MBIA Corp. owns the 273,417 square foot office building on approximately 38 acres of property in Armonk, New York, in which the Company, MBIA Corp. and MBIA Asset Management have their headquarters. MBIA Corp. also has offices with approximately 29,905 square feet of rental space in New York, New York; San Francisco, California; Paris, France; Madrid, Spain; Sydney, Australia; London, England; Milan, Italy; Tokyo, Japan; and Mexico City, Mexico. MBIA Asset Management has 7,607 square feet of office space in Denver, Colorado. The Company believes that these facilities are adequate and suitable for its current needs.
This annual report of MBIA Inc. (“MBIA” or the “Company”) includes statements that are not historical or current facts and are “forward-looking statements” made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “believe,” “anticipate,” “project,” “plan,” “expect,” “intend,” “will likely result,” “looking forward” or “will continue,” and similar expressions identify forward-looking statements. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. MBIA cautions readers not to place undue reliance on any such forward-looking statements, which speak only to their respective dates. The following are some of the factors that could affect financial performance or could cause actual results to differ materially from estimates contained in or underlying the Company’s forward-looking statements:
the possibility that we will not be able to raise sufficient capital to avoid a downgrade of our financial strength ratings;
In December 2006, MBIA completed the sale of Capital Asset Holdings GP, Inc. and certain affiliated entities (“Capital Asset”), a servicer of delinquent tax liens, to a third party company that is engaged in tax lien servicing and collection and that had been overseeing the servicing operations of Capital Asset since July 2006. The sale of Capital Asset also included three variable interest entities (“VIEs”) established in connection with MBIA-insured securitizations of Capital Asset tax liens, which were consolidated within the Company’s insurance operations in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 46(R), “Consolidation of Variable Interest Entities (Revised).”
On December 19, 2007, S&P released ratings announcements concerning a number of financial guarantee insurers, including MBIA Corp., resulting from worsening expectations for the performance of insured subprime RMBS and CDOs of asset-backed securities. S&P affirmed MBIA Corp.’s insurance financial strength rating at “AAA” but changed its outlook for MBIA Corp. to “negative” from “stable”, while confirming the outlook of two of MBIA Corp.’s competitors as “stable.” S&P indicated in its announcement that its “research has led S&P to the conclusion that the potential for further mortgage market deterioration remains uncertain and will challenge the ability of the insurers to accurately gauge their ongoing additional capital needs in the near term. As a result, S&P is effectively adopting a negative outlook for those firms with significant exposure to domestic subprime mortgages and/or meaningful lower credit quality exposures. The assignment of a negative outlook also reflects Standard & Poor’s assessment with regard to the strength of a company’s capital position when weighted against projected stress case losses as well as the comprehensiveness and degree of completion of projected capitalization strengthening efforts underway.”
On January 17, 2008, S&P released updated results to its Bond Insurance Stress Test for financial guarantors in light of its revised assumptions for subprime-related exposures. In its report, S&P concluded that the increased stress losses resulting from the revised
assumptions was not significant for MBIA in the context of its capital position and intended capital plan. As such, MBIA Corp.’s ratings and outlook, as well as those of all other financial guarantee companies, remained unchanged from their previous position announced by S&P on December 19, 2007.
On January 30, 2008, S&P announced that it placed on CreditWatch with negative implications or downgraded its ratings on 6,389 classes from U.S. RMBS transactions backed by U.S. first-lien subprime mortgage collateral rated between January 2006 and June 2007. At the same time, S&P placed on CreditWatch negative 1,953 ratings from 572 global CDO of asset-backed securities (“ABS”) and CDO of CDO transactions. The rating actions were primarily driven by S&P’s revised surveillance assumptions for subprime RMBS and their related impact on ABS CDOs and CDOs of CDOs, which had been announced on January 15, 2008.
On January 31, 2008, S&P placed the “AAA” insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the “AA-” rating of MBIA Inc.’s senior debt and the “AA” ratings of MBIA Corp.’s North Castle Custodial Trusts I-VIII on CreditWatch with negative implications. This rating action by S&P was the result of S&P’s most recent review of MBIA’s capital plan. S&P stated in its announcement regarding the change that “Although MBIA succeeded in accessing $1.5 billion of additional capital, the magnitude of projected losses underscores our view that time is of the essence in the completion of capital-raising efforts.”
On February 25, 2008, S&P affirmed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the “AA-” rating of MBIA Inc.’s senior debt and the “AA” ratings of MBIA Corp.’s North Castle Custodial Trusts I-VIII, with a negative outlook. S&P stated in its announcement regarding the change that “MBIA’s success in accessing $2.6 billion of additional claims-paying resources is a strong statement of management’s ability to address the concerns relating to the capital adequacy of the Company.”
On December 5, 2007, Moody’s published a comment intended to update the market about Moody’s analytic work as well as to offer additional details about the methods and process underlying their assessment of the continuing deterioration in the RMBS market on their ratings of financial guarantee insurers, including MBIA Corp. In its comment, Moody’s indicated three factors that would largely determine whether Moody’s takes rating actions on those financial guarantee insurers most exposed to deterioration in the mortgage markets: (1) current capital adequacy-whether the guarantor meets Moody’s capital adequacy benchmarks for its rating: (2) prospective capital adequacy-whether the guarantor will meet Moody’s capital adequacy benchmark in the near and medium term, and (3) strength of the franchise and business model-whether the guarantor will be able to access, going forward, attractive business opportunities consistent with its rating level. Moody’s further indicated that, based on additional analysis of MBIA Corp.’s RMBS portfolio, Moody’s believed that MBIA Corp. was somewhat likely to exhibit a capital shortfall.
On January 17, 2008, Moody’s placed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the Aa2 ratings of MBIA Corp.’s $1.0 billion of 14% fixed-to-floating rate surplus notes (“Surplus Notes”) issued on January 16, 2008, and the Aa3 ratings of the junior obligations of MBIA Corp. and the senior debt of MBIA Inc. on review for possible downgrade. Moody’s stated in its announcement that “the rating action reflects Moody’s growing concern about the potential volatility in ultimate performance of mortgage and mortgage-related CDO risks, and the corresponding implications for MBIA’s risk-adjusted capital adequacy.”
Due to the continued deterioration in the performance of U.S. subprime mortgages, on February 1, 2008, Fitch announced that it placed on rating watch negative approximately $139 billion of 2,972 rated classes of 2006 and 2007 subprime RMBS. Fitch also increased its loss expectations for U.S. subprime RMBS backed predominantly by first-lien mortgages originated in 2006 and the first half of 2007, with average cumulative loss expectations as a percentage of the initial securitized balance of 21% and 26%, respectively.
To enable the Company to maintain appropriate claims-paying resources in order to sustain the triple-A financial strength ratings assigned to MBIA Corp., a comprehensive capital strengthening plan was announced on January 9, 2008. See “Capital Resources-Capital Strengthening Plan” for additional information. We believe that the Company’s consolidated capital resources, inclusive of the capital strengthening actions taken through February 2008, are adequate to support our ongoing businesses, fund our growth and meet the rating agencies’ requirements for the triple-A claims-paying ratings of MBIA Corp. If required and subject to market conditions, we believe that MBIA could raise additional capital and/or take measures to preserve capital necessary to maintain its triple-A ratings. The triple-A ratings are important to the operation of the Company’s business and any reduction in these ratings could have a material adverse effect on MBIA Corp.’s ability to compete and could also have a material adverse effect on the business, operations and financial results of the Company.
The Company’s financial guarantee insurance provides an unconditional and irrevocable guarantee of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that the Company has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon such acceleration by the Company. Loss and loss adjustment expense (“LAE”) reserves are established by the Company’s Loss Reserve Committee, which consists of members of senior management, and require the use of judgment and estimates with respect to the occurrence, timing and amount of a loss on an insured obligation.
Each quarter the Company calculates its provision for the unallocated loss reserve as a fixed percent of scheduled net earned premium of the insurance operations. Annually, the Loss Reserve Committee evaluates the appropriateness of this fixed percent loss factor. In performing this evaluation, the Loss Reserve Committee considers the composition of the Company’s insured portfolio by municipal sector, structured asset class, remaining maturity and credit quality, along with the latest industry data, including historical default and recovery experience for the relevant sectors of the fixed-income market. In addition, the Company considers its own historical loss activity and how those losses develop over time. The Loss Reserve Committee reviews the results of its annual evaluation over a period of several years to determine whether any long-term trends are developing that indicates the loss factor should be increased or decreased. Therefore, case basis reserves established in any year may be above or below the loss factor without requiring an increase or decrease to the loss factor. However, if a catastrophic or unusually large loss occurred in a single year, the Loss Reserve Committee would consider taking an immediate charge through “Losses and loss adjustment expenses” and possibly also increase the loss factor in order to maintain an adequate level of loss reserves.
During the years ended December 31, 2007, 2006 and 2005, the Company’s loss and LAE provision for the unallocated loss reserve, based on a loss factor of 12%, was $86 million, $81 million and $84 million, respectively. The provisions recorded for each year represent loss and loss adjustment expenses as reported on the Company’s income statement. However, as a result of the continued stress in the mortgage markets and an increase in defaults on mortgage-backed securities, specific case basis reserve increases for the year ended December 31, 2007 significantly exceeded the 12% loss factor currently used by the Company. In the fourth quarter of 2007, the Company recorded $614 million of loss and LAE, in addition to the provision based on its loss factor, related to MBIA’s insured exposure to prime, second-lien RMBS transactions consisting of home equity lines of credit and closed-end second-lien mortgages. Additionally, in the fourth quarter of 2007, the Company recorded $200 million of loss and LAE to increase its unallocated loss reserve for probable losses on its RMBS exposure that have not been specifically identified to individual policies as of December 31, 2007. Therefore, loss and LAE for 2007 totaled $900 million. For the year ended December 31, 2006, the Company’s additions to specific case basis reserves were less than the 12% loss factor. However, additions to specific case basis reserves in the year ended December 31, 2005 exceeded the 12% loss factor. With the exception of the additional loss and LAE recorded in 2007, the
Company has calculated its provision for the unallocated loss reserve as 12% of scheduled net earned premium of its insurance operations since 2002. MBIA continually monitors its insured portfolio and actual loss experience in order to identify trends that would indicate a reasonably likely significant change to one or more of the variables on which the loss factor is based. If MBIA determines that any changes to one or more of these variables is likely to have an impact on the level of probable losses in its insured portfolio, the Company will increase or decrease its loss factor accordingly, which will result in an increase or decrease in its loss and loss adjustment expenses.
The Company establishes specific reserves in an amount equal to the Company’s estimate of identified or case basis reserves with respect to specific policies. A number of variables are taken into account in establishing specific case basis reserves for individual policies that depend primarily on the nature of the underlying insured obligation. These variables include the nature and creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured and the expected recovery rates on the insured obligation, the projected cash flow or market value of any assets that support the insured obligation and the historical and projected loss rates on such assets. Factors that may affect the actual ultimate realized losses for any policy include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral.
As of December 31, 2007, the Company’s total net loss reserves of $1.3 billion represent 0.13% of its outstanding net debt service insured of $1,022 billion. We believe that these reserves are adequate to cover ultimate net losses. Given that the reserves are based on estimates, there can be no assurance that the ultimate liability will not exceed such estimates resulting in the Company recognizing additional loss and loss adjustment expense in earnings. While the underlying principles applied to loss reserving are consistent across the financial guarantee industry, differences exist with regard to the methodology and measurement of loss reserves. Alternative methods may produce different estimates than the method used by the Company. Additionally, the accounting for non-derivative financial guarantee loss reserves is possibly subject to change. See “Note 2: Significant Accounting Policies” in the Notes to Consolidated Financial Statements for a description of the Company’s loss and loss adjustment expense accounting policy.
The fair market values of financial instruments held or issued by the Company are determined through the use of observable market data when available. Market data is retrieved from a variety of third-party data sources, including direct dealer quotes, for input into the Company’s valuation systems. Valuation systems are determined based on the characteristics of transactions and the availability of market data. The fair values of financial assets and liabilities are primarily calculated using prices from an independent pricing service, which uses observable market-based inputs when available, direct dealer quotes or market data relevant to individual financial instruments. However, dealer market data may not be available for certain types of contracts that are infrequently purchased and sold. For these contracts, the Company may use alternate methods for determining fair values, such as dealer market quotes for similar contracts or cash flow modeling. Alternate valuation methods generally require management to exercise considerable judgment in the use of estimates and assumptions, and changes to certain factors may produce materially different values. In addition, actual market exchanges may occur at materially different amounts.
MBIA regularly monitors its investments in which fair value is less than amortized cost in order to assess whether such a decline in value is other than temporary and, therefore, should be reflected as a realized loss in net income. Such an assessment requires the Company to determine the cause of the decline and whether the Company possesses both the ability and intent to hold the investment to maturity or until the value recovers to an amount at least equal to amortized cost. Additionally, this assessment requires
Through MBIA Corp. we issue insurance policies insuring payments due on derivative instruments and through the Company and other non-insurance subsidiaries we directly enter into derivative instruments for purposes of hedging risks associated with our assets and liabilities. We account for derivative instruments in accordance with SFAS 133, which requires that all such contracts be recorded on our balance sheet at fair value. The fair value of derivative instruments is determined as the amount that would be exchanged in a current transaction between willing parties. Changes in the fair value of derivative instruments are recorded each period in current earnings within “Net gains (losses) on financial instruments at fair value and foreign exchange” or in shareholders’ equity within “Accumulated other comprehensive income (loss),” depending on whether the derivative is designated as a hedge, and if so designated, the type of hedge. All of our derivative contracts are transacted as over-the-counter (“OTC”) derivatives.
Through MBIA Corp., we regularly insure derivative instruments as part of our core financial guarantee business, which represent the majority of the Company’s notional derivative exposure. In most cases these derivative instruments do not qualify for the financial guarantee scope exception under SFAS 133 and, therefore, must be stated at fair value. In February 2008, we decided not to insure credit derivative instruments except in transactions related to the reduction of our existing insured derivative exposure. Prior to this decision, we insured credit derivatives that referenced primarily structured pools of cash securities and credit default swaps (“CDS”). We generally provided credit default swap protection on the most senior liabilities of structured finance transactions, and at inception of the contract our exposure generally had more subordination than needed to achieve triple-A ratings from credit rating agencies (referred to as “Super Triple-A” exposure). The collateral for the insured derivatives were cash securities and credit default swaps referencing primarily corporate, asset-backed, residential mortgage-backed, commercial mortgage-backed and collateralized debt obligation securities.
(iii) payments upon settlement of individual collateral losses as they occur upon erosion of deal deductibles.
Our insured CDS valuation model simulates what a bond insurer would charge to guarantee the transactions on the measurement date, based on the market-implied default risk of the underlying collateral and the subordination. Implicit in this approach is the notion that bond insurers would be willing to accept these contracts from us at a price equal to what they could issue them for in the current market. The majority of our transactions are valued using a probabilistic approach to price the risk associated with our exposure on the credit derivative contract. We apply a Binomial Expansion Technique (“BET”) based model to the transaction structures to derive a probabilistic measure of expected loss for our exposure using market pricing on the underlying collateral within the transaction. At any point in time, the mark-to-market gain or loss on a transaction is the difference between the original price of risk (the original market-implied expected loss) and the current price of the risk.
This approach is used to value almost all of the credit default swaps on tranched portfolios of credits (“portfolio CDS”) or on senior tranches of collateralized debt obligations (“CDOs”) of the insured portfolio. There are various inputs and assumptions that are key within this approach and these are listed below.
Defaults are modeled such that they are spaced evenly over time
The main modifications we have made to the BET developed by Moody’s are that a) we use market credit spreads to determine default probability instead of using historical loss experience, and b) for collateral pools where the spread distribution is characterized by extremes we model each segment of the pool individually instead of using an overall pool average.
The specific model inputs are listed below, including how we derive inputs for market credit spreads on the underlying transaction collateral, how we determine credit quality (using a Weighted Average Rating Factor), correlation/diversity estimation, and recovery rates.
1. Actual collateral specific credit spreads (if up-to-date and reliable market based spreads are available, they are used)
The process is a monthly update for the percentage of each type of collateral in each deal based on the most up-to-date reporting received from the respective trustees. Using the most recent monthly applicable market spread data based on the hierarchy above, we then calculate a weighted average spread to be used in the valuation process (i.e., the spread for each component of collateral is weighted by its percentage of total collateral to calculate the weighted average spread).
Diversity Scores - The diversity of industry or asset class is calculated internally, if not reported by the trustee on a regular basis. A lower diversity score will negatively impact the valuation for our senior tranche since a low diversity score represents higher assumed correlation, increasing the chances of a large number of defaults, and thereby increasing the risk of loss in the senior tranche.
Recovery Rate - Represents the percentage of par to be recovered from asset defaults. Our recovery rate assumptions are based on historical averages. We use rating agency data and adjust the reported recovery rates to take account of specific collateral in the insured derivative.
In the fourth quarter of 2007, we refined our approach to take account of trustee provided asset backed spreads that had widened to extremely high levels. In these limited situations, instead of using market spreads, MBIA assumed that all such collateral defaulted.
The Company performed its annual impairment testing of goodwill as of January 1, 2007 and January 1, 2008. On both dates, the fair values of the reporting segments exceeded their carrying values indicating that goodwill was not impaired. Alternate valuation methods would have likely produced different fair values. However, the Company believes that the valuation methods used provided the best estimates of fair value.
Deferred income taxes are recorded with respect to the temporary differences between the tax bases of assets and liabilities and the reported amounts in the Company’s financial statements that will result in deductible or taxable amounts in future years when the reported amounts of assets and liabilities are recovered or settled. Such temporary differences relate principally to premium revenue recognition, deferred acquisition costs, unrealized appreciation or depreciation of investments and derivatives, and MBIA Corp.’s statutory contingency reserve. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized. Determining whether to establish a valuation allowance and, if so, the amount of the valuation allowance requires management to exercise judgment and make assumptions regarding whether tax benefits will be realized in future periods.
As of December 31, 2007, MBIA recorded a net deferred tax asset of $1.2 billion, which principally comprised a $1.1 billion tax benefit related to losses on financial instruments at fair value and foreign exchange. The Company estimates that it is more likely than not the entire amount of such benefit will be realized in future periods and has not established a valuation allowance. If the Company was to establish a valuation allowance against its deferred tax asset, it would reduce its asset and increase its provision for income taxes in its statement of operations.
In 2006, consolidated revenues from continuing operations increased 18% to $2.7 billion from $2.3 billion in 2005. Growth in insurance revenues resulted from an increase in net investment income and net realized gains from investment securities. An increase in investment management services’ interest income resulting from growth in the asset/liability products segment was partially offset by a decrease in investment management services’ net gains on derivative instruments and foreign exchange. Consolidated expenses from continuing operations increased 23% to $1.6 billion in 2006 from $1.3 billion in 2005. This increase was principally due to an
increase in investment management services’ interest expense due to growth in the asset/liability products segment and insurance interest expense, both of which were commensurate with the increase in interest income. Offsetting the increase in consolidated expenses was a reduction in corporate expenses resulting from $75 million of estimated penalties and disgorgement recorded in the third quarter of 2005 in connection with the settlement of regulatory investigations of the Company. Net income for 2006 of $819 million was up 15% from $711 million for 2005. Net income per diluted share was $5.99 for 2006 compared with $5.18 per diluted share for 2005, a 16% increase. The slightly larger percent increase in net income per diluted share compared with net income resulted from an approximately 526,000 decrease in the average number of diluted shares outstanding as a result of share repurchases the Company made in the first half of 2005.
The Company’s book value at December 31, 2007 was $29.16 per share, down 45% from $53.43 per share at December 31, 2006. The decrease was principally driven by net losses from operations, an increase in treasury stock as a result of share repurchases by the Company, and unrealized losses recorded on the Company’s investment portfolio in 2007.
The following table presents the financial results of the insurance operations for 2007, 2006 and 2005. The results include revenues and expenses from transactions with the Company’s investment management services and corporate operations.
In 2007, total revenues from the Company’s insurance operations were a loss of $2.1 billion compared with income of $1.5 billion in 2006. The decrease in insurance operations’ revenues in 2007 compared with 2006 resulted from a $3.6 billion loss on financial instruments at fair value and foreign exchange, which was primarily the result of adverse changes in the fair value of the Company’s insurance credit derivative portfolio and a $85.7 million adjustment in the Company’s carrying value of its investment in Channel Re. The adjustment in the Company’s carrying value of its investment in Channel Re contributed to the loss on financial instruments at fair value and foreign exchange as a result of eliminations the Company was required to make under the equity method of accounting. These losses were partially offset by a $110 million mark-to-market gain on the Company’s CPCT facility. In addition, there was a decline in fees and reimbursements and net investment income in 2007 compared with 2006. Partially offsetting the impact of the decreases in insurance revenues were increases in net realized gains and premiums earned. Total insurance expenses increased 212% to $1.2 billion in 2007 from $379 million in 2006. The increase in insurance expenses was due to the $614 million of case basis reserves and $200 million of non-specific unallocated reserves related to MBIA’s prime, second-lien RMBS exposure. Partially offsetting the increase in losses and LAE was a decrease in operating expenses due to an increase in costs allocated from the insurance segment to other segments and a decline in loss prevention expenses. Gross operating expenses (expenses before ceding commission income and the deferral or amortization of acquisition costs) decreased 8% in 2007 compared with 2006 as a result of an increase in costs allocated to our investment management services and corporate operations and a decrease in loss prevention costs.
GPW reflects premiums received and accrued for in the period and does not include the present value of future cash receipts expected from installment premium policies originated during the period. GPW was $999 million in 2007, up 8% from 2006 due to increases in U.S. public finance and global structured finance business written, as discussed in the respective sections below.
In 2006, GPW decreased 9% compared with 2005, reflecting declines in U.S. public finance and global structured finance business written. NPW decreased 7% compared with 2005, resulting from the decline in GPW, slightly offset by a reduction in premiums ceded to reinsurers. Premiums ceded to reinsurers from all insurance operations for 2006 declined to 12% of GPW from 14% for 2005. Net premiums earned declined 1% in 2006 compared with 2005 due to a 5% decrease in scheduled premiums earned offset by a 15% increase in refunded premiums earned. The decrease in scheduled premiums earned resulted from declining business production since 2003 and the effects of heavy refunding activity over the same period.
MBIA evaluates the premium rates it charges for insurance guarantees through the use of internal and external rating agency quantitative models. These models assess the Company’s premium rates and return on capital results on a risk adjusted basis. In addition, market research data is used to evaluate pricing levels across the financial guarantee industry for comparable risks, when available. Since 2005, domestic municipal spreads contracted to tighter levels through mid-2007. Since mid-2007, in light of credit market volatility, we have also noticed spreads moving wider, in particular in the domestic municipal sectors. We expect that over time this may result in an increase in premium rates.
CREDIT QUALITY Financial guarantee insurance companies use a variety of approaches to assess the underlying credit risk profile of their insured portfolios. MBIA uses both an internally developed credit rating system as well as third-party rating sources in the analysis of credit quality measures of its insured portfolio. In evaluating credit risk, the Company obtains, when available, the underlying rating of the insured obligation before the benefit of its insurance policy from nationally recognized rating agencies (Moody’s, S&P and Fitch). All references to insured credit quality distributions contained herein reflect the underlying rating levels from these third-party sources. Other companies within the financial guarantee industry may report credit quality information based upon internal ratings that would not be comparable to MBIA’s presentation.
As of January 31, 2008, the credit quality distribution of MBIA’s net par insured did not materially change from December 31, 2007.
GLOBAL PUBLIC FINANCE MARKET MBIA’s premium writings and premium earnings in both the new issue and secondary global public finance markets are presented in the following table:
In 2006, global public finance GPW decreased 10% to $511 million from $569 million in 2005. This decrease was due to a decline in U.S. business written resulting from lower debt issuance, weak market conditions and strong competition. Partially offsetting this decline was an increase in non-U.S. business written primarily resulting from transportation and utility transactions in the Latin American and Australian markets. NPW decreased 7% in 2006 compared with 2005 as a result of the decrease in GPW, partially offset by a lower cession rate. The global public finance cession rate for business written during 2006 was 6% compared with 10% during 2005. The decrease in the overall cession rate was due to a decline in both U.S. and non-U.S. business ceded. Global public finance net premiums earned increased 2% to $504 million from $495 million in 2005. An 11% increase in refunded premiums earned was offset by a 2% decline in scheduled premiums earned. Refunded premiums earned increased as a result of the continued low interest rate environment in the U.S. and several international transactions that had significant unearned premium at the time of their refunding. Scheduled premiums earned were adversely affected by high refunding levels in 2006 and prior years.
While we fully expect to continue to insure transactions in the global public finance markets during 2008, we believe that global public finance business written by MBIA will be well below our 2007 levels. We also believe that the Company’s continued insurance activity in the first two months of 2008 validates the fundamental benefits that bond insurance provides to the municipal market despite the turbulence throughout the credit markets, the rating agencies’ recent rating actions and the publicity around these issues and around monoline financial guarantors in general.
Global structured finance GPW increased 12% in 2007 to $460 million from $410 million in 2006 as a result of increases in both U.S. and non-U.S. business written. The increase in U.S. business written was primarily from CMBS pools, investment-grade corporate CDO, multi-sector CDO and direct RMBS transactions. The increase in non-U.S. business written was primarily from investment-grade CDO transactions. NPW in 2007 increased 15% to $388 million from $336 million in 2006 due to the increase in GPW and a lower cession rate. The global structured finance cession rate for business written during 2007 was 16% compared with 18% for 2006. Global structured finance net premiums earned of $386 million in 2007 were 11% higher than 2006. As structured finance policies are typically collected on an installment basis, the increase in net premiums earned was commensurate with the increase in U.S. and non-U.S. NPW in 2007.
Global structured finance GPW decreased 9% in 2006 to $410 million compared with $449 million 2005, resulting primarily from a decrease in non-U.S. business written. In 2006, the global structured finance sector was adversely affected by increased competition, tight credit spreads and greater investor demand for uninsured transactions. NPW in 2006 decreased 8% compared with 2005 due to the decrease in GPW. The global structured finance cession rate for business written during 2006 was 18% compared with 19% for 2005. Global structured finance net premiums earned in 2006 of $349 million were 6% below 2005. The decrease in net premiums earned resulted from the decline in business written in 2006 and prepayments and maturities of business written in prior years.
On February 25, 2008, the Company announced that it has suspended the writing of all new structured finance business for approximately six months and has ceased insuring new credit derivative contracts except in transactions related to the reduction of existing derivative exposure. For the years ended December 31, 2007, 2006 and 2005, the Company’s net premiums written on insured credit derivative transactions were $117 million, $73 million and $74 million, respectively, and the Company’s net premiums earned on insured credit derivative transactions were $116 million, $80 million and $73 million, respectively. As a result, we expect that our structured finance business written during 2008 will be significantly less than 2007 levels.
-Includes investment income related to VIEs and Northwest Airlines’ EETCs and interest received on reimbursed expenses.
FEES AND REIMBURSEMENTS The Company collects fees for services performed in connection with certain transactions. In addition, the Company may be entitled to reimbursement of third-party expenses that it incurs in connection with certain transactions. Depending upon the type of fee received and whether it is related to an insurance policy, the fee is either earned when it is received or deferred and earned over the life of the related transaction. Work, waiver and consent, termination, administrative and management fees are earned when the related services are completed and the fee is received. Structuring fees and commitment fees are earned on a straight-line basis over the life of the related insurance policy. Expense reimbursements are earned when received.
In 2007, fees and reimbursements decreased 38% from 2006 to $21 million, primarily resulting from a decrease in expense reimbursements associated with loss prevention efforts. In 2006, fees and reimbursements increased 19% from 2005 to $33 million, primarily resulting from an increase in expense reimbursements associated with two remediated transactions. Due to the transaction-specific nature inherent in fees and reimbursements, these revenues can vary significantly from year to year.
NET REALIZED GAINS AND LOSSES Net realized gains in our insurance operations were $56 million in 2007 compared with net realized gains of $6 million in 2006 and net realized losses of $3 million in 2005. Net realized gains and losses are largely due to sales of investment securities. Net realized gains in 2007 included $32 million of gains related to the disposition of Delta and Northwest Airlines’ enhanced equipment trust certificates the Company received from insurance remediations. Net realized gains in 2006 included an $11 million gain related to the sale of the Company’s investment in RAM Holdings, Inc., the holding company of RAM Reinsurance Company Ltd. and a $25 million impairment loss recorded on a salvage receivable. In 2005, net realized losses were primarily due to $19 million of impairment losses on receivables the Company recorded through salvage and subrogation rights. Partially offsetting the impairment losses were net gains from sales of investment securities.
NET GAINS AND LOSSES ON FINANCIAL INSTRUMENTS AT FAIR VALUE AND FOREIGN EXCHANGE Net gains and losses on financial instruments at fair value and foreign exchange in our insurance operations primarily represents changes in the market value of the Company’s insured structured credit derivative portfolio, its CPCT facility and changes in the U.S. dollar value of non-U.S. dollar assets and liabilities. Gains and losses on structured credit derivatives are largely driven by movements in credit spreads and collateral ratings.
Net losses on financial instruments at fair value and foreign exchange were $3.6 billion in 2007 and primarily consisted of mark-to-market net losses of $3.7 billion on insured structured credit derivative contracts resulting from the widening of underlying reference obligation credit spread levels and changes in credit quality ratings of the underlying reference obligations. Of the $3.7 billion in mark-to-market net losses on insured structured credit derivative contracts in 2007, $200 million represents estimated credit impairment related to three CDO-squared transactions for which the Company expects to incur actual claims in the future. In the absence of further credit impairment, the cumulative marks should reverse over the remaining life of the insured credit derivatives. These credit derivative contracts have similar terms and conditions to the Company’s non-derivative insurance contracts and are evaluated for impairment under the same monitoring process. Additionally, the Company is not required to post collateral to counterparties of these contracts, thereby avoiding liquidity risks typical of standard credit derivative contracts. Included in the mark-to-market net losses on insured credit derivative contracts are mark-to-market losses relating to exposure ceded to Channel Re, which resulted in an adjustment to the carrying value of MBIA’s equity ownership interest in Channel Re from $85.7 million at September 30, 2007 to zero under the equity method of accounting. While MBIA’s carrying value of its investment in Channel Re reflects losses ceded to Channel Re by MBIA, the benefit of these cessions are eliminated in our statements of operations up to the amount of our ownership resulting in higher net losses on our insured credit derivative contracts. See the “Reinsurance” section included herein for additional information on Channel Re.
The following table estimates the attribution of the mark-to-market loss by sector:
The Company continues to monitor current market conditions including market spreads, credit quality ratings and subordination levels. In January and February 2008, the Company has observed a further widening of market spreads and credit quality ratings downgrades of certain tranches within MBIA’s insured CDOs. As a result of the further market spread widening and the deterioration of asset credit quality ratings, the Company could suffer additional mark-to-market losses in the first quarter of 2008 and in subsequent quarters, although the ultimate amount of such losses will depend on future market developments. In some cases, the downgrade of tranches subordinate to the tranche that the Company insures could trigger the diversion of cash to the insured tranche thereby shortening the tenor of the Company’s insured tranche and substantially reducing the Company’s exposure to actual claims and losses and reducing the related mark-to-market loss. For further information on the fair value of derivative instruments, see the preceding “Critical Accounting Estimates” section.
In 2007, in addition to the aforementioned mark-to-market losses on insured structured credit derivative contracts, the Company recorded a $110 million mark-to-market gain on its CPCT facility. This soft capital facility constitutes a financial instrument which
LOSSES AND LOSS ADJUSTMENT EXPENSES The following table presents the case-specific, reinsurance recoverable and unallocated components of the Company’s total loss and LAE reserves, as well as its loss provision and case basis activity, at December 31, 2007, 2006 and 2005.
The Company recorded $900 million in losses and LAE in 2007, an $819 million increase from 2006. In 2007, the Company recorded $86 million of losses and LAE based on the Company’s policy of applying a 12% loss factor to the insurance segment’s scheduled net premiums earned. In addition, in 2007 the Company recorded $814 million of losses and LAE representing $614 million of specific case basis reserves and $200 million of non-specific unallocated reserves related to MBIA’s prime, second-lien RMBS exposure. In 2006 and 2005, the Company recorded $81 million and $84 million in losses and LAE, respectively, based on the Company’s 12% loss factor reserving policy. At December 31, 2007, the Company had $435 million in unallocated loss reserves, which represent the Company’s estimate of losses associated with credit deterioration that has occurred in the Company’s insured portfolio and are available for future case-specific activity. See “Critical Accounting Estimates-Loss and Loss Adjustment Expenses” for a discussion of the Company’s loss reserving methodology.
Total case basis activity transferred from the Company’s unallocated loss reserve was $678 million in 2007, $75 million in 2006 and $189 million in 2005. During 2007, case basis activity primarily consisted of the aforementioned $614 million of case basis reserves related to the Company’s prime, second-lien RMBS exposure and loss reserves for insured obligations related to the Student Loan Finance Corporation (“SFC”) and a multi-sector CDO executed in the cash market, as well as insured obligations within the home equity loan (pre 2005 vintage) and manufactured housing sectors. Partially offsetting these loss reserves were reversals of previously established case basis reserves within the aircraft enhanced equipment trust certificates (“EETCs”) sector. During 2006, case basis activity primarily consisted of insured obligations within the CDO, equipment lease pools and home equity loan sectors, MBIA’s guaranteed tax lien portfolio and insured obligations issued by Allegheny Health, Education and Research Foundation (“AHERF”). Case basis activity related to AHERF was partially the result of a reduction in expected litigation recoveries from the AHERF bankruptcy estate. Partially offsetting this activity were reversals of previously established case basis reserves relating to the aircraft EETCs and manufactured housing sectors. During 2005, case basis activity primarily consisted of loss reserves for insured obligations within the EETCs, CDO and manufactured housing sectors and within MBIA’s guaranteed tax lien portfolios.
the claims that MBIA has paid to date under its insurance policies. As a result of the settlement, MBIA recorded a $20 million case basis loss in the first quarter of 2007. The loss represents a reduction to MBIA’s expected recoveries for claims it has paid to date under its policies. The approximately $362 million of outstanding par amount of the bonds insured by MBIA were repaid in full during the second quarter of 2007.
MBIA insures mortgage-backed securities backed by subprime mortgages directly through residential mortgage-backed securities securitizations and indirectly through CDOs, in which MBIA guarantees the triple-A rated portion of such transactions. Over the last two quarters, there has been growing stress in the subprime mortgage market, particularly related to mortgage loans originated during 2005, 2006, and 2007. As of December 31, 2007, the Company had $4.3 billion of net par outstanding from direct exposure to the subprime mortgage sector. While transactions guaranteed by MBIA include collateral consisting of mortgages originated during 2005, 2006 and 2007, given the amount of subordination below MBIA’s insured portion of such transactions available to absorb any losses from collateral defaults, MBIA currently does not expect material ultimate losses on these transactions. As of December 31, 2007, there are no insured subprime mortgage transactions with 2005, 2006, and 2007 subprime mortgage collateral appearing on the Company’s Classified List or Caution Lists. An explanation of the Company’s “Classified List” and “Caution Lists” is provided below.
MBIA also insures mortgage-backed securities backed by prime and near prime mortgages, including revolving home equity loans and closed-end second mortgages. In the fourth quarter of 2007, the Company observed deterioration in the performance of several of its prime and near prime home equity transactions and established $614 million of case basis reserves for future payments. During the fourth quarter of 2007, the Company paid $44 million in claims, net of reinsurance, on seven credits in this sector. Additionally, in the fourth quarter of 2007, the Company established $200 million of non-specific unallocated loss reserves to reflect MBIA’s estimate of probable losses as a result of the adverse developments in the residential mortgage market related to prime, second-lien mortgage exposure, but which have not yet been specifically identified to individual policies. The Company expects that loss payments on its prime, second-lien mortgage exposure during 2008 will amount to a significant portion of its current reserves for such exposure.
MBIA continues to closely monitor the manufactured housing sector, which has experienced stress during the last several years. MBIA ceased writing business in this sector, other than through certain CDO transactions, in 2000. At December 31, 2007, the Company had $30 million in case basis reserves, net of reinsurance, covering net insured par outstanding of $119 million on three credits within the manufactured housing sector. The Company had additional manufactured housing exposure of $1.8 billion in net insured par outstanding as of December 31, 2007, of which approximately 23% has been placed on the Company’s “Caution List-Medium” and “Caution List-High.”
In the event MBIA determines that it must pay a claim or that a claim is probable and estimable with respect to an insured issue, it places the issue on its “Classified List” and establishes a case basis reserve for that insured issue. As of December 31, 2007, MBIA had 47 open case basis issues on its “Classified List” that had $829 million in aggregate case reserves, net of reinsurance. The Company does not establish any case basis reserves for issues that are listed as “Caution List-Low,” “Caution List-Medium” or “Caution List-High” until such issues are placed on the Company’s “Classified List.”
Company. The amount the Company records as salvage and subrogation may be influenced by several factors during any period, such as the level of claim payments made for which the Company is entitled to reimbursements, amounts collected and impairment write-downs.
In the first quarter of 2006 and in connection with its remediation efforts, MBIA exercised a call right with respect to $411 million of MBIA-insured Northwest Airlines’ enhanced equipment trust certificates issued by Northwest Airlines Pass Through Trust 2000-1G (the “Certificates”). Under the terms of the trust agreement relating to the Certificates, MBIA had the right to call the Certificates at par as a result of the bankruptcy filing by Northwest Airlines. MBIA entered into an agreement with a third party under which the third party financed the call of the Certificates and purchased the Certificates from MBIA as part of a planned future securitization of the Certificates. MBIA’s insurance policy guaranteeing payment of the Certificates remains in effect.
REINSURANCE Reinsurance enables the Company to cede exposure for purposes of syndicating risk and increasing its capacity to write new business while complying with its single risk and credit guidelines. When a reinsurer is downgraded by one or more of the rating agencies, less capital credit is given to MBIA under rating agency models. As a result, a downgrade of one or more of MBIA’s key reinsurers could affect MBIA Corp.’s financial strength rating and ability to write new business. Over the past several years, most of MBIA’s reinsurers have been downgraded and others remain under review. The Company generally retains the right to reassume the business ceded to reinsurers under certain circumstances, including rating downgrades of its reinsurers. Additionally, MBIA requires certain unauthorized reinsurers to maintain bank letters of credit or establish trust accounts to cover liabilities ceded to such reinsurers under reinsurance contracts. The Company remains liable on a primary basis for all reinsured risk, and although MBIA believes that its reinsurers remain capable of meeting their obligations, there can be no assurance of such in the future.
POLICY ACQUISITION COSTS AND OPERATING EXPENSES Expenses that vary with and are primarily related to the production of the Company’s insurance business (policy acquisition costs) are deferred and recognized over the period in which the related premiums are earned. If an insured issue is refunded and the related premium is earned early, the associated acquisition costs previously deferred are also recognized early.
result of its study, MBIA determines that fewer costs are attributable to acquiring new insurance business, assuming a consistent gross expense level, operating expenses reported by the Company will increase.
Gross insurance expenses decreased 8% in 2007 compared with 2006 as a result of an increase in costs allocated to our investment management services and corporate operations and a decrease in loss prevention efforts. In 2006, gross insurance expenses increased 2% compared with 2005 primarily as a result of an increase in compensation costs. In 2007, the amortization of deferred acquisition costs increased 1% compared with 2006, in line with the increase in insurance premiums earned. At December 31, 2007, 2006 and 2005 there was an increase in the ratio of deferred expenses carried as assets on the balance sheet to deferred revenues carried as liabilities on the balance sheet plus the present value of future installment premiums. The increasing ratio reflects higher costs associated with acquiring new policies relative to a smaller growth in deferred and future installment premiums.
Operating expenses decreased 15% to $133 million in 2007 from $156 million in 2006. The decrease in operating expenses in 2007 compared with 2006 was due to the aforementioned increase in costs allocated to our investment management services and corporate operations and a decrease in loss prevention efforts. For 2006, operating expenses increased 10% to $156 million from $141 million in 2005. The increase in operating expenses in 2006 compared with 2005 was due to an increase in compensation costs primarily related to the acceleration of expenses associated with certain existing long-term incentive compensation awards and the adoption of new employee retirement benefits. Additionally, operating expenses increased as a result of the decrease in the rate at which costs are deferred as policy acquisition costs, which was effective in the third quarter of 2005.
VARIABLE INTEREST ENTITIES The Company provides credit enhancement services to global finance clients through third-party special purpose vehicles (“SPVs”). Third-party SPVs are used in a variety of structures guaranteed by MBIA. The Company has determined that such SPVs fall within the definition of a VIE under FIN 46(R). Under the provisions of FIN 46(R), MBIA must determine whether it has a variable interest in a VIE and if so, whether that variable interest would cause MBIA to be the primary
COLLATERALIZED DEBT OBLIGATIONS AND RELATED INSTRUMENTS As part of its insurance operations, the Company provides guarantees on CDO tranches, as well as protection on structured CMBS and corporate credit pools.
The range represents the minimum and maximum subordination for deals written in that year.
The Company recognized $200 million of total credit impairment on 3 deals insured during 2006 and 2007, with a total net par of $3.1 billion.
In the Company’s insured Multi-Sector CDO transactions, the Company benefits from two sources of subordination. For cash flow transactions where the Company has guaranteed timely interest and ultimate principal at maturity or ultimate principal at maturity only, the securities underlying the Company’s wrapped tranches are primarily high grade interests in securitizations with subordination that must be fully eroded before the Company’s subordination in the reference CDO is impacted. For asset coverage with deductible guarantees, the CDO level of subordination, or deductible, must be fully depleted by individual credit events before the Company would be exposed to a claim. The amounts of subordination available to the Company for its Multi-Sector CDO transactions are presented as a percentage range of net par in the table above.
Of the Company’s $30.1 billion net par Multi-Sector CDO portfolio at December 31, 2007, the underlying credit ratings of the collateral that support the Subprime RMBS, Non-subprime RMBS, and CDOs of Multi-Sector High Grade exposures along with vintage are presented in the following tables. The collateral level detail for each year insured was calculated using a weighted average of the net par written for deals closed during that particular year. The total collateral amount of the portfolio exceeds the net par written as a result of credit enhancement (such as overcollateralization and subordination) and reinsurance.
The Structured CMBS Pools and CRE CDO portfolio is a diversified global portfolio of high quality and highly-rated structured transactions primarily supported by collateral from the commercial real estate sector. The Company did not experience any material credit deterioration to this book in 2007. This portfolio can be sub-divided into two distinct pools: Structured CMBS pools and CRE CDOs.
The Company’s investment management services operations provide an array of products and services to the public, not-for-profit and corporate sectors. Such products and services are provided primarily through wholly owned subsidiaries of MBIA Asset Management and include cash management, discretionary asset management and fund administration services and investment agreement, medium-term note and commercial paper programs related to funding assets for third-party clients and for investment purposes. The investment management services operations consist of three operating segments: asset/liability products, which include investment agreements and medium-term notes (“MTNs”) not related to the conduit segment; advisory services, which consist of third-party and related-party fee-based asset management; and conduits. The following table summarizes the consolidated investment management services’ results and assets under management over the last three years. The results include revenues and expenses from transactions with the Company’s insurance and corporate operations.
management increased by $0.7 billion due to new clients, and growth in Customized Asset Management. Total investment management services’ expenses in 2007 were $1.5 billion, up 37% compared with 2006. This increase was primarily driven by higher interest expense from the growth in asset/liability products segment activity, which is consistent with the growth in revenues.
In 2006, investment management services’ revenues of $1.2 billion increased 34% over 2005. Excluding net realized gains from investment securities and net gains on financial instruments at fair value and foreign exchange, revenues of $1.2 billion increased 38% over 2005. The increase in revenues was primarily attributable to growth in the Company’s asset/liability products segment and advisory services segment. Advisory services’ revenues were favorable compared to 2005 as a result of growth in managed assets, particularly in municipal investment pools which benefited from investor focus on higher overnight rates and the flat yield curve environment. Total investment management services’ expenses in 2006 were $1.1 billion, up 40% compared with 2005. This increase was primarily driven by higher interest expense from the growth in asset/liability products segment activity and higher yielding conduit segment liabilities, both of which were consistent with the growth in revenues.
Net gains on financial instruments at fair value and foreign exchange from the investment management services operations in 2007 were $199 million compared with net gains of $13 million and net gains of $43 million in 2006 and 2005, respectively. The net gains in 2007 were primarily generated from gains on total return swaps used to hedge certain bond positions, for which the Company did not receive hedge accounting treatment under SFAS 133, partially offset by unfavorable foreign exchange on the re-measurement of Euro denominated liabilities against British pound sterling and losses on certain hybrid financial instruments. The net gains in 2006 were primarily generated from gains on foreign exchange partially offset by losses on derivative instruments. The net gains on financial instruments at fair value and foreign exchange in 2005 were primarily the result of an increase in U.S. dollar interest rates resulting in higher market values on pay fixed/receive floating U.S. dollar interest rate swaps associated with the asset/liability products and conduit segments.
Asset/liability products’ pre-tax income, excluding realized gains and losses from investment securities and gains and losses on financial instruments at fair value and foreign exchange, totaled $84.1 million in 2007, up 23% over 2006. At December 31, 2007, principal and accrued interest outstanding on investment agreement and medium-term note obligations and securities sold under agreements to repurchase totaled $26.7 billion compared with $20.3 billion at December 31, 2006. Assets supporting these agreements had market values plus accrued interest of $25.9 billion and $20.7 billion at December 31, 2007 and December 31, 2006, respectively. These assets comprise high quality securities with an average credit quality rating of double-A. In 2006, asset/liability products’ pre-tax income, excluding realized gains and losses from investment securities and gains and losses on financial instruments at fair value and foreign exchange, totaled $68.5 million, up 21% over 2005.
Conduit program pre-tax income, excluding gains and losses on financial instruments at fair value and foreign exchange, totaled $8.8 million in 2007 compared with $11.5 million in 2006 and $10.7 million in 2005. Certain of MBIA’s consolidated subsidiaries have invested in MBIA’s conduit debt obligations or have received compensation for services provided to MBIA’s conduits. As such, MBIA has eliminated intercompany transactions with its conduits from its consolidated balance sheet and income statement. After the elimination of such intercompany assets and liabilities, conduit investments totaled $4.3 billion and conduit debt obligations totaled $4.3 billion at December 31, 2007. The effect of the elimination on the Company’s consolidated balance sheet is a reduction of fixed-maturity investments, representing investments in conduit medium-term notes by other MBIA subsidiaries, with a corresponding reduction of conduit medium-term notes.
NON-CONSOLIDATED STRUCTURED INVESTMENT VEHICLES, CONDUITS AND COLLATERALIZED DEBT OBLIGATIONS The Company provides structured funding to global finance clients through the use of certain MBIA-administered, bankruptcy-remote special purpose vehicles. The Company has determined that such SPVs fall within the definition of a VIE under FIN 46(R).
During 2006, the Company structured two non-consolidated investment programs, Hudson-Thames, a SIV, and East-Fleet Finance Limited (“East-Fleet”), a funding conduit. For both of these entities, a subsidiary of MBIA Asset Management provided fee-based asset management and administrative services, acting under approved management agreements and at the direction of independent boards of directors of the entities. The obligations issued by Hudson-Thames and East-Fleet are not guaranteed by the Company, and the Company has no liquidity obligations to Hudson-Thames or East-Fleet. A subsidiary of MBIA Asset Management is also the program manager for several CDOs and provides fee-based asset management and administrative services, acting under approved management agreements. The Company had no investment in these CDOs as of December 31, 2007. The obligations issued by these CDOs are not guaranteed by the Company, and the Company has no liquidity or other obligations related to these programs.
At inception and throughout the course of Hudson-Thames’ operations, the Company conducted consolidation analyses under the provisions of FIN 46(R) upon the occurrence of certain reconsideration events. Reconsideration was triggered by a change in the make-up of the capital structure of Hudson-Thames following a new investment or redemption of junior notes. The Company utilized a stochastic Monte Carlo model to project potential favorable and unfavorable outcomes related to asset credit risk, interest rate risk and expenses. The Company’s share of variability absorbed was measured based on the modeled outcomes for its investments in the notes of Hudson-Thames and the management fees it would receive under each scenario. At no time did modeled results indicate that the Company would absorb the majority of the variability and, therefore, the Company concluded that while Hudson-Thames met the definition of a VIE, MBIA was not the primary beneficiary and need not consolidate Hudson-Thames. Had the Company concluded that consolidation was warranted, there would have been no impact to its December 31, 2007 balance sheet given that the program had ceased operations. The impact based on the maximum size that the program achieved would have been an increase to the Company’s assets of approximately $2 billion, or 4%, and a corresponding increase in liabilities and shareholders’ equity. These increases would not have been expected to result in any impact on the Company’s debt covenants, capital ratios or credit ratings.
The objective of East-Fleet was to issue senior commercial paper and invest in term-matched repurchase agreements guaranteed by major banks and brokers-dealers rated “A-1/P-1” or better by S&P and Moody’s, respectively, who use the repurchase agreement market to finance assets. As of December 31, 2007, East-Fleet commercial paper outstanding totaled $1.2 billion, a decrease of $6.4 billion from December 31, 2006. Adverse conditions in the structured finance and asset-backed commercial paper markets beginning in the third quarter of 2007 reduced demand by clients for financing and increased the cost of East-Fleet commercial paper funding, together causing the outstanding balance of commercial paper to decline. However, the entity continued to operate normally throughout 2007. Due to the cash matched funding of assets and liabilities, East-Fleet is not exposed to liquidity risk and is not required to liquidate assets in the market in order to pay off senior notes.
At the inception of East-Fleet’s operations, the Company conducted consolidation analyses under the provisions of FIN 46(R). The Company has no investment in either the senior or junior notes of East-Fleet. Therefore, the Company’s share of variable interest outcomes was measured solely based on the program management fees its asset management subsidiary earns. The Company utilized a stochastic Monte Carlo model to project potential favorable and unfavorable outcomes related to asset credit risk, interest rate risk and expenses. The Company’s share of variability absorbed was measured based on the management fees it would receive under each scenario. Modeled results indicated that the manager would not absorb the majority of the variability and, therefore, the Company concluded that while East-Fleet met the definition of a VIE, MBIA was not the primary beneficiary and need not consolidate East-Fleet. The Company’s variable interest is limited to the management fee and the Company believes that there are no possible scenarios under which it would consolidate the VIE. Had the Company concluded that consolidation was warranted, the impact to its December 31, 2007 balance sheet would have been an increase in the Company’s assets of $1.2 billion, or 3%, and a corresponding increase in liabilities and shareholders’ equity. These increases would not have been expected to result in any impact on the Company’s debt covenants, capital ratios or credit ratings.
The corporate operations primarily consist of holding company activities. The following table summarizes the consolidated corporate operation’s results over the last three years. The results include revenues and expenses from transactions with the Company’s insurance and investment management services operations.
In 2007, net investment income in the corporate operations increased 6% to $14.2 million from $13.5 million in 2006. The increase was primarily due to higher invested assets driven by dividends paid by MBIA Corp. to MBIA Inc. in April 2007 and December 2006, as well as higher investment yields, partially offset by losses from several of the Company’s alternative investments. In 2006, net investment income decreased 19% from $16.6 million in 2005. The decrease in 2006 compared with 2005 was driven by lower average invested assets offset by slightly higher investment yields. The decrease in 2006 average invested assets resulted from the retirement of $100 million of debt in the fourth quarter of 2005 and dividends paid by MBIA Corp. to MBIA Inc. during 2006.
Corporate expenses were $29 million, $18 million and $97 million for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in corporate expenses in 2007 compared with 2006 was primarily due to an increase in costs allocated from the insurance operations. Corporate expenses in 2005 included a $75 million accrual for penalties and disgorgement related to the settlement of regulatory investigations of the Company, as well as additional legal and consulting costs associated with these investigations.
The Company manages its capital resources to minimize its cost of capital while maintaining appropriate claims-paying resources to sustain its triple-A claims-paying ratings. Capital resources are defined by the Company as total shareholders’ equity, long-term debt issued for general corporate purposes and various soft capital credit facilities. At December 31, 2007, total shareholders’ equity was $3.7 billion and total long-term debt was $1.2 billion. The Company uses debt financing to lower its overall cost of capital. MBIA maintains debt at levels it considers to be prudent based on its cash flow and total capital (shareholders’ equity plus long-term debt). The following table presents the Company’s long-term debt and the ratio used to measure it:
guarantors’ insured portfolios. To enable the Company to maintain appropriate claims-paying resources in order to sustain the triple-A financial strength ratings assigned to MBIA Corp., a comprehensive capital strengthening plan was announced on January 9, 2008. Each of the components of the capital strengthening plan and developments through February 2008 are discussed below.
On February 6, 2008, the Company and Warburg Pincus amended the Warburg Pincus Agreement to provide that Warburg Pincus would backstop a common stock offering by agreeing to purchase up to $750 million of convertible participating preferred stock. Warburg Pincus was also granted the option to purchase up to $300 million of preferred stock prior to the closing of a common stock offering or February 15, 2008. Finally, Warburg Pincus was granted “B2” warrants which, upon obtaining certain approvals, would become exercisable to purchase between 4 million and 8 million shares of MBIA common stock, whether or not the common stock offering was completed.
On February 13, 2008, the Company completed a public offering of 94.65 million shares of MBIA common stock at $12.15 per share. Warburg Pincus informed the Company that it purchased $300 million in common stock as part of the offering. The Company did not use the $750 million Warburg Pincus backstop. In addition, Warburg Pincus did not exercise its right to purchase up to $300 million in preferred stock. Pursuant to the amended Warburg Pincus Agreement, Warburg Pincus was granted 4 million of “B2” warrants at a price of $16.20 per share. In addition, under anti-dilution provisions in the Warburg Pincus Agreement, the terms of the warrants issued to Warburg Pincus on January 30, 2008 were amended, which resulted in (a) the 8.7 million of warrants exercisable at $40 per share were revised to 11.5 million warrants exercisable at $30.25 per share and (b) the 7.4 million of “B” warrants exercisable at $40 per share were revised to 9.8 million “B” warrants exercisable at $30.25 per share. The Company intends to contribute most of the net proceeds of the common stock offering to its insurance operations to support its business plan.
On January 16, 2008, MBIA Corp. issued Surplus Notes due January 15, 2033. The Surplus Notes have an initial interest rate of 14 percent until January 15, 2013 and thereafter at an interest rate of three-month LIBOR plus 11.26 percent. The Surplus Notes are callable at par at MBIA Corp.’s option on the fifth anniversary of the date of issuance and every fifth anniversary thereafter, subject to prior approval by the Superintendent of the New York State Insurance Department (“NYSID”) and other restrictions. The cash received from the Surplus Notes will be used for general corporate purposes.
In July 2004, the Company received authorization from its Board of Directors to repurchase 1 million shares of common stock under a share repurchase program. On August 5, 2004, the Company’s Board of Directors authorized the repurchase of an additional 14 million shares of common stock in connection with this program. As of December 31, 2006, the Company had repurchased a total of 10 million shares under the program at an average price of $57.25 per share. During 2006, the Company did not repurchase any shares under this share repurchase program.
In the third quarter of 2007, the Company decided to suspend share repurchases under the program in light of concerns and uncertainties regarding the housing markets, the structured finance sector and the U.S. economy, leaving $340 million available under our $1 billion share buyback program. The Company may reevaluate this decision from time to time and resume share repurchases when it deems appropriate.
MBIA Corp. has access to $400 million through a CPCT facility issued by eight trusts (the “Trusts”), which were created for the primary purpose of issuing CPCT securities and investing the proceeds in high-quality commercial paper or short-term U.S. Government obligations. The CPCT securities are remarketed every 28 days with the interest rate set by means of an auction and with two trusts remarketing each week. In the event that there are insufficient bids at any auction to remarket all of the CPCT securities of any trust, the rate is reset for the next 28 days at the maximum prescribed rate with the investors of the CPCT securities continuing to hold them until the next auction in which sufficient bids are received. The maximum prescribed rate is 30-day LIBOR plus 150 basis points if MBIA Corp. maintains a financial strength rating from S&P and Moody’s at or above AA- and Aa3, respectively, or 30-day LIBOR plus 200 basis points if MBIA Corp.’s financial strength rating falls below either AA- or Aa3. Due to the decline in the demand for short-term structured securities during the end of the third quarter of 2007 through the fourth quarter of 2007, all CPCT securities were unable to be remarketed at their most recent remarketing date, resulting in the current investors of the CPCT securities receiving the maximum prescribed interest rate from August 14, 2007 through December 31, 2007.
MBIA Corp. has a put option to sell to the Trusts the perpetual preferred stock of MBIA Corp. If MBIA Corp. exercises its put option, the Trusts will transfer the proceeds to MBIA Corp. in exchange for the preferred stock that will be held by the Trusts. The Trusts are vehicles for providing MBIA Corp. the opportunity to access new capital at its sole discretion through the exercise of the put options. As of December 31, 2007, the Trusts were rated AA and Aa2 by S&P and Moody’s, respectively. However, in January 2008 the trusts were downgraded by S&P and Moody’s to AA- and Aa3, respectively. To date, MBIA Corp. has not exercised its put options under any of these arrangements. The Company continues to receive 100% capital credit for this facility. However, the Company anticipates incurring additional expenses of $1.5 million per quarter to maintain this facility if the CPCT securities continue to incur interest at the maximum prescribed rate compared with expenses incurred in prior quarters.
From time to time, MBIA accesses the capital markets to support the growth of its businesses. As such, the Company filed a registration statement on Form S-3ASR with the SEC in June 2007 for an indeterminate amount which replaced and canceled remaining
balances on all prior shelf registration statements filed with the SEC. This shelf registration permits the Company to issue various debt and equity securities described in the prospectus filed as part of the registration statement. In February 2008, MBIA filed amendments to its Form S-3ASR to allow the issuance of $1.15 billion of common stock as part of its capital strengthening plan.
Cash needs in our insurance operations are primarily for the payment of insurance claims, operating expenses, dividends to MBIA Inc. and, in 2008, interest on surplus notes. As of December 31, 2007, MBIA Corp. had cash and available-for-sale investments of $10.4 billion and access to a total of $850 million through its standby line of credit facility and its CPCT facility. MBIA Corp.’s net cash flow from operating activities for 2007 was $977 million and was primarily generated from premium writings and investment income. During 2008, we expect that we will be required to make significant insurance claim payments related to MBIA Corp.’s insured RMBS and home equity loan exposure, as discussed below.
The Company has significant liquidity requirements within the asset/liability products segment of its investment management services operations. The asset/liability products segment has issued diversified funding liabilities over various products, maturities and markets. Included in these liabilities are investment agreements in which counterparties have the ability to withdraw monies on dates other than those specified in the related draw-down schedules. Proceeds from the issuance of funding liabilities are invested in high quality, diversified assets that produce an acceptable spread return. The weighted average life and the duration of the asset portfolio are closely matched to the liability portfolio.
Cash needs in the asset/liability products segment are primarily for principal and interest payments on funding liabilities and payment of operating expenses. Sources of cash include scheduled maturities of high quality assets, net investment income and dedicated capital held within the investment management services operations and, if needed, assets which can be sold or used in secured repurchase agreement borrowings. As of December 31, 2007, the asset/liability products segment had cash and investments of $25.8 billion. We believe that the segment’s liquidity resources, in the ordinary course of business, are adequate to meet its needs.
The consolidated liquidity and operating cash requirements of the Company are met by cash flows generated from operations, which were more than adequate to meet cash needs in the year ended December 31, 2007. The Company’s operating cash flows provided by continuing operations totaled $1.02 billion for the year ended December 31, 2007 compared with $663.5 million for the year ended December 31, 2006. The majority of net cash provided by operating activities is generated from premium writings and investment income in the Company’s insurance operations. The increase in operating cash flows principally resulted from a decrease in loss payments and a decrease in income taxes paid in the year ended December 31, 2007 compared with the year ended December 31, 2006.
During 2007, net cash provided by financing activities was $5.3 billion compared with $4.2 billion during 2006. The increase of $1.1 billion was primarily related to the issuance of investment agreements by the Company’s investment management services operations’ asset/liability products program, which funded the purchase of the fixed-maturity investments mentioned above, partially offset by an increase in the purchase of treasury stock.
Under New York State insurance law, without prior approval of the Superintendent of the NYSID, financial guarantee insurance companies can pay dividends from earned surplus subject to retaining a minimum capital requirement. The payment of regular dividends in any 12-month period are limited to the lesser of (i) 10% of policyholders’ surplus as shown on MBIA Corp.’s latest filed statutory financial statements and (ii) 100% of adjusted net investment income. In the year ended December 31, 2006, MBIA Corp. declared and paid dividends of $339 million to MBIA Inc. without prior approval by the NYSID. In the fourth quarter of 2006, MBIA Corp. received approval from the NYSID to pay a total dividend of $500 million, which MBIA Corp. declared and paid to
At December 31, 2007, MBIA maintained a revolving credit facility totaling $500 million with a group of highly rated global banks. During the second quarter of 2006, the Company negotiated more favorable terms of the facility, including an extension of the maturity from April 2010 to May 2011. The facility contains certain covenants including, among others, that the consolidated net worth of MBIA Inc. and MBIA Corp. will not fall below $2.8 billion and that the ratio of consolidated debt to equity for MBIA Inc. and MBIA Corp. will not exceed 30%, at any time. This facility does not include any credit rating triggers or any provisions that could require the posting of collateral. The Company was in compliance with all of the revolving credit facility covenants as of December 31, 2007. During 2007, there were no balances outstanding under the facility. In January 2008, the Company amended the current credit facility to treat the Surplus Notes as equity in the net worth and leverage calculations.
Triple-A One Funding Corporation (“Triple-A One”), an MBIA-administered multi-seller conduit consolidated in the Company’s conduit segment, issues commercial paper to fund the purchase of assets from structured finance clients. Assets purchased by Triple-A One are insured by MBIA Corp. Triple-A One maintains backstop liquidity facilities for each transaction, covering 100% of the face amount of commercial paper outstanding, with banks rated A-1/P-1 or better by S&P and Moody’s, respectively. These liquidity facilities are designed to allow Triple-A One to repay investors in the event of a market disruption in which Triple-A One is unable to issue new commercial paper to replace maturing commercial paper. The financial guarantee policies issued by MBIA Corp. to insure the assets of Triple-A One cannot be accelerated to repay maturing commercial paper or borrowings under liquidity facilities and only guarantee ultimate payments over time relating to the assets. Through December 31, 2007, no borrowings have been made under any of Triple-A One’s liquidity facilities. In February 2008, Triple-A One borrowed $15 million for one day under its liquidity facilities to repay maturing commercial paper. The borrowing under the liquidity facilities was repaid by issuing new commercial paper.
The fair value of the Company’s investments is based on prices obtained through third party pricing services, which include quoted prices in active markets and prices based on market-based inputs that are either directly or indirectly observable, as well as prices from dealers in relevant markets. Differences between fair value and amortized cost arise primarily as a result of changes in interest rates and general market credit spreads occurring after a fixed-income security is purchased, although other factors influence fair value, including specific credit-related changes, supply and demand forces and other market factors. When the Company holds an available-for-sale investment to maturity, any unrealized gain or loss currently recorded in accumulated other comprehensive income (loss) in the shareholders’ equity section of the balance sheet will be reversed. As a result, the Company expects to realize a value substantially equal to amortized cost. However, when investments are sold prior to maturity, the Company will realize any gain or loss in net income. The Conduit portfolios are considered held-to-maturity, as the Company has the ability and intent to hold these investments to their contractual maturity. Therefore, these portfolios are reported on the Company’s consolidated balance sheet at amortized cost and are not adjusted to reflect unrealized changes in fair value.
Investments for which the Company has recorded unrealized losses are tested quarterly for other-than-temporary impairment. For each security that meets the threshold of either 20% impaired at the time of review or 5% impaired at the time of review with a fair value below amortized cost for a consecutive 12-month period, a further analysis of the security is performed to assess if the impairment is other-than-temporary. Due to the deterioration in the performance of asset-backed securities in the second half of 2007, this analysis was enhanced to include greater scrutiny of factors influencing the performance of such securities. As of December 31, 2007, the Company had an unrealized net loss of $910 million related to its investment management services operations’ investment portfolio, which primarily resulted from changes in the market value of asset-backed securities due to significant widening of market credit spreads. Included in the unrealized net loss of $910 million were unrealized net losses totaling $814 million within the asset-backed sector, primarily consisting of credit card, auto loan, student loan, home equity loan and CDO investments. See “Note 11: Investments” and “Note 12: Investment Income and Gains and Losses” in the Notes to Consolidated Financial Statements for further information on the Company’s investment portfolios and related gains and losses. The Company’s investment management services operations has entered into total return swaps that economically hedge changes in the value of certain investments. For 2007, MBIA recorded a $270 million gain on these total return swaps within “Net gains (losses) on financial instruments at fair value and foreign exchange” in the Company’s consolidated statement of operations. During January and February of 2008, the Company has observed a further deterioration in the credit ratings of certain investments. The Company will incorporate any such changes in credit ratings, as well as other market factors that changed during 2008, in its evaluation of investments for other-than-temporary impairment at the end of the first quarter of 2008.
In purchasing Insured Investments, the Company independently assesses the underlying credit quality, structure and liquidity of each investment, in addition to the creditworthiness of the insurer. Insured Investments are diverse by sector, issuer and size of holding. The Company assigns underlying ratings to its Insured Investments without giving effect to financial guarantees based on the lower of underlying ratings assigned by S&P or Moody’s when an underlying rating is published by either rating agency, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment. At December 31, 2007, based on the actual or estimated underlying ratings in the consolidated investment portfolio, excluding conduit segment investments, without giving effect to financial guarantees, (i) the weighted-average rating of the investment portfolio would be in the Aa range, (ii) the weighted-average rating of just the Insured Investments in the investment portfolio would be in the A range and (iii) less than 2% of the investment portfolio would be rated below investment grade.
The underlying ratings of the MBIA Insured Investments as of December 31, 2007 are reflected in the following table. Amounts represent the fair value of such investments including the benefit of the MBIA guarantee. The ratings in the table below are the lower underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating agency, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment.
Due to the uncertainty with respect to the timing of future cash flow and the ultimate outcome associated with the Company’s unrecognized tax benefits at December 31, 2007, the Company is unable to make reliable estimates of the period of cash settlement with the applicable taxing authority. Therefore, the contractual obligations table above does not include any unrecognized tax benefits relating to FIN 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement 109.”
In general, MBIA’s market risk relates to changes in the value of financial instruments that arise from adverse movements in factors such as interest rates, credit spreads and foreign exchange rates. MBIA is exposed to changes in interest rates that affect the fair value of its financial instruments, namely investment securities, investment agreement liabilities, medium-term notes, debentures and certain derivative transactions. The Company’s investment portfolio holdings are primarily U.S. dollar-denominated fixed-income securities including municipal bonds, U.S. Government bonds, mortgage-backed securities, collateralized mortgage obligations, corporate bonds and asset-backed securities. In periods of rising and/or volatile interest rates, profitability could be adversely affected should the Company have to liquidate these securities.
Interest rate sensitivity can be estimated by projecting a hypothetical instantaneous increase or decrease in interest rates. The following table presents the estimated pre-tax change in fair value of the Company’s financial instruments as of December 31, 2007 from instantaneous shifts in interest rates.
MBIA issues insurance policies insuring payments due on structured credit derivative contracts and directly enters into credit derivative contracts, which are marked-to-market through earnings under the requirements of SFAS 133. The insurance transactions primarily consist of structured credit default swaps on pools of various types of reference obligations with considerable subordination beneath MBIA’s risk exposure at the time of issuance. All these transactions are insured by the Company’s insurance operations. The majority of these structured credit default swaps relate to structured finance transactions with underlying reference obligations of cash securities and credit default swaps referencing liabilities of corporations or of other structured finance securitizations. The asset classes of the underlying reference obligations include corporate, asset-backed, residential mortgage-backed and commercial mortgage-backed securities. These transactions are usually underwritten at or above a triple-A credit rating level. As of December 31, 2007, approximately 90% of the tranches insured by the Company were rated triple-A. Additionally, MBIA’s investment management services operations enter into single-name credit default swaps as part of its asset management activities. During 2007, the value of the Company’s credit derivative contracts were affected predominantly by changes in credit spreads of the underlying reference obligations’ collateral and ratings downgrades of securities backing collateralized debt obligations. As credit spreads and ratings change, the values of credit derivative contracts will change and the resulting gains or losses will be recorded within net income.
Sensitivity to changes in the collateral portfolio credit quality can be estimated by projecting a hypothetical change in rating migrations. The following table presents the estimated pre-tax change in fair value and the cumulative estimated net fair value of the Company’s insurance credit derivatives portfolio of a one and three notch rating change in the credit quality as of December 31, 2007. A notch represents a one step movement up or down in the credit rating. Estimated changes in fair value are calculated using the valuation methods described in the “Critical Accounting Estimates” section included herein. Contracts for which fair value is calculated using specific dealer quotes or actual transaction prices are excluded from the following table as the Company is unable to obtain data necessary to model hypothetical changes in such contracts.
Recovery rates on defaulted collateral is an input into the Company’s proprietary valuation model. Sensitivity to changes in the recovery rate assumptions used by the Company can be estimated by projecting a hypothetical change in these assumptions. The following table presents the estimated pre-tax change in fair value and the cumulative estimated net fair value of the Company’s insurance credit derivatives portfolio of a 10% and 20% change in the recovery rate assumptions as of December 31, 2007. Estimated changes in fair value are calculated using the valuation methods described in the “Critical Accounting Estimates” section included herein. Contracts for which fair value is calculated using specific dealer quotes or actual transaction prices are excluded from the following table as the Company is unable to obtain data necessary to model hypothetical changes in such contracts.