The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the related notes which appear in Item 8. This discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and under the headings “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.”
Prior to January of 2008 (as more fully discussed below under “-Recent Developments”), we provided credit enhancement and protection products to the public finance and structured finance markets throughout the United States and internationally through the issuance of financial guarantee insurance policies and credit default swap (“CDS”) contracts, as well as the reinsurance of financial guarantee insurance and CDS contracts written by other insurers. Financial guarantee insurance provides an unconditional and irrevocable guarantee to the holder of a debt obligation of full and timely payment of the guaranteed principal and interest. In the event of a default under the obligation, the insurer has recourse against the issuer or any related collateral (which is more common in the case of insured asset-backed obligations or other non-municipal debt) for amounts paid under the terms of the policy. CDS contracts are derivative contracts that offer credit protection relating to a particular security or pools of specified securities. Under the terms of a CDS contract, the seller of credit protection makes a specified payment to the buyer of credit protection upon the occurrence of one or more specified credit events with respect to a referenced security.
Adverse developments in the credit markets generally and the mortgage market specifically that began in the second half of 2007 and continued through 2008 have resulted in material adverse effects on our business, results of operations, and financial condition, including (i) significant adverse development of anticipated claims on our guarantees, under our CDS contracts, of collateralized debt obligations (“CDOs”) of asset-backed securities (“ABS CDOs”) and significant adverse development of reserves for unpaid losses and loss adjustment expenses on our guarantees, under our insurance contracts, of residential mortgage-backed securities (“RMBS”), and (ii) downgrades of our insurance financial strength (“IFS”) ratings by Moody’s Investors Service, Inc. (“Moody’s”), Fitch Ratings (“Fitch”) and Standard & Poor’s Ratings Services (“S&P”), which ratings had been fundamental to our ability to conduct business and which have caused us to cease writing substantially all new business since January of 2008, resulting in the loss of future incremental earnings and cash flow. As of March 30, 2009, Syncora Guarantee is rated “Ca” by Moody’s and “CC” by S&P; the Company has terminated the agreement for the provision of ratings with Fitch.
During the second quarter of 2008, we recorded a material increase in adverse development of anticipated claims on our guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on our guarantees of RMBS causing us to be unable to maintain Syncora Guarantee’s compliance with its $65 million minimum policyholders’ surplus requirement under New York Insurance Law as of June 30, 2008. In light of this material adverse development, and in accordance with our previously disclosed strategic plan, on July 28, 2008 we, certain financial institutions that are counterparties to CDS contracts with Syncora Guarantee (the “Counterparties”), Merrill Lynch & Co., Inc. (“Merrill Lynch”) and certain of its affiliates, and XL Capital and certain of its affiliates, entered into a Master Commutation, Release and Restructuring Agreement, dated July 28, 2008, as amended (the “Master Transaction Agreement”), and certain other related agreements (hereafter referred to collectively as the “2008 MTA”). The transactions comprising the 2008 MTA closed on August 5, 2008 (the “Closing Date”), except for the transactions comprising the FSA Master Agreement (as defined below), which closed on August 4, 2008. The transactions comprising the 2008 MTA are described below along with certain summary financial information
During the fourth quarter of 2008, we recorded a material increase in adverse development relating to anticipated claims on our guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on our guarantees of RMBS. As a result of the material increase in adverse development relating to anticipated claims on our guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on our guarantees of RMBS recorded during 2008, Syncora Guarantee reported a policyholders’ deficit of $2.4 billion as of December 31, 2008. Failure to maintain positive statutory policyholders’ surplus or non-compliance with the $65 million statutory minimum policyholders’ surplus requirement permits the New York Superintendent of Insurance (the “New York Superintendent”) to seek court appointment as rehabilitator or liquidator of Syncora Guarantee. As a result of this material adverse development, and in accordance with our previously disclosed strategic plan, effective as of March 5, 2009, Syncora Guarantee signed a non-binding letter of intent with certain of the Counterparties (the “Letter of Intent”) whereby the parties agreed to negotiate in good faith to seek to promptly agree on mutually agreeable definitive documentation, in the form of a master transaction agreement and related agreements (hereafter referred to collectively as the “2009 MTA”). In addition, pursuant to the RMBS Transaction Agreement, dated as of March 5, 2009 (the “RMBS Transaction Agreement”), on March 11, 2009, the fund referenced therein (the “Fund”) commenced a tender offer to acquire certain residential mortgage-backed securities that are insured by Syncora Guarantee (the “RMBS Securities”). The 2009 MTA and tender offer represent the principal elements of the second phase of our strategic plan. The transactions contemplated by the Letter of Intent and the related transactions are described below.
Description of the Transactions Contemplated by the Letter of Intent and Related Transactions
The non-binding terms and conditions in the Letter of Intent contemplate the participation of all of the 23 Counterparties. To date, 18 of the 19 significant Counterparties have indicated their willingness to enter into the transactions contemplated by the Letter of Intent, subject to final documentation and participation by the remaining Counterparties. The 19 significant Counterparties represent substantially all of Syncora Guarantee’s anticipated claims with respect to CDS contracts. One significant Counterparty has indicated that it is presently not contemplating entering into the transactions contemplated by the Letter of Intent. Syncora Guarantee is discussing with the remaining Counterparties alternative terms and conditions that would permit the consummation of the 2009 MTA without the participation of all of the Counterparties. There can be no assurance that the 2009 MTA will be consummated by a sufficient number of Counterparties or at all.
Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information
The Master Transaction Agreement provided for the termination, commutation or elimination of certain reinsurance agreements, guarantees and other arrangements among us and XL Capital and certain of its subsidiaries, and between Syncora Guarantee and Syncora Guarantee Re, in exchange for a cash payment by XL Capital to us of $1.775 billion, the issuance and transfer of 8 million class A ordinary shares of XL Capital in the aggregate to Syncora Guarantee and Syncora Guarantee Re, and the transfer of XL Capital’s common shares of Syncora Holdings to a trust, the SCA Shareholder Entity, for the benefit of Syncora Guarantee until such time as an agreement between Syncora Guarantee and the Counterparties is reached, and thereafter the shares will be held for the benefit of the Counterparties. As a result of the transfer of the shares of Syncora Holdings to the SCA Shareholder Entity, XL Capital no longer has the right to vote, nominate directors to our Board of Directors or any other rights. On the Closing Date, the four XL Capital-nominated directors on our Board of Directors resigned. Pursuant to a shareholder agreement with the SCA Shareholder Entity, the trust has a number of rights including the right to vote the shares and to nominate directors to our Board of Directors, such number of directors as would equal one nominee less than a majority (if our Board of Directors consists of nine or fewer Directors) or two nominees less than a majority (if our Board of Directors consists of ten or more Directors). Effective November 19, 2008, pursuant to the shareholder agreement, the SCA Shareholder Entity appointed four members to our Board of Directors. We also entered into a registration rights agreement with the SCA Shareholder Entity providing for demand registration rights, a shelf registration if we are so eligible and piggyback registration rights. Until the common shares of Syncora Holdings are transferred from the aforementioned trust to Counterparties or otherwise sold in the open market, for accounting purposes, they are considered to be treasury shares.
Concurrent with the execution of the Master Transaction Agreement, Syncora Holdings, Syncora Guarantee and Syncora Guarantee Re entered into an agreement (the “Merrill Agreement”) with Merrill Lynch, Merrill Lynch International (“MLI”) and eight trusts affiliated with Syncora Holdings (the “CDS Trusts”), the obligations of which were guaranteed by policies issued by Syncora Guarantee. The Merrill Agreement provided for the termination of eight CDS contracts (the “Swaps”) and the related financial guarantee insurance policies issued by Syncora Guarantee with insured gross par outstanding as of June 30, 2008 of approximately $3.7 billion, in exchange for a payment by Syncora Guarantee to Merrill Lynch of an aggregate amount of $500 million. As part of the closing of the transactions comprising the Merrill Agreement, the parties provided mutual releases of claims with respect to the Swaps and the related policies. In addition, Syncora Guarantee and MLI have agreed to dismiss previously disclosed litigation related to seven of the Swaps. As a result of the termination of the Swaps, we recorded a realized loss of $94.0 million during the year ended December 31, 2008.
We and XL Capital obtained approvals from the NYID and the Bermuda Monetary Authority (the “BMA”) for the Master Transaction Agreement and the transactions comprising such agreement. Other required approvals related to the Master Transaction Agreement have been received from the Delaware Department of Insurance. The NYID has also approved the Merrill Agreement and the transactions comprising such agreement.
Concurrent with the execution of the Master Transaction Agreement, we also entered into an agreement (the “FSA Master Agreement”) with FSA. The FSA Master Agreement provided for the commutation of all reinsurance ceded by FSA and its subsidiaries to Syncora Guarantee Re, including that ceded under the amended and restated master facultative reinsurance agreement, dated as of November 3, 1998 (the “Old Master Facultative Agreement”) that was the subject of a guarantee issued by XLI (see Note 10 to the Consolidated Financial Statements). Commutation of the Old Master Facultative Reinsurance Agreement and all cessions thereunder was a condition to the obligations of XL Capital under the Master Transaction Agreement. Pursuant to the FSA Master Agreement, FSA and Syncora Guarantee Re entered into the commutation and release agreement (the “Commutation Agreement”), under which all existing cessions to Syncora Guarantee Re by FSA were commuted in return for a payment by Syncora Guarantee Re of approximately $165.4 million, representing statutory reserves less ceding commission plus a commutation premium. In turn, FSA and one of its subsidiaries entered into a new master facultative reinsurance agreement (the “New Master Facultative Agreement”) and related reinsurance memorandum (the “Reinsurance Memorandum”) with Syncora Guarantee, under which FSA ceded certain of the commuted risks to Syncora Guarantee in return for a payment by FSA to Syncora Guarantee of approximately $88.6 million, representing the statutory unearned premium reserve for such risks, less ceding commission. FSA has undertaken to use its best efforts to reassume such reinsurance from Syncora Guarantee for a period of nine months after the closing, subject to limitations under Article 69 of the New York Insurance Law, which imposes aggregate and single risk limits on insurance that can be written by a financial guaranty insurer, FSA’s internal and rating agency single risk limits, other potential limitations and FSA’s underwriting guidelines. Syncora Guarantee was required to fund a trust in an initial amount of approximately $104.1 million to collateralize its obligations to FSA under the reinsurance agreement ($92.7 million as of December 31, 2008), which includes regulatory mandated contingency reserves. Finally, Syncora Holdings purchased all class A preferred shares of Syncora Guarantee Re held by FSA and its subsidiary, with a liquidation preference of $39 million, for approximately $2.9 million pursuant to an agreement for the sale and purchase of preferred shares (the “Preferred Shares Purchase Agreement”). As a result of the Commutation Agreement and New Master Facultative Agreement, we recorded a loss of $17.9 million during the year ended December 31, 2008. In addition, as a result of our purchase of the class A preferred shares of Syncora Guarantee Re, we recorded a gain of $36.1 million during the year ended December 31, 2008, which was recorded in retained earnings and not reflected in our net loss.
Concurrent with the execution of the Master Transaction Agreement, we entered into Amendment No. 2, Forbearance and Limited Waiver Agreement (“Amendment No. 2”) with the lenders under our credit agreement, dated as of August 1, 2006 (the “Credit Agreement”). Pursuant to Amendment No. 2, we agreed (i) to permanently reduce the availability under our revolving credit facility from $250 million to zero, (ii) to reduce the availability under the letter of credit facility to the amount of the letter of credit exposure as of July 28, 2008 and subsequently further reduce such exposure for any outstanding letters of credit for FSA’s benefit upon the closing the Commutation Agreement, and (iii) to collateralize the remaining letters of credit after the consummation of the transactions comprising the Master Transaction Agreement. In consideration of the foregoing, the lenders under the Credit Agreement agreed to (i) forbear from declaring certain defaults, if any, as set forth in the Amendment No. 2, (ii) waive such defaults, if any, upon the satisfaction of certain conditions set forth in the Amendment No. 2, (iii) grant certain waivers in connection with the consummation of the Master Transaction Agreement and (iv) not instruct the Administrative Agent to send, and the Administrative Agent has agreed that it shall not send, a notice of non-renewal with respect to any outstanding letters of credit (other than the letter of credit for FSA’s benefit, which was canceled and returned to the Administrative Agent prior to the Closing Date) with regard to any renewal of a letter of credit during calendar year 2008. There can be no assurance that the Administrative Agent and the lenders will renew the outstanding letters of credit when they are subject to renewal during calendar year 2009. The amount of letters of credit outstanding under the Credit Agreement and the amount of collateral posted by us in support of
On March 31, 2009, we entered into Amendment No. 3 and Waiver Agreement (“Amendment No. 3”) with the lenders under the Credit Agreement, whereby we agreed to collateralize the remaining letters of credit in an amount equal to 105% of the total letter of credit exposure as of such date, plus any accrued and unpaid interest and fees thereon, plus all other accrued and unpaid obligations of the account parties under the Credit Agreement. In consideration of the foregoing, the lenders under the Credit Agreement have agreed to permanently waive (i) the requirement that audited financial statements of each account party (other than Syncora Guarantee) be delivered within 90 days of the end of the fiscal year (provided that such audited financial statements shall be delivered within 120 days of the end of the fiscal year); (ii) the requirement that audited financial statements as reported on by the independent public accountants not have a “going concern” or like qualification or exception nor any qualification or exception as to the scope of such audit; (iii) the covenant relating to Syncora Holdings’ ratio of total funded debt to total capitalization; (iv) the covenant relating to Syncora Holdings’ consolidated net worth; and (v) any defaults as a result of the account parties not satisfying the requirements waived in clauses (i) through (iv) above or certain other requirements set forth in the Credit Agreement (as more fully described in Amendment No. 3 and Waiver Agreement).
The effect of the transactions comprising the 2008 MTA on our financial position and results of operations are presented below:
Represents the effect of repurchasing the class A preferred shares of Syncora Guarantee Re.
Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern, and Description of Our On-Going Strategic Plan
We continue to be exposed to certain significant risks and uncertainties that could materially adversely affect our results of operations, financial condition and liquidity, including the following:
Substantially all of Syncora Guarantee’s CDS contracts have mark-to-market termination payments following the occurrence of events that are outside Syncora Guarantee’s control, such as Syncora Guarantee being placed into receivership or rehabilitation by the NYID or the NYID taking control of Syncora Guarantee or, in limited cases, Syncora Guarantee’s insolvency. Mark-to-market termination payments for deals in which Syncora Guarantee would have to pay a termination payment are generally calculated either based on “market quotation” or “loss” (each as defined in the ISDA Master Agreement). “Market quotation” is calculated as an amount (based on quotations received from dealers in the market) that the counterparty would have to pay another party (other than monoline financial guarantee insurance companies) to have such party takeover Syncora Guarantee’s position in the CDS contract. “Loss” is an amount that a counterparty reasonably determines in good faith to be its total losses and costs in connection with the CDS contract, including any loss of bargain, cost of funding or, at the election of such counterparty, but without duplication, loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge or related trading position. There can be no assurance that counterparties to Syncora Guarantee’s CDS contracts, including the Counterparties, will not assert that events have occurred which require Syncora Guarantee to make mark-to-market termination payments. If such events were to occur, the aggregate termination payments that may be asserted against Syncora Guarantee would significantly exceed our ability to make such payments and, accordingly, such events would have a material adverse effect on our financial position and results of operations. The fair value of our CDS contracts recorded in our financial statements at December 31, 2008 does not reflect the effect of mark-to-market termination payments.
Under a reinsurance agreement between Syncora Guarantee and Syncora Guarantee-UK (the “Treaty”), Syncora Guarantee has agreed to reinsure, on a quota share basis, up to 97% of the financial guarantee business written by Syncora Guarantee-UK. In the event that, among other things, either of the parties becomes insolvent or has a receiver appointed, the other party shall have the right to terminate the Treaty. In the event of such termination, Syncora Guarantee will forego the right to receive any future premiums and Syncora Guarantee-UK may also have a right to claim back all or a proportion of any premiums already paid to Syncora Guarantee under the Treaty in relation to the period after the date the Treaty is terminated. The Financial Services Authority (“FSA UK”) also, as the applicable regulator of Syncora Guarantee-UK in the United Kingdom, would have broad and extensive powers under the Financial Services and Markets Act 2000 which could be exercised in the event that either Syncora Guarantee or Syncora Guarantee-UK became insolvent or had a receiver appointed, including to vary or cancel Syncora Guarantee-UK’s permission to carry on any of its regulated activities. If any of the aforementioned events should occur, it will have a material adverse effect on Syncora Guarantee’s financial position and results of operations, as well as its ability to comply with its mimimum policyholders’s surplus requirement.
We may be unable to enter into or consummate the transactions contemplated by the 2009 MTA or close the tender offer, which would have a material adverse effect on our financial condition and results of operations. In the absence of a successful restructuring that achieves remediation of RMBS exposures and CDS exposures of the magnitude contemplated by the Letter of Intent and the tender offer, Syncora Guarantee will continue to report a policyholders’ deficit and the New York Superintendent may seek court appointment as rehabilitator or liquidator of Syncora Guarantee. Moreover, in the absence of a successful restructuring and in the exercise of its fiduciary duties, Syncora Guarantee’s Board of Directors may request the New York Superintendent to seek such court appointment. In such circumstances, it is likely that the New York Superintendent would institute such proceedings. If Syncora Guarantee should become subject to a regulatory proceeding, or, in limited cases, if Syncora Guarantee should become insolvent, the holders of certain of the CDS contracts Syncora Guarantee has insured may assert the right to terminate the contracts and assert claims against Syncora Guarantee to pay them the termination values, which under current market conditions would be in excess of Syncora Guarantee’s resources. If Syncora Guarantee were required to pay the termination values, Syncora Guarantee would not have sufficient liquidity to fund its obligations as they become due.
although Syncora Guarantee’s Board of Directors could subsequently decide to recommence claim payments. Any decision to suspend claim payments could have a number of material adverse consequences, including but not limited to litigation potential loss of control rights, the potential assertion of mark-to-market termination payments by counterparties to Syncora Guarantee’s CDS contracts with respect to CDS contracts on which Syncora Guarantee fails to pay a claim, and adverse reaction from our regulators, including the NYID, FSA UK and the BMA, including, in the case of the NYID, a decision to seek to commence a rehabilitation or liquidation of Syncora Guarantee. There can be no assurance there would not be other material adverse consequences if Syncora Guarantee failed to pay claims.
Management is principally focused on: (i) seeking to successfully consummate the 2009 MTA and the tender offer, (ii) maintaining or enhancing our liquidity, and (iii) remediating troubled credits to minimize claim payments, maximize recoveries and mitigate ultimate expected losses. We anticipate that in connection with the 2009 MTA Syncora Guarantee will agree, except in certain limited circumstances, not recommence writing any new business.
In seeking to reduce exposure to CDS contracts and other guaranteed products and otherwise improve our financial position and liquidity, we may from time to time, directly or indirectly, seek to purchase (on the open market or otherwise) or commute our guaranteed exposures. The amount of exposure reduced and the nature of any such actions will depend on market conditions, pricing levels, our cash position, and other considerations. On March 11, 2009, the Fund commenced a tender offer to acquire the RMBS Securities. See “-Description of the Transactions Contemplated by the Letter of Intent and Related Transactions.”
In addition to the aforementioned downgrades of our IFS ratings, Moody’s, S&P and Fitch have also downgraded our debt and other ratings.
On January 7, 2009, the New York Stock Exchange (“NYSE”) notified us that it filed a notification of removal from listing on Form 25 pursuant to Rule 12d2-2(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with the Securities and Exchange Commission to delist our common shares as we were no longer in compliance with two NYSE listing standards because our average global market capitalization over a consecutive 30 trading-day period was less than $75 million and, at the same time, total stockholders’ equity was less than $75 million, and the average closing price of our common shares was less than $1.00 over a consecutive 30 trading-day period. The delisting of our shares could further reduce the price of our common shares and the liquidity of the trading market for our common shares. Our common shares are currently traded over the counter and quoted on the Pink Sheets quotation service. We intend to deregister our common shares and the Syncora Holdings Series A Preference Shares. See “Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities-Deregistration.”
Developments” and “-Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern, and Description of Our On-Going Strategic Plan”.
Our net investment income is a function of the amount of our invested assets and the yield that we earn on those assets. The investment yield will be a function of market interest rates at the time of investment, as well as the type, credit quality and duration of our invested assets. In addition, we could realize gains or losses on the sale of securities in our investment portfolio or recognize an other-than-temporary impairment as a result of changing market conditions, including changes in market interest rates, and changes in the credit quality of our invested assets. See “-Critical Accounting Policies and Estimates-Investments” and Note 7 to the Consolidated Financial Statements.
The change in fair value of our credit derivatives is primarily based on changes in credit spreads, the credit quality of the referenced securities, rates of return, our Non-Performance Risk, as defined and explained below, and various other factors. See “-Critical Accounting Policies and Estimates-Valuation of Credit Default Swaps” and “-Overview of Our Business-Other Measures Used by Management to Evaluate Results of Operations and Financial Condition.”
Our expenses primarily consist of losses and loss adjustment expenses, acquisition costs, and operating expenses. Acquisition costs are related to the production of financial guarantee insurance business and commissions paid on reinsurance assumed, net of commission revenues earned on ceded business. Acquisition costs are generally deferred and recognized over the period in which the related premiums are earned. As discussed above, we suspended writing substantially all new business since January of 2008. Operating expenses consist primarily of costs relating to professional and consulting fees, compensation of our employees, information technology, and office premises.
We believe that adjusted shareholders’ equity (“Adjusted Shareholders’ Equity”), a non-GAAP financial measure, is an important metric to assist investors in understanding our current financial position. Adjusted Shareholders’ Equity represents shareholders’ equity in accordance with GAAP adjusted to:
exclude the consolidated net credit derivative liability reported by us at December 31, 2008, which represents an estimate of the fair value of our guarantees issued in the form of CDS contracts, and
include the present value of the liability at December 31, 2008 for anticipated losses expected to be incurred by us on our CDS contracts if we were to hold such CDS contracts to maturity and pay claims as they arise over the remaining life of such contracts. Our liability for losses expected to be incurred on our CDS contracts primarily relates to our in-force guarantees of ABS CDOs.
the beneficial effect on our net credit derivative liability of Non-Performance Risk resulted in an increase in our shareholders’ equity, in accordance with GAAP, of approximately $14.2 billion.
aforementioned exposures, as well as “-Critical Accounting Policies and Estimates-Reserves for Losses and Loss Adjustment Expenses”.
Set forth below is certain additional information in regard to our exposure to RMBS and CDOs:
most creditworthy borrowers and less stringent than the standards generally acceptable to Fannie Mae and Freddie Mac with regard to the borrower’s credit standing and repayment ability.
Subprime (2nd lien) mortgage loans are secured by second liens on residential properties to non-prime borrowers. See Subprime (1st lien) for a description of the underwriting standards.
Prime (1st lien) mortgage loans are secured by first liens on one-to-four family residential properties. The underwriting standards used to underwrite prime mortgage loans are the standards applied to the most creditworthy borrowers and are generally acceptable to Fannie Mae and Freddie Mac.
The following tables show the current internal and rating agency ratings on all of our direct RMBS exposure by deal, grouped by collateral type. The internal ratings are based on reviews during the fourth quarter of 2008. Rating agencies’ ratings represent their most recent published ratings.
Our internal ratings are based on our internal credit assessment of each transaction taking into account the overall credit strengths and weaknesses, transaction structure and the trends in the asset sector. We base our analysis on information
received from the trustees or from the issuer, as well as on-site visits to issuers, servicers, collateral managers and project sites. If updated modeling has been performed, modeling results are also considered. We also take into consideration the rating agencies’ rationale for their ratings, and, accordingly, our ratings are typically consistent with the rating agencies. However, variations exist as we make internal conclusions that may result in different ratings.
Includes loans in process of foreclosure, loans where the mortgagee has filed for bankruptcy, and real estate owned.
Our internal ratings are based on our internal credit assessment of each transaction taking into account the overall credit strengths and weaknesses, transaction structure and the trends in the asset sector. We base our analysis on information received from the trustees or from the issuer, as well as on-site visits to issuers, servicers, collateral managers and project sites. If updated modeling has been performed, modeling results are also considered. We also take into consideration the rating agencies’ rationale for their ratings, and, accordingly, our ratings are typically consistent with the rating agencies. However, variations exist as we make internal conclusions that may result in different ratings.
Includes loans in process of foreclosure, loans where the mortgagee has filed for bankruptcy, and real estate owned
Based on S&P ratings if available and internal ratings if no S&P rating is available.
A CDO is an investment or a security that is collateralized by, or synthetically references, a pool of debt obligations such as corporate loans, bonds and ABS.
An ABS CDO is a CDO that is collateralized by, or synthetically references, a pool of asset-backed securities, though mostly RMBS.
A CLO is a CDO that is collateralized by, or synthetically references, a pool of leveraged bank loans to corporate entities generally rated below investment grade, i.e. rated below “BBB-” by S&P, “Baa3” by Moody’s and “BBB-” by Fitch.
A CDO of CDOs, or CDO squared, is a CDO that is collateralized by, or synthetically references, a pool of other CDO securities.
Includes $13.9 billion secured primarily by “AAA”, “AA”, and “A” rated RMBS collateral at inception and $0.3 billion secured primarily by “BBB” rated RMBS collateral at inception. Ratings represent the lower of ratings by S&P or Moody’s.
The following table presents the net notional exposure of our ABS CDO(1) portfolio by vintage (year the CDO was issued) as of December 31, 2008:
ABS CDOs secured primarily by “AAA,” “AA,” and “A” rated RMBS collateral at inception.
Prime RMBS includes securities with a weighted average Fair Isaac’s Credit Organization (“FICO”) score at or above 700 per third party data sources. Midprime RMBS includes securities with a weighted average FICO score below 700 but above 640 per third party data sources.
Note: The Company has additional exposure to three pre-2003 vintage mezzanine ABS CDOs with collateral pools consisting of less than 50% RMBS. The aggregate net par insured for these deals totaled $48.7 million as of December 31, 2008.
Subordination is calculated based on the par value of the CDO’s assets including cash in the principal account per December 2008 reported data.
Moody’s and S&P ratings as of March 20, 2009. The symbol “/*-” indicates rating is on review for downgrade.
In addition to the CDO squared exposures listed above, the Company has CDO squared exposure written in financial guarantee form with net par outstanding as of December 31, 2008 of $559.8 million.
At December 31, 2008 and 2007, management estimated that we would incur anticipated claims and recoveries resulting in losses on our in-force CDS contracts, after giving effect to reinsurance, of $3,238.4 million and $645.1 million, respectively ($3,238.4 million and $829.8 million, respectively, before giving effect to reinsurance). Such losses primarily relate to our guarantees of ABS CDOs and represent: (i) the net present value of claims expected to be paid subsequent to the measurement date, less (ii) the net present value of expected recoveries subsequent to the measurement date, and the net present value of installment premiums due from the counterparties to such guarantees subsequent to the measurement date. The amount of expected claims and recoveries is based on assumptions and estimates extending over many years into the future. Such estimates are subject to the inherent limitation on our ability to predict the aggregate course of future events. It should, therefore, be expected that the actual emergence of claims and recoveries will vary, perhaps materially, from any estimate. As of December 31, 2008, no claim notices have been received with respect to these transactions. However, subsequent thereto through March 27, 2009, we have received claim notices under two CDS contracts guaranteeing ABS CDOs which aggregated approximately $5.7 million, of which $0.5 million has been paid to date. In addition, the Company commuted certain of its guarantees of ABS CDOs with Merrill Lynch and its affiliates during 2008 for a payment of $500 million (see “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”). Management continues to monitor our ABS CDO exposure and will revise its estimates if necessary, as new information becomes available.
The key assumptions in our modeling of direct RMBS holdings within ABS CDOs include:
The projected default rate for currently performing loans which were based on the loan’s characteristics at origination including:
Loan risk factors (option adjustable rate mortgages, negative amortization, investor property, second home, and second lien)
Level of borrower documentation (low documentation, stated documentation, or no documentation)
The roll rate projections of defaults for loans that are currently delinquent in the pool
As of December 31, 2008, our forecast of average cumulative losses for 2006 and 2007 subprime RMBS was 25.6% (with a range from 10% to 44%) and 28.8% (with a range from 12% to 44%), respectively.
The discussion and analysis of our financial condition and results of operations are based on our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates, and those differences may be material.
Critical accounting policies and estimates are defined as those that require management to make significant judgments, as well as those where results therefrom may be materially different under different assumptions and conditions. We have identified the accounting for losses and loss adjustment expenses, the valuation of CDS contracts and investments, premium revenue recognition, deferred acquisition costs, and deferred income taxes, as critical accounting policies.
Our financial guarantees insure scheduled payments of principal and interest due on various types of financial obligations against payment default by the issuers of such obligations. We establish reserves for unpaid losses and loss adjustment expenses on such business based on our best estimate of the ultimate expected incurred losses. Our estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including estimates regarding the occurrence and amount of a loss on an insured obligation. Actual experience may differ from estimates and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the level of interest rates, credit deterioration of insured obligations, and changes in the value of specific assets supporting insured obligations. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor. Any estimate of future loss is subject to the inherent limitation on our ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate.
Amount is net of $8.6 million, representing the net present value of future installment premiums at December 31, 2007 with regard to certain of our guarantees on which case reserves are recorded at December 31, 2007.
In assessing whether a loss is probable, management considers all available qualitative and quantitative evidence. Qualitative evidence may take various forms and the nature of such evidence will depend upon the type of insured obligation and the nature and sources of cash flows to fund the insured obligation’s debt service. For example, such evidence with respect to an insured special revenue obligation, such as an obligation supported by cash flows from a toll road, would consider traffic statistics such as highway volume and related demographic information, whereas an insured mortgage-backed securitization would consider the quality of the mortgage loans supporting the insured obligation including delinquency, default and foreclosure rates, loan to value statistics, market valuation of the mortgaged properties and other pertinent information. In addition, management will make qualitative judgments with respect to the amount by which certain other structural protections built into the transaction are expected to limit our loss exposure. Examples of such structural protections may include: (i) rate covenants, which generally stipulate that issuers (i.e. public finance issuers) set rates for services at certain pre-determined levels (i.e. water and sewer rates which support debt obligations supported by such revenues), (ii) springing liens, which generally require the issuer to provide additional collateral upon the breach of a covenant or trigger incorporated into the terms of the transaction, (iii) consultant call-in rights, which provide, under certain circumstances, for a consultant to be engaged to make certain binding recommendations, such as raising rates or reducing expenses, (iv) the ability to transfer servicing of collateral assets to another party, and (v) other legal rights and remedies pursuant to representations and warranties made by the issuer and written into the terms of such transactions. Quantitative information may
take the form of cash flow projections of the assets supporting the insured debt obligation (which may include, in addition to collateral assets supporting the obligation, structural protections subordinate to the attachment point of our risk, such as cash reserve accounts and letters of credit), as well as (to the extent applicable) other metrics indicative of the performance of such assets and the trends therein. See “-Overview of Our Business-Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern and Description of Our On-Going Strategic Plan-Continuing Risks and Uncertainties.” Management’s ability to make a reasonable estimate of its expected loss depends upon its evaluation of the totality of both the available quantitative and qualitative evidence, and no one quantitative or qualitative factor is dispositive.
In addition to case basis reserves, we maintain an unallocated loss reserve for expected losses inherent in our in-force business (consisting of both financial guarantee insurance and reinsurance business) that we expect to emerge in the future. Our unallocated loss reserves represent our estimated ultimate liability from claims expected to be incurred in the future under our in-force insured and reinsured policies less outstanding case basis reserves and cumulative paid claims to date on such policies. Our unallocated reserves are estimated by management based upon an actuarial reserving analysis. The actuarial methodology applied by us is in accordance with Actuarial Standards of Practice No. 36, Determination of Reasonable Provision. The methodology applied is based on the selection of an expected ultimate loss ratio (“UELR”), as well as an expected loss emergence pattern (i.e., the expected pattern of the expiration of risk on insured and reinsured in-force policies). Salvage and subrogation recoveries are implicit in our selected UELR as such ratio is derived from industry loss experience, which is net of salvage and subrogation recoveries (i.e., from the liquidation of supporting or pledged collateral assets). The implicit inclusion of salvage and subrogation recoveries in our selected UELR is consistent with management’s explicit consideration of collateral support in the establishment of its case basis reserves. In May 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 163 (“SFAS 163”), Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”). SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008. Upon adoption of SFAS 163, we will no longer be able to record unallocated reserves and will be required to de-recognize our existing unallocated reserves. See “Recent Accounting Pronouncements-Statement of Financial Accounting Standards (“SFAS”) No. 163, Accounting for Financial Guarantee Insurance Contracts-An interpretation of FASB Statement No. 60.”
We update our estimates of losses and loss adjustment expense reserves quarterly and any resulting changes in reserves are recorded as a charge or credit to earnings in the period such estimates are changed. In connection therewith, our unallocated reserves are adjusted each period to reflect (i) revisions to management’s estimated UELR, if any, and (ii) the underlying par risk amortization of the related insured and reinsured in-force business (i.e., loss emergence pattern). As stated above, our estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. As management establishes case basis reserves and pays claims it may, based on its judgment, reduce or increase the UELR used to determine unallocated reserves to reflect its best estimate of our expected ultimate loss experience. In addition, under our accounting policy management may, based on its judgment, reduce unallocated reserves in response to significant case basis reserve and or paid loss activity. Management would only expect such reductions to occur in limited instances, such as economic events generating significant loss activity across a broad cross-section of the portfolio. Management has not viewed our case basis reserve and paid loss activity to date to warrant such a reduction of our unallocated reserves. While material case basis reserves were established in 2007 and 2008, these reserves were concentrated in certain sectors of our financial guarantee portfolio and were associated with unprecedented credit-market events. As such, these events did not alter our perspective of the UELR associated with the remainder of the portfolio and the required level of unallocated reserves. In each quarterly period, there is an interplay between case basis reserves, unallocated reserves and cumulative paid losses to date, such that the aggregate thereof represents management’s best estimate of the ultimate losses it expects to incur on our in-force business. The process of establishing unallocated reserves and periodically revising such reserves to reflect the underlying par risk amortization and management’s current best estimate of ultimate losses will ultimately cause the
cumulative loss experience over the life of a particular underwriting year’s business to equal the cumulative inception-to-date actual paid losses on such business.
The selection of our UELR (and subsequent periodic updates thereof) is based on management’s judgment which considers: (i) the characteristics of our in-force financial guarantee insurance and reinsurance business (e.g., principally the mix of our in-force financial guarantee insurance and reinsurance business between public finance and structured finance business; however, we also considered the various bond sectors comprising our insured and reinsured in-force business which are discussed in detail in Note 15 to our Consolidated Financial Statements, as well as the credit profile of our insured and reinsured portfolio of business), (ii) our actual loss experience, (iii) the characteristics, as discussed above in relation to our in-force financial guarantee insurance and reinsurance business, of the insured in-force business of companies comprising the financial guarantee industry, and (iv) the actual loss experience of companies comprising the industry, as discussed below. Other factors impacting market default levels and the assumptions important to our reserving methodology are implicit in our IELR. Such factors may include interest rates, inflation, taxes, industry trends in the valuation of certain asset classes and the overall credit environment. Based on this comparison, we adjust our UELR, as we consider necessary, to ensure that such ratio continues to be appropriate for the risks inherent in our in-force business.
The activities of our surveillance department are integral to the identification of specific credits that have experienced deterioration in credit quality and to the assessment of whether losses on such credits are probable, as well as any estimation of the amount of loss expected to be incurred with respect to such credits. Closely monitored credits are divided into four categories: (i) Special Monitoring List-low investment grade credits where a material covenant or trigger may be breached and closer monitoring is warranted; (ii) Yellow Flag List-credits that we determine to be non-investment grade but a loss is unlikely, including credits where claims may have been paid or may be paid but reimbursement is likely; (iii) Red Flag List-credits where a loss is possible but not probable or reasonably estimable, including credits where claims may have been paid or may be paid but full recovery is in doubt; and (iv) Loss List-credits where a loss is probable and reasonably estimable. Credits that are not closely monitored credits are considered fundamentally sound, normal risk.
The following table sets forth our guaranteed in-force net par outstanding as of December 31, 2008 and 2007.
CDS contracts are derivative contracts which offer credit protection relating to a particular security or pools of securities which are specifically referenced in the CDS contract. Under the terms of a CDS contract, the seller of credit protection (the issuer of the CDS contract) makes a specified payment to the buyer of such protection (the CDS contract counterparty) upon the occurrence of one or more credit events specified in the CDS contract with respect to a referenced security or securities. The terms of the CDS contracts issued by us generally only require us to make a payment upon the occurrence of one or more specified credit events after exhaustion of various levels of subordination or first-loss protection. In addition, pursuant to the terms of our CDS contracts, we are precluded from transferring such contracts to other market participants without the consent of the counterparty.
Securities or assets referenced in our in-force CDS contracts include structured pools of obligations, such as ABS CDOs, CLOs, corporate CDOs, CDOs of CDOs and CMBS. Such pools were rated investment-grade or better at the issuance of the CDS contract.
Our policy has been to hold its CDS contracts to maturity and not to manage such contracts to realize gains or losses from periodic market fluctuations. However, in certain circumstances, we may enter into an off-setting position or back-to-back arrangement, commute, terminate, or restructure a CDS contract prior to maturity for risk management purposes (for example, upon a deterioration in underlying credit quality or for the purposes of managing our capital). In connection with the 2008 MTA, we commuted several of our CDS contracts and back-to-back arrangements. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”. In addition, the transactions contemplated by the Letter of Intent also
As derivative financial instruments, CDS contracts are required under GAAP to be reported at fair value in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” and, effective January 1, 2008, measured in accordance with Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), with changes in fair value during the period included in earnings. SFAS 157 specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. This hierarchy requires the use of observable market data when available. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect assumptions about market data based on management’s judgment. In accordance with SFAS 157, the fair value hierarchy prioritizes model inputs into three broad levels as follows:
Level 3-Model-derived valuations in which one or more significant inputs or significant value drivers are unobservable.
The principal drivers of the fair value of our CDS contracts include: (i) general market credit spreads for the type(s) of assets referenced in our CDS contracts, (ii) the specific quality and performance of the actual assets referenced in our CDS contracts, (iii) the amount of subordination in the transaction before our liability under the CDS contract attaches, (iv) other customized structural features of such contracts (e.g. terms, conditions, covenants), (v) supply and demand factors, including the volume of new issuance and financial guarantee market penetration, as well as the level of competition in the marketplace, and (vi) the market perception of our ability to meet our obligations under our CDS contracts which may be implied by the cost of buying credit protection on Syncora Guarantee.
generally contain some form of subordination prior to the attachment of our liability. We are not required to post collateral, and upon default, we generally make payments on a “pay-as-you-go” basis after the subordination in a transaction is exhausted.
Key variables used in our valuation of substantially all of our CDS contracts at December 31, 2008 include the balance of unpaid notional, expected term, fair values of the underlying reference obligations, reference obligation credit ratings, assumptions about current financial guarantee CDS fee levels relative to reference obligation spreads, our Non-Performance Risk and other factors (see “-Overview of Our Business-Other Measures Used by Management to Evaluate Results of Operations and Financial Condition” for a discussion of Non-Performance Risk). Fair values of the underlying reference obligations are obtained from broker quotes when available, or are derived from other market indications such as new issuance and secondary spreads and quoted values for similar transactions and indices, such as ABX or CDX. Our valuation of such CDS contracts does not generally provide for any adjustment to broker quotes. While such broker quotes are non-binding, the brokers from whom we obtain such quotes actively monitor and participate in the markets where such collateral is traded. Accordingly, we believe that such brokers rely on observable market information to the greatest extent possible when determining such quotes; however, such brokers may also rely on their internal models and unobservable inputs in making such determinations.
Implicit in the fair values obtained by us on the underlying reference obligations are the market’s assumptions about default probabilities, default timing, correlation, recovery rates and collateral values. In general, we use a percentage of the credit spread over LIBOR (the “premium percentage”) that we believe is consistent with (i) levels attainable in the market just prior to the collapse of the market for CDS from financial guarantors and (ii) historical premium pricing for high credit spread transactions. We believe that the premium percentage available in the market has dropped significantly as the credit spreads for the underlying reference securities have widened to
The basis of our estimate of the fair value of our CDS contracts at December 31, 2008 described above reflects the absence of observable transactions in our principal market. Should such transactions occur in the future, it may significantly affect our estimate of the fair value of our CDS contracts.
loss development will not occur in the future or that the aforementioned commutations will offset the increase in our derivative liability. At December 31, 2008 and 2007, the notional amount outstanding of our in-force CDS contracts was $57.8 billion and $65.3 billion, respectively. The remaining WAL of such CDS contracts at December 31, 2008 was 10.2 years. In addition, based on such notional amount as of December 31, 2008 and 2007, approximately 60% and 93%, respectively, of referenced assets underlying such in-force CDS contracts were rated (based on S&P’s ratings) “AAA”, 18% and 7%, respectively, were rated at or above investment-grade, and 22% and less than 1%, respectively, were rated below investment-grade at such dates.
Description of Valuation Methodology Used by the Company at December 31, 2007
As of December 31, 2007, our estimate of the fair value of our in-force CDS contracts was based on valuation techniques involving management judgment in regard to a number of factors, including:
estimates of rates of return which would be required by market participants to assume the risks in our CDS contracts in the then current market environment,
the quality of the specific assets referenced in our CDS contracts at the measurement date,
the market perception of risk associated with asset classes referenced in our CDS contracts,
In forming our best estimate of the fair value of our CDS contracts subsequent to June 30, 2007, however, we concluded that limited reliance could be placed on price indices because events and conditions in the credit markets associated with subprime mortgage collateral and corporate loans resulted in limited or no transaction activity in many financial instruments since June 30, 2007 (including CDOs of high grade ABS, CLOs, RMBS, and other CDOs), causing financial institutions which publish the indices that we historically relied upon to estimate the fair value of our CDS contracts either to refrain from updating such indices or base changes in the indices partly on judgments in regard to estimated price levels and not actual executed trades. In addition, evidence suggested that the limited price information available in the marketplace in regard to such instruments was influenced by trades resulting from margin calls and liquidity issues that are
generally not part of the risks associated with our business model or CDS contracts. As a result of the factors discussed above, the fair value of our CDS contracts at December 31, 2007 was estimated by us primarily as follows:
in substantially all other instances our estimate of the fair value of our CDS contracts ascribed significant weight to our judgments regarding rates of return required by market participants in the current market environment and the amount of subordination required by market participants before their liability would attach under the CDS contracts. Our judgment in regard to the appropriate rate of return that would be required by a market participant considered all of the other factors discussed above. Our judgment in regard to the amount of subordination required by market participants before the liability would attach under the CDS contracts generally assumed that, in the current market environment at December 31, 2007, to transfer the risk in an existing contract we would need subordination sufficient to qualify for a triple-A rating from Moody’s and S&P. Accordingly, for any contract rated below triple-A by us or the rating agencies (which consisted only of ABS CDO contracts), the estimated fair value was calculated by adding additional subordination sufficient to meet S&P standards for a triple-A rating based on S&P requirements at December 31, 2007 to the amount of additional premium required to be paid to transfer the risk to achieve the selected rate of return. Such premium was calculated by adjusting the present value of the expected remaining future net cash flows under such contracts (which are comprised of the remaining expected future premiums to be received under the contract, less estimated maintenance expenses and a provision for expected losses that will manifest in the future) to reflect our best estimate of the rates of return that would be required by a market participant to assume the risks on such contracts.
As of December 31, 2008, based on fair value, approximately 55% of our investments were long-term debt securities, and our portfolio had an average duration of 1.8 years, compared with 89% and 3.3 years as of December 31, 2007. Changes in interest rates affect the value of our investment portfolio. As interest rates fall, the fair value of debt securities increases, and as interest rates rise, the fair value of debt securities decreases. The following table summarizes the estimated change in fair value net of related income taxes of our investments in debt securities as of December 31, 2008 based upon an assumed parallel shift in interest rates across the entire yield curve:
For the years ended December 31, 2008 and 2007, we recorded other-than-temporary impairment charges of $238.9 million and $1.2 million, respectively. The other-than-temporary impairment charge recorded during the year ended December 31, 2008, was due to our inability to assert that we have the intent and ability to hold securities in an unrealized loss position until they mature or recover in value. Our inability to make such assertion is due to the expectation that we will need to sell a significant amount of our invested assets to fund the transactions contemplated by the Letter of Intent if they are consummated. See “Overview of Our Business-Description of the Transactions Contemplated by the Letter of Intent and Related Transactions.”
While premium earnings would be ratably recorded as revenue throughout the period of risk, application of a straight-line method to amortizing obligations would not appropriately match premiums earned to our exposure to underlying risk. Therefore, we believe our upfront premium earnings methodology is the most appropriate methodology for us to utilize.
financial guarantee insurance industry have been changed, causing us to de-recognize our reserves for unallocated losses and loss adjustment expenses, which has had a material adverse effect on our reported operating results and financial condition.”
Our accounting policies for the recognition of ceded premiums, ceding commissions and ceded losses and loss adjustment expenses under our ceded reinsurance contracts mirror the policies described under our critical accounting policy discussion above for premium revenue recognition, deferred ceding commissions, and reserves for losses and loss adjustment expenses. We describe our premium revenue recognition for reinsurance contracts under “-Reserves for Losses and Loss Adjustment Expenses” and with regard to ceded reinsurance under “-Liquidity and Capital Resources-Ceded Reinsurance Recoverables.”
The following table presents, for the years ended December 31, 2008, 2007 and 2006, the amount of guarantee premiums written attributable to upfront and installment policies and contracts and a reconciliation of guarantee premiums written to gross premiums written.
The following table presents, for the years ended December 31, 2008, 2007 and 2006, the amount of guarantee premiums assumed from affiliates of FSA, XLI, and other third-party primary companies and a reconciliation of guarantee premiums assumed to reinsurance premiums assumed.
Reinsurance premiums assumed in 2007 were $56.2 million, an increase of $2.0 million, or 3.7%, as compared to $54.2 million recorded in 2006. The increase was the result of upfront deals assumed
Installment premiums written are earned ratably over the installment period, generally one to three months, which is consistent with the expiration of the underlying risk or amortization of the underlying insured par. Upfront premiums written are earned in proportion to the expiration of the related risk. The methodology employed to earn upfront premiums requires that such premiums be apportioned to individual sinking fund payments of a bond issue according to the bond issue’s amortization schedule. The apportionment is based on the ratio of the principal amount of each sinking fund payment to the total principal amount of the bond issue. After the premium is allocated to each sinking fund payment, such allocated premium is earned on a straight-line basis over the period of that sinking fund payment. In addition, when a Refunding occurs, the remaining deferred premium revenue is earned at that time. While guarantee premiums assumed are earned based on reports from the reinsured companies, we believe that the underlying reinsured companies
generally follow the revenue recognition policies and practices discussed above. See “-Critical Accounting Policies and Estimates-Premium Revenue Recognition.”
Net investment income was $132.3 million in 2008, an increase of $11.6 million, or 9.6%, as compared to $120.7 million in 2007. The increase in net investment income was due primarily to higher average invested assets. The increase in our average invested assets in 2008, as compared to 2007, was primarily attributable to net proceeds of approximately $1.4 billion received by us in connection with the 2008 MTA (see “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”) as well as the net proceeds from the issuance of Syncora Guarantee Re’s Non-Cumulative Perpetual Series B Preferred Shares (the “Series B Preferred Shares”) on February 11, 2008. See “-Liquidity and Capital Resources-Syncora Guarantee Capital Facility.”
Net investment income was $120.7 million in 2007, an increase of $43.0 million, or 55.3%, as compared to $77.7 million in 2006. The increase in net investment income was due primarily to higher average invested assets. The increase in our average invested assets in 2007, as compared to 2006, was primarily attributable to the net proceeds from our preferred stock issuance in April 2007, the net cash inflows from our operations and the reinvestment of investment income.
The following tables present net investment income, average invested assets, and the effective yield on our average invested assets for the years ended December 31, 2008, 2007 and 2006, and the average duration of our invested assets as of December 31, 2008 and 2007:
Net realized losses in 2007 were primarily attributable to other-than-temporary impairment charges of $1.2 million and portfolio management actions relating to the management of duration, yield and exposure to certain credit risks amounting to $1.3 million. Net realized losses in 2006 were primarily due to an impairment charge of $15.1 million relating to notes acquired in satisfaction of a claim. See Note 16(e) to the Consolidated Financial Statements for a more detailed discussion.
Our derivative financial instruments consist of our CDS contracts. In addition, prior to its exercise on February 11, 2008, the put option under Syncora Guarantee’s capital facility was required to be accounted for at fair value. See “-Liquidity and Capital Resources-Syncora Guarantee Capital Facility.” The change in fair value of our CDS contracts and the aforementioned put option are included for reporting purposes in the “Net change in fair value of derivatives” line item in our Consolidated Financial Statements. This line item consists of two components, which are separately presented in the consolidated statements of operations: (1) “Realized gains and losses and other settlements” and (2) “Unrealized gains and losses.” The “Realized gains and losses and other settlements” component includes (i) net premiums received and receivable on issued credit derivatives, (ii) net premiums paid and payable on purchased credit derivatives, (iii) losses paid and payable to credit derivative counterparties due to the occurrence of a credit event or settlement, and (iv) losses recovered and recoverable on purchased credit derivatives due to the occurrence of a credit event. The “Unrealized gains and losses” component includes anticipated claims payable and anticipated recoveries, as well as all other changes in fair value. See “-Critical Accounting Policies and Estimates-Valuation of Credit Default Swaps” and Note 6 to the Consolidated Financial Statements.
The net change in fair value of derivatives was a net gain of $494.6 million for the year ended December 31, 2008, as compared to a net loss of $1,295.0 million in 2007. The components of these amounts are as follows:
The realized loss of $126.6 million for the year ended December 31, 2008 consists primarily of: (i) a realized loss of $500.0 million incurred in connection with the termination of the Swaps with Merrill Lynch and MLI, in connection with the 2008 MTA, partially offset by (ii) net of gains of $131.7 million resulting from the commutation of certain back-to-back arrangements with affiliates of XL Capital and certain non-affiliates of the Company in connection with the 2008 MTA (see “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”), (iii) a $179.6 million gain recognized in connection with the exercise of the put option under Syncora Guarantee’s capital facility (see “-Liquidity and Capital Resources-Syncora Guarantee Capital Facility”), and (iv) $61.6 million of earned premiums from our in-force CDS contracts (see “-Net Premiums Earned” above).
The following table presents, for the periods indicated, the activity in our reserves for losses and loss adjustment expenses, net of reinsurance:
Net losses and loss adjustment expenses in 2007 were $69.4 million, an increase of $56.5 million as compared to $12.9 million recorded in 2006. The increase in net losses and loss adjustment expenses primarily resulted from a charge of $216.7 million ($37.2 million net of reinsurance) relating to adverse loss development on certain of our guarantees of obligations supported by HELOC and CES mortgage collateral which was due to deterioration in the credit quality of such collateral, as well as a charge of $9.5 million with respect to two related reinsured international transportation project financings. See Notes 16(a) and 16(g) to the Consolidated Financial Statements for additional information.
Capitalized acquisition costs consist of premium and excise taxes, rating agency fees and legal costs associated with the production of new business, as well as a portion of compensation, travel and entertainment and marketing costs. Such capitalized acquisition costs are reduced by ceding commission income on premiums ceded to reinsurers.
Operating expenses were $230.8 million for the year ended December 31, 2008, an increase of $131.9 million or 133.4%, as compared to $98.9 million for 2007. The increase resulted primarily from: (i) substantially higher expenses for professional services (including legal, financial advisory, consulting, accounting and tax services) in connection with the 2008 MTA, as well as ongoing restructuring efforts, including the transactions contemplated by the Letter of Intent, (ii) a charge for the abandonment of certain leased office premises, (iii) an impairment charge related to our insurance licenses, and (iv) severance costs associated with the reduction of our workforce.
For the year ended December 31, 2007, we reported income tax expense of $16.4 million, an increase of $13.3 million, as compared to income tax expense of $3.1 million reported in 2006.
Minority interest consists of the Series A redeemable preferred shares of Syncora Guarantee and the Series B Preferred Shares issued by Syncora Guarantee Re. In connection with the merger, on September 4, 2008, of Syncora Guarantee Re with and into Syncora Guarantee, the Series A preferred shares were cancelled and the Series B Preferred Shares became Syncora Guarantee’s Series B Preferred Shares.
Dividends on preferred shares of subsidiary were $5.4 million for the year ended December 31, 2008, an increase of $1.9 million, as compared to $3.5 million in 2007. The increase was due to the dividends on the Series B Preferred Shares, which were issued on February 11, 2008, offset by a decrease in dividends on the Series A preferred shares as a result of an extraordinary dividend and redemption. See “-Liquidity and Capital Resources-Syncora Guarantee Capital Facility” and “-Liquidity and Capital Resources-Syncora Guarantee Re Series A Preferred Shares Extraordinary Dividend and Redemption”.
Dividends on preferred shares of subsidiary were $3.5 million for year ended December 31, 2007, a decrease of $4.5 million, as compared to $8.0 million in 2006. The decrease was due to the aforementioned extraordinary dividend and redemption.
We define liquidity resources to include our investments in debt securities, short-term investments, cash and cash equivalents, and accrued investment income. Previously our definition of
liquidity resources also included the Syncora Guarantee capital facility (see “-Syncora Guarantee Capital Facility” below for details) and the capacity for revolving credit loans under the Credit Agreement (see “-Letter of Credit and Liquidity Facility” below for details). In connection with the 2008 MTA, the revolving credit loan capacity under the Credit Agreement was permanently reduced to zero. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”. In addition, on February 11, 2008, Syncora Guarantee Re issued Series B Preferred Shares (see “-Syncora Guarantee Capital Facility” below for details).
As a holding company, our cash flow consists of dividends from our insurance subsidiary, Syncora Guarantee, if declared and paid, and investment income on our invested assets, offset by expenses incurred for employee compensation and other expenses consisting primarily of costs incurred as a stand-alone public holding company, including board of directors fees, directors and officers liability insurance, independent auditor fees, stock registrar and listing fees, legal and other advisory fees, and annual report and proxy production and distribution costs.
In the ordinary course of business, we evaluate our liquidity resource needs in light of our expenses, our dividend policy, and the dividend paying ability of Syncora Guarantee. Based on our liquidity resources as of December 31, 2008, which aggregated $31.9 million at our holding company on a stand-alone basis, the income we expect to receive from such liquidity resources, and our estimated expenses, we believe that our holding company will have sufficient liquidity to fund its obligations over the next twelve months. There can be no assurance that actual results will not differ materially from our estimates.
The payment of dividends or advances from Syncora Guarantee is subject to regulatory restrictions. New York Insurance Law contains a test governing the amount of dividends that Syncora Guarantee can pay in any year and, as a result of the application of such test, Syncora Guarantee cannot currently pay dividends. In addition, Syncora Guarantee entered into an undertaking with the NYID pursuant to which it agreed not to pay any dividends to the shareholders of Syncora Guarantee, including Syncora Holdings without the prior consent of the NYID during a two-year period commencing on November 18, 2008.
be appointed as additional directors to the board of Syncora Holdings. As of March 31, 2009, dividends on the Syncora Holdings Series A Preference Shares have not been paid in an aggregate amount equivalent to six quarterly periods and therefore holders of the Syncora Holdings Series A Preference Shares have the right to elect two persons to serve on our Board of Directors.
assets of Syncora Guarantee. Any agreement with the Counterparties will require addressing Syncora Guarantee’s public finance business to the satisfaction of the New York Superintendent.
The inwards agreements under which Syncora Guarantee Re reinsured and now Syncora Guarantee reinsures business and provides credit protection in the form of derivatives contain ratings-based triggers whereby if Syncora Guarantee is downgraded to a level of “AA+” to “A+” (which have been triggered), depending upon the agreement, the ceding company or counterparty has the right, but not the obligation, to terminate the agreement and take back generally all or a fixed percentage of all transactions transferred under a given agreement. Syncora Guarantee may generally, but is not obligated to, provide collateral to an extent which gives the primary insurer the ability to obtain full financial credit for our reinsurance or credit protection. If the ceding company or counterparty elects to terminate the agreement on a cut-off basis and depending upon the agreement, Syncora Guarantee may be required to pay to the ceding company or counterparty the statutory unearned premiums on the policies or contracts and Syncora Guarantee would forgo any future installment premiums for which its coverage is terminated. In connection with the 2008 MTA, FSA has undertaken to use its best efforts to reassume such reinsurance from Syncora Guarantee for a period of nine months after the Closing Date. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information. In addition, under certain of our agreements with ceding companies and counterparties, in the event of a downgrade of Syncora Guarantee (which has already occurred) or upon the occurrence of other trigger events, the ceding companies or counterparties that have ceded or transferred business to us generally have the right (subject to applicable cure periods) to a stipulated increase in ceding commissions (which will, if such right is exercised, continue to adversely affect our liquidity) to a prearranged level in line with the rating of Syncora Guarantee and any such increases will reduce cash flow from operations. Other termination triggers also exist such as: (i) decline in our policyholders’ surplus of more than 25% from one quarter to the next, (ii) insolvency, (iii) illegality and other standard termination provisions. The ceding company or counterparty typically has the option as to whether policies are terminated on a run-off or cut-off basis.
Should Syncora Guarantee recapture business as a result of the downgrade of its respective reinsurers (when permitted by the related reinsurance agreement) or as a result of a commutation or termination, such re-recaptured policies or contracts may be policies or contracts where losses are expected or may develop, further increasing our losses.
Cash Flows. Syncora Guarantee reported net cash used in operating activities of approximately $1,776.5 million for the year ended December 31, 2008, an approximate $2,064.2 million decrease, as compared to $287.7 million of net cash provided by operating activities during 2007. The decrease in Syncora Guarantee’s net cash provided by operations is primarily due to the transfer of $971.8
million to restricted funds primarily for the benefit of our Counterparties and other ceding companies, claim payments made during the 2008 period as well as lower business production as compared to the prior year, as a result of suspending the writing of substantially all new business.
The following tables present, by reinsurer/counterparty, the amount of our in-force principal/notional exposure transferred to such reinsurer/counterparty as of December 31, 2008 and 2007:
“AAA Companies” means those firms that have both an “AAA” rating from S&P and an “Aaa” rating from Moody’s.
On August 1, 2006, we and certain of our subsidiaries entered into an aggregate $500 million, five-year letter of credit and revolving credit facility (the “Facility”) with a syndicate of banks, for which Citibank N.A. is the administrative agent (the “Administrative Agent”). The Facility provides for letters of credit of up to $250 million and up to $250 million of revolving credit loans with the aggregate amount of outstanding letters of credit and revolving credit loans thereunder not to exceed $500 million. Concurrent with the execution of the Master Transaction Agreement, we entered into Amendment No. 2 with the lenders under the Credit Agreement. Pursuant to Amendment No. 2 we agreed (i) to permanently reduce the availability under its revolving credit facility from $250 million to zero, (ii) to reduce the availability under the letter of credit facility to the amount of the letter of credit exposure as of July 28, 2008 and subsequently further reduce such exposure for any outstanding letters of credit for FSA’s benefit upon the closing the Commutation Agreement, and (iii) to collateralize the remaining letters of credit after the consummation of the transactions comprising the Master Transaction Agreement. In consideration of the foregoing, the lenders under the Credit Agreement have agreed to (i) forbear from declaring certain defaults, if any, as set forth in the Amendment No. 2, (ii) waive such defaults, if any, upon the satisfaction of certain conditions set forth in the Amendment No. 2, (iii) grant certain waivers in connection with the consummation of the Master Transaction Agreement and (iv) not instruct the Administrative Agent to send, and the Administrative Agent has agreed that it shall not send, a notice of non-renewal with respect to any outstanding letters of credit (other than the letter of credit for FSA’s benefit, which was canceled and returned to the Administrative Agent prior to the Closing Date) with regard to any renewal of a letter of credit during calendar year 2008. There is no assurance that the Administrative Agent and the lenders will renew the outstanding letters of credit when they are subject to renewal during calendar year 2009.
On March 31, 2009, we entered into Amendment No. 3 with the lenders under the Credit Agreement, whereby we agreed to collateralize the remaining letters of credit in an amount equal to 105% of the total letter of credit exposure as of such date, plus any accrued and unpaid interest and fees thereon, plus all other accrued and unpaid obligations of the account parties under the Credit Agreement. In consideration of the foregoing, the lenders under the Credit Agreement have agreed to permanently waive (i) the requirement that audited financial statements of each account party (other than Syncora Guarantee) be delivered within 90 days of the end of the fiscal year (provided that such audited financial statements shall be delivered within 120 days of the end of the fiscal year); (ii) the requirement that audited financial statements as reported on by the independent public accountants, not have a “going concern” or like qualification or exception nor any qualification or exception as to the scope of such audit; (iii) the covenant relating to Syncora Holdings’ ratio of total funded debt to total capitalization; (iv) the covenant relating to Syncora Holdings’ consolidated net worth; and (v) any defaults as a result of the account parties not satisfying the requirements waived in clauses (i) through (iv) above or certain other requirements set forth in the Credit Agreement (as more fully described in Amendment No. 3).
The Facility contains financial covenants that require that we at any time (a) prior to August 1, 2008, maintain a minimum consolidated net worth (defined as total shareholders’ equity before accumulated other comprehensive income and excluding the effect of any adjustments required under SFAS No. 133) of $857.4 million, (b) on or after August 1, 2008, maintain a minimum consolidated net worth (as defined above) equal to the greater of (1) $857.4 million or (2) an amount equal to 65% of the consolidated net worth (as defined above) as of the end of the then most recent fiscal year or fiscal quarter of Syncora Holdings for which financial statements shall have been delivered, and (c) maintain a maximum total funded debt-to-total capitalization ratio of 30%. As described above, we received a permanent waiver from the lenders with respect to the consolidated net worth covenant. The Facility also contains certain covenants, including restrictions on mergers, acquisitions and other business consolidations; the sale of assets; incurrence of indebtedness; liens on our assets; and transactions with affiliates. In addition, the Facility contains certain customary provisions regarding events of default, including payment defaults, breaches of representations and warranties, covenant defaults, cross-default and cross-acceleration to certain other indebtedness, certain events of bankruptcy and insolvency, material judgments, certain events under the Employee Retirement Income Security Act of 1974, as amended, and changes of control. The Facility also requires that we deliver audited financial statements without a "going concern" or like qualification or exception and without any qualification or exception as to the scope of such audit. As described above, we received a permanent waiver from the lenders with respect to the requirement that our audited financial statements do not contain a “going concern” or like qualification or exception and without any qualification or exception as to the scope of such audit. As of December 31, 2008, Syncora Guarantee had letters of credit outstanding under the Facility of $15.2 million, which were established for the benefit of primary insurance companies reinsured by us. No revolving loans have been drawn by us under the Facility since its inception. Primary companies reinsured by us may require us to provide collateral or letters of credit so they can receive reinsurance credit under certain U.S. state laws. In addition, under certain of our reinsurance agreements, we have the option to provide collateral or letters of credit in favor of the primary companies we reinsure in the event of a downgrade of our credit ratings or other events which would diminish the reinsurance credit provided to such primary companies by the rating agencies for our reinsurance. Although our credit ratings were downgraded, as of the date hereof, we have not received a request from any of the primary companies we reinsure to provide collateral or letters of credit and we have not made any determination whether we will provide collateral or letters of credit to such primary companies. As of December 31, 2008, we had no additional letter of credit capacity available.
The Series B Preferred Shares were created in conjunction with the establishment of the Asset Trust. The Series B Preferred Shares are non-cumulative redeemable perpetual preferred shares with a par value of $120 per share. The Series B Preferred Shares rank prior to Syncora Guarantee’s common shares, and have a liquidation preference of $100,000 each. In the event that Syncora Guarantee exercises its put option to the Asset Trust and the Series B Preferred Shares are issued, the holders of outstanding Series B Preferred Shares shall be entitled to receive, in preference to the holders of Syncora Guarantee’s,common shares, cash dividends at a percentage rate per Series B Preferred Share as follows:
for any subsequent dividend period, one-month LIBOR plus 2.00% per annum, calculated on an actual/360 basis.
In May 2008, the FASB issued SFAS 163, Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”). SFAS 163 clarifies how SFAS 60 applies to financial guarantee insurance contracts. SFAS 163, among other things, changes current industry practices with respect to the recognition of premium revenue and claim liabilities. Under SFAS 163, a claim liability on a financial guarantee insurance contract is recognized when the insurance enterprise expects that a claim loss will exceed the deferred premium revenue (liability) for that contract based on expected cash flows. The discount rate used to measure the claim liability is based on the risk-free market rate and must be updated each quarter. Premium revenue recognition, under SFAS 163 is based on
In September 2006, the FASB issued SFAS 157 “Fair Value Measurements” (“SFAS 157”) which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This Statement is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, where the FASB previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within these fiscal years. We adopted the provisions of SFAS 157 on January 1, 2008. See Note 6 to our Consolidated Financial Statements for disclosure of the effect on our financial position and results of operations of the adoption of SFAS 157 and Note 6 and 7 to the Consolidated Financial Statements for certain other disclosures required under SFAS 157.
In October 2008, the FASB issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active: An Amendment of FASB Statement No. 157” (“FSP No. FAS 157-3”). FSP No. FAS 157-3 applies to financial assets within the scope of SFAS 157 for which other accounting pronouncements require or permit fair value measurements. FSP No. FAS 157-3 clarifies the application of SFAS 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is not active. The provisions are effective upon issuance, including prior periods for which financial statements have not been issued. The provisions of this FSP need not be applied to immaterial items. We adopted FSP No. FAS 157-3 upon its issuance and it did not have any effect on our financial condition, results of operations or cash flows.
In September 2008, the FASB issued FSP No. FAS 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161” (“FSP No. FAS 133- 1 and FIN 45-4”). FSP No. FAS 133-1 and FIN 45-4 require enhanced disclosures about credit derivatives and guarantees and amends FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to exclude derivative instruments accounted for at fair value under SFAS No. 133. We adopted FSP No. FAS 133-1 and FIN 45-4 for our financial statements prepared as of and for the year ended December 31, 2008. Since FSP No. FAS 133-1 and FIN 45-4 only requires additional disclosures concerning credit derivatives and guarantees, adoption of FSP No. FAS 133-1 and FIN 45-4 did not affect our financial condition, results of operations or cash flows.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 provides us an irrevocable option to report selected financial assets and liabilities at fair value with changes in fair value recorded in earnings. The option is applied, on a contract-by-contract basis, to an entire contract and not only to specific risks, specific cash flows or other portions of that contract. Upfront costs and fees related to a contract for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. SFAS 159 was effective for us on January 1, 2008. We did not elect to report any financial assets or liabilities at fair value under SFAS 159.
In June 2007, the FASB ratified the consensus reached by the EITF on Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards.” EITF Issue No. 06-11 requires that the tax benefit with respect to dividends or dividend equivalents for non-
vested restricted shares or restricted share units that are paid to employees be recorded as an increase to additional paid-in-capital. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007, with early adoption permitted. We adopted EITF Issue No. 06-11 on January 1, 2008 and it did not have any effect on our financial statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures About Derivative Instruments and Hedging Activities-An Amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 establishes the disclosure requirements for derivative instruments and for hedging activities. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Early application is encouraged. SFAS 161 is not expected to have any effect on our results of operations or financial position.
The average duration of our investment portfolio was 1.8 years at December 31, 2008 as compared to 3.3 years as of December 31, 2007.
The table below shows the percentage of our fixed-income portfolio by credit rating (excluding cash and cash equivalents) at December 31, 2008:
Ratings represent S&P classifications. If S&P classifications are unavailable, Moody’s ratings are used.
The following table summarizes our consolidated debt securities portfolio at December 31, 2008:
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. This report includes forward-looking statements that reflect our current views with respect to future events and financial performance. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “anticipate,” “will,” “may” and similar statements of a future or forward-looking nature identify forward-looking statements. All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements.
higher losses on guaranteed obligations due to deterioration in the credit markets;
the effect of adverse developments in the credit and mortgage markets on our in-force business
higher loss reserves estimates and the adequacy of the loss reserves;
uncertainty as to the fair value of our CDS contracts and liabilities thereon;
Syncora Guarantee being required to make mark-to-market termination payments under its CDS contracts;
payment of claims on our guaranteed obligations, including Jefferson County, Alabama and RMBS transactions;
unavailability of funds due to capitalization of Drop-Down Company under the 2009 MTA;
unavailability of funds due to consideration paid to certain of the Counterparties under the 2009 MTA;
the commencement of new litigation or the outcome of current and new litigation;
losses from fraudulent conduct due to unconditional and irrevocable nature of financial guarantee insurance;
problems with the transaction servicers in relation to our structured finance transactions; and
To the Board of Directors and Shareholders of Syncora Holdings Ltd.:
On March 17, 2006, XL Capital Ltd (“XL Capital”) formed Syncora Holdings Ltd. (“Syncora Holdings”) (formerly known as Security Capital Assurance Ltd), as a wholly-owned Bermuda based subsidiary holding company. On July 1, 2006, XL Capital contributed all of its ownership interests in its financial guarantee insurance and financial guarantee reinsurance operating businesses to Syncora Holdings. The aforementioned operating businesses consisted of: (i) Syncora Guarantee Inc. (“Syncora Guarantee”) (a New York domiciled financial guarantee insurance company formerly known as XL Capital Assurance Inc.) and its wholly-owned subsidiary, Syncora Guarantee (U.K.) Ltd. (“Syncora Guarantee-UK”, formerly known as XL Capital Assurance (U.K.) Limited) and (ii) Syncora Guarantee Re Ltd. (“Syncora Guarantee Re”) (a Bermuda domiciled financial guarantee reinsurance company formerly known as XL Financial Assurance Ltd.). Syncora Holdings, Syncora Guarantee, and all other subsidiaries of Syncora Holdings are hereafter collectively referred to as the “Company.” Syncora Guarantee was an indirect wholly-owned subsidiary of XL Capital and all of Syncora Guarantee Re was indirectly owned by XL Capital, except for a preferred stock interest which was owned by Financial Security Assurance Holdings Ltd. or its subsidiaries (“FSA”), an entity which is otherwise not related to XL Capital or the Company (See Note 10). On August 4, 2006, Syncora Holdings completed an initial public offering (the “IPO”). In addition, XL Capital sold common shares of Syncora Holdings from its holdings directly to the public in a secondary offering concurrent with the IPO. Immediately after the IPO and the secondary offering, XL Capital, through its wholly-owned subsidiary XL Insurance (Bermuda) Ltd (“XLI”), owned approximately a 63% economic interest in Syncora Holdings, adjusted for restricted share awards to the Company’s employees and management granted at the effective date of the IPO. In June 2007, XLI completed the sale of additional common shares of Syncora Holdings from its holdings. Immediately after such sale, XLI owned approximately a 46% voting and economic interest in Syncora Holdings, adjusted for restricted share awards to the Company’s employees and management outstanding as of such date. Prior to XLI’s sale of common shares of Syncora Holdings in June 2007, its voting interest in Syncora Holdings was subject to limitations contained in Syncora Holdings’ bye-laws. On August 5, 2008, the Company consummated the transactions comprising the 2008 MTA, as defined below in Note 4, pursuant to which XL Capital transferred all of the common shares of Syncora Holdings it owned to be held in trust by CCRA Purpose Trust (the “SCA Shareholder Entity”). On September 4, 2008, Syncora Guarantee Re merged with and into Syncora Guarantee, with Syncora Guarantee being the surviving company.
Syncora Guarantee’s compliance with its $65 million minimum policyholders’ surplus requirement under New York Insurance Law as of June 30, 2008. In light of this material adverse development, and in accordance with its previously disclosed strategic plan, on July 28, 2008 the Company, certain financial institutions that are counterparties to credit default swap (“CDS”) contracts with Syncora Guarantee (the “Counterparties”), Merrill Lynch & Co., Inc. (“Merrill Lynch”) and certain of its affiliates, and XL Capital and certain of its affiliates, entered into a Master Commutation, Release and Restructuring Agreement, dated July 28, 2008, as amended (the “Master Transaction Agreement”), and certain other related agreements (hereafter referred to collectively as “the 2008 MTA”). The transactions comprising the 2008 MTA closed on August 5, 2008 (the “Closing Date”), except for the transactions comprising the FSA Master Agreement (as defined below), which closed on August 4, 2008. The transactions comprising the 2008 MTA are described in Note 4 along with summary financial information presenting the effect of the transactions comprising the 2008 MTA on the Company’s financial position and results of operations as of and for the year ended December 31, 2008.
During the third quarter of 2008, the Company recorded further significant adverse development of its anticipated claims on its guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on its guarantees of RMBS which would have caused Syncora Guarantee to be unable to maintain its compliance with its $65 million minimum policyholders’ surplus requirement under New York Insurance Law as of September 30, 2008. However, at the request of the Company, the New York State Insurance Department (the “NYID”), pursuant to section 6903 of New York Insurance Law, granted Syncora Guarantee approval in connection with the preparation of its statutory financial statements for the quarter ended September 30, 2008 to release statutory-basis contingency reserves on policies that have been terminated and on policies on which Syncora Guarantee has established case basis reserves for losses and loss adjustment expenses, which differs from accounting practices prescribed by the National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures Manual and adopted by the State of New York (“NAIC SAP”). As a result of such approval, Syncora Guarantee reported policyholders’ surplus of $83.3 million at September 30, 2008. Absent such approval, Syncora Guarantee would have reported a policyholders’ surplus at September 30, 2008 of $19.1 million. Policyholders’ surplus is based on statutory-basis accounting practices which differ from accounting principles generally accepted in the United States of America (“GAAP”). Such differences may be material. The aforementioned approval was also extended by the NYID in connection with the preparation of Syncora Guarantee’s statutory financial statements as of and for the year ended December 31, 2008. There can be no assurance that the NYID will continue to allow Syncora Guarantee to apply such practices.
As a result of the aforementioned recent developments and the continuing risks and uncertainties affecting the Company discussed in Note 5, the Company has concluded that there is substantial doubt about its ability to continue as a going concern. The Company’s financial statements as of December 31, 2008 and 2007 and for the years ended December 31, 2008, 2007, and 2006 are prepared assuming the Company continues as a going concern and do not include any adjustment that might result from its inability to continue as a going concern. See Note 5 for a more detailed discussion.
3. Description of the Transactions Contemplated by the Letter of Intent and Related Transactions
All of the terms and conditions described above are subject to definitive documentation satisfactory to all of the parties. There can be no assurance that the parties will enter into such
agreements in accordance with these terms and conditions or at all. In addition, consummation of the transactions contemplated by the 2009 MTA will be subject to various closing conditions and there can be no assurance that the transactions contemplated thereby will be consummated. In addition, we need to enter into settlement agreements with certain third-parties as part of the second phase of our strategic plan.
4. Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information
common shares of Syncora Holdings are transferred from the aforementioned trust to Counterparties or otherwise sold in the open market, for accounting purposes, they are considered to be treasury shares.
with Syncora Guarantee, under which FSA ceded certain of the commuted risks to Syncora Guarantee in return for a payment by FSA to Syncora Guarantee of approximately $88.6 million, representing the statutory unearned premium reserve for such risks, less ceding commission. FSA has undertaken to use its best efforts to reassume such reinsurance from Syncora Guarantee for a period of nine months after the closing, subject to limitations under Article 69 of the New York Insurance Law, which imposes aggregate and single risk limits on insurance that can be written by a financial guaranty insurer, FSA’s internal and rating agency single risk limits, other potential limitations and FSA’s underwriting guidelines. Syncora Guarantee was required to fund a trust in an initial amount of approximately $104.1 million to collateralize its obligations to FSA under the reinsurance agreement ($92.7 million as of December 31, 2008), which includes regulatory mandated contingency reserves. Finally, Syncora Holdings purchased all class A preferred shares of Syncora Guarantee Re held by FSA and its subsidiary, with a liquidation preference of $39 million, for approximately $2.9 million pursuant to an agreement for the sale and purchase of preferred shares. As a result of the Commutation Agreement and New Master Facultative Agreement, the Company recorded a loss of $17.9 million during the year ended December 31, 2008. In addition, as a result of Syncora Holdings’ purchase of the class A preferred shares of Syncora Guarantee Re, the Company recorded a gain of $36.1 million during the year ended December 31, 2008, which was recorded in retained earnings and not reflected in the Company’s net loss.
Concurrent with the execution of the Master Transaction Agreement, the Company entered into Amendment No. 2, Forbearance and Limited Waiver Agreement (“Amendment No. 2”) with the lenders under the Company’s credit agreement, dated as of August 1, 2006 (the “Credit Agreement”). Pursuant to Amendment No. 2, Forbearance and Limited Waiver Agreement, the Company agreed (i) to permanently reduce the availability under the revolving credit facility from $250 million to zero, (ii) to reduce the availability under the letter of credit facility to the amount of the letter of credit exposure as of July 28, 2008 and subsequently further reduce such exposure for any outstanding letters of credit for FSA’s benefit upon the closing the Commutation Agreement, and (iii) to collateralize the remaining letters of credit after the consummation of the transactions comprising the Master Transaction Agreement. In consideration of the foregoing, the lenders under the Credit Agreement agreed to (i) forbear from declaring certain defaults, if any, as set forth in the Amendment No. 2, (ii) waive such defaults, if any, upon the satisfaction of certain conditions set forth in the Amendment No. 2, (iii) grant certain waivers in connection with the consummation of the Master Transaction Agreement and (iv) not instruct the Administrative Agent to send, and the Administrative Agent has agreed that it shall not send, a notice of non-renewal with respect to any outstanding letters of credit (other than the letter of credit for FSA’s benefit, which was canceled and returned to the Administrative Agent prior to the Closing Date) with regard to any renewal of a letter of credit during calendar year 2008. There can be no assurance that the Administrative Agent and the lenders will renew the outstanding letters of credit when they are subject to renewal during calendar year 2009. The amount of letters of credit outstanding under the Credit Agreement and the amount of collateral posted by the Company in support of such letters of credit was approximately $15.2 million and $24.3 million as of the December 31, 2008, respectively.
In consideration for the releases and waivers agreed to by the Counterparties as part of the Master Transaction Agreement, Syncora Guarantee agreed to segregate an aggregate amount of $820 million in cash plus interest thereon, premiums paid by the Counterparties from July 28, 2008 through October 31, 2008 and any proceeds from the sale by the trust of the common shares of Syncora Holdings formerly owned by XL Capital (in the event such shares are sold) for the purpose of commuting, terminating, amending or otherwise restructuring existing agreements with the Counterparties pursuant to an agreement to be negotiated with the Counterparties, which agreement is contemplated by the Letter of Intent. At December 31, 2008, the carrying value of invested assets in the segregated account was approximately $837.6 million. Pursuant to the terms of the 2008 MTA, Syncora Guarantee agreed to certain restrictions on its ability to access the segregated funds and to commute, terminate, amend or otherwise restructure policies and contracts to which it is a party. In the event that Syncora Guarantee becomes subject to a rehabilitation or liquidation proceeding, the funds shall no longer be separately held, segregated or limited in use for commutations or restructurings, and will be part of the general assets of Syncora Guarantee.
In addition to that discussed above, with the exception of the merger of Syncora Guarantee Re with and into Syncora Guarantee discussed below which was consummated on September 4, 2008, the Company executed the following transactions on or about the Closing Date:
discontinuance of Syncora Guarantee Re as a Bermuda corporation and continuance of Syncora Guarantee Re as a Delaware corporation, contribution by Syncora Holdings of all its ownership interests in Syncora Guarantee Re to Syncora Guarantee, which was followed by the merger of Syncora Guarantee Re with and into Syncora Guarantee on September 4, 2008, with Syncora Guarantee being the surviving company. Subsequent to the merger of Syncora Guarantee Re with and into Syncora Guarantee, the Company’s financial guarantee reinsurance segment ceased to exist.
Represents effect of termination, commutation or elimination of certain reinsurance agreements and other arrangements between the Company and XL Capital (see Note 10).
Represents the effect of terminating the Swaps issued to Merrill Lynch and MLI by Syncora Guarantee.
5. Description of Continuing Risks and Uncertainties, Assessment of the Company’s Ability to Continue as a Going Concern, and Description of the Company’s On-Going Strategic Plan
Pursuant to section 6903 of the New York Insurance Law, the NYID has granted Syncora Guarantee approval, in connection with the preparation of its statutory basis financial statements as of and for the year ended December 31, 2008, to release contingency reserves on terminated policies and policies on which Syncora Guarantee has established case basis reserves for losses and loss adjustment expenses, however, there can be no assurance that the NYID will continue to permit Syncora Guarantee to apply such accounting practices in the future.
The Company continues to be materially exposed to risks associated with any continuing deterioration in the credit market sectors discussed above, as well as the spread of such deterioration to other sectors of the economy to which the Company has material business exposure, including commercial mortgage-backed securities (“CMBS”) and collateralized loan obligations (“CLOs”). The extent and duration of any continued deterioration of the credit markets is unknown, as is the effect, if any, on potential claim payments and the ultimate amount of losses the Company may incur on obligations it has guaranteed, and potential losses the Company may incur on its invested assets.
losses on its guarantees of ABS CDOs and first lien RMBS transactions is its assumption regarding the expected cumulative loss on mortgage loan collateral supporting such securities. The most uncertain component of that assumption is the future performance of currently performing (non- delinquent) mortgage loan collateral. If the actual rate at which currently performing loans become delinquent is materially greater than assumed, there will be a material adverse effect on the Company’s estimate of ultimate losses on the aforementioned guarantees and, accordingly, its financial position and results of operations. The Company’s estimate of ultimate losses on its guarantees of obligations supported by home equity line of credit (“HELOC”) and closed end second (“CES”) mortgage loan collateral is largely dependent on the Company’s default rate assumption. In this regard, the Company assumed that the default rate will begin to improve by early 2010. If actual loan performance improves later than assumed or does not improve as much as expected, there will be a material adverse effect on the Company’s ultimate losses on its guarantees of obligations supported by HELOCs and CES mortgage loan collateral and, accordingly, its financial position and results of operations. The Company’s default assumptions for first lien RMBS transactions is based on current delinquent loans and analysis of historical defaults for loans with similar characteristics. A loss severity is applied to the first lien RMBS defaults ranging from 41-68% to determine the expected loss on the collateral in those transactions. The Company uses traditional default and prepayment curves to model its unpaid loss. If loss severity is higher than the rates applied, there may be a material adverse effect on our ultimate losses. See Note 16(a) for further information.
Substantially all of Syncora Guarantee’s CDS contracts have mark-to-market termination payments following the occurrence of events that are outside Syncora Guarantee’s control, such as Syncora Guarantee being placed into receivership or rehabilitation by the NYID or the NYID taking control of Syncora Guarantee or, in limited cases, Syncora Guarantee’s insolvency. Mark-to-market termination payments for deals in which Syncora Guarantee would have to pay a termination payment are generally calculated either based on “market quotation” or “loss” (each as defined in the International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement). “Market quotation” is calculated as an amount (based on quotations received from dealers in the market) that the counterparty would have to pay another party (other than monoline financial guarantee insurance companies) to have such party takeover Syncora Guarantee’s position in the CDS contract. “Loss” is an amount that a counterparty reasonably determines in good faith to be its total losses and costs in connection with the CDS contract, including any loss of bargain, cost of funding or, at the election of such counterparty, but without duplication, loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge or related trading position. There can be no assurance that counterparties to Syncora Guarantee’s CDS contracts, including the Counterparties, will not assert that events have occurred which require Syncora Guarantee to make mark-to-market termination payments. If such events were to occur, the aggregate termination payments that may be asserted against Syncora Guarantee would significantly exceed its ability to make such payments and, accordingly, such events would have a material adverse effect on the Company’s financial position and results of operations. The fair value of the Company’s CDS contracts recorded in its financial statements at December 31, 2008 does not reflect the effect of mark-to-market termination payments.
may also have a right to claim back all or a proportion of any premiums already paid to Syncora Guarantee under the Treaty in relation to the period after the date the Treaty is terminated. The Financial Services Authority (“FSA UK”) also, as the applicable regulator of Syncora Guarantee-UK in the United Kingdom, would have broad and extensive powers under the Financial Services and Markets Act 2000 which could be exercised in the event that either Syncora Guarantee or Syncora Guarantee-UK became insolvent or had a receiver appointed, including to vary or cancel Syncora Guarantee-UK’s permission to carry on any of its regulated activities. If any of the aforementioned events should occur, it will have a material adverse effect on Syncora Guarantee’s financial position and results of operations, as well as its ability to comply with its minimum policyholders’ surplus requirement.
The Company may be unable to enter into or consummate the transactions contemplated by the 2009 MTA or close the tender offer, which would have a material adverse effect on our financial condition and results of operations. In the absence of a successful restructuring that achieves remediation of RMBS exposures and CDS exposures, of the magnitude contemplated by the Letter of Intent and the tender offer, Syncora Guarantee will continue to report a policyholders’ deficit and the New York Superintendent may seek court appointment as rehabilitator or liquidator of Syncora Guarantee. Moreover, in the absence of a successful restructuring and in the exercise of its fiduciary duties, Syncora Guarantee’s Board of Directors may request the New York Superintendent to seek such court appointment. In such circumstances, it is likely that the New York Superintendent would institute such proceedings. If Syncora Guarantee should become subject to a regulatory proceeding, or, in limited cases, if Syncora Guarantee should become insolvent, the holders of certain of the CDS contracts Syncora Guarantee has insured may assert the right to terminate the contracts and assert claims that Syncora Guarantee pay them the termination values, which under current market conditions would be in excess of Syncora Guarantee’s resources. If Syncora Guarantee were required to pay the termination values, Syncora Guarantee would not have sufficient liquidity to fund its obligations as they become due.
adverse consequences, including but not limited to litigation, potential loss of control rights, the potential assertion of mark-to-market termination payments by counterparties to Syncora Guarantee’s CDS contracts with respect to CDS contracts on which Syncora Guarantee fails to pay a claim and adverse reaction from our regulators, including the NYID, FSA UK and the BMA, including, in the case of the NYID, a decision to seek to commence a rehabilitation or liquidation of Syncora Guarantee. There can be no assurance there would not be other material adverse consequences if Syncora Guarantee failed to pay claims.
In management’s opinion, the principal factors affecting the Company’s ability to continue as a going concern are (i) whether the Company is successful in consummating the transactions contemplated by the Letter of Intent and related transactions and the tender offer, as well as the effect on the Company’s financial condition from the consummation of such transactions, (ii) non-assertion by certain counterparties to the Company’s CDS contracts of a mark-to-market termination event, (iii) the risk of adverse loss development on its remaining in-force business after the successful consummation of the transactions contemplated by the Letter of Intent and related transactions and the tender offer that would cause Syncora Guarantee not to be in compliance with its $65 million minimum policyholders’ surplus requirement under New York Insurance Law, and (iv) the risk of intervention by the NYID as a result of the financial condition of Syncora Guarantee or FSA UK as a result of Syncora Guarantee-UK’s financial condition.
The accompanying Consolidated Financial Statements present the historical consolidated financial position, results of operations and cash flows of the Company. These Consolidated Financial Statements have been prepared in conformity with GAAP, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could, and likely will, differ from those estimates. Accounting policies requiring significant estimates consist of those relating to the Company’s credit derivative contracts, deferred acquisition costs, investments, and reserves for losses and loss adjustment expenses, as discussed in this note.
Prior to the adoption of this revised presentation the Company reported (i) premiums received or receivable from the issuance of credit derivative contracts in line item captions in the consolidated statement of operations entitled “Gross premiums written,” “Reinsurance premium assumed,” “Ceded premiums,” “Net premiums written” and “Net premiums earned,” as appropriate, (ii) losses from actual and expected payments to counterparties under such contracts in the line item caption in the consolidated statement of operations entitled “Net losses and loss adjustment expenses” and (iii) all other changes in the fair value of such instruments in the line item caption in the consolidated statement of operations entitled “Net realized and unrealized losses on credit derivatives.” In the consolidated balance sheet, the Company reclassified all credit default swap-related balances previously included in “Unpaid losses and loss adjustment expenses” and “Reinsurance balances recoverable on unpaid losses” to either “Derivative liabilities” or “Derivative assets,” depending on the net position of the credit default swap contract at each balance sheet date.
Certain reclassifications have been made to prior period consolidated financial statement amounts, including that discussed above, to conform to current period presentation. There was no effect on net (loss) income or shareholders’ equity as a result of these reclassifications. The following is a summary of reclassifications made to prior period consolidated financial statement amounts to conform to current year presentation:
All of the Company’s investments in debt and equity securities are considered available-for-sale and accordingly are carried at fair value. The fair value of investments is based on quoted market prices received from nationally recognized pricing services or, in the absence of quoted market prices, dealer quotes or matrix pricing. Adverse credit market conditions during the second half of 2007 caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers. The net unrealized appreciation or depreciation on investments, net of deferred income taxes, is included in accumulated other comprehensive income (loss). Any unrealized depreciation in value considered by management to be other-than-temporary is charged to income in the period that such determination is made.
The Company’s financial guarantees insure scheduled payments of principal and interest due on various types of financial obligations against payment default by the issuers of such obligations. The Company establishes reserves for losses and loss adjustment expenses on such business based on its best estimate of the ultimate expected incurred losses. The Company’s estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including estimates regarding the occurrence and amount of a loss on an insured obligation. Actual experience may differ from estimates and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the level of interest rates, credit deterioration of insured obligations, and changes in the value of specific assets supporting insured obligations. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor. Any estimate of future costs is subject to the inherent limitation on the Company’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate.
Case basis reserves on insured business are established by the Company with respect to a specific policy or contract upon receipt of a claim notice or when management determines that (i) a claim is probable in the future based on specific credit events that have occurred and (ii) the amount of the ultimate loss that the Company will incur can be reasonably estimated. As specific case basis reserves are established management considers whether any changes are required to the assumptions underlying the calculation of unallocated reserves (which are discussed below) as a result of such activity. The amount of the case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that the Company expects to make,
The selection of the Company’s UELR (and subsequent periodic updates thereof) is based on management’s judgment, which considers: (i) the characteristics of the Company’s in-force financial guarantee insurance and reinsurance business (e.g., principally the mix of the Company’s in-force financial guarantee insurance and reinsurance business between public finance and structured finance business; however, management also considered the various bond sectors comprising the Company’s insured and reinsured in-force business which are discussed in detail in Note 15, as well as the credit profile of the Company’s insured and reinsured portfolio of business), (ii) the Company’s actual loss experience, (iii) the characteristics, as discussed above in relation to the Company’s in-force financial guarantee insurance and reinsurance business, of the insured in-force business of companies comprising the financial guarantee insurance industry, and (iv) the actual loss experience of companies comprising the financial guarantee insurance industry, as discussed below. Other factors impacting market default levels and the assumptions important to the Company’s reserving methodology are implicit in the Company’s UELR. Such factors may include interest rates, inflation, taxes, industry trends in the valuation of certain asset classes and the overall credit environment. Based on this comparison, the Company adjusts its UELR, as it consider necessary, to ensure that such ratio continues to be appropriate for the risks inherent in the Company’s in-force business.
The Company analyzes the actual loss experience of companies comprising the financial guarantee insurance industry annually. The analysis utilizes loss and premium data filed by the three largest companies in the financial guarantee insurance industry in Schedule P of their annual statutory financial statements. These statutory filings provide data for ten calendar years and exclude unallocated reserves. Information on unallocated reserves is obtained from Annual Reports filed with the SEC on Form 10-K and is combined with the Schedule P data to estimate ultimate loss ratios for each of the preceding ten years.
Based on this analysis, the Company selected a UELR in 2006, 2007 and 2008 of 20%. The Company has not changed the UELR in 2008 or 2007 because of its view that the losses recorded by the Company and others in the industry are concentrated in residential mortgage exposures which are not correlated to the rest of the Company’s in-force business. The Company’s expected loss emergence pattern is determined by underwriting year based on the par amortization schedules of the underlying insured and reinsured debt obligations comprising its in-force business. The Company adjusts or realigns the expected loss emergence pattern each quarter to reflect the underlying changes in its in-force business (for example, changes in the average life of in-force business resulting from changes in the mix of business and risk or par expiration).
The Company’s methodology applies the UELR to earned premium during the period from its entire in-force book of business (after exclusion of the effect on earned premiums of Refundings and
full limit losses because no more risk exists on these policies). Significant changes to any variables on which the Company’s UELR is based, over an extended period of time, will likely result in an increase or decrease in such ratio. For example, a shift in the mix of in-force business to sectors with high default rates would likely increase the Company’s UELR, while a shift in the mix of in-force business to sectors with low default rates would likely decrease the Company’s UELR. Additionally, increases in default rates relative to the Company’s in-force business and in the Company’s actual loss experience or decreases in statistical recovery rates and in the Company’s actual recovery experience would increase the UELR, while the inverse would likely decrease the UELR.
The Company’s unallocated loss reserve is established on an undiscounted basis and represents management’s best estimate of losses that the Company will incur in the future as a result of credit deterioration in the Company’s in-force business but which have not yet been specifically identified. The Company does not attempt to apportion unallocated reserves by type of product.
The Company believes that its reserves are adequate to cover its expected ultimate losses. However, due to the inherent uncertainties of estimating reserves for losses and loss adjustment expenses, actual experience may differ from the estimates reflected in the Company’s financial statements, and the differences may be material. While the Company believes that the underlying principles applied to loss reserving are consistent across the financial guarantee industry, differences may exist with regard to the methodology and measurement of such reserves. While the Company believes that the principles it applies are the most appropriate for the Company’s business and have been applied consistently during the years presented, alternate methods may produce different estimates as compared to the current methodology used by the Company.
Although SFAS 60 provides guidance to insurance enterprises, the Company does not believe SFAS 60 comprehensively addresses the unique attributes of financial guarantee insurance contracts, as the standard was developed prior to the maturity of the financial guarantee industry. SFAS 60 provides guidance with respect to insurance contracts that are either short-duration or long-duration in nature. Financial guarantee contracts typically have attributes of both and, therefore, are difficult to classify as either. For instance, financial guarantee contracts are reported for regulatory purposes as property and liability insurance, normally considered short-duration, but have elements of long-duration contracts in that they are irrevocable and extend over a period that may be in excess of 30 years. The Company does, however, recognize premium revenue and policy acquisition costs in a manner consistent with the guidance provided in SFAS 60 for short-duration contracts. If the Company and the rest of the financial guarantee industry were required to classify its insurance contracts as either short-duration or long-duration or if new specific guidance for financial guarantee insurance emerges, different methods of accounting could apply with respect to loss reserving and liability recognition, and possibly extend to premium revenue and policy acquisition cost recognition. Additionally, there are differences in the methodology and measurement of loss reserves followed by other financial guarantee companies.
The Company’s policy has been to hold its CDS contracts to maturity and not to manage such contracts to realize gains or losses from periodic market fluctuations. However, in certain circumstances, the Company may enter into an off-setting position or back-to-back arrangement, commute, terminate or restructure a CDS contract prior to maturity for risk management purposes (for example, upon a deterioration in underlying credit quality or for the purposes of managing its capital). In connection with the 2008 MTA, the Company commuted several of its CDS contracts and back-to-back arrangements. In addition, the transactions contemplated by the Letter of Intent also include commutation of CDS contracts. See Notes 3 and 4.
The principal drivers of the fair value of the Company’s CDS contracts include: (i) general market credit spreads for the type(s) of assets referenced in CDS contracts, (ii) the specific quality and performance of the actual assets referenced in the contracts, (iii) the amount of subordination in the transaction before the Company’s liability attaches, (iv) other customized structural features of such contracts (e.g. terms, conditions, covenants), (v) supply and demand factors, including the volume of new issuance and financial guarantee market penetration, as well as the level of competition in the marketplace, and (vi) the market perception of the Company’s ability to meet its obligations under its CDS contracts which may be implied by the cost of buying credit protection on Syncora Guarantee.
market for the Company’s CDS contracts. Fair value is defined as the price at which an asset or a liability could be bought or transferred in a current transaction between willing parties. Fair value is determined based on quoted market prices, if available. Quoted market prices are available only on a limited portion of the Company’s in-force portfolio of CDS contracts. If quoted market prices are not available, fair value is estimated based on valuation techniques involving management’s judgment. In determining the fair value of its CDS contracts, the Company uses various valuation approaches with priority given to observable market prices when they are available. Market prices are generally available for traded securities and market standard CDS contracts but are less available or unavailable for highly-customized CDS contracts. Most of the Company’s CDS contracts are highly customized structured credit derivative transactions that are not traded and do not have observable market prices. Due to the significance of unobservable inputs required to value such CDS contracts, they are considered to be Level 3 under the SFAS 157 fair value hierarchy.
payments upon settlement of individual collateral losses as they occur upon erosion of subordination.
The Company’s CDS contracts are structured to prevent large one-time claims upon a specified credit event and generally allow for payments over time (i.e. “pay as you go” basis) or at final maturity. Also, the Company’s CDS contracts are generally governed by a single transaction ISDA Master Agreement relating only to that particular transaction/contract. Under most monoline financial guarantee standard termination provisions, there is no requirement for mark-to-market termination payments upon the early termination of a guaranteed CDS contract. However, substantially all of the Company’s CDS contracts provide for mark-to-market termination payments following the occurrence of events that are outside the Company’s control, such as Syncora Guarantee being placed into receivership or rehabilitation or a regulator taking control of Syncora Guarantee or Syncora Guarantee’s insolvency. Under current market conditions such termination payments would result in a substantial liability to the Company which would be substantially in excess of that currently recorded by the Company in accordance with SFAS 157 and its ability to pay (see Note 5). An additional difference between the Company’s CDS contracts and the typical market standard CDS contracts is that, except in the circumstances noted above, there is no acceleration of the payment to be made under the Company’s CDS contracts unless the Company, at its option, elects to accelerate. Furthermore, by law, the Company’s guarantees are unconditional and irrevocable, and cannot be transferred to most other capital market participants as they are not licensed to write such business. However, through the purchase of back-to-back credit protection, the risk of loss (but not counterparty risk) on these contracts can be transferred to other financial guarantee insurance and reinsurance companies.
Description of Valuation Methodology Used by the Company at December 31, 2008
Implicit in the fair values obtained by the Company on the underlying reference obligations are the market’s assumptions about default probabilities, default timing, correlation, recovery rates and collateral values. In general, the Company is using a percentage of the credit spread over LIBOR (the “premium percentage”) that management believes is consistent with (i) levels attainable in the market just prior to the collapse of the market for CDS from financial guarantors and (ii) historical premium pricing for high credit spread transactions. Management believes that the premium percentage available in the market has dropped significantly as the credit spreads for the underlying reference securities have widened to levels not seen historically. These credit spreads reflect the lack of liquidity in the market and this liquidity premium historically has flowed directly to the CDS counterparty as the funding institution. Though management believes the actual premium percentage would be far below those seen in previous markets, with no observable market transactions to use as a benchmark, management has decided to set a floor on the premium percentage of 30%. This level is consistent with the bottom range of our historical premium pricing for CDS transactions. Under this approach, the financial guarantee CDS fee used for a particular contract in the Company’s fair value calculations represent a consistent percentage, period to period, of the credit spread determinable from the reference index value as of the measurement date. This results in a CDS fair value (before adjustment for Non-Performance Risk, as defined below) that fluctuates in proportion with the reference index value.
For example, assuming that at the end of the previous reporting period the credit spread of a reference index was 100 basis points and the current market premium for a transaction that is priced off of that reference index was set at 30 basis points (30% of the reference index), if at the end of the current reporting period the reference index moved to 150 basis points (a 50% increase), the current market premium for such a transaction would be set at 45 basis points (also a 50% increase). Thus, the model indicates that the Company would need to receive an additional 15 basis points (45 bps currently less the 30 bps reported last period) for issuing a CDS on the reference obligation in the current reporting period. To compute the current period change in fair value we discount the product of the outstanding notional amount of the CDS and the contractual premium over the life of the reference obligation, using a counterparty discount rate and subtract from that, the discounted product of the outstanding notional amount of the CDS and calculated current market premium, over the life of the reference obligation using a Syncora-specific discount rate.
For CDS contracts issued on ABS CDOs, the Company utilizes non-binding broker quotes on the underlying obligations to project principal and interest shortfalls and the timing of such shortfalls. The Company then discounts the shortfalls using a Company-specific discount rate and nets from this the discounted expected premium using a counterparty discount rate (based on the published credit spreads of the counterparty), to arrive at the fair value of the CDS. No adjustments
have been made to third party broker quotes as these are intended to capture all elements of the fair value of the underlying securities.
In addition to that discussed above, the fair value of the Company’s CDS contracts reflects the risk that the Company will not be able to honor its obligations under its CDS contracts (its “Non-Performance Risk”) as implied by the market price of buying credit protection on Syncora Guarantee. Non-Performance Risk is reflected in the fair value of the Company’s CDS contracts by incorporating the spread on CDS contracts traded on Syncora Guarantee into the discount rate used. The Company estimates a discount rate for each CDS contract based on the swap rate and the Company’s credit spread for the duration that is the closest to the remaining weighted average life (“WAL”) of the obligation referenced in the CDS contract. Reflecting Non-Performance Risk in the Company’s estimate of the fair value of its CDS contracts was the only change in its valuation methodology caused by the adoption of SFAS 157. At December 31, 2008, the effect of reflecting Non-Performance Risk in the Company’s estimate of the fair value of its CDS contracts was a reduction in the Company’s net derivative liability of approximately $14.2 billion. The spread on 10-year CDS contracts traded on Syncora Guarantee at December 31, 2008 was 60.16%. If the transactions contemplated by the Letter of Intent are consummated, specifically the commutations of CDS contracts with Counterparties as discussed in Note 3, the uncertainty associated with future adverse loss development on the Company’s guarantees will be reduced and management believes that, as a result, the cost of buying credit protection on Syncora Guarantee should decline. The effect of a decline in the cost of buying credit protection on Syncora Guarantee will increase the Company’s derivative liability on the remaining in-force CDS contracts; however, the Company believes that any such increase should be offset in part by the effect on its derivative liability from the aforementioned commutations. However, there can be no assurance that material adverse loss development will not occur in the future or that the aforementioned commutations with will offset the increase in the Company’s derivative liability. At December 31, 2008 and 2007, the notional amount outstanding of the Company’s in-force CDS contracts was $57.8 billion and $65.3 billion, respectively. The remaining WAL of such CDS contracts at December 31, 2008 was 10.2 years. In addition, based on such notional amount as of December 31, 2008 and 2007, approximately 60% and 93%, respectively, of referenced assets underlying such in-force CDS contracts were rated (based on S&P’s ratings) “AAA”, 18% and 7%, respectively, were rated at or above investment- grade, and 22% and less than 1%, respectively, were rated below investment-grade at such dates, respectively.
The following table provides the components of the income statement line item entitled, “Change in fair value of derivatives” related to derivative contracts for the year ended December 31, 2008:
Includes premiums received and receivable on CDS contracts issued net of premiums paid or payable on purchased contracts.
The following table provides the components of the income statement line item entitled, “Change in fair value of derivatives” related to derivative contracts for the years ended December 31, 2008, 2007 and 2006:
contracts by the present value of the remaining expected future premiums to be received under the contract. Management concluded that results from this calculation represented a reasonable estimate of the fair value of the Company’s CDS contracts at that time.
in substantially all other instances management’s estimate of the fair value of the Company’s CDS contracts ascribed significant weight to management’s judgments regarding rates of return required by market participants in the current market environment and the amount of subordination required by market participants before their liability would attach under the CDS contracts. Management’s judgment in regard to the appropriate rate of return that would be required by a market participant considered all of the other factors discussed above. Management’s judgment in regard to the amount of subordination required by market participants before the liability would attach under the CDS contracts generally assumed that, in the current market environment at December 31, 2007, to transfer the risk in an existing contract it would need subordination sufficient to qualify for a triple-A rating from Moody’s and S&P. Accordingly, for any contract rated below triple-A by the Company or the rating agencies (which consisted only of ABS CDO contracts), the estimated fair value was calculated by adding additional subordination sufficient to meet S&P standards for a triple-A rating based on S&P requirements at December 31, 2007 to the amount of additional premium required to be paid to transfer the risk to achieve the selected rate of return. Such premium was calculated by adjusting the present value of the expected remaining future net cash flows under such contracts (which are comprised of the remaining expected future premiums to be received under the contract, less estimated maintenance expenses and a provision for expected losses that will manifest in the future) to reflect management’s best estimate of the rates of return that would be required by a market participant to assume the risks on such contracts.
The Company insured obligations issued by variable interest entities (“VIEs”) in the ordinary course of the Company’s business. The Company provided financial guarantee insurance of structured transactions backed by pools of assets of specified types, municipal obligations supported
by the issuers’ ability to charge fees for specified services or projects, and corporate risk obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions were often securitized through VIEs. In synthetic transactions, the Company guaranteed payment obligations of counterparties, including VIEs, through CDS contracts referencing asset portfolios. The Company only provided financial guarantee insurance of these VIEs for premiums at market rates but did not hold any equity positions or subordinated debt in these off-balance sheet arrangements. These financial guarantee contracts represent variable interests held by the Company in VIEs.
In underwriting financial guarantees, the Company generally required that guaranteed obligations be investment-grade prior to the provision of credit enhancement. Typically, in the case of ABS and other structured obligations, such investment grade ratings were based upon subordination, cash reserves and other structural protections. Consequently, the Company determined that it is not the primary beneficiary of any VIEs in which it holds a variable interest. Accordingly, these VIEs are not consolidated by the Company.
Basic earnings per share amounts are calculated by dividing net (loss) or income by the weighted average number of common shares outstanding during the year excluding the dilutive effect of stock option and restricted stock awards outstanding. Diluted earnings per share amounts are calculated by dividing net income by the sum of the weighted average number of common shares outstanding during the year plus additional shares from all potential dilutive securities. The Company’s dilutive securities consist of stock option and restricted stock awards outstanding. The additional shares included in the denominator when calculating diluted earnings per share is calculated in accordance with the treasury stock method. The treasury stock method assumes that a company uses the proceeds from the exercise of awards to repurchase common stock at the average market price during the period. The assumed proceeds under the treasury stock method include: (i) the purchase price that the grantee will pay in the future, if any (e.g., the exercise price of a stock option); (ii) compensation cost for future service that the company has not yet recognized; and (iii) certain tax benefits when the award generates a tax deduction. However, the calculation of diluted loss per share excludes the dilutive effect of stock option and restricted stock awards outstanding if it would have an anti-dilutive effect on net loss per share. See Note 23.
The expected term of the financial guarantee insurance contract if (1) prepayments on the insured financial obligation are probable, (2) the timing and amount of prepayments can be reasonably estimated, and (3) the pool of assets underlying the insured financial obligation are homogeneous and are contractually prepayable. Any adjustments for subsequent changes in those prepayment assumptions would be made on a prospective basis. In all other instances, contractual terms would be used, and
The discount rate used to measure the premium receivable (asset) and the deferred premium revenue (liability) should be the risk-free rate.
The Company expects that the initial effect of applying SFAS 163 will be material to the Company’s financial statements. In particular, the Company expects that implementation of SFAS 163 will cause the Company to de-recognize its reserves for unallocated losses and loss adjustment expenses, and preclude it from providing such reserves in the future (see Note 6 and 16).
SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years. In addition, beginning in the third quarter of 2008, the Company was required to make certain disclosures describing the Company’s guarantees that were being closely monitored as a result of deterioration or other adverse developments (see Note 16).
FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active: An Amendment of FASB Statement No. 157”
FSP No. FAS 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161”
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 provides the Company an irrevocable option to report selected financial assets and liabilities at fair value with changes in fair value recorded in earnings. The option is applied, on a contract-by-contract basis, to an entire contract and not only to specific risks, specific cash flows or other portions of that contract. Upfront costs and fees related to a contract for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. SFAS 159 was effective for the Company on January 1, 2008. The Company did not elect to report any financial assets or liabilities at fair value under SFAS 159.
The amortized cost and fair value of investments as of December 31, 2008 and 2007 are as follows:
The Company has gross unrealized losses on securities which it considers to be temporary impairments. Such individual security positions have been evaluated by management, based on specific criteria, to determine if these impairments should be considered other-than-temporary. These criteria include assessment of the severity and length of time securities have been impaired, along with management’s ability and intent to hold the securities to recovery (which considers the Company’s liquidity position), among other factors. For the years ended December 31, 2008 and December 31, 2007, the Company recorded other-than-temporary impairment charges of $238.9 million and $1.2 million, respectively. The Company did not record any other-than-temporary
declines in the fair value of debt securities or short-term investments for the year ended December 31, 2006.
The following tables present the aggregate gross unrealized losses and fair value by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2008 and 2007, respectively:
The following table presents the fair value of the Company’s investments at December 31, 2008 based on the fair value hierarchy level of the inputs used to determine the fair value of such investments as prescribed under SFAS 157. See Note 6 for a description of the fair value hierarchy requirements of SFAS 157.
Prior to April, 2006 the redemption price of the Series A Preferred Shares was estimated at the end of each reporting period and changes in the redemption value were accreted over the period from the date of issuance to the earliest redemption date using the interest method. Pursuant to resolution of Syncora Guarantee Re’s shareholders on April 2006, Syncora Guarantee Re restructured the terms of its Series A Redeemable Preferred Shares and changed its bye-laws accordingly. In accordance with the resolution, the participating dividend of the preference shares was eliminated, the stated value of the preferred shares held by FSA was increased to $54.0 million, and the fixed dividend rate was increased from 5% to 8.25%.
For the year ended December 31, 2006, the Company recorded $8.0 million of “minority interest-dividends on redeemable preferred shares” which reflects the effect of the restructured terms of the Series A Preferred Shares referred to above.
for any dividend period ending on or prior to December 9, 2009, one-month LIBOR plus 1.00% per annum, calculated on an actual/360 day basis; and
for any subsequent dividend period, one-month LIBOR plus 2.00% per annum, calculated on an actual/360 day basis.
Prior to the IPO, the Company purchased various services from affiliates of XL Capital under various agreements and continued to purchase such services under new agreements that became effective at the date of the IPO. Such services principally included: (i) information technology support, (ii) reinsurance and retrocessional consulting and management services and (iii) actuarial, finance, legal, internal audit services and certain investment management services. Since the IPO, the Company has undertaken to perform certain of the services itself or to outsource such services to other vendors and has, accordingly, discontinued the purchase of all the services that were provided by XL Capital. For the years ended December 31, 2008, 2007 and 2006, the Company incurred costs under the aforementioned agreements aggregating $2.5 million, $4.3 million and $3.0 million, respectively, which are reflected in “Operating expenses” in the accompanying consolidated statements of operations.
The Company has the following reinsurance agreements with affiliates. Certain of the agreements discussed below may be terminated under certain conditions, as defined in the agreements. As noted below, many of these agreements were terminated or commuted on the Closing Date in connection with the 2008 MTA (see Note 4).
On August 4, 2006, Syncora Guarantee Re terminated a facultative quota share reinsurance treaty with XLI that had been effective since 2001. As a result of the termination, XLI returned $26.5 million of premiums to Syncora Guarantee Re, Syncora Guarantee Re returned ceding commissions of $7.8 million to XLI, and XLI paid Syncora Guarantee Re $18.7 million.
On August 4, 2006, Syncora Guarantee Re and XLI agreed to cancel from inception the reinsurance of certain business ceded under a facultative quota share reinsurance treaty that was effective since 1999. As a result of this cancellation, Syncora Guarantee Re paid XLI $0.2 million, XLI assumed Syncora Guarantee Re’s obligation for $1.2 million of reserves for losses and loss adjustment expenses, and Syncora Guarantee Re recorded a capital contribution of $1.0 million. In addition, on such date, Syncora Guarantee Re assumed certain business from XLI pursuant to the aforementioned reinsurance treaty. As a result thereof, Syncora Guarantee Re recorded assumed premiums of approximately $8.0 million, ceding commissions of approximately $1.0 million and received cash from XLI of approximately $7.0 million.
Effective October 1, 2001, Syncora Guarantee Re entered into an excess of loss reinsurance agreement with XLI. This agreement covered a portion of Syncora Guarantee Re’s liability arising as a result of losses on policies it reinsured and credit derivatives it issued that were in excess of certain limits and were not covered by Syncora Guarantee Re’s other reinsurance agreements. Syncora Guarantee Re was charged a premium of $0.5 million per annum for this coverage. This agreement provided indemnification only for the portion of any loss covered by the agreement in excess of 10% of Syncora Guarantee Re’s Bermuda statutory surplus, up to an aggregate amount of $500 million, and excluded coverage for liabilities arising other than pursuant to the terms of an underlying policy.
Syncora Guarantee Re entered into the Old Master Facultative Agreement (see Note 4) to reinsure certain policies issued by FSA which guarantee the timely payment of the principal of and interest on various types of debt obligations. Syncora Guarantee Re’s obligations under certain of these arrangements were guaranteed by XLI. Effective upon the IPO, the guarantee was terminated with respect to all new business assumed by Syncora Guarantee Re under such arrangement, but the guarantee remained in effect with respect to cessions under the agreement prior to the IPO. In connection with the 2008 MTA discussed in Note 4, Syncora Guarantee Re commuted the Old Master Facultative Agreement and Syncora Guarantee entered into the New Facultative Master Agreement to reinsure a portion of the protection previously provided to FSA by Syncora Guarantee Re. To effect the commutation of the Old Master Facultative Agreement, Syncora Guarantee Re paid FSA $165.4 million and in connection with the reassumption of a portion of such business by Syncora Guarantee under the New Master Facultative Agreement, Syncora Guarantee received a payment from FSA of $88.6 million. In addition, in connection with the 2008 MTA described in Note 4, XLI’s guarantee of Syncora Guarantee Re’s obligations to FSA, relating to cessions under reinsurance agreements prior to the IPO, was terminated. Subsequent to the Closing Date, FSA commuted a portion of the business assumed by Syncora Guarantee under the New Facultative Master Agreement.
Syncora Guarantee Re guaranteed certain of XLI’s obligations in connection with certain transactions where XLI’s customer required such credit enhancement. Each of these transactions has a “double trigger” structure, meaning that Syncora Guarantee Re does not have to pay a claim unless both the underlying transaction and XLI default. For each of these transactions, Syncora Guarantee Re entered into a reimbursement agreement with XLI, pursuant to which XLI pays Syncora Guarantee Re a fee for providing its guarantee and XLI grants Syncora Guarantee Re a security interest in a portion of the payments received by it from its client. Pursuant to the merger of Syncora Guarantee Re with and into Syncora Guarantee, these guarantees are now the guarantees of Syncora Guarantee. As of December 31, 2008 and 2007, Syncora Guarantee Re’s aggregate net par outstanding relating to such guarantees was $365.5 million and $511.1 million, respectively.
Effective May 1, 2004, XLI entered into an agreement with Syncora Guarantee which unconditionally and irrevocably guaranteed to Syncora Guarantee the full and complete payment when due of all of Syncora Guarantee Re’s obligations under its facultative quota share reinsurance agreement with Syncora Guarantee, under which agreement Syncora Guarantee Re has assumed business from Syncora Guarantee since December 19, 2000.
the 2008 MTA discussed in Note 4, the facultative quota share reinsurance agreement was commuted and XLI’s guarantee of Syncora Guarantee Re’s obligations to Syncora Guarantee, relating to cessions under reinsurance agreements prior to the IPO, was eliminated in consideration of a payment by XLI to Syncora Guarantee Re of approximately $1.6 billion, which was recorded by the Company as a capital contribution (see Note 4).
The Company previously provided financial guarantee insurance policies insuring timely payment of investment agreements issued by XL Asset Funding Company I LLC (“XLAF”), a wholly-owned subsidiary of XL Capital. These investment agreements contained ratings triggers based on the rating of Syncora Guarantee, which were triggered upon Syncora Guarantee’s ratings downgrades by Moody’s, S&P and Fitch. As a result, XLAF repaid these investment agreements prior to June 30, 2008. As of December 31, 2008 and 2007, the aggregate face amount of such investment agreements guaranteed by Syncora Guarantee was zero and $4.0 billion, respectively. Notwithstanding the repayment of all outstanding investment agreements, XLAF remains obligated to Syncora Guarantee to indemnify it for certain losses, costs and expenses.
In addition, the Company insures XLAF’s obligations under certain derivative contracts issued and purchased by XLAF. As of December 31, 2008 and 2007, the total notional value of such contracts insured was $150.0 million and $162.9 million, respectively.
The following table summarizes the affiliated components of each line item in the consolidated balance sheets where applicable:
Premiums earned for the years ended December 31, 2008, 2007, and 2006 include $130.6 million, $14.7 million and $27.4 million, respectively, related to refunded and called bonds and other accelerations.
Accelerated amortization of deferred acquisition costs due to Refundings was $8.3 million, $2.7 million and $2.2 million for the years ended December 31, 2008, 2007 and 2006, respectively.
revolving credit loans thereunder not to exceed $500 million. Pursuant to the Credit Agreement Amendment, Syncora Holdings agreed (i) to permanently reduce the availability under its revolving credit facility from $250 million to zero, (ii) to reduce the availability under the letter of credit facility to the amount of the letter of credit exposure as of July 28, 2008 and, subsequently, further reduce such exposure for any outstanding letters of credit for FSA’s benefit upon the closing the Commutation Agreement, and (iii) collateralize the remaining letters of credit after the consummation of the transactions comprising the 2008 Master Transaction Agreement. See Note 4 for further information regarding the Credit Agreement Amendment.
As of December 31, 2008 and 2007, the Company’s net outstanding par exposure under its in-force financial guarantee insurance and reinsurance policies and contracts aggregated to $133.7 billion and $165.0 billion, respectively, including the Company’s notional exposure under CDS contracts aggregating to $56.2 billion and $59.6 billion, respectively.
The following tables present certain information with respect to the par amounts insured and notional amounts guaranteed by the Company at December 31, 2008 and 2007, before and after reinsurance (or on a “gross” and “net” basis, respectively):
The par amounts insured as of December 31, 2008 and 2007 and the terms of maturity are as follows:
Includes policies in all segments: U.S. Public Finance, U.S. Structured Finance and International Finance.
In addition, the Company seeks to maintain a diversified portfolio of guaranteed obligations designed to spread its risk across a number of geographic areas. Set forth below is the distribution of the Company’s par and notional exposures by geographic location as of December 31, 2008 and 2007:
Set forth below is the Company’s par exposure from the issuance of financial guarantee insurance policies and its notional exposure from the issuance of CDS contracts as of December 31, 2008 and 2007:
During 2008, the Company recorded a provision for losses before reinsurance of approximately $1,850.6 million ($1,789.8 million after reinsurance) relating to its exposure to guarantees of obligations supported by residential mortgages due to unprecedented credit-market events. See Note 16.
The Company is exposed to residential mortgages directly, through its guarantees of RMBS and indirectly, through its guarantees of ABS CDOs.
Ratings represent the lower of S&P or the Company’s internal rating by deal as of February 25, 2009.
The following table presents the net notional exposure of the referenced assets underlying the Company’s CDO of ABS portfolio by rating as of December 31, 2008:
The Company’s liability for losses and loss adjustment expenses consists of case basis reserves and unallocated reserves. The provision for losses and loss adjustment expenses represents the expense recorded to establish the total reserve (case basis and unallocated reserves) at a level determined by management to be adequate for losses inherent in the financial guarantee portfolio as of the reporting date. Activity in the liability for losses and loss adjustment expenses is summarized as follows:
Set forth below is a discussion of certain case basis reserves established by the Company during the years ended December 31, 2008, 2007, and 2006.
The cash flow model projects expected cash flows from the underlying mortgage notes. The model output is dependent on, and sensitive to, key input assumptions, including assumptions regarding default rates, draw rates, recoveries and prepayment rates. The cash flow from the mortgages is then run through the “waterfall” as set forth in the indenture for each transaction. Claims in respect of principal result when the outstanding principal balance of the mortgages is less than the outstanding principal balance of the insured notes. Recoveries result when cash flow from the mortgages is available for repayment, typically after the insured notes are paid off in full.
remain depressed for longer than expected, the plateau of peak CDR could be longer than modeled. If the plateau were one-quarter longer it would result in an increase in expected unpaid loss of $123 million. If the plateau were one-year longer the expected loss would increase by $410 million.
that it may be required to pay claims relating to the warrants over the remainder of calendar year 2009 of approximately $138.0 million. The actual amount of claims the Company may be required to pay in the future may differ from such estimates and the differences could be material.
See Note 18 for information regarding litigation related to the Company’s insurance of the warrants.
As of December 31, 2008 and 2007, the Company carried a reserve for unpaid losses and loss adjustment expenses of $41.3 million and $8.7 million after giving effect to reinsurance, respectively, ($41.3 million and $74.0 million, respectively, before giving effect to reinsurance, which was all provided by affiliates of XL Capital), representing the net present value loss expected to be incurred in the future with respect to an insured project financing. Such reserves were based on assumptions and estimates extending over many years into the future. There is currently no payment default with respect to this transaction. Management continues to monitor the exposure and will revise its loss estimate if necessary, as new information becomes available.
In December 2005, certain notes that were insured by the Company and collateralized by loans to medical providers (the “Insured Notes”) defaulted upon their maturity. In satisfaction of the resulting claim, the Company purchased the Insured Notes for $20.2 million, which represented the remaining outstanding principal and accrued interest on the Insured Notes. The Insured Notes were recorded as an investment at their estimated fair value of $19.5 million at the date of acquisition. The difference between the estimated fair value of the Insured Notes at the date they were acquired and the consideration paid to acquire the notes was recorded as a paid loss of $0.7 million. The estimate of fair value of the Insured Notes was based on the Company’s estimate of the fair value of the underlying
collateral. During 2006, the Company recognized an impairment charge of $15.1 million relating to the Insured Notes and the balance of the Insured Notes was paid down. In addition, during 2006 the Company recorded a charge for $5.0 million relating to other exposures under this transaction. With respect to the aforementioned charges, the Company was indemnified for $6.1 million by XLA pursuant to an indemnification discussed above and in Note 10.
During 2007, the Company recorded a provision for loss of $9.5 million representing the net present value of claims expected to be incurred with respect to two related reinsured international transportation project financings. Because this loss represented a full limit loss, the remaining deferred premium revenue pertaining to the transactions, which aggregated approximately $5.5 million, was fully earned resulting in a net loss of approximately $4.0 million.
While material case basis reserves were established by the Company during the fourth quarter of 2007 and during the year ended December 31, 2008, these reserves were concentrated in certain sectors of its financial guarantee portfolio and were associated with unprecedented credit-market events. As such, these events did not alter management’s estimate of the UELR associated with the remainder of the portfolio and, accordingly, the required level of unallocated reserves. For the years ended December 31, 2008, 2007 and 2006, the Company recorded a net provision for unallocated reserves of $4.2 million, $17.5 million and $14.3 million, respectively. The reduction in the
The Company’s surveillance department is responsible for monitoring the performance of its in-force portfolio. The surveillance department maintains a list of credits that it has determined need to be closely monitored and, for certain of those credits, the department undertakes remediation activities it determines to be appropriate in order to mitigate the likelihood and/or amount of any loss that it could incur with respect to such credits.
The Company’s surveillance department focuses its review on monitoring the lower rated bond sectors and potentially troubled sectors, which have included RMBS, CMBS, CDOs and CLOs. It tracks performance monthly to try to ensure that covenants have not been breached. If a covenant is breached, the Company may have the right to put the transaction into rapid amortization so that all cash flow generated from that transaction is used to pay down principal and stay current with interest. Typically, the surveillance department reviews periodic servicing and trustee reports to track coverage levels, enhancement levels, delinquency levels, loss frequency, loss severity and total losses and compares such performance metrics with the metrics that were made available at the time the transaction was closed. If losses are above projections, the surveillance department will analyze the reasons for the deviation. In some cases, it may be an indication of servicing problems, where loans are delinquent and are not put into foreclosure in time to maximize recovery. Typically, once per year, the surveillance department will review servicers of loans and other assets supporting the Company’s insured obligations to better understand their servicing practices and to identify potential servicing problems, if any. The Company believes that this is an important safeguard, as servicers are required to indemnify the Company against failure to adhere to the servicing standards set forth in the servicing agreements.
Syncora Holdings is not subject to any taxes in Bermuda on either income or capital gains under current Bermuda law. In the event that there is a change such that these taxes are imposed, Syncora Holdings would be exempted from any such tax until March 2016 pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966, and Amended Act of 1987.
Section 382 of the Internal Revenue Code (“Section 382”) contains rules that limit the ability of a corporation that experiences an “ownership change” to utilize its net operating loss carryforwards (“NOLs”) and certain built-in losses recognized in periods following the ownership change. An ownership change is generally any change in ownership of more than 50 percentage points of a corporation’s stock over a 3-year period. These rules generally operate by focusing on ownership changes among stockholders owning directly or indirectly 5% or more of the stock of a corporation or any change in ownership arising from a new issuance of stock by the corporation.
On August 5, 2008, the Company experienced an ownership change for purposes of Section 382. As a result of this ownership change, the Company’s ability to utilize NOLs and certain built-in losses existing as of August 5, 2008 will be subject to an annual limitation in the future. This limitation is generally determined by multiplying the value of the Company as of the ownership change date by the applicable long-term tax-exempt rate.
Tax years 2005 through 2008 are subject to examination by federal authorities. There are no federal, state or local tax audits underway for the Company as of December 31, 2008.
In the ordinary course of business, the Company is subject to litigation or other legal proceedings. It is the opinion of management, after consultation with legal counsel and based upon the information available, that the expected outcome of any outstanding litigation, individually or in the aggregate, will not have a material adverse effect on the Company’s financial position, results of operations or liquidity. The Company intends to vigorously defend itself against all such actions.
claims that defendants’ public statements, including the registration statement and prospectus related to the secondary offering, contained false and misleading statements and omitted to disclose material facts necessary to make the statements contained therein not misleading, in violation of the Securities Act of 1933, as amended (the “Securities Act”) and the Exchange Act. The complaint seeks unspecified damages and other relief. Syncora Holdings filed a motion to dismiss on behalf of itself and the individual defendants.
In July 2008 through January 2009, lawsuits were filed by a number of California municipal entities in California state court against several bond insurers, including Syncora Guarantee, and two individual defendants. The complaints include allegations that defendants failed to fully disclose their investments in subprime mortgage-backed securities and insurance of subprime instruments and that the defendants conspired to perpetuate and maintain a dual system of bond rating in violation of California State antitrust laws and California State common law. The complaints seek unspecified damages and other relief.
On June 17, 2008, Charles Wilson, on behalf of himself and a class consisting of every Jefferson County, Alabama taxpayer and sewer ratepayer since January 1, 1993, filed suit against Syncora Guarantee and numerous other defendants. The suit alleges that through the wrongful conduct of the members of the Jefferson County Commission, most notably Larry Langford, the County incurred a bonded indebtedness of approximately $3.2 billion relating to improvements to its sewer system. The complaint alleges that the commissioners, in a conspiracy with several individuals, financial companies, law firms, and bond insurers, completed several swap transactions whereby the bonds, which were primarily fixed interest securities, were swapped to variable rate and auction rate securities. These swaps, the complaint alleges, were done primarily to facilitate the inappropriate payment of exorbitant fees to several bond brokers and financial advisors. With respect to the bond insurers, including Syncora Guarantee, the complaint alleges that the insurers negligently insured the bonds while allowing themselves to become undercapitalized and downgraded by the rating services, which in turn downgraded the bonds. The plaintiffs allege damages on the ground that their sewer rates are much higher than they otherwise would have been without the wrongdoing of all parties. We have filed a motion to dismiss which is currently pending before the court. Plaintiffs have also voluntarily dismissed Jefferson County taxpayers as members of the putative class, leaving only the sewer system ratepayers. Several of the defendants have filed motion seeking recusal of the Judge based on his daughter being a Jefferson County ratepayer, and thus a member of the putative class of plaintiffs.
The Company’s lease commitments are primarily comprised of its office premise leases at 1221 Avenue of the Americas, New York, New York, 25 Copthall Ave-London, Merritt 7 Corporate Park, Norwalk, Connecticut and office space lease commitments with respect to 250 Park Avenue, New York, New York and 595 Market Street, San Francisco, California. In addition, the Company is liable under an information technology outsourcing agreement that it entered into with International Business Machines Corporation (“IBM”) on October 1, 2006. Pursuant to the agreement IBM will: (i) provide the Company with all its information technology hardware, (ii) provide all support services to maintain such hardware and provide for efficient disaster recovery, (iii) develop a transition plan for the Company’s systems from its existing hardware to new hardware, and (iv) maintain the Company’s technology at a level that allows the Company to take advantage of technological advances. In consideration for these services the Company is obligated to pay IBM approximately $4.0 million per annum for the five year term of the contract. The Company incurred expenses of $5.3 million, $4.6 million and $0 under this agreement for the years ended December 31, 2008, 2007 and 2006, respectively.
The table below presents the Company’s minimum lease payment obligations under the aforementioned lease commitments and outsourcing agreement, as well as estimated sub-lease income from the sub-lease of space at the aforementioned locations.
Net rent expense was $9.5 million, $9.3 million and $6.2 million for the years ended December 31, 2008, 2007, and 2006, respectively.
Losses and loss adjustment expenses, net of reinsurance balances recoverable: The carrying value is assumed to be fair value, because the provision is established for non-specific expected levels of losses resulting from credit failures.
Installment premiums: The fair value of installment premiums is estimated based on the present value of the future contractual premium revenues, net of reinsurance, that would be paid under a reinsurance agreement with a third party to transfer the Company’s financial guarantee risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract. The fair value is derived by calculating the present value of the estimated future cash flow stream (net premium and ceding commissions) discounted at 7.0% at December 31, 2008 and 2007.
Includes $129.6 million which is netted against certain of the Company’s case basis reserves for losses and loss adjustment expenses at December 31, 2008. See Note 16.
The ability of Syncora Guarantee to declare and pay Syncora Holdings a dividend is governed by the Insurance Law of the State of New York (the “Insurance Law”). Under the Insurance Law, Syncora Guarantee is permitted to pay dividends each calendar year, without the prior approval of the New York Superintendent in an amount equal to the lesser of ten percent of its policyholders’ surplus as of the end of the preceding calendar year or its net investment income for the preceding calendar year, as determined in accordance with Statutory Accounting Practices prescribed or permitted by the NYID. The Insurance Law also provides that Syncora Guarantee may distribute dividends to its shareholders in excess of the aforementioned amount only upon giving notice of its intention to declare such dividend, and the amount thereof, to the New York Superintendent. Moreover, a New York- domiciled insurer may not declare or distribute any dividends except out of earned surplus. The New York Superintendent may disapprove such distribution if he finds that the financial condition of Syncora Guarantee does not warrant such distribution.
In connection with the 2008 MTA discussed in Note 4, Syncora Guarantee entered into an undertaking with the NYID pursuant to which it agreed not to make any dividends or distributions without the NYID’s express written consent until November 18, 2010 (two years after the shares of Syncora Holdings were placed into trust for the benefit of the Company and the Counterparties).
Among other requirements, Article 69 of the Insurance Law provides that financial guarantee insurance companies maintain minimum policyholders’ surplus of $65 million. As of December 31, 2008, Syncora Guarantee reported a policyholders’ deficit of $2.4 billion and, accordingly, was not in compliance with its minimum policyholders’ surplus requirement. As discussed in Note 2, failure to maintain positive statutory policyholders’ surplus or non-compliance with the statutory minimum policyholders’ surplus requirement permits the NYID to intervene in Syncora Guarantee’s operations. For example, under these or certain other circumstances, the New York Superintendent could seek court appointment as rehabilitator or liquidator of Syncora Guarantee.
For the years ended December 31, 2008 and 2007, Syncora Guarantee reported, in accordance with accounting practices prescribed or permitted by the NYID (see Note 2), net loss of $4.8 billion and $522.3 million, respectively, and a policyholders’ deficit of $2.4 billion as of December 31, 2008, as compared to a policyholders’ surplus of $138.9 million at December 31, 2007.
Set forth below is a description of the Company’s long-term incentive plan and the awards made under the plans:
The Plan is administered by the Compensation Committee or such other Board committee (or the entire Board) as may be designated by the Board, which the Company refers to as the “Committee.” The Committee will determine which eligible employees, consultants and directors receive Awards, the types of Awards to be received and the terms and conditions thereof. However, the exercise price of options and SARs will not be less than the fair market value of the shares on the date of grant, and the term will not be longer than ten years from the date of grant. In light of the developments discussed in Notes 2, 3, and 4, the Company, in 2008, substantially curtailed the issuance of awards under the Plan.
In the event of a change in control (as defined in the Plan), all awards granted under the Plan then outstanding but not then exercisable (or subject to restrictions) shall become immediately exercisable, all restrictions shall lapse, and any performance criteria shall be deemed satisfied, unless otherwise provided in the applicable Award agreement. A change of control occurred in connection with the transfer of XL Capital’s common shares of Syncora Holdings as described in Note 4.
An aggregate of 3,848,182 common shares has been reserved for issuance under the Plan, subject to anti-dilution adjustments in the event of certain changes in the Company’s capital structure. Shares issued pursuant to the Plan will be either authorized but unissued shares or treasury shares. Pursuant to the Amended and Restated 2006 Long Term Incentive and Share Award Plan approved by shareholders in May 2007, the aggregate number of common shares reserved for issuance under the Plan was increased by 2,750,000 shares. The Awards vest as set forth in the applicable Award agreements, and the requisite service period is equivalent to the vesting period. Awards under the Plan contain certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability.
directors. The stock options awarded under the Plan in 2006 had a weighted average grant-date fair value of $6.06 and the restricted stock had a weighted average grant-date fair value of $20.50. During the year ended December 31, 2006, the Company recognized approximately $0.7 million of compensation expense, net of tax, related to its stock option Awards.
The fair value of each option Award is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for the years ended December 31, 2008 and 2007:
The following is a summary of stock options as of December 31, 2008, and related activity for the year then ended:
The following is a summary of restricted stock awards as of December 31, 2008, and related activity for year then ended:
For the years ended December 31, 2008 and 2007, the Company recognized approximately $9.0 million and $6.2 million of compensation expense related to its restricted stock awards, respectively.
To reduce long-term operating costs and align resources with its current needs (see Note 2), effective March 31, 2008 the Company reduced its workforce by approximately 60 positions, which consisted primarily of insurance business origination staff. Subsequently, the Company made certain further reductions in its workforce. As a result of these workforce reductions the Company recorded a charge of approximately $19.5 million during the year ended December 31, 2008.