Bluepoint Re. Limited ("Bluepoint").
In July 2008, FSA agreed to re-assume all reinsurance ceded to SGR, which consisted of $8.4 billion in outstanding par, in exchange for the June 30, 2008 statutory basis ceded unearned premium, net of its applicable ceding commission, any case basis reserves established at that date and a $35.0 million commutation premium. FSA agreed to cede a portion of this business, approximately $6.4 billion of outstanding par with no outstanding case basis reserves, to Syncora Guarantee Inc. ("SGI") (formerly XL Capital Assurance), an affiliate of SGR, as of the re-assumption date. Ceded net unearned premiums and future ceded case reserves are secured by collateral then held in a trust. Since SGI was an affiliate of SGR, FSA did not consider the portion of the business bought back from SGR and subsequently ceded to SGI as commuted and as a result did not record any commutation gain on that portion of the business. FSA recorded a commutation gain of $10.0 million on the business it retained, which was recorded in "other income" in the statement of operations and comprehensive income. In 2008, $14.8 million of earned premium related to this commutation.
In September 2008, FSA agreed to re-assume a portion of the business it ceded to SGI in July for the statutory basis ceded unearned premium, net of its applicable ceding commissions. This resulted in a commutation gain of $10.0 million, which was recorded in "other income" in the statement of operations and comprehensive income. In 2008, $1.5 million of earned premium related to this commutation.
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 headquarters. The Company moved to this 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.
The entitlements of the Chief Executive Officer and the President of the Company under their employment agreements with the Company are in dispute. In addition, holders of shares under the
Interim lead counsel for the MDL 1950 plaintiffs filed a Consolidated Class Action Complaint ("Consolidated Complaint") in August 2008 alleging violations of the federal antitrust laws. Defendants filed motions to dismiss the Consolidated Complaint. The MDL 1950 court has determined that it will handle federal claims alleged in the Consolidated Complaint before addressing state claims. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
(a)City of Los Angeles v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of Los Angeles, Case No. BC 394944, removed to the U.S. District Court for the Central District of California ("C.D. Cal.") as Case No. 2:08-cv-5574, transferred to S.D.N.Y. as Case No. 1:08-cv-10351);
(b)City of Stockton v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-477851, removed to the N.D. Cal. as Case No. 3:08-cv-4060, transferred to S.D.N.Y. as Case No. 1:08-cv-10350);
The Company has received various regulatory inquiries and requests for information regarding a variety of subjects. These include subpoenas duces tecum and interrogatories from the State of Connecticut Attorney General and the Attorney General of the State of California related to antitrust concerns associated with the methodologies used by rating agencies for determining the credit rating of municipal debt, including a proposal by Moody's to assign corporate equivalent ratings to municipal obligations, and the Company's communications with rating agencies. The Company is in the process of satisfying such requests. The Company may receive additional inquiries from these or other regulators and expects to provide additional information to such regulators regarding their inquiries in the future.
In December 2008 and January 2009, FSA and various other financial guarantors were named in three complaints filed in the Superior Court, San Francisco County: (a) City of Los Angeles Department of Water and Power v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CG-08-483689; Sacramento Municipal Utility District v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CGC-08-483691; and (c) City of Sacramento v. Ambac Financial Group Inc. et. al (filed on or about January 6, 2009), Case No. CGC-09-483862. These complaints alleged participation in a conspiracy in violation of California's antitrust laws to maintain a dual credit rating scale that misstated the credit default risk of municipal bond issuers and created market demand for municipal bond insurance and participation in risky financial transactions in other lines of business that damaged each bond insurer's financial condition (thereby undermining the value of each of their guaranties), and a failure to adequately disclose the impact of those transactions on their financial condition. These latter allegations form the predicate for five separate causes of action against each of the Insurers: breach of contract, breach of the covenant of good faith and fair dealing, fraud, negligence, and negligent misrepresentation. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
There are no other material legal proceedings pending to which the Company is subject.
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 dividends of $30.0 million in 2008, no dividends in 2007 and $140.0 million in 2006. Based upon FSA's statutory statements for December 31, 2008, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $62.0 million, subject to certain limitations.
In 2008, Dexia Holdings contributed $1,012.1 million of capital to FSA Holdings, which included $4.3 million contributed by a liquidation of program shares and phantom program shares held by directors. In the first quarter of 2008, FSA Holdings contributed capital to FSA of $500 million. In the third quarter of 2008, FSA issued a non-interest bearing surplus note with no term to FSA Holdings in exchange for $300 million. In the fourth quarter of 2008, FSA Holdings contributed $207.8 million to FSAM, part of the FP segment.
FSA has a credit arrangement aggregating $150.0 million provided by commercial banks and intended for general application to insured transactions. If FSA is downgraded below Aa3 by Moody's and AA- by S&P, the lenders may terminate the commitment, and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 by Moody's and BBB- by S&P, any outstanding loans become due and payable. At December 31, 2008, there were no borrowings under this arrangement, which expires on April 21, 2011.
FSA has a standby line of credit in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5%, which amounted to $1,612.0 million at December 31, 2008. The obligation to repay loans under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a ten-year term expiring on April 30, 2015. The ratings downgrade of FSA by Moody's to Aa3 in November 2008 resulted in an increase to the commitment fee. No amounts have been utilized under this commitment at December 31, 2008.
Certain notes held by FSA Global contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its own debt issuances that relate to such notes, it entered into several liquidity facilities with Dexia for $419.4 million. Certain notes held by FSA Global benefit from a liquidity facility with XL Insurance Ltd. for $341.5 million.
In the third quarter of 2008, to address FP segment liquidity requirements, Dexia entered into an agreement to provide FSAM the First Dexia Line of Credit, a $5 billion committed, unsecured, standby line of credit. At December 31, 2008, there were $1.3 billion in draws outstanding under the First Dexia Line of Credit. In February 2009, Dexia and FSAM entered into an agreement for a second committed, unsecured, standby line of credit of $3 billion (the "Second Dexia Line of Credit"). At March 2, 2009, the amount outstanding on the First Dexia Line of Credit had increased to $2.7 billion.
In addition, on November 13, 2008, the Company entered into two agreements with Dexia and its affiliates in support of its FP business, which provide a $3.5 billion collateral swap facility and a $500 million capital facility to cover economic losses beyond the $316.5 million of pre-tax loss estimated at the end of June 2008.
The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on public finance and asset-backed obligations. The FP segment includes the VIEs and the GIC operations of the Company, which historically issued medium term notes through a reverse inquiry process to institutional investors and GICs to municipalities and other market participants. Since the November 2008 execution of the Purchase Agreement, no new GICs have been issued. See Note 1 for a description of each segment's business. The following tables summarize the financial information by segment as of and for the years ended December 31, 2008, 2007 and 2006:
The GIC Subsidiaries and VIEs in the FP segment pay premiums to FSA, which is in the financial guaranty segment. In addition, management of FSA provides management, oversight and administrative support services ("indirect FP expenses") to the entities in the FP segment. The Company's management evaluates the FP segment based on the separate results of operation of the GIC Subsidiaries and FSAM, excluding the premium paid to FSA and including the indirect FP expenses. For the VIEs, the premium paid approximates the indirect expenses incurred by FSA.
The Company enters into various related party transactions, primarily with Dexia and, until mid-2008, SGR. The primary related party transactions during 2008 between the Company and Dexia are as follows:
•Dexia acts as intermediary in certain CDS transactions. The premiums earned and fair-value adjustments related to those contracts are recorded in the consolidated statements of operations and comprehensive income.
•The Company has debt issued to Dexia and records related interest expense in the consolidated statements of operations and comprehensive income and accrued interest expense on the balance sheet.
•The Company reimbursed Dexia Crédit Local for the portion of former director Bruno Deletré's Dexia Crédit Local compensation that related to his work as liaison with the Company on behalf of Dexia until July 2008.
SGR had an equity interest in FSA International until 2005, at which time the Company repurchased shares in FSA International held by SGR. The Company had a preferred stock investment in SGR until third quarter of 2008. The primary related party transactions with SGR are as follows.
(2)The Company ceded business to XL Insurance (Bermuda) Ltd. Prior to 2008, SGR was considered a related party. 25. STATUTORY ACCOUNTING PRACTICES
GAAP differs in certain significant respects from statutory accounting practices, applicable to insurance companies, that are prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices:
•upfront premiums are earned when related principal and interest have expired rather than earned over the expected period of coverage;
(2)Represents amortized cost of investments insured by other monolines. Amortized cost includes write-downs of securities that were deemed to be OTTI.
(4)Represents par balances for the insured portfolios and amortized cost for the investment portfolios.
(2)Amount revised from the one reported in the Company's quarterly report on Form 10-Q for March 31, 2008 to reflect a reclassification of foreign exchange loss from "net unrealized gains (losses) on financial instruments at fair value" to "foreign exchange (gains) losses from financial products segment." Fourth quarter 2008 results include OTTI charges on FP Segment Investment Portfolio of $8.6 billion (See Note 6) and loss expense of $1.9 billion (see Note 9).
The following table shows the components of "other income." In 2008, other income includes $20.1 million related to commutation gains. See Note 26 for more information.
(1)DCP and SERP assets are held to defease the Company's plan obligations and the changes in fair value may vary significantly from period to period. Increases or decreases in the fair value of the assets are primarily offset by like changes in the related liability, which are recorded in other operating expenses.