National’s primary business is insuring new issue and secondary market municipal bonds, consistent with our portfolio management and return requirements, and to maximize the economics of our existing insured portfolio through effective surveillance and remediation. Our corporate segment consists of general corporate activities, including providing general support services to MBIA’s other operating businesses and asset and capital management. MBIA Corp.’s primary objectives are to satisfy claims of its policyholders, and to maximize future recoveries, if any, for its senior lending and other surplus note holders and, thereafter, its preferred stock holders. MBIA Corp. is executing this strategy by reducing and mitigating potential losses on its insurance exposures and pursuing various actions focused on maximizing the collection of recoveries. We do not expect to write new business in our international and structured finance insurance segment.
Effective on January 10, 2017, MBIA Corp.’s wholly-owned subsidiary, MBIA UK (Holdings) Limited (“MBIA UK Holdings”), sold its operating subsidiary, MBIA UK, to Assured Guaranty Corp. (“Assured”), a subsidiary of Assured Guaranty Ltd. Prior to 2015, MBIA managed two other operating segments, advisory services and conduit. Our advisory services segment was primarily operated through Cutwater Holdings, LLC and its subsidiaries (“Cutwater”). Effective on January 1, 2015, we exited our advisory business through the sale of Cutwater to a subsidiary of The Bank of New York Mellon Corporation. In the second quarter of 2014, we exited our conduit business through the liquidation of Meridian Funding Company, LLC (“Meridian”). Refer to the following “Executive Overview” section for a further discussion on the sale of MBIA UK.
Increased new business writings at National to $1.6 billion of gross par exposure and 158 insurance policies issued in 2016 from $597 million of gross par exposure and 59 insurance policies issued in 2015.
Entered into an agreement to sell MBIA UK and secured a $325 million financing, each described further below, to enable MBIA Corp. to satisfy, on January 20, 2017, a claim of $770 million on an insurance policy insuring certain notes issued by Zohar II 2005-1, Limited (“Zohar II”).
Puerto Rico debt service outstanding decreased $401 million during 2016, which included gross claim payments by National in the aggregate of $173 million. National also provided $139 million of liquidity to Puerto Rico through the purchase of notes. Subsequent to December 31, 2016, we paid additional gross claims on our Puerto Rico exposure in the aggregate of $24 million.
While National succeeded in more than doubling its new business generation, it continued to experience several challenges to its business. A low interest rate environment and the competitive landscape continued to suppress demand for its municipal bond insurance. In addition, continued financial stress of some municipal bond issuers, including Puerto Rico, inhibited National from seeking to redeploy its excess capital. MBIA Corp. continued to satisfy its obligations when due and continues to reduce and mitigate potential losses on its insurance exposures, while turning its focus to pursuing various legal actions to maximize the collection of recoveries. Refer to the following “Results of Operations” section for a further discussion of our 2016 key activities and challenges.
(1)-Combined operating income (loss) and combined operating income (loss) per diluted share are non-GAAP measures. Refer to the following “Results of Operations” section for a discussion of operating income (loss) and operating income (loss) per diluted share and a reconciliation of GAAP net income to operating income (loss) and GAAP net income per diluted share to operating income (loss) per diluted share.
(1)-Adjusted book value per share is a non-GAAP measure. Refer to the following “Results of Operations” section for a discussion of adjusted book value and a reconciliation of GAAP book value per share to adjusted book value per share.
National is the largest U.S. public finance-only bond insurer in the financial guarantee industry as measured by total insured gross par outstanding of $110.4 billion as of December 31, 2016. National’s ability to write new business and to compete with other financial guarantors is largely dependent on the financial strength ratings assigned to National by Kroll Bond Rating Agency (“Kroll”), Standard & Poor’s Financial Services LLC (“S&P”) and Moody’s Investors Service, Inc. (“Moody’s”). As of December 31, 2016, National had the following ratings: AA+ with a stable outlook by Kroll; AA- with a stable outlook by S&P; and A3 with a negative outlook by Moody’s.
For the issuer, the value of financial guarantee insurance is largely determined by the spread between the interest rate on insured versus uninsured debt. For the investor, the decision to purchase insured bonds is influenced by the overall yield environment. In the current environment of low interest rates, investors may choose to purchase uninsured bonds to increase their returns. An environment of higher interest rates and/or wider spreads would likely enhance the new business opportunities for National. We also believe the current stress in certain sectors of the municipal bond market reinforces the value of National’s guarantee of timely payment of interest and principal. Refer to the “U.S. Public Finance Insurance” section for additional information on National’s new business.
During 2016, MBIA Corp. was particularly focused on ensuring its ability to cover any payment that might come due on an insurance policy it had written insuring certain notes (the “Zohar II Notes”) issued by Zohar II, which matured on January 20, 2017 (the “Zohar II Maturity Date”), and on exercising its rights and remedies to seek reimbursement of the $149 million claim it paid in November of 2015 (the “Zohar I Claim”) on its policy insuring the class A-1 and A-2 notes issued by Zohar CDO 2003-1, Limited (“Zohar I”).
MBIA Corp. was presented with a claim of $770 million (the “Zohar II Claim”) under the policy it had issued on the Zohar II Notes (the “Zohar II Policy”). MBIA Corp. fully satisfied its obligations under the Zohar II Policy. In order to do so, MBIA Corp. used approximately $60 million from its own resources and executed the following two related transactions on January 10, 2017: 1) MBIA UK Holdings sold its operating subsidiary, MBIA UK, and made a cash payment of $23 million, to Assured, in exchange for the receipt by MBIA UK Holdings of certain Zohar II Notes owned by Assured, which had an aggregate outstanding principal amount of $347 million as of December 31, 2016,which notes were distributed as a dividend to MBIA Corp. upon consummation of the sale of MBIA UK (the “Sale Transaction”); and 2) MBIA Corp. consummated a financing facility (the “Facility”) with affiliates of certain holders of 14% Fixed-to-Floating Rate Surplus Notes of MBIA Corp. (collectively, the “Senior Lenders”), and with MBIA Inc., pursuant to which the Senior Lenders provided $325 million of senior financing and MBIA Inc. provided $38 million of subordinated financing to MZ Funding LLC (“MZ Funding”), a newly formed wholly-owned subsidiary of the Company, which in turn lent the proceeds of such financing to MBIA Corp. Refer to (i) “Results of Operations - Summary of Consolidated Results” for a summary of the net financial impact from the Sale Transaction; (ii) “Capital Resources - MBIA Insurance Corporation” for information on the impact from the Sale Transaction on MBIA Insurance Corporation’s statutory capital; (iii) “Note 1: Business Developments and Risks and Uncertainties” in the Notes to Consolidated Financial Statements for a further discussion on the Sale Transaction and assets and liabilities classified as held for sale; and (iv) “Liquidity” for additional information on the Facility.
Failure to recover a substantial amount of the payments made on the Zohar I Claim and the Zohar II Claim, and/or certain RMBS recoveries, could impede MBIA Corp.’s ability to meet its future obligations. Refer to “Risk Factors-MBIA Corp. Risk Factors-Continuing elevated loss payments and delay or failure in realizing expected recoveries on insured transactions may materially and adversely affect MBIA Insurance Corporation’s statutory capital and its ability to meet liquidity needs and could cause the NYSDFS to put MBIA Insurance Corporation into a rehabilitation or liquidation proceeding if the NYSDFS concludes that MBIA Insurance Corporation will not be able to pay expected claims.” in Part I, Item 1A of this Form 10-K for a further discussion.
Economic and financial market trends could impact MBIA’s business outlook and its financial results. Many states and municipalities have experienced growing tax collections that resulted from increased economic activity and higher assessed property valuations. The economic improvement at the state and local level strengthens the credit quality of the issuers of our insured municipal bonds, improves the performance of our insured U.S. public finance portfolio and could reduce the amount of National’s incurred losses. A decrease in oil prices could have a positive impact on certain sales taxes to the extent consumer spending increases as a result. However, some states and municipalities will experience a decrease in revenues where their economies are reliant on the oil and gas industries. With higher projected interest rates and the urgent need for renewed investment in our nation’s infrastructure, the value proposition of bond insurance is becoming more compelling and thus we expect that will lead to increased demand for our product.
Loss and loss adjustment expense (“LAE”) reserves are established by loss reserve committees in each of our major operating insurance companies (National, MBIA Insurance Corporation and MBIA UK) and reviewed by our executive Loss Reserve Committee, which consists of members of senior management. Loss and LAE reserves include case basis reserves and accruals for LAE incurred with respect to non-derivative financial guarantees. Case basis reserves represent our estimate of expected losses to be paid under insurance contracts, net of expected recoveries, on insured obligations that have defaulted or are expected to default. These reserves require the use of judgment and estimates with respect to the occurrence, timing and amount of paid losses and recoveries on insured obligations. Given that the reserves are based on such estimates and assumptions, there can be no assurance that the actual ultimate losses will not be greater than or less than such estimates resulting in the Company recognizing additional or reversing excess loss and LAE reserves through earnings.
Refer to “Note 7: Fair Value of Financial Instruments” in the Notes to Consolidated Financial Statements for further information about the Company’s financial assets and liabilities that are accounted for at fair value, including valuation techniques and significant inputs.
The decrease in consolidated total revenues was primarily due to the loss from the sale of MBIA UK (refer to “Sale of MBIA UK” below for further information), a decrease in net gains on insured derivatives and lower net premiums earned due to higher refunding activity in 2015. Net losses on insured derivatives in 2016 were primarily the result of claim payments on commercial mortgage-backed securities (“CMBS”) transactions. Net gains on insured derivatives in 2015 were principally the result of changes in transaction-specific factors, such as credit ratings, partially offset by claim payments.
Consolidated total expenses for the years ended December 31, 2016 and 2015 included $220 million and $123 million, respectively, of net insurance loss and LAE. This increase was principally due to loss incurred on certain Puerto Rico exposures and insured second-lien residential mortgage-backed securities (“RMBS”) transactions, partially offset by decreases in insured collateralized debt obligation (“CDO”) losses.
The following table presents the net expected impact to our consolidated financial statements related to the sale of MBIA UK for the year ended December 31, 2016 and the expected 2017 impact. Refer to “Note 1: Business Developments and Risks and Uncertainties” in the Notes to Consolidated Financial Statements for a further discussion on the Sale Transaction and assets and liabilities classified as held for sale.
(1)-Reporting within “Other net realized gains (losses)” on our consolidated statement of operations and reflected in the results of our international and structured finance insurance segment.
(3)-Primarily relates to an increase in deferred tax liabilities from a basis difference of MBIA UK, which is due to a change in assertion of MBIA UK paying future dividends over time to calculating deferred taxes on the basis of the sale of MBIA UK and a valuation allowance against certain foreign tax credits. These are included in “Provision (benefit) for income taxes” on our consolidated statement of operations.
(4)-These amounts were included in the 2016 loss recorded to the statement of operations and are reversed out of accumulated other comprehensive income in the first quarter of 2017 when the sale was consummated.
(5)-Relates to an increase in deferred tax liabilities due to foreign currency exchange that was recorded in “Accumulated other comprehensive income” on our consolidated balance sheets.
The decrease in consolidated total revenues was due to decreases in net gains on insured derivatives and certain fees and reimbursements. Net gains on insured derivatives in 2015 were principally the result of changes in transaction-specific factors, such as credit ratings, partially offset by claim payments. Net gains on insured derivatives in 2014 were principally the result of commuting derivative liabilities at prices below their fair values, partially offset by settlement and claim payments.
Elimination of the impact of mark-to-market gains (losses) on financial instruments that primarily include interest rate swaps and hybrid financial instruments. Also eliminated are the mark-to market gains (losses) on warrants issued by the Company. All of these amounts fluctuate based on market interest rates, credit spreads, MBIA Inc.’s common stock price and other market factors.
Elimination of foreign exchange gains (losses) on the remeasurement of certain assets and liabilities and transactions in non-functional currencies. Given the possibility of volatility in foreign exchange markets, we exclude the impact of foreign exchange gains (losses) to provide a measurement of comparability of operating income (loss).
The following table presents our combined operating income (loss) and operating income (loss) per diluted common share and provides reconciliations of GAAP net income (loss) to operating income (loss) and GAAP net income (loss) per diluted common share to operating income (loss) per diluted common share for the years ended December 31, 2016, 2015 and 2014:
(3)-Reported within “Provision (benefit) for income taxes” on the Company’s consolidated statements of operations.
In addition to book value per share, we also analyze adjusted book value (“ABV”) per share, a non-GAAP measure. We consider ABV a measure of fundamental value of the Company and the change in ABV an important measure of financial performance. We have refined our calculation of ABV as of December 31, 2016 and have conformed the prior year’s calculation to the current presentation. ABV now adjusts GAAP book value to remove the legal entity book value of MBIA Corp., but continues to include all deferred taxes available to the Company. Previously, ABV adjusted GAAP book value to remove the book value of our international and structured finance insurance segment and included all deferred taxes available to the Company. In addition, ABV adjusts for certain items which the Company believes will reverse from GAAP book value through GAAP earnings and other comprehensive income, as well as to add in the impact of certain items which the Company believes will be realized in GAAP book value in future periods. The Company has limited such adjustments to those items that it deems to be important to fundamental value and performance and for which the likelihood and amount can be reasonably estimated. We have presented ABV to allow investors and analysts to evaluate the Company using the same measure that MBIA’s management regularly uses to measure financial performance and value. ABV is not a substitute for and should not be viewed in isolation of GAAP book value, and our definition of ABV may differ from that used by other companies.
Our U.S. public finance insurance business is primarily conducted through National. The financial guarantees issued by National provide unconditional and irrevocable guarantees of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event National has exercised, at its discretion, the right to accelerate insured obligations upon default or otherwise. National’s guarantees insure municipal bonds, including tax-exempt and taxable indebtedness of U.S. political subdivisions, as well as utilities, airports, health care institutions, higher educational facilities, student loan issuers, housing authorities and other similar agencies and obligations issued by private entities that finance projects that serve a substantial public purpose. Municipal bonds and privately issued bonds used for the financing of public purpose projects are generally supported by taxes, assessments, user fees or tariffs related to the use of these projects, lease payments or other similar types of revenue streams.
NET PREMIUMS EARNED Net premiums earned on financial guarantees represent gross premiums earned net of premiums ceded to reinsurers, and include scheduled premium earnings and premium earnings from refunded issues. The decrease in net premiums earned for 2016 compared with 2015 resulted from decreases in refunded premiums earned of $42 million and scheduled premiums earned of $26 million. The increase in net premiums earned for 2015 compared with 2014 resulted from an increase in refunded premiums earned of $50 million, partially offset by a decrease in scheduled premiums earned of $35 million. Scheduled premium earnings declined due to the refunding and maturity of insured issues in prior periods. Refunding activity over the past several years has accelerated premium earnings in prior periods and reduced the amount of scheduled premiums that would have been earned in the current period.
NET GAINS (LOSSES) ON FINANCIAL INSTRUMENTS AT FAIR VALUE AND FOREIGN EXCHANGE The favorable change in net gains (losses) on financial instruments at fair value and foreign exchange for 2016 compared with 2015 was principally due to increases in net realized gains from the sales of securities in order to generate liquidity for anticipated claim payments on certain Puerto Rico exposures and from favorable market conditions. The unfavorable change in net gains (losses) on financial instruments at fair value and foreign exchange for 2015 compared with 2014 was principally due to decreases in net realized gains from the sales of securities from the ongoing management of our U.S. public finance insurance investment portfolio and unfavorable market fluctuations on financial instruments.
(2)-Gross loss and LAE reserves with respect to Puerto Rico exposures reflect the expected loss and LAE payments net of expected recoveries on such reserves.
Insurance loss recoverable as of December 31, 2016 increased compared with December 31, 2015 primarily as a result of increases in expected recoveries on certain Puerto Rico exposures. Loss and LAE Reserves as of December 31, 2016 increased compared with December 31, 2015 primarily as a result of increases in expected payments on certain Puerto Rico exposures.
POLICY ACQUISITION COSTS AND OPERATING EXPENSES U.S. public finance insurance segment expenses for the years ended December 31, 2016, 2015 and 2014 are presented in the following table:
Gross expenses represent total insurance expenses before the deferral of any policy acquisition costs. Amortization of deferred acquisition costs decreased for 2016 compared with 2015 due to higher refunding activity in 2015. Amortization of deferred acquisition costs increased for 2015 compared with 2014 due to higher refunding activity in 2015. When an insured obligation refunds, we accelerate any remaining deferred acquisition costs associated with the policy covering the refunded insured obligation. We did not defer a material amount of policy acquisition costs during 2016, 2015 or 2014.
NON-GAAP OPERATING INCOME (LOSS) In addition to the above results, we also analyze the operating performance of our U.S. public finance insurance segment using operating income (loss), a non-GAAP measure. We believe operating income (loss), as used by management, is useful for an understanding of the results of operations of the Company. Operating income (loss) is not a substitute for net income (loss) determined in accordance with GAAP, and our definition of operating income (loss) may differ from that used by other companies.
The following table presents the credit quality distribution of National’s U.S. public finance outstanding gross par insured as of December 31, 2016 and 2015. CABs are reported at the par amount at the time of issuance of the insurance policy. All ratings are as of the period presented and represent S&P ratings. If transactions are not rated by S&P, a Moody’s equivalent rating is used. If transactions are not rated by either S&P or Moody’s, an internal equivalent rating is used.
(1)-Includes CABs that reflect the gross par amount at the time of issuance of the insurance policy.
(3)-As a result of debt service payments made as of January 1, 2017, National’s total Puerto Rico debt service outstanding declined by $75 million.
For many years Puerto Rico’s economy has suffered from stagnation, net migration of people out of Puerto Rico and weak government fiscal management that has led to recurring budget deficits and increased borrowing to finance such deficits. As a result of mounting debt, deteriorating credit ratings and lack of market confidence, Puerto Rico does not have access to the capital markets at reasonable rates.
On August 31, 2016, the President of the United States announced the appointment of the seven members who will comprise the Oversight Board. The Oversight Board elected its Chairman, adopted its bylaws and established a sub-committee to search for and hire a permanent Executive Director and General Counsel. Additionally, it retained legal and financial advisors. Among other matters, the Oversight Board and its advisors will evaluate Puerto Rico’s fiscal plan and potential restructuring options, and consider how to address such proposals under the guidelines provided by PROMESA. The Oversight Board originally set a target of certifying a Fiscal and Economic Growth Plan (“FEGP”) no later than January 31, 2017. However, after a request of additional time by the new Governor of Puerto Rico, the Oversight Board moved the date to certify the FEGP until March 15, 2017. Furthermore, the Oversight Board extended the stay provided under PROMESA from February 28, 2017 until May 1, 2017.
Consistent with Section 409 of PROMESA, an Economic Task Force was established in July of 2016. Under the law, this Economic Task Force is charged with identifying impediments to Puerto Rico’s growth and recommending changes to promote long-term economic growth and stability, spur new job creation, reduce child poverty, and attract investment in the territory. Its report was released on December 20, 2016 and contained numerous recommendations for Congress to address Puerto Rico’s Medicaid and Medicare programs, expand the federal child tax credit, and consider other tax reforms. It also recommended that Congress analyze and vote on Puerto Rico becoming the 51st state.
Pursuant to the Moratorium Act, the Puerto Rico Fiscal Agency and Financial Advisory Authority (“AAFAF”) was established as Puerto Rico’s financial adviser replacing the Government Development Bank (“GDB”). On January 20, 2017, the Governor of Puerto Rico signed into law the Puerto Rico Fiscal Agency and Financial Advisory Authority Act (Act 2-2017) which defines the responsibilities of AAFAF including acting as fiscal agent, financial adviser and informative agent of all governmental entities and to assist in confronting Puerto Rico’s fiscal crisis and economic emergency. AAFAF is in charge of collaboration, communication and cooperation between the Government of Puerto Rico and the Oversight Board. Further, AAFAF is responsible for the supervision, execution and administration of the FEGP. Also under color of the authority provided by the Moratorium Act, on May 17, 2016, the then Governor of Puerto Rico signed an executive order to suspend through June 30, 2016 PRHTA’s obligations to transfer to the fiscal agent certain toll revenues and any other revenues allocated to or received by PRHTA and authorize PRHTA’s use of such revenues for the ongoing provision of services essential to protect the health, safety, and welfare of the residents of Puerto Rico. On June 30, 2016, the then Governor of Puerto Rico signed two executive orders that, collectively, extended the May 17, 2016 suspension of revenue transfers to the fiscal agent and suspended the payment of PRHTA’s debt obligations under the 1968 and 1998 Resolutions coming due during the term of the Moratorium Act (but not the transfer of revenues pledged for the payment of outstanding loans owed to the GDB, which were modified solely to the extent necessary to provide PRHTA with the revenues it requires to fund operating expenses or essential services). In addition, one of the executive orders issued on June 30, 2016 also suspended the University of Puerto Rico’s (“UPR”) obligation to (a) transfer certain pledged revenues to the trustee for revenue bonds issued by UPR, and (b) make payments pursuant to the Lease Agreement between UPR and Desarrollos Universitarios Inc., which payments support the debt service payments on certain educational facilities revenue bonds issued by the Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority (“AFICA”). The UPR revenue bonds and AFICA educational facilities revenue bonds insured by National were paid from pledged revenues on June 1, 2016 and July 1, 2016, respectively. As a result of suspending UPR’s obligation to transfer funds to the trustee for debt service, National downgraded the internal rating of UPR to “d” during the third quarter of 2016. Holders of debt insured by National and issued by UPR, Puerto Rico Industrial Development Company, PBA, and most of PRHTA, were paid through reserves or funded by monthly deposits held by the respective trustee or fiscal agent. National paid an additional $4 million of claims on PRHTA debt in July of 2016 when the GDB refused to release debt service reserve funds held by it. Similarly, subsequent to December 31, 2016, National paid additional claims of $0.8 million against PRHTA bonds, relating to debt service due on January 1, 2017.
On December 15, 2016, the Supporting Creditors and PREPA reached an agreement to extend the RSA until March 31, 2017. As part of the extension, PREPA made the full interest payment of $192 million on January 1, 2017. The extension agreement also contained a milestone date of January 31, 2017 for the parties to reach an agreement on the RSA’s implementation under PROMESA, or another mutually agreed upon mechanism. On January 27, 2017, however, AAFAF announced that it will lead future negotiations on behalf of PREPA, and requested and received an extension of the January 31, 2017 milestone until March 31, 2017.
The Puerto Rico Energy Commission (“PREC”) has heard two separate but parallel rate cases. In June of 2016, PREC approved a volumetric transition charge for both residential and non-residential customers. The transition charge will be used to pay the debt issued by the SPE. Also in June of 2016, the PREC issued an order approving a requested provisional rate of approximately $0.013/kWh requested by PREPA. On January 11, 2017, the PREC approved an average permanent rate increase of 1.025 cents/kWh. The increase is smaller than the previously approved temporary rate, so PREPA will have to reimburse the $45 million annualized difference to customers. Among the adjustments made, PREC found that PREPA mistakenly double-counted $37 million of subsidy expenses. PREC also disallowed $41 million of capital expenditures for Aguirre Offshore Gas Port, capping spending on that project to $15 million. The rate increase will go into effect on March 13, 2017.
As set forth above, National has significant exposure to PRHTA. In December of 2015, the Governor of Puerto Rico signed an executive order to redirect certain revenues previously allocated to select public corporation and certain other government agencies (“clawback”), including PRHTA. On January 1, 2016, Puerto Rico made all of its debt service payments due except for bond payments totaling $37 million relating to the Puerto Rico Infrastructure Authority (“PRIFA”) and Public Finance Corporation. Following the missed payment by PRIFA, certain bond insurers (not including National) filed a lawsuit against Puerto Rico claiming that the clawback of the revenues violated the U.S. constitution and the laws of Puerto Rico. Puerto Rico has made a motion to dismiss that case but it is subject to the stay under PROMESA. The outcome of that legal challenge is uncertain, and further, while adoption of the clawback measure was intended to provide short-term relief, Puerto Rico’s lack of a comprehensive plan or clear evidence of steps to conserve resources necessary to meet its near term debt service obligations raises questions as to whether the intercept will continue to be a short-term measure.
Other than Inter American University of Puerto Rico Inc., S&P, Fitch Ratings and/or Moody’s have downgraded the ratings of all Puerto Rico issuers to below investment grade with a negative outlook due to narrowing liquidity, sluggish economic growth and persistent structural deficits. Additionally, subsequent to the declaration of a state of emergency and suspension of debt service payments by the then Governor of Puerto Rico, S&P revised its rating for Puerto Rico, its GO, PREPA and PRHTA’s subordinated transportation revenue bonds, series 1998, state infrastructure bank, to “D” (default).
The following table summarizes the consolidated results of our corporate segment for the years ended December 31, 2016, 2015 and 2014:
NET GAINS (LOSSES) ON FINANCIAL INSTRUMENTS AT FAIR VALUE AND FOREIGN EXCHANGE The unfavorable change in net gains (losses) on financial instruments at fair value and foreign exchange for 2016 compared with 2015 was primarily due to a decrease in foreign exchange gains on Euro denominated liabilities from a decline in the strengthening of the U.S. dollar and unfavorable changes in the fair value of the outstanding warrants issued on MBIA Inc. common stock. The changes in the fair value of outstanding warrants were primarily attributable to an increase in MBIA Inc.’s common stock, partially offset by changes in volatility, which are used in the valuation of the warrants. The favorable change in net gains (losses) on financial instruments at fair value and foreign exchange for 2015 compared with 2014 was primarily due to gains from the termination of derivatives, partially offset by a decrease in foreign exchange gains on Euro denominated liabilities, an increase in losses from mark-to-market changes of our interest rate swaps and a decrease in gains from the changes in the fair value of the outstanding warrants issued on MBIA Inc. common stock. The changes in the fair value of outstanding warrants were primarily attributable to a decrease in MBIA Inc.’s common stock, partially offset by an increase in volatility, which are used in the valuation of the warrants.
OTHER NET REALIZED GAINS (LOSSES) The decrease in other net realized gains (losses) for 2016 compared with 2015 was primarily due to the results from the sale of Cutwater. The increase in other net realized gains (losses) for 2015 compared with 2014 was primarily due to the gain from the sale of Cutwater.
OPERATING EXPENSES Operating expenses decreased for 2015 compared with 2014 primarily due to decreases in office related expenses as a result of the relocation of our headquarters to a leased facility in the fourth quarter of 2014, as well as a decrease in legal costs.
PROVISION (BENEFIT) FOR INCOME TAXES The 2016 benefit for income taxes was impacted by foreign tax credit adjustments, the fluctuation of the value of nontaxable warrants issued by the Company and nondeductible equity-based compensation expense. The 2015 provision for income taxes was impacted by nondeductible equity-based compensation expense. The 2014 benefit for income taxes includes a favorable adjustment of $87 million for the release of the full valuation allowance against the portion of our deferred tax asset which resulted from the sales of previously impaired investments. In addition for 2014, there was a $61 million reversal in our reserve for uncertain tax positions.
NON-GAAP OPERATING INCOME (LOSS) In addition to the above results, we also analyze the operating performance of our corporate segment using operating income (loss), a non-GAAP measure. We believe operating income (loss), as used by management, is useful for an understanding of the results of operations of the Company. Operating income (loss) is not a substitute for net income (loss) determined in accordance with GAAP, and our definition of operating income (loss) may differ from that used by other companies.
(1)-Gross amounts are reported within “Net gains (losses) on financial instruments at fair value and foreign exchange” on the Company’s consolidated statements of operations.
As of December 31, 2016, MBIA Corp.’s total insured gross par outstanding was $30.9 billion. Included in this amount was $12.0 billion of gross par outstanding related to MBIA UK which was sold to Assured on January 10, 2017. Since December 31, 2007, MBIA Corp.’s total insured gross par outstanding has decreased approximately 91% from $331.2 billion.
NET PREMIUMS EARNED Our international and structured finance insurance segment generates net premiums from insurance policies accounted for as financial guarantee contracts. Certain premiums may be eliminated in our consolidated financial statements as a result of the Company consolidating VIEs. In addition, we generate net premiums from insured credit derivatives that are included in “Realized gains (losses) and other settlements on insured derivatives” on our consolidated statements of operations. The following table provides net premiums earned from our financial guarantee contracts for the years ended December 31, 2016, 2015 and 2014:
Net premiums earned represent gross premiums earned net of premiums ceded to reinsurers, and include scheduled premium earnings and premium earnings from refunded issues. Net premiums earned decreased for 2016 compared with 2015 and 2014 primarily due to decreases in scheduled premiums earned from the maturity and early settlements of insured transactions with no writings of new insurance policies.
FEES AND REIMBURSEMENTS The increase in fees and reimbursements for 2016 compared with 2015 was primarily due to an increase in termination and waiver and consent fees related to the ongoing management of our international and structured finance insurance business, partially offset by a decrease in ceding commission income as a result of lower refunding activity. The decrease in fees and reimbursements for 2015 compared with 2014 was primarily due to a decrease in termination and waiver and consent fees, partially offset by an increase in ceding commission income due to higher refunding activity. Due to the transaction-specific nature inherent in fees and reimbursements, these revenues can vary significantly from period to period.
NET CHANGE IN FAIR VALUE OF INSURED DERIVATIVES The Company no longer insures new credit derivative contracts. Realized losses on insured derivatives include payments made net of premiums and fees earned and salvage received. For 2016 and 2015, realized losses on insured derivatives resulted from claim payments on a pool of CMBS. For 2014, realized losses on insured derivatives resulted primarily from settlements and claim payments on a pool of CMBS. For 2016, 2015 and 2014, premiums and fees earned on insured derivatives were $3 million, $12 million and $18 million, respectively. Premiums earned related to insured credit derivatives will decrease over time as a result of settlements prior to maturity and scheduled amortizations.
For the year ended December 31, 2016, unrealized gains on insured derivatives were principally the result of a decline in the weighted average life on transactions, favorable changes in spreads/prices on the underlying collateral and a reversal of unrealized losses due to commutations partially offset by the effects of MBIA’s nonperformance risk on its derivative liabilities. For the year ended December 31, 2015, unrealized gains on insured derivatives were principally the result of refining the credit rating of underlying collateral. For the year ended December 31, 2014, unrealized gains on insured derivatives were principally associated with the reversal of unrealized losses from commutations.
As of December 31, 2016, the cost of a five-year CDS referencing MBIA Corp. was 11.84% upfront plus 5% per annum compared with 42.95% upfront plus 5% per annum and 16.71% upfront plus 5% per annum as of December 31, 2015 and 2014, respectively. As of December 31, 2016 and 2015, the fair value of MBIA Corp.’s insured CDS liability was $63 million and $85 million, respectively. Our mark-to-market on insured credit derivatives uses the most appropriate of the one to ten-year CDS cost for each transaction, and those costs ranged from 4.25% upfront plus 5% per annum to 12.59% upfront plus 5% per annum as of December 31, 2016. As of December 31, 2015, those costs ranged from 26.24% upfront plus 5% per annum to 44.55% upfront plus 5% per annum. As of December 31, 2014, those costs ranged from 3.68% upfront plus 5% per annum to 18.98% upfront plus 5% per annum.
REVENUES OF CONSOLIDATED VIEs For 2016, total revenues of consolidated VIEs were $31 million compared with total revenues of $128 million for 2015 and $102 million for 2014. The decrease in revenues of consolidated VIEs for 2016 compared with 2015 was primarily due to a decrease in net investment income from the deconsolidation of VIEs and lower mark-to-market gains on assets of consolidated VIEs. The increase in revenues of consolidated VIEs for 2015 compared with 2014 was primarily due to an increase in net investment income of certain consolidated VIEs, primarily due to events that occurred resulting in increased cash flows related to these VIEs, partially offset by lower mark-to-market gains on assets of consolidated VIEs, primarily due to the absence of lower expected payments in 2015. We elected to record at fair value certain instruments that are consolidated under accounting guidance for consolidation of VIEs, and as such, changes in fair value are reflected in earnings.
LOSS AND LOSS ADJUSTMENT EXPENSES MBIA’s insured portfolio management group within our international and structured finance insurance business is responsible for monitoring international and structured finance insured obligations. The level and frequency of monitoring of any insured obligation depends on the type, size, rating and our assessed performance of the insured issue.
Refer to “Note 6: Loss and Loss Adjustment Expense Reserves” in the Notes to Consolidated Financial Statements for further information about our insurance loss recoverable and loss and LAE reserves. The following table presents information about our insurance loss recoverable and reserves as of December 31, 2016 and 2015.
(1)-The decrease was primarily due to a decrease in expected future recoveries on CDOs as a result of the consolidation and elimination of a VIE and a decrease in projected collections of excess spread within insured second-lien RMBS.
Included in MBIA Corp.’s loss and LAE reserves are estimated future claims payments for insured obligations for which a payment default has occurred and MBIA Corp. has already paid a claim and for insured obligations where a payment default has not yet occurred. The following table includes LAE reserves, but excludes par outstanding, as of December 31, 2016 and 2015 for one and two issues, respectively, that had no expected future claim payments or par outstanding, but for which MBIA Corp. was obligated to pay LAE incurred in prior periods. As of December 31, 2016 and 2015, loss and LAE reserves comprised the following:
Gross expenses represent total insurance expenses before the deferral of any policy acquisition costs. Gross expenses decreased for 2016 compared with 2015 primarily due to decreases in premium taxes and assessments, compensation expense and building related expense. Gross expenses decreased for 2015 compared with 2014 primarily due to decreases in compensation expense, legal and consulting fees. Operating expenses decreased for 2016 compared with 2015 and 2014 due to decreases in gross expenses.
INSURED PORTFOLIO EXPOSURE The credit quality of our international and structured finance insured portfolio is assessed in the same manner as our U.S. public finance insured portfolio. As of December 31, 2016 and 2015, 25% and 22%, respectively, of our international and structured finance insured portfolio, was rated below investment grade, before giving effect to MBIA’s guarantees, based on MBIA’s internal ratings, which are generally more current than the underlying ratings provided by S&P and Moody’s for this subset of our insured portfolio.
The following is a summary of selected significant exposures within the insured portfolio of our international and structured finance insurance segment. Many of these sectors are and have been considered volatile over the past several years. We may experience considerable incurred losses and future expected payments in certain of these sectors. There can be no assurance that the loss reserves described below will be sufficient or that we will not experience losses on transactions on which we currently have no loss reserves, in particular if the economy deteriorates. We may seek to purchase, directly or indirectly, obligations guaranteed by MBIA or seek to commute policies. The amount of insurance exposure reduced, if any, and the nature of any such actions will depend on market conditions, pricing levels from time to time, and other considerations. In some cases, these activities may result in a reduction of loss reserves, but in all cases they are intended to limit our ultimate losses and reduce the future volatility in loss development on the related policies. Our ability to purchase guaranteed obligations and to commute policies will depend on management’s assessment of available liquidity.
MBIA Corp. insures mortgage-backed securities (“MBS”) backed by residential mortgage loans, including second-lien RMBS transactions (revolving home equity lines of credit (“HELOC”) loans and closed-end second (“CES”) mortgages). MBIA Corp. also insures MBS backed by first-lien alternative A-paper (“Alt-A”) and subprime mortgage loans directly through RMBS securitizations. There was considerable stress and deterioration in the mortgage market since 2008 reflected by heightened delinquencies and losses, particularly related to mortgage loans originated during 2005, 2006 and 2007.
The following table presents the gross par outstanding of MBIA Corp.’s total direct RMBS insured exposure as of December 31, 2016 and 2015. Amounts include the gross par outstanding related to transactions that the Company consolidates under accounting guidance for VIEs.
(1)-Includes international exposure of $349 million and $449 million as of December 31, 2016 and 2015, respectively.
As of December 31, 2016 and 2015, MBIA Corp.’s CDO portfolio represented 8% and 14%, respectively, of its total insured gross par outstanding. In addition to the below table, MBIA Corp. insures approximately $345 million in commercial real estate (“CRE”) loan pools, comprising both European and domestic assets. The distribution of our insured CDO and related instruments portfolio by collateral type is presented in the following table:
For 2016, our effective tax rate applied to our loss before income taxes was lower than the U.S. statutory tax rate of 35% primarily due to the provision for deferred taxes on the basis differences of our foreign subsidiary, MBIA UK, which resulted from the change in assertion of MBIA UK paying future dividends over time to calculating deferred taxes on the basis of the sale of MBIA UK and a valuation allowance against certain foreign tax credits.
For 2014, our effective tax rate applied to our income before income taxes was lower than the U.S. statutory rate of 35% primarily due to a decrease in our valuation allowance against our deferred tax asset from asset sales of previously impaired assets and a decrease in our reserve for uncertain tax positions.
Refer to “Note 11: Income Taxes” in the Notes to Consolidated Financial Statements for a further discussion of income taxes, including any valuation allowance against the Company’s deferred tax assets and its accounting for tax uncertainties.
The Company manages its capital resources to minimize its cost of capital while maintaining appropriate claims-paying resources (“CPR”) for National and MBIA Corp. The Company’s capital resources consist of total shareholders’ equity, total debt issued by MBIA Inc. for general corporate purposes, and surplus notes issued by MBIA Corp. Total capital resources were $4.7 billion and $5.2 billion as of December 31, 2016 and 2015, respectively. MBIA Inc. uses its capital resources to support the business activities of its subsidiaries. As of December 31, 2016, MBIA Inc.’s investments in subsidiaries totaled $3.7 billion.
Repurchases of debt and common stock may be made from time to time in the open market or in private transactions as permitted by securities laws and other legal requirements. We may also choose to redeem debt obligations where permitted by the relevant agreements. MBIA Inc. or its subsidiaries may repurchase or redeem outstanding common shares of MBIA Inc. and outstanding debt obligations at prices that we deem to be economically advantageous.
The Company and its subsidiaries’ share repurchases that were authorized under share repurchase programs, for the years ended December 31, 2016, 2015 and 2014 are presented in the following table:
On February 23, 2016, the Company’s Board of Directors authorized the repurchase by the Company and its subsidiaries of up to $100 million of its outstanding shares under a new share repurchase authorization. During 2016, we repurchased 1.7 million common shares of MBIA Inc. at an average share price of $7.02 under this new share repurchase authorization.
During 2016, we repurchased $6 million par value outstanding of GFL MTNs issued by our corporate segment at a weighted average cost of approximately 97% of par value.
In order to maintain its New York State financial guarantee insurance license, National is required to maintain a minimum of $65 million of policyholders’ surplus. National is also required to maintain contingency reserves to provide protection to policyholders in the event of extreme losses in adverse economic events. Refer to the following “MBIA Corp.-Capital and Surplus” section for additional information about contingency reserves under New York Insurance Law (“NYIL”).
(1)-Calculated using a discount rate of 3.18% and 3.04% as of December 31, 2016 and 2015, respectively.
MBIA Insurance Corporation reported total statutory capital of $492 million as of December 31, 2016 compared with $885 million as of December 31, 2015. As of December 31, 2016, statutory capital comprised $238 million of policyholders’ surplus and $254 million of contingency reserves. As of December 31, 2015, statutory capital comprised $609 million of policyholders’ surplus and $276 million of contingency reserves. For the year ended December 31, 2016, MBIA Insurance Corporation had a statutory net loss of $323 million. Included in the net loss for 2016 was a loss of $114 million to adjust the carrying value of MBIA UK to its estimated fair value less costs to sell. In addition, MBIA Insurance Corporation’s policyholders’ surplus was negatively impacted as of December 31, 2016 and 2015 by $112 million and $75 million, respectively, as it was not permitted to treat the portion of its investment in subsidiaries in excess of 60% of net admitted assets less the par value of common and preferred stock and liabilities as an admitted asset, as required under NYIL. MBIA Insurance Corporation’s policyholders’ surplus as of December 31, 2016 and 2015 included negative unassigned surplus of $1.8 billion and $1.4 billion, respectively. MBIA Insurance Corporation’s policyholders’ surplus may be further negatively impacted if future additional insured losses are incurred and the percentage of its assets invested in subsidiaries continues to increase.
The $112 million reduction to policyholders’ surplus as of December 31, 2016 will be reversed in the first quarter of 2017 to reflect the sale of MBIA UK. In addition, in the first quarter of 2017, MBIA Insurance Corporation will release contingency reserves of approximately $20 million related to the maturity of the Zohar II Notes, as well as, record a gain of $18 million related to the appreciation to the par value of the Zohar II Notes received as consideration. Therefore, in the first quarter of 2017, MBIA Insurance Corporation’s policyholders’ surplus will increase approximately $150 million as a result of these transactions.
As of December 31, 2016, MBIA Insurance Corporation recognized estimated recoveries of $404 million, net of reinsurance on a statutory basis related to put-backs of ineligible mortgage loans in its insured transactions and $395 million related to excess spread recoveries on RMBS, net of reinsurance. These excess spread recoveries represented 80% of MBIA Insurance Corporation’s statutory capital as of December 31, 2016. There can be no assurance that we will be successful or that we will not be delayed in realizing these recoveries. Refer to “Note 6: Loss and Loss Adjustment Expense Reserves” in the Notes to Consolidated Financial Statements for additional information about these recoveries.
Under NYIL, MBIA Insurance Corporation is also required to establish a contingency reserve to provide protection to policyholders in the event of extreme losses in adverse economic events. The amount of the reserve is based on the percentage of principal insured or premiums earned, depending on the type of obligation (net of collateral, reinsurance, refunding, refinancings and certain insured securities). Reductions in the contingency reserve may be recognized based on excessive reserves and under certain stipulated conditions, subject to the approval of the Superintendent of the NYSDFS. As a result of regulatory approved reductions, MBIA Insurance Corporation’s contingency reserves of $254 million as of December 31, 2016 represented reserves on 33 of the 278 outstanding credits insured by MBIA Insurance Corporation.
In connection with MBIA Insurance Corporation obtaining approval from the NYSDFS to release excessive contingency reserves in previous periods, MBIA Insurance Corporation agreed that it would not pay any dividends without prior approval from the NYSDFS. Due to its significant negative earned surplus, MBIA Insurance Corporation has not had the statutory capacity to pay dividends since December 31, 2009. Based on estimated future income, MBIA Insurance Corporation is not expected to have any statutory capacity to pay any dividends.
As of December 31, 2016, the par amount outstanding of MBIA Insurance Corporation’s 14% Fixed-to-Floating Rate Surplus Notes due January 15, 2033 (the “Surplus Notes”) was $953 million. Section 1307 of the NYIL and the Fiscal Agency Agreement governing the surplus notes (the “Fiscal Agency Agreement”), which was approved as it relates to Section 1307 by the NYSDFS in connection with the issuance of the Surplus Notes, each impose restrictions on the payments of principal and interest (or the redemption price or any make-whole premium) on the Surplus Notes (“Surplus Note Payments”). Section 1307 of the NYIL provides that any payments on surplus notes issued by an insurer “shall be repaid only out of free and divisible surplus of such insurer with the approval of the Superintendent whenever, in his/her judgment, the financial condition of such insurer warrants.” The Superintendent of Financial Services (the “Superintendent”) has broad discretion in determining whether to allow us to make Surplus Note Payments. We are not aware of any guidelines or interpretations that govern the exercise of the Superintendent’s discretion under Section 1307 in determining whether the financial condition of an insurer warrants the making of such payments. The Fiscal Agency Agreement provides that (a) Surplus Note Payments may be made only with the prior approval of the Superintendent, whenever, in his/her judgment, the financial condition of MBIA Insurance Corporation warrants, and (b) any such Surplus Note Payments may only be made to the extent MBIA Insurance Corporation has sufficient “Eligible Surplus” to make such payments. The Fiscal Agency Agreement defines “Eligible Surplus” as MBIA Insurance Corporation “surplus as regards policyholders,” less the sum of its “common capital stock” and “preferred capital stock”, as shown on its annual and quarterly statements filed with state insurance regulatory authorities. While the NYIL does not explicitly set forth the calculation of “free and divisible surplus”, MBIA believes that the calculation of Eligible Surplus, as set forth in the Fiscal Agency Agreement and as accepted by the NYSDFS, is the appropriate calculation of “free and divisible surplus.” MBIA Insurance Corporation had negative “free and divisible surplus,” determined as set forth above, of $53 million as of December 31, 2016 representing a decrease of $371 million from December 31, 2015. The decrease in MBIA Insurance Corporation’s “free and divisible surplus” during 2016 primarily resulted from a statutory net loss of $323 million during 2016. MBIA Insurance Corporation is required to seek the Superintendent’s approval to make payments of interest and principal when scheduled on the Surplus Notes. There is no assurance the Superintendent will approve Surplus Note Payments. Notwithstanding the sufficiency of MBIA Insurance Corporation’s Eligible Surplus available for the payment of Surplus Note Payments, the NYSDFS may deny approval of any Surplus Note Payments if the Superintendent concludes that MBIA Insurance Corporation’s financial condition does not warrant such approval.
(1)-Calculated using a discount rate of 5.15% and 5.18% as of December 31, 2016 and 2015, respectively.
(3)-This amount primarily consists of expected recoveries related to the Company’s excess spread and put-backs.
As of December 31, 2016 and 2015, National held cash and investments of $4.2 billion and $4.5 billion, respectively, of which $366 million and $336 million, respectively, were highly liquid and comprised highly rated commercial paper, money market funds and municipal, U.S. agency and corporate bonds.
Currently, the majority of the cash and securities of MBIA Inc. is pledged against investment agreement liabilities, the Asset Swap and derivatives, which limits its ability to raise liquidity through asset sales. If the market value or rating eligibility of the assets which are pledged against MBIA Inc.’s obligations were to decline, we would be required to pledge additional eligible assets in order to meet minimum required collateral amounts against these liabilities. To mitigate these risks, we seek to maintain cash and liquidity resources that we believe will be sufficient to make all payments due on our obligations and to meet other financial requirements, such as posting collateral. Contingent liquidity resources include: (1) sales of invested assets exposed to credit spread stress risk, which may occur at losses; (2) termination and settlement of interest rate swap agreements; and (3) accessing the capital markets. These actions, if taken, are expected to result in either additional liquidity or reduced exposure to adverse credit spread movements. There can be no assurance that these actions will be sufficient to fully mitigate this risk. Information concerning our credit spread sensitivity appears in Part II, Item 7A, “Quantitative and Qualitative Disclosures about Market Risk.”
As of December 31, 2016 and 2015, MBIA Corp. held cash and investments of $328 million and $997 million, respectively, of which $201 million and $264 million, respectively, comprised cash and highly liquid assets that were immediately available to MBIA Insurance Corporation. As of December 31, 2016, $539 million of cash and investments was excluded in the balance for MBIA Corp. due to the sale of MBIA UK in January of 2017.
The liquidity position of MBIA Corp. has been stressed by payments related to: RMBS exposures, both first and second-lien; CMBS exposures; commutations of insured transactions that reduced both exposure and potential loss volatility; and the Zohar I and Zohar II Claim payments. Refer to “Executive Overview” for a further discussion on the payment of the Zohar I and Zohar II Claims.
As component parts of the Facility, MZ Funding entered into a Credit Agreement with MBIA Corp. (the “Credit Agreement”; and the loans thereunder, the “MBIA Loans”) pursuant to which it immediately lent the proceeds of the Notes to MBIA Corp.
If at the end of any fiscal quarter, MBIA’s “Available Liquidity” (as defined in the Credit Agreement) exceeds $150 million and MBIA Corp.’s “Statutory Surplus” (as defined in the Credit Agreement) exceeds $250 million, MBIA Corp. will make a payment on the MBIA Loans in the amount by which the Available Liquidity exceeds $150 million, except that during the first 18 months after the closing of MBIA Loans, the payment may be limited to the amount of the accrued but unpaid interest with the amount of any recovery in excess of accrued interest placed in an interest bearing account subject to the liens in favor of the Senior Lenders in lieu of the payment of principal on the MBIA Loans. This payment, which is referred to as the “Cash Sweep,” will be subject to approval, or non-disapproval, of the NYSDFS. In the event the NYSDFS objects to or otherwise prevents any portion of the payments described above, MBIA Corp. shall, subject to NYSDFS approval to make such payment, pay all approved portions of the Cash Sweep Amount, as provided for herein, and, if such deposit is approved by the NYSDFS, deposit any unapproved portion of the Cash Sweep Amount into the Mandatory Prepayment Account (as defined in the Credit Agreement).
The Facility is secured by a first priority security interest in all of MBIA Corp.’s right, title and interest in the Zohar I Collateral and the Zohar II Collateral, as such terms are defined in the Security Agreement (collectively, including any proceeds thereof, the “Collateral”). In addition, the Insured Senior Notes are secured by a pledge of the Company’s interest in MZ Funding pursuant to the Pledge Agreement. Any payments or recoveries made on the Zohar II Collateral will be allocated on a pro-rata basis to repayment of the Insured Senior Notes and the MBIA Corp. Payment.
Net cash used by operating activities increased for the year ended December 31, 2016 compared with 2015 primarily due to an increase in losses and LAE paid of $113 million and a decrease in investment income received of $35 million, partially offset by a decrease in interest paid of $30 million and an increase in premiums, fees and reimbursements received of $20 million. Net cash used by operating activities decreased for the year ended December 31, 2015 compared with 2014 primarily due to decreases in insured derivative commutations and loss payments of $390 million and operating and employee related expenses of $108 million, partially offset by decreases in premiums, fees and reimbursements and investment income received of $164 million.
Net cash provided by investing activities increased for the year ended December 31, 2016 compared with 2015 primarily due to an increase in net proceeds from sales, paydowns and maturities of held-to-maturity investments of consolidated VIEs of $1.7 billion related to the deconsolidation of VIEs in 2016. Net cash provided by investing activities increased slightly for the year ended December 31, 2015 compared with 2014 primarily due to increases in net proceeds from purchases, sales, paydowns and maturities of investments and loans of $316 million and increases in the proceeds from derivative settlements, the sale of Cutwater and the sale of our Armonk, New York facility of $86 million. These increases were partially offset by a decrease in cash acquired from consolidated VIEs of $214 million and an increase in collateral posting of $175 million.
MBIA’s consolidated investment portfolio includes investments that are insured by various financial guarantee insurers (“Insured Investments”), including investments insured by National and MBIA Corp. (“Company-Insured Investments”). As of December 31, 2016, Insured Investments at fair value represented $489 million or 9% of consolidated investments, of which $334 million or 6% of consolidated investments were Company-Insured Investments. As of December 31, 2016, based on the actual or estimated underlying ratings of our consolidated investment portfolio, without giving effect to financial guarantees, the weighted average rating of only the Insured Investments in the investment portfolio would be in the Baa range.
In purchasing Insured Investments, the Company’s third-party portfolio manager 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 third-party portfolio manager assigns underlying ratings to Insured Investments without giving effect to financial guarantees based on underlying ratings assigned by Moody’s or S&P, when a rating is not published by Moody’s. When a Moody’s or S&P underlying rating is not available, the underlying rating is based on the portfolio manager’s best estimate of the rating of such investment. A downgrade of a financial guarantee insurer has historically had an adverse effect on the fair value of investments insured by the downgraded financial guarantee insurer. If the Company determines that declines in the fair values of Insured Investments are other-than-temporary, the Company will record a realized loss through earnings.
Without giving effect to the National and MBIA Corp. guarantees of the Company-Insured Investments in the consolidated investment portfolio, as of December 31, 2016, based on actual or estimated underlying ratings, the weighted average rating of the consolidated investment portfolio was in the Aa range. The weighted average rating of only the Company-Insured Investments was in the Below investment grade range, and investments rated below investment grade in the Company-Insured Investments were 4% of the total consolidated investment portfolio.
As of December 31, 2016 and 2015, we held impaired AFS investments (investments for which fair value was less than amortized cost) with a fair value of $2.2 billion and $2.8 billion, respectively.
Surplus notes, investment agreements, MTNs, and long-term debt include principal and interest and exclude premiums or discounts. Liabilities issued at discounts reflect principal due at maturity. Interest payments on floating rate obligations are estimated using applicable forward rates. Principal and interest on callable obligations or obligations that allow investors to withdraw funds prior to legal maturity are based on the expected call or withdrawal dates of such obligations. Liabilities denominated in foreign currencies are presented in U.S. dollars using applicable exchange rates as of December 31, 2016.
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2016, 2015 and 2014
Refer to “Item 6. Selected Financial Data” for Supplementary Financial Information
MBIA Inc., together with its consolidated subsidiaries, (collectively, “MBIA” or the “Company”) operates one of the largest financial guarantee insurance businesses in the industry. MBIA manages three operating segments: 1) United States (“U.S.”) public finance insurance; 2) corporate; and 3) international and structured finance insurance. The Company’s U.S. public finance insurance business is primarily operated through National Public Finance Guarantee Corporation (“National”) and its international and structured finance insurance business is primarily operated through MBIA Insurance Corporation and its subsidiaries (“MBIA Corp.”). Unless otherwise indicated or the context otherwise requires, references to “MBIA Corp.” are (i) for any references relating to the period ended January 10, 2017, to MBIA Insurance Corporation, together with its subsidiaries, MBIA UK Insurance Limited (“MBIA UK”), and MBIA Mexico S.A. de C.V. (“MBIA Mexico”) and (ii) for any references relating to the period after January 10, 2017, to MBIA Insurance Corporation together with MBIA Mexico.
National’s ability to write new business and compete with other financial guarantors is largely dependent on the financial strength ratings assigned to National by the rating agencies. As of December 31, 2016, National had the following ratings: AA+ with a stable outlook by Kroll Bond Rating Agency; AA- with a stable outlook by Standard & Poor’s Financial Services LLC (“S&P”); and A3 with a negative outlook by Moody’s Investors Service, Inc. (“Moody’s”).
(1)-Amount includes the fair value of the Zohar II Notes received from the sale of MBIA UK less the cash payment of $23 million to Assured.
(2)-Includes $97 million of losses related to items that continue to be included in accumulated other comprehensive income (loss) until ultimate sale.
The assets and liabilities of MBIA UK were classified as held for sale as of December 31, 2016 and presented within “Assets held for sale” and “Liabilities held for sale” on the Company’s consolidated balance sheet. Income (loss) before income taxes for MBIA UK was income of $45 million, a loss of $5 million, and income of $71 million for the years ended December 31, 2016, 2015 and 2014, respectively. The following table summarizes the components of assets and liabilities held for sale as of December 31, 2016:
On January 10, 2017, MBIA Corp. consummated a financing facility (the “Facility”) with affiliates of certain holders of 14% Fixed-to-Floating Rate Surplus Notes of MBIA Corp. (collectively, the “Senior Lenders”), and with MBIA Inc., pursuant to which the Senior Lenders have provided $325 million of senior financing and MBIA Inc. has provided $38 million of subordinated financing to MZ Funding LLC (“MZ Funding”), a newly formed wholly-owned subsidiary of the Company, which in turn lent the proceeds of such financing to MBIA Corp. MBIA Corp. issued financial guarantee insurance policies insuring MZ Funding’s obligations to the Senior Lender and MBIA Inc. under the Facility. Refer to “Note 10: Debt” for further information about the Facility.
MBIA Corp.’s primary objectives are to satisfy claims of its policyholders, and to maximize future recoveries, if any, for its Senior Lenders and surplus note holders and, thereafter, its preferred stock holders. MBIA Corp. is executing this strategy by reducing and mitigating potential losses on its insurance exposures and pursuing various actions focused on maximizing the collection of recoveries. The Company does not expect to write new business in its international and structured finance insurance segment for the foreseeable future.
On the Zohar II Maturity Date, Zohar II failed to pay the amounts due on the Zohar II Notes. Accordingly, MBIA Corp. was presented with a claim of $770 million (the “Zohar II Claim”). MBIA Corp. was able to satisfy the Zohar II Claim as a result of having completed the Sale Transaction and by borrowing from the Facility, as described above, together with using approximately $60 million from its own resources. MBIA Corp. will seek to recover the payment it made (plus interest and expenses) with respect to the Zohar II Claim, and anticipates that the primary source of the recovery will come from the monetization of the assets of Zohar II, which include, among other things, loans made to, and equity interests in, companies purportedly controlled by the sponsor and former collateral manager of Zohar I and Zohar II (the “Zohar Sponsor”) (all the assets of Zohar II, the “Zohar II Assets”). There can be no assurance, however, that the value of the Zohar II Assets will be sufficient to permit MBIA Corp. to recover all or substantially all of the payment it made on the Zohar II Claim.
MBIA Corp. expects over time to recover a substantial amount of the payments made on the Zohar I Claim and the Zohar II Claim. Failure to recover a substantial amount of such payments could impede its ability to make payments when due on other policies. MBIA Corp. believes that if the New York State Department of Financial Services (“NYSDFS”) concludes at any time that MBIA Insurance Corporation will not be able to pay its policyholder claims, the NYSDFS would likely put MBIA Insurance Corporation into a rehabilitation or liquidation proceeding under Article 74 of the New York Insurance Law (“NYIL”) and/or take such other actions as the NYSDFS may deem necessary to protect the interests of MBIA Insurance Corporation’s policyholders. The determination to commence such a proceeding or take other such actions is within the exclusive control of the NYSDFS.
The amount and timing of projected collections from excess spread from residential mortgage-backed securities (“RMBS”) and the put-back recoverable from Credit Suisse are uncertain. Refer to “Note 6: Loss and Loss Adjustment Expense Reserves” for information about MBIA Corp.’s loss reserves and recoveries.
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. As additional information becomes available or actual amounts become determinable, the recorded estimates are revised and reflected in operating results.
Certain amounts have been reclassified in prior years’ financial statements to conform to the current presentation. This includes a change in the presentation of short-term investments held as available-for-sale (“AFS”) to classify only fixed-maturity securities with a remaining maturity of less than one year at the date of purchase in “Short-term investments held as available-for-sale, at fair value” on the Company’s consolidated balance sheet. In prior periods, short-term investments held as AFS previously included all fixed-maturity securities with a remaining effective term to maturity of less than one year. The change in presentation effected “Short-term investments held as available-for-sale, at fair value” and “Fixed maturities held as available-for-sale, at fair value” on the Company’s consolidated balance sheet in prior periods. The reclassifications had no impact on total revenues, expenses, assets, liabilities, shareholders’ equity, operating cash flows, investing cash flows, or financing cash flows for all periods presented.
Level 2-Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 2 assets include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, securities which are priced using observable inputs and derivative contracts whose values are determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.
The Company recognizes in earnings all stock-based payment transactions at the fair value of the stock-based compensation provided. Refer to “Note 16: Long-term Incentive Plans” for a further discussion regarding the methodology utilized in recognizing employee stock compensation expense.
In June of 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-12, “Compensation-Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period.” ASU 2014-12 requires that a performance target that affects vesting of share-based payment awards and that could be achieved after an employee’s requisite service period be accounted for as a performance condition. ASU 2014-12 was effective for interim and annual periods beginning January 1, 2016. The adoption of ASU 2014-12 did not affect the Company’s consolidated financial statements.
In August of 2014, the FASB issued ASU 2014-13, “Consolidation (Topic 810): Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity.” ASU 2014-13 applies to a consolidated collateralized financing entity defined as a VIE that holds financial assets and issues beneficial interests in those financial assets that are classified as financial liabilities. The Company may elect to measure the financial assets and the financial liabilities of a consolidated collateralized financing entity using a measurement alternative provided in ASU 2014-13. The measurement alternative requires both the financial assets and the financial liabilities of the consolidated collateralized financing entity to be measured using the more observable of the fair value of the financial assets and the fair value of the financial liabilities with the changes in fair value recognized to earnings. Upon adoption, a reporting entity may apply the measurement alternative to existing consolidated collateralized financing entities. ASU 2014-13 was effective for interim and annual periods beginning January 1, 2016. The adoption of ASU 2014-13 did not affect the Company’s consolidated financial statements.
In August of 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” ASU 2014-15 requires management to evaluate whether there are conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern, and to provide certain disclosures when it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued. ASU 2014-15 was effective for the annual period ended December 31, 2016 and for interim and annual periods beginning January 1, 2017. The adoption of ASU 2014-15 did not affect the Company’s consolidated financial statements.
Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (ASU 2015-03)
In April of 2015, the FASB issued ASU 2015-03, “Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs.” ASU 2015-03 requires debt issuance costs related to a debt liability measured at amortized cost to be reported in the balance sheet as a direct deduction from the face amount of the debt liability. ASU 2015-03 was effective for interim and annual periods beginning January 1, 2016. The adoption of ASU 2015-03 was applied retrospectively and all previously reported amounts have been conformed to the current presentation. The adoption of ASU 2015-03 did not materially impact the Company’s consolidated financial statements.
In January of 2016, the FASB issued ASU 2016-01, “Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 requires certain equity investments other than those accounted for under the equity method of accounting or result in consolidation of the investee to be measured at fair value with changes in fair value recognized in net income, and permits an entity to measure equity investments that do not have readily determinable fair values at cost less any impairment plus or minus adjustments for certain changes in observable prices. An entity is also required to evaluate the need for a valuation allowance on a deferred tax asset related to AFS debt securities in combination with the entity’s other deferred tax assets. ASU 2016-01 requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability that results from a change in the instrument-specific credit risk for financial liabilities that the entity has elected to measure at fair value in accordance with the fair value option for financial instruments. ASU 2016-01 is effective for interim and annual periods beginning January 1, 2018, and is applied on a modified retrospective basis. Early adoption is not permitted with the exception of early application of the guidance that requires separate presentation in other comprehensive income of the change in the instrument-specific credit risk for financial liabilities measured at fair value in accordance with the fair value option is permitted as of the beginning of the fiscal year of adoption of the standard. The Company is evaluating the impact of adopting ASU 2016-01.
(4)-Reported within “Unearned premium revenue” on MBIA’s consolidated balance sheets. Excludes $134 million that is included within “Liabilities held for sale” on the Company’s consolidated balance sheet.
The following tables present a roll forward of the Company’s premiums receivable for the years ended December 31, 2016 and 2015.
(1)-Primarily consists of premiums receivable of $267 million reported within “Assets held for sale” on MBIA’s consolidated balance sheet.
“Caution List-Medium” -Includes issuers where debt service protection is adequate under current and anticipated circumstances, although adverse trends have developed and are more pronounced than for “Caution List - Low.” Issuers in this category may have breached one or more covenants or triggers. These issuers are more closely monitored by IPM but generally take remedial action on their own.
“Classified List” -Includes all insured obligations where MBIA has paid a claim or where a claim payment is expected. It also includes insured obligations where a significant LAE payment has been made, or is expected to be made, to mitigate a claim payment. This may include property improvements, bond purchases and commutation payments. Generally, IPM is actively remediating these credits where possible, including restructurings through legal proceedings, usually with the assistance of specialist counsel and advisors.
In establishing case basis loss reserves, the Company calculates the present value of probability-weighted estimated loss payments, net of estimated recoveries, using a discount rate equal to the risk-free rate applicable to the currency and the weighted average remaining life of the insurance contract as required by accounting principles for financial guarantee contracts. Yields on U.S. Treasury offerings are used to discount loss reserves denominated in U.S. dollars, which represent the majority of the loss reserves. Similarly, yields on foreign government offerings are used to discount loss reserves denominated in currencies other than the U.S. dollar. If the Company were to apply different discount rates, its case basis reserves may have been higher or lower than those established as of December 31, 2016. For example, a higher discount rate applied to expected future payments would have decreased the amount of a case basis reserve established by the Company and a lower rate would have increased the amount of a reserve established by the Company. Similarly, a higher discount rate applied to the potential future recoveries would have decreased the amount of a loss recoverable established by the Company and a lower rate would have increased the amount of a loss recoverable established by the Company.
Certain local governments remain under financial and budgetary stress and a few have filed for protection under the United States Bankruptcy Code, or have entered into state statutory proceedings established to assist municipalities in managing through periods of severe fiscal stress. This could lead to an increase in defaults by such entities on the payment of their obligations and losses or impairments in greater amounts on the Company’s insured transactions. The Company monitors and analyzes these situations closely, however, the overall extent and duration of such events are uncertain. Also, the filing for protection under the United States Bankruptcy Code or entering state statutory proceedings does not necessarily result in a default or indicate that an ultimate loss will occur.
The international and structured finance insurance segment’s case basis reserves and insurance loss recoveries recorded in accordance with GAAP do not include estimates for policies insuring credit derivatives or on financial guarantee VIEs that are eliminated in consolidation. Policies insuring credit derivative contracts are accounted for as derivatives and are carried at fair value in the Company’s consolidated financial statements under GAAP. The fair values of insured credit derivative contracts are influenced by a variety of market and transaction-specific factors that may be unrelated to potential future claim payments under the Company’s insurance policies. In the absence of credit impairments on insured credit derivative contracts or the early termination of such contracts at a loss, the cumulative unrealized losses recorded from these contracts should reverse before or at the maturity of the contracts. As the Company’s insured credit derivatives have similar terms, conditions, risks, and economic profiles to its financial guarantee insurance policies, the Company evaluates them for impairment, under Statutory accounting, in the same way that it estimates loss and LAE for its financial guarantee policies. Refer to “Note 9: Derivative Instruments” for a further discussion of the Company’s use of derivatives and their impact on the Company’s consolidated financial statements.
The Company’s RMBS reserves and recoveries relate to financial guarantee insurance policies. The Company’s first-lien RMBS case basis reserves primarily relate to RMBS backed by alternative A-paper and subprime mortgage loans. The Company’s second-lien RMBS case basis reserves relate to RMBS backed by home equity lines of credit and closed-end second mortgages. The Company calculated RMBS case basis reserves as of December 31, 2016 for both first and second-lien RMBS transactions using a process called the “Roll Rate Methodology.” The Roll Rate Methodology is a multi-step process using databases of loan level information, proprietary internal cash flow models, and commercially available models to estimate potential losses and recoveries on insured bonds. “Roll Rate” is defined as the probability that current loans become delinquent and subsequently default and loans in the delinquent pipeline are charged-off or liquidated. Generally, Roll Rates are calculated for the previous twelve months and averaged. The loss reserve estimates are based on a probability-weighted average of three scenarios of loan losses (base case, stress case, and an additional stress case). Additional data used for both second and first-liens include historic averages of deal specific voluntary prepayment rates, forward projections of the London Interbank Offered Rate (“LIBOR”) interest rates, and historic averages of deal-specific loss severities.
For first-lien RMBS, the Company estimates the amount of loans that are expected to be liquidated through foreclosure or short sale. The time to liquidation for a defaulted loan is specific to the loan’s delinquency bucket.
The Company monitors portfolio performance on a monthly basis against projected performance, reviewing delinquencies, roll rates, and prepayment rates (including voluntary and involuntary). However, loan performance remains difficult to predict and losses may exceed expectations. In the event of a material deviation in actual performance from projected performance, the Company would increase or decrease the case basis reserves accordingly. If actual performance were to remain at the current levels for six additional months compared to the probability-weighted outcome currently used by the Company, the addition to its second-lien case basis reserves would be approximately $28 million.
The Company primarily records two types of recoveries related to insured RMBS exposures: excess spread that is generated from the trust structures in the insured transactions; and second-lien “put-back” claims related to those mortgage loans whose inclusion in insured securitizations failed to comply with representations and warranties (“ineligible loans”).
Excess spread within insured RMBS securitizations is the difference between interest inflows on mortgage loan collateral and interest outflows on the insured RMBS notes. The amount of excess spread depends on the future loss trends (which include future delinquency trends, average time to charge-off/liquidate delinquent loans, and the availability of pool mortgage insurance), the future spread between Prime and LIBOR interest rates, and borrower refinancing behavior (which may be affected by a continued low interest rate environment) that results in voluntary prepayments. Minor deviations in loss trends and voluntary prepayments may substantially impact the amounts collected from excess spread. Excess spread may also include estimated recoverables from mortgage insurance contracts and subsequent recoveries on charged-off loans associated with the insured RMBS securitizations.
To date, MBIA has settled the majority of the Company’s put-back claims. Only its claims against Credit Suisse remain outstanding. To date, settlement amounts have been consistent with the put-back recoveries that had been included in the Company’s financial statements at the time preceding the settlement.
Based on the Company’s assessment of the strength of its contractual put-back rights against Credit Suisse, which it is pursuing through litigation claims, as well as on its prior settlements with other sellers/servicers and success of other monolines’ put-back settlements, the Company believes it will prevail in enforcing its contractual rights and that it is entitled to collect the full amount of its incurred losses, which totaled $435 million through December 31, 2016. The Company is also entitled to collect interest on amounts paid; it believes that in context of its put-back litigation, the appropriate interest rate should be the New York State statutory rate. However, the Company currently calculates its put-back recoveries using the contractual interest rate, which is lower than the New York State statutory rate.
The Company also has loss and LAE reserves on certain transactions within its CDO portfolio, including its multi-sector CDO and high yield corporate CDO asset classes that were insured in the form of financial guarantee policies. MBIA’s insured multi-sector CDOs are transactions that include a variety of collateral ranging from corporate bonds to structured finance assets (which includes, but are not limited to, RMBS-related collateral, multi-sector and corporate CDOs). MBIA’s high yield corporate CDO portfolio comprises middle-market/special-opportunity corporate loan transactions.
The Company considers several factors when developing the range of potential outcomes and their impact on MBIA. The following approaches require substantial judgments about the future performance of each transaction:
(2)-As of December 31, 2016 and 2015, $53 million and $87 million were eliminated from “Insurance loss recoverable”. As of December 31, 2015, $6 million was eliminated from “Loss and loss adjustment expense reserves” on the Company’s consolidated balance sheets, respectively.
(3)-Reflected in “Loan repurchase commitments” presented under the heading “Assets of consolidated variable interest entities” on the Company’s consolidated balance sheets.
(4) -As of December 31, 2016 and 2015, $45 million and $34 million were included in “Insurance loss recoverable” and $29 million and $46 million were included in “Loss and loss adjustment expense reserves” on the Company’s consolidated balance sheets, respectively.
(1)-Primarily changes in amount of actual loss payments on a high yield corporate CDO.
The increase in the Company’s gross loss and LAE reserves during 2016 were primarily related to increases due to changes in assumptions on insured first and second-lien RMBS transactions and U.S. public finance transactions. These were partially offset by decreases in changes in assumptions on CDOs.
Current period changes in the Company’s estimate of potential recoveries may be recorded as an insurance loss recoverable asset, netted against the gross loss and LAE reserve liability, or both. The following tables present changes in the Company’s insurance loss recoverable and changes in recoveries on unpaid losses reported within the Company’s claim liability for the years ended December 31, 2016 and 2015. Changes in insurance loss recoverable attributable to the accretion of the discount on the recoverable, changes in discount rates, changes in amount and timing of estimated collections, changes in assumptions and changes in LAE recoveries are recorded in “Losses and loss adjustment” expenses in the Company’s consolidated statements of operations. As of December 31, 2015, the Company’s insurance loss recoverable included $6 million related to LAE.
The decrease in the Company’s insurance loss recoverable and recoveries on unpaid losses during 2016 was primarily due to a decrease in expected future recoveries on CDOs as the result of the consolidation of a VIE and related elimination of a VIE and a decrease in changes in the amount of expected collections on first and second-lien RMBS issues, partially offset by an increase related to changes in assumptions on certain Puerto Rico exposures.
The decrease in the Company’s insurance loss recoverable and recoveries on unpaid losses during 2015 was primarily due to actual collections, changes in the amount of expected collections and changes in assumptions on first and second-lien RMBS issues and changes in assumptions on an international road transaction. These were partially offset by the effects of changes in assumptions on CDOs.
For 2016, losses and LAE primarily related to increases in actual and expected payments on certain Puerto Rico exposures and insured first and second-lien RMBS transactions and decreases in projected collections from excess spread within insured second-lien RMBS securitizations. These were partially offset by increases in recoveries of actual and expected payments on certain Puerto Rico exposures and decreases in actual and expected payments on CDOs.
For 2014, losses and LAE primarily related to increases in expected payments on insured first-lien RMBS transactions and CDOs, decreases in projected collections from excess spread within insured second-lien RMBS securitizations and expected recoveries on an international road transaction. These were partially offset by decreases in expected payments on an international road transaction and increases in recoveries of expected payments related to insured first-lien RMBS transactions.
(4)-Represents discount related to Gross Claim Liability and Gross Potential Recoveries.
The following table provides information about the financial guarantees and related claim liability included in each of MBIA’s surveillance categories as of December 31, 2015:
The increase during 2016 in the Company’s number of policies on the classified list reflected in the preceding tables was primarily related to certain Puerto Rico policies. The gross claim liabilities in the preceding tables represent the Company’s estimate of undiscounted probability-weighted estimated future claim payments. The gross claim liability with respect to Puerto Rico and Zohar II exposures are net of expected recoveries. As of December 31, 2016 and 2015, the gross claim liability primarily related to insured first-lien RMBS transactions.
The gross potential recoveries represent the Company’s estimate of undiscounted probability-weighted recoveries of actual claim payments and recoveries of estimated future claim payments. Gross potential recoveries exclude amounts related to Puerto Rico and Zohar II exposures that have been netted against the claim liability. As of December 31, 2016, the gross potential recoveries principally related to U.S. public finance transactions and insured second-lien RMBS transactions. As of December 31, 2015, the gross potential recoveries principally related to insured second-lien RMBS transactions. The Company’s recoveries have been, and remain based on either salvage rights, the rights conferred to MBIA through the transactional documents (inclusive of the insurance agreement), or subrogation rights embedded within financial guarantee insurance policies. Expected salvage and subrogation recoveries, as well as recoveries from other remediation efforts, reduce the Company’s claim liability. Once a claim payment has been made, the claim liability has been satisfied and MBIA’s right to recovery is no longer considered an offset to future expected claim payments, it is recorded as a salvage asset. The amount of recoveries recorded by the Company is limited to paid claims plus the present value of projected estimated future claim payments. As claim payments are made, the recorded amount of potential recoveries may exceed the remaining amount of the claim liability for a given policy. The gross claim liability and gross potential recoveries reflect the elimination of claim liabilities and potential recoveries related to VIEs consolidated by the Company. As of December 31, 2016 and 2015, reinsurance recoverable on paid and unpaid losses was $6 million and were included in “Other assets” on the Company’s consolidated balance sheets.
Financial assets held by the Company primarily consist of investments in debt securities. Substantially all of the Company’s investments are priced by independent third parties, including pricing services and brokers. Typically, the Company receives one pricing service value or broker quote for each instrument, which represents a non-binding indication of value. The Company, along with its third-party portfolio manager, reviews the assumptions, inputs and methodologies used by pricing services and brokers to obtain reasonable assurance that the prices used in its valuations reflect fair value. When the Company and its third-party portfolio manager believe a third-party quotation differs significantly from its internally developed expectation of fair value, whether higher or lower, the Company reviews its data or assumptions with the provider. This review includes comparing significant assumptions such as prepayment speeds, default ratios, forward yield curves, credit spreads and other significant quantitative inputs to internal assumptions, and working with the price provider to reconcile the differences. The price provider may subsequently provide an updated price. In the event that the price provider does not update its price, and the Company still does not agree with the price provided, its third-party portfolio manager will obtain a price from another third-party provider or use an internally developed price which it believes represents the fair value of the investment. The fair values of investments for which internal prices were used were not significant to the aggregate fair value of the Company’s investment portfolio as of December 31, 2016 or 2015. All challenges to third-party prices are reviewed by staff of the Company as well as its third-party portfolio manager with relevant expertise to ensure reasonableness of assumptions. A pricing analysis is reviewed and approved by the Company’s valuation committee.
Valuation techniques for financial instruments measured at fair value or disclosed at fair value are described below.
The investment in the fixed-income fund was measured at fair value as of December 31, 2016 by applying the net asset value per share practical expedient. The investment in the fixed-income fund may be redeemed on a quarterly basis with prior redemption notification of ninety days subject to withdrawal limitations. The investment is required to be held for a minimum of twelve months, and any subsequent quarterly redemption is limited to 25% of the investment or a complete redemption over four consecutive quarters in the amounts of 25%, 33%, 50%, and 100% of the remaining investment balance as of the first, second, third and fourth consecutive quarters, respectively.
The fair value of the held-to-maturity (“HTM”) investments is determined using discounted cash flow models. Key inputs include unobservable cash flows projected over the expected term of the investment discounted using observable interest rate yield curves of similar securities.
Investments based on quoted market prices of identical investments in active markets are classified as Level 1 of the fair value hierarchy. Level 1 investments generally consist of U.S. Treasury and government agency, foreign government, money market securities and perpetual debt and equity securities. Quoted market prices of investments in less active markets, as well as investments which are valued based on other than quoted prices for which the inputs are observable, such as interest rate yield curves, are categorized in Level 2 of the fair value hierarchy. Investments that contain significant inputs that are not observable are categorized as Level 3.
Cash and Cash Equivalents, Receivable for Investments Sold, Securities Sold, Not Yet Purchased, Payable for Investments Purchased, and Accrued Investment Income
Loans receivable at fair value are comprised of loans held by consolidated VIEs consisting of residential mortgage, corporate and commercial loans. Fair values of residential mortgage loans are determined using quoted prices for MBS issued by the respective VIE and adjusted for the fair values of the financial guarantees provided by MBIA Corp. on the related MBS. Fair values of corporate and commercial loans are either obtained from a pricing service and determined using actively quoted prices obtained from multiple market participants, or based on discounted cash flow methodologies. Loans receivable at fair value are categorized in Level 3 of the fair value hierarchy based on an unobservable input that is significant to the fair value measurement in its entirety.
The carrying amounts of accrued interest expense on all other long-term debt approximate fair value due to the short-term nature of the interest payment. Long-term debt is categorized in Level 2 of the fair value hierarchy.
The VIEs have entered into derivative transactions consisting of cross currency swaps and interest rate caps. Fair values of over-the-counter (“OTC”) derivatives are determined using valuation models based on observable and/or unobservable inputs. These observable and market-based inputs include interest rates and volatilities. These derivatives are categorized in Level 2 or Level 3 of the fair value hierarchy based on the lowest level input that is significant to the fair value measurement in its entirety.
The corporate segment has entered into derivative transactions primarily consisting of interest rate swaps. Fair values of OTC derivatives are determined using valuation models based on observable inputs, nonperformance risk of the Company and nonperformance risk of the counterparties. Observable and market-based inputs include interest rate yields, credit spreads and volatilities. These derivatives are categorized in Level 2 or Level 3 of the fair value hierarchy based on the lowest level input that is significant to the fair value measurement in its entirety.
Approximately 97% of the balance sheet fair value of insured credit derivatives as of December 31, 2016 was valued based on the Binomial Expansion Technique (“BET”) Model. Approximately 3% of the balance sheet fair value of insured credit derivatives as of December 31, 2016 was valued based on the internally developed Direct Price Model and the Dual Default model. The valuation of insured derivatives includes the impact of its credit standing. The insured credit derivatives are categorized as Level 3 of the fair value hierarchy based on unobservable inputs that are significant to the fair value measurement in its entirety.
Inputs to the process of determining fair value for structured transactions using the BET Model include estimates of collateral loss, allocation of loss to separate tranches of the capital structure, credit spreads, recovery rates and nonperformance risk and weighted average life.
As of December 31, 2016 and 2015, the Company’s net insured CDS derivative liability was $64 million and $85 million, respectively, based on the results of the aforementioned models. A significant driver of changes in fair value is MBIA Corp.’s nonperformance risk. In aggregate, the nonperformance calculation resulted in a pre-tax net insured derivative liability that was $11 million and $99 million lower than the net liability that would have been estimated if MBIA Corp. excluded nonperformance risk in its valuation as of December 31, 2016 and 2015, respectively.
Stock warrants issued by the Company are valued using the Black-Scholes model and are recorded at fair value. Inputs into the warrant valuation include the Company’s stock price, a volatility parameter, interest rates, and dividend data. As all significant inputs are market-based and observable, warrants are categorized in Level 2 of the fair value hierarchy.
Gross Financial Guarantees -The fair value of gross financial guarantees is determined using discounted cash flow techniques based on inputs that include (i) assumptions of expected losses on financial guarantee policies where loss reserves have not been recognized, (ii) amount of losses expected on financial guarantee policies where loss reserves have been established, net of expected recoveries, (iii) the cost of capital reserves required to support the financial guarantee liability, (iv) operating expenses, and (v) discount rates. The MBIA Corp. CDS spread and recovery rate are used as the discount rate for MBIA Corp., while the CDS spread and recovery rate of a similar municipal bond insurance company are used as the discount rate for National, as National does not have a published CDS spread and recovery rate.
Ceded Financial Guarantees - The fair value of ceded financial guarantees is determined by applying the percentage ceded to reinsurers to the related fair value of the gross financial guarantees. The carrying value of ceded financial guarantees consists of prepaid reinsurance premiums and reinsurance recoverable on paid and unpaid losses as reported within “Other assets” on the Company’s consolidated balance sheets.
The significant unobservable inputs used in the fair value measurement of the Company’s loan repurchase commitments of consolidated VIEs are the recovery rates and breach rates. Recovery rates reflect the estimates of future cash flows reduced for litigation delays and risks and/or potential financial distress of the sellers/servicers. The estimated recoveries of the loan repurchase commitments may differ from the actual recoveries that may be received in the future. Breach rates represent the rate at which mortgages fail to comply with stated representations and warranties of the sellers/servicers. Significant increases or decreases in the recovery rates and the breach rates would result in significantly higher or lower fair values of the loan repurchase commitments, respectively. Additionally, changes in the legal environment and the ability of the counterparties to pay would impact the recovery rate assumptions, which could significantly impact the fair value measurement. Any significant challenges by the counterparties to the Company’s determination of breaches of representations and warranties could have a material adverse impact on the fair value measurement. Recovery rates and breach rates are determined independently. Changes in one input will not necessarily have any impact on the other input.
The following tables present the fair value of the Company’s assets (including short-term investments) and liabilities measured and reported at fair value on a recurring basis as of December 31, 2016 and 2015:
Level 3 assets at fair value as of December 31, 2016 and 2015 represented approximately 21% and 19%, respectively, of total assets measured at fair value. Level 3 liabilities at fair value as of December 31, 2016 and 2015 represented approximately 37% and 52%, respectively, of total liabilities measured at fair value.
The following tables present the fair values and carrying values of the Company’s assets and liabilities that are disclosed at fair value but not reported at fair value on the Company’s consolidated balance sheets as of December 31, 2016 and 2015:
The following tables present information about changes in Level 3 assets (including short-term investments) and liabilities measured at fair value on a recurring basis for the years ended December 31, 2016 and 2015:
For the year ended December 31, 2016, transfers into Level 3 and out of Level 2 were principally related to other asset-backed, commercial mortgage-backed, corporate obligations, state and municipal bonds, and RMBS, where inputs, which are significant to their valuation, became unobservable during the period. Corporate obligations, other asset-backed, and state and municipal bonds, comprised the majority of the instruments transferred out of Level 3 where inputs, which are significant to their valuation, became observable during the period. These inputs included spreads, prepayment speeds, default speeds, default severities, yield curves observable at commonly quoted intervals, and market corroborated inputs. There were no transfers into or out of Level 1.
The following table presents the changes in fair value included in the Company’s consolidated statements of operations for the years ended December 31, 2016, 2015 and 2014 for financial instruments for which the fair value option was elected:
Substantially all gains and losses included in earnings during the years ended December 31, 2016 and 2015 on loans receivable and VIE notes reported in the preceding table are attributable to credit risk. This is primarily due to the high rate of defaults on loans and the collateral supporting the VIE notes, resulting in depressed pricing of the financial instruments.
The following tables present the amortized cost, fair value, corresponding gross unrealized gains and losses and OTTI for AFS and HTM investments in the Company’s consolidated investment portfolio as of December 31, 2016 and 2015:
The following table presents the distribution by contractual maturity of AFS and HTM fixed-maturity securities at amortized cost and fair value as of December 31, 2016. Contractual maturity may differ from expected maturity as borrowers may have the right to call or prepay obligations.
The fair value of securities on deposit with various regulatory authorities as of December 31, 2016 and 2015 was $11 million and $10 million, respectively. These deposits are required to comply with state insurance laws.
The following tables present the gross unrealized losses related to AFS and HTM investments as of December 31, 2016 and 2015:
Gross unrealized losses on AFS investments decreased as of December 31, 2016 compared with December 31, 2015 primarily due to narrowing of credit spreads, partially offset by higher interest rates.
The following table presents the fair value and gross unrealized loss by credit rating category of ABS, MBS and corporate obligations included in the Company’s consolidated AFS investment portfolio, as of December 31, 2016, for which fair value was less than amortized cost. The credit ratings are based on ratings from Moody’s as of December 31, 2016 or an alternate ratings source, such as S&P, when a security is not rated by Moody’s. For investments that are insured by various third-party guarantee insurers, the credit rating reflects the higher of the insurer’s rating or the underlying bond’s rating.
RMBS investments are evaluated for OTTI using several quantitative tools. Loan level data is obtained and analyzed in a model that produces prepayment, default, and severity vectors. The model uses macro inputs, including housing price assumptions and interest rates. The vector outputs are used as inputs to a third-party cash flow model, which considers deal waterfall dynamics and structural features, to generate cash flows for an RMBS investment. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income of the security to arrive at a present value amount. If the present value of the cash flows is less than the Company’s amortized cost for the investment, the difference is recorded as an OTTI loss.
The following table provides information about securities held by the Company as of December 31, 2016 that were in an unrealized loss position and insured by a financial guarantor, along with the amount of insurance loss reserves corresponding to the par amount owned by the Company:
The portion of certain OTTI losses on fixed-maturity securities that does not represent credit losses is recognized in AOCI. For these impairments, the net amount recognized in earnings represents the difference between the amortized cost of the security and the net present value of its projected future discounted cash flows prior to impairment. Any remaining difference between the fair value and amortized cost is recognized in AOCI. The following table presents the amount of credit loss impairments recognized in earnings on fixed-maturity securities held by MBIA as of the dates indicated, for which a portion of the OTTI losses was recognized in AOCI, and the corresponding changes in such amounts. The additional credit loss impairments for the years ended December 31, 2016, 2015 and 2014, primarily related to a corporate obligation that incurred liquidity concerns, ongoing credit risk and other adverse financial conditions.
The following tables present information about credit derivatives sold by the Company’s insurance operations that were outstanding as of December 31, 2016 and 2015. Credit ratings represent the lower of underlying ratings assigned to the collateral by Moody’s, S&P or MBIA.
Internal credit ratings assigned by MBIA on the underlying collateral are derived by the Company’s surveillance group. In assigning an internal rating, current status reports from issuers and trustees, as well as publicly available transaction-specific information, are reviewed. Also, where appropriate, cash flow analyses and collateral valuations are considered. The maximum potential amount of future payments (undiscounted) on CDS contracts are estimated as the notional value plus any additional debt service costs, such as interest or other amounts owing on CDS contracts. The maximum amount of future debt service payments that MBIA may be required to make under these guarantees as of December 31, 2016 is $637 million. The maximum potential amount of future payments (undiscounted) on insured swaps are estimated as the notional value of such contracts.
As of December 31, 2016, the total fair value of the Company’s derivative assets was $25 million, of which $23 million was reported within “Other assets” and “Other assets” presented under “Assets of consolidated variable interest entities” on the Company’s consolidated balance sheets. Embedded derivatives of $2 million were reported within “Medium-term notes” on the Company’s consolidated balance sheets.
As of December 31, 2016, the total fair value of the Company’s derivative liabilities was $316 million, of which $299 million was reported within “Derivative liabilities” on the Company’s consolidated balance sheets. Embedded derivatives of $17 million were reported within “Medium-term notes” on the Company’s consolidated balance sheets.
As of December 31, 2015, the total fair value of the Company’s derivative liabilities, after counterparty netting of $1 million and cash collateral posted by the Company of $31 million, was $374 million, of which $359 million was reported within “Derivative liabilities” and “Derivative liabilities” presented under “Liabilities of consolidated variable interest entities” on the Company’s consolidated balance sheets. Embedded derivatives of $15 million were reported within “Medium-term notes” on the Company’s consolidated balance sheets.
(2)-Callable anytime at the greater of par or the present value of the remaining scheduled payments of principal and interest.
In addition to the preceding table, as of December 31, 2016, National owned $136 million principal amount of the 5.700% Senior Notes due 2034 and MBIA Inc., through its corporate segment, owned $13 million of MBIA Corp. surplus notes that are eliminated on a consolidated basis.
The aggregate maturities of principal payments of long-term debt obligations in each of the next five years ending December 31, and thereafter, are as follows:
In connection with the Zohar II Claim, in January of 2017, MBIA Corp. consummated the Facility with the Senior Lenders and with MBIA Inc., pursuant to which the Senior Lenders have provided $325 million of senior financing and MBIA Inc. has provided $38 million of subordinated financing to MZ Funding, which in turn lent the proceeds of such financing to MBIA Corp. Under the Facility, MBIA Inc. has agreed to provide an additional $50 million subordinated financing to MZ Funding, which MZ Funding would then lend to MBIA Corp., if needed by MBIA Insurance Corporation for liquidity purposes. The loans to MBIA Corp. under the Facility mature on January 20, 2020 and bear interest at 14% per annum. The Facility is secured by a first priority security interest in all of MBIA Corp.’s right, title and interest in to recovery of its claims from the assets of Zohar I and Zohar II which include, among other things, loans made to, and equity interests in, companies purportedly controlled by the Zohar Sponsor and any claims that the Company may have against the Zohar Sponsor.
(2)-Includes discounts net of carrying amount adjustments of $66 million, net of accrued interest of $5 million.
(1)-Amounts reflect principal due at maturity for notes issued at a discount.
(2)-Includes discounts net of carrying amount adjustments and bifurcated embedded derivatives of $279 million, fair value adjustments of $57 million, net of accrued interest of $3 million.
VIE notes are variable interest rate debt instruments that were issued primarily in U.S. dollars by consolidated VIEs within the Company’s international and structured finance insurance segment. These VIE notes consist of debt instruments issued by issuer-sponsored consolidated VIEs collateralized by assets held by those consolidated VIEs. As of December 31, 2016, for VIE notes not accounted for at fair value, contractual interest rates ranged from 1.07% to 2.77% and the weighted average interest rate was 2.25%.
The tax effects of temporary differences that give rise to deferred tax assets and liabilities as of December 31, 2016 and 2015 are presented in the following table:
However, as the prediction of adequate future taxable income and foreign sourced income within the carryforward period is not assured, the Company has concluded that a valuation allowance for the foreign tax credits being carried forward is appropriate. As of December 31, 2016, the valuation allowance was $7 million.
It is also possible that some or all of the Company’s foreign tax credits expected to offset U.S. taxes on the sale of MBIA UK could ultimately expire unused. Therefore, a valuation allowance to reduce the Company’s U.S. deferred tax asset related to foreign tax credits may be required at the time the sale of MBIA UK is completed.
The Company has a tax sharing agreement among its members effective January 1, 1987. The agreement was amended and restated effective September 8, 2011 to change the method of calculating each domestic insurer’s tax liability to the method permitted by paragraph 3(a) of Department Circular Letter #33 (1979). The agreement was submitted to the NYSDFS for review and non-disapproval pursuant to Section 1505 of the New York Insurance Law. Refer to “Note 2: Significant Accounting Policies” for further discussion on the Company’s tax sharing agreement.
As of December 31, 2015, U.S. deferred income taxes were provided on the differences in the book and tax basis in the Company’s carrying value of MBIA UK and certain other entities on the basis that foreign dividends would be remitted over time as the Company no longer intended to permanently reinvest these earnings. Due to the held for sale accounting for MBIA UK as of December 31, 2016, the Company has revised its calculation of deferred income taxes with respect to the differences in book and tax basis. The revision to deferred taxes related to MBIA UK is due to a change in assertion of MBIA UK paying future dividends over time to calculating deferred taxes on the basis of the sale of MBIA UK.
The Company’s policy is to record and disclose any change in unrecognized tax benefits (“UTB”) and related interest and/or penalties to income tax in the consolidated statements of operations. The Company includes interest as a component of income tax expense. As of December 31, 2016 and 2015, the Company had no UTB.
LaCrosse Financial Products, LLC, a wholly-owned affiliate, in which MBIA Insurance Corporation has written insurance policies guaranteeing the obligations under CDS. Certain policies cover payments potentially due under CDS, including termination payments that may become due in certain circumstances, including the occurrence of certain insolvency or payment defaults under the CDS or derivatives contracts by the insured counterparty or by the guarantor.
The following tables provide the Company’s segment results for the years ended December 31, 2016, 2015 and 2014:
The creditworthiness of each insured obligation is evaluated prior to the issuance of insurance, and each insured obligation must comply with National’s or MBIA Corp.’s underwriting guidelines. Further, the payments to be made by the issuer on the bonds or notes may be backed by a pledge of revenues, reserve funds, letters of credit, investment contracts or collateral in the form of mortgages or other assets. The right to such funds or collateral would typically become National’s or MBIA Corp.’s upon the payment of a claim by either National or MBIA Corp.
As of December 31, 2016, insurance in force, which represents principal and interest or other amounts owing on insured obligations, had an expected maturity range of 1 to 41 years. The distribution of MBIA Corp.’s and National’s combined insurance in force by geographic location, excluding $1.9 billion and $2.2 billion relating to debt obligations guaranteed by MBIA Corp. on behalf of affiliated companies as of December 31, 2016 and 2015, respectively, is presented in the following table:
(2)-Includes investor owned utilities, industrial development and pollution control revenue bonds.
Included in the preceding tables, as of December 31, 2016, there was $18.6 billion of insurance in force related to MBIA UK, which was sold to Assured in January of 2017. Refer to “Note 1: Business Developments and Risks and Uncertainties” for a discussion on the sale of MBIA UK. The insurance operations have entered into certain guarantees of derivative contracts, included in the preceding tables, which are accounted for as derivative instruments. MBIA generally guarantees the timely payment of principal and interest related to these derivatives upon the occurrence of a credit event with respect to a referenced obligation. The maximum amount of future payments that MBIA may be required to make under these guarantees is $1 billion. MBIA’s guarantees of derivative contracts have a legal maximum maturity range of 1 to 40 years. A small number of insured credit derivative contracts have long-dated maturities, which comprise the longest maturity dates of the underlying collateral. However, the expected maturities of such contracts are much shorter due to amortizations and prepayments in the underlying collateral pools. The fair values of these guarantees as of December 31, 2016 and 2015 are recorded on the consolidated balance sheets as derivative liabilities, representing gross losses, of $66 million and $88 million, respectively.
Investment agreement contracts and MTNs issued by the Company’s corporate segment are insured by MBIA Corp. and are not included in the previous tables. If MBIA Inc. or these subsidiaries were to have insufficient assets to pay amounts due, MBIA Corp. would be obligated to make such payments under its insurance policies. As of December 31, 2016, the maximum amount of future payments that MBIA Corp. could be required to make under these guarantees is $1.9 billion. These guarantees, which have a maximum maturity range of 1 to 21 years, were entered into on an arm’s length basis. MBIA Corp. has both direct recourse provisions and subrogation rights in these transactions. If MBIA Corp. is required to make a payment under any of these affiliate guarantees, it would have the right to seek reimbursement from such affiliate and to liquidate any collateral to recover amounts paid under the guarantee.
Reinsurance enables the Company to cede exposure for purposes of syndicating risk. When a reinsurer is downgraded by one or more of the rating agencies, less capital credit is given to MBIA under rating agency models and the overall value of the reinsurance to MBIA is reduced. The Company generally retains the right to reassume the business ceded to reinsurers under certain circumstances, including a reinsurer’s rating downgrade below specified thresholds. The Company does not use reinsurance on new policies to decrease its insured exposure.
As of December 31, 2016, the aggregate amount of insured par outstanding ceded by MBIA to reinsurers under reinsurance agreements was $4.2 billion compared with $5.3 billion as of December 31, 2015. As of December 31, 2016, $3.4 billion of the ceded par outstanding was ceded from the Company’s U.S. public finance insurance segment and $804 million was ceded from the Company’s international and structured finance insurance segment. Under National’s reinsurance agreement with MBIA Corp., if a reinsurer of MBIA Corp. is unable to pay claims ceded by MBIA Corp. on U.S. public finance exposure, National will assume liability for such ceded claim payments. The following table presents information about the Company’s reinsurance agreements as of December 31, 2016 for its U.S. public finance and international and structured finance insurance operations.
National and MBIA Insurance Corporation are subject to insurance regulations and supervision of the State of New York (their state of incorporation) and all U.S. and non-U.S. jurisdictions in which they are licensed to conduct insurance business. In order to maintain their New York State financial guarantee insurance license, National and MBIA Insurance Corporation are required to maintain a minimum of $65 million of policyholders’ surplus. MBIA UK is authorized by the Prudential Regulation Authority (“PRA”) and regulated by the Financial Conduct Authority (“FCA”) and the PRA in the United Kingdom. MBIA Mexico is regulated by the Comisión Nacional de Seguros y Fianzas in Mexico. The extent of insurance regulation and supervision varies by jurisdiction, but New York and most other jurisdictions have laws and regulations prescribing minimum standards of solvency and business conduct, which must be maintained by insurance companies. Among other things, these laws prescribe permitted classes and concentrations of investments and limit both the aggregate and individual securities risks that National and MBIA Insurance Corporation may insure on a net basis based on the type of obligations insured. In addition, some insurance laws and regulations require the approval or filing of policy forms and rates. National and MBIA Insurance Corporation are required to file detailed annual financial statements with the NYSDFS and MBIA UK is required to file annual regulatory returns with the PRA and the FCA. The operations and accounts of National and MBIA Insurance Corporation are subject to examination by regulatory agencies at regular intervals.
In 2016, MBIA Insurance Corporation did not declare or pay any dividends to MBIA Inc. or the holders of its preferred stock. MBIA Insurance Corporation is currently unable to pay dividends, including those related to its preferred stock, as a result of its earned surplus deficit as of December 31, 2016 and is not expected to have any statutory capacity to pay any dividends in the near term. In connection with MBIA Insurance Corporation obtaining approval from the NYSDFS to release excessive contingency reserves in prior periods, as described below, MBIA Insurance Corporation agreed that it would not pay any dividends without prior approval from the NYSDFS.
Under the NYIL, MBIA Insurance Corporation is also required to establish a contingency reserve to provide protection to policyholders in the event of extreme losses in adverse economic events. The amount of the reserve is based on the percentage of principal insured or premiums earned, depending on the type of obligation (net of collateral, reinsurance, refunding, refinancings and certain insured securities). Under the NYIL, MBIA Insurance Corporation is required to invest its minimum surplus and contingency reserves, and 50% of its loss reserves and unearned premium reserves, in certain qualifying assets. As of December 31, 2016, MBIA Insurance Corporation maintained its minimum requirement of policyholders’ surplus but did not have enough qualifying assets to support its contingency reserves and 50% of its loss reserves and unearned premium reserves. Not having enough qualifying assets to support its contingency reserves limits the amount of earned surplus that might otherwise be available for the payment of dividends. Reductions in the contingency reserve may be recognized based on excess reserves and under certain stipulated conditions, subject to the approval of the Superintendent of the NYSDFS.
In addition to the above two plans, the Company maintains a non-qualified deferred compensation plan. Contributions to the above qualified plans that exceed limitations established by federal regulations are then contributed to the non-qualified deferred compensation plan. The non-qualified pension expense for the years ended December 31, 2016, 2015 and 2014 was $2 million, $1 million, and $2 million, respectively. The non-qualified profit sharing/401(k) expense for each of the years ended December 31, 2016, 2015 and 2014 was $1 million for each year.
Under the restricted stock component of the Omnibus Plan, certain employees are granted restricted shares of the Company’s common stock. These awards have a restriction period lasting three to five years depending on the type of award, after which time the awards fully vest. During the vesting period, these shares may not be sold. Restricted stock may be granted to all employees.
The fair value of the restricted shares awarded, net of cancellations, determined on the grant date was $5 million and $4 million for 2016 and 2015, respectively. The amount of unearned compensation, net of estimated forfeitures, was $9 million as of December 31, 2016, which is expected to be recognized as expense over a weighted average period of 2.1 years. Unearned compensation is amortized to expense over the appropriate three to five-year vesting period.
Compensation expense related to the restricted shares, net of estimated forfeitures, was $16 million, $20 million and $18 million for the years ended December 31, 2016, 2015 and 2014, respectively. The tax charge related to the restricted shares awards during 2016 and 2015 was $1 million and $2 million, respectively. The tax benefit related to the restricted share awards during 2014 was $2 million.
A summary of the Company’s restricted shares outstanding as of December 31, 2016, 2015 and 2014, and changes during the years ended on those dates, is presented in the following table:
During 2014, the Company granted three million restricted shares to certain key employees which have a vesting schedule dependent on the achievement of certain stock price targets of the Company. The grants and corresponding compensation expense have been included in the above restricted stock disclosures. As permitted by the accounting guidance for share-based payments, the Company estimates the fair value of awards that contain market performance conditions at the date of grant using a binomial lattice model with a Monte Carlo simulation. The binomial lattice model can better incorporate assumptions about a stock price path because the model can accommodate a large number of potential stock prices over the award’s term in comparison to the Black-Scholes model.
In February of 2015, the Company reported the expiration of the Warburg Warrant, Warburg B Warrant and Warburg B2 Warrant. In April of 2016, Warburg transferred the Gross-Up Warrant to Highbridge International LLC.
In the fourth quarter of 2014, the Company’s Board of Directors authorized the repurchase of common stock up to $200 million under a new share repurchase program. On July 29, 2015, the Company’s Board of Directors authorized the repurchase by the Company or its subsidiaries of up to $100 million of its outstanding shares under a new share repurchase program, which superseded and terminated the prior fourth quarter 2014 authorization. The prior authorization had approximately $61 million of unused capacity at the time it was terminated. On October 28, 2015, the Company’s Board of Directors authorized the repurchase by the Company or its subsidiaries of up to $100 million of its outstanding common stock under a new share repurchase program, as the Company’s July 29, 2015 authorization was fully exhausted. During 2016, the Company exhausted any remaining capacity under the October 28, 2015 repurchase program.
On February 23, 2016, the Company’s Board of Directors authorized the repurchase by the Company and its subsidiaries of up to $100 million of its outstanding shares under a new share repurchase authorization. As of December 31, 2016, $88 million remained available under this new program.
As of December 31, 2016, MBIA Insurance Corporation had 2,759 shares of preferred stock issued and outstanding with a carrying value of $28 million, including 1,444 shares held by MBIA Inc. that were purchased at a weighted average price of $10,900 per share or 10.9% of face value and 1,315 shares held by unaffiliated investors. During 2016, MBIA Inc. did not repurchase any additional shares.
The following table presents the changes in the components of AOCI for the years ended December 31, 2016, 2015 and 2014:
The following table presents the details of the reclassifications from AOCI for the years ended December 31, 2016, 2015 and 2014:
On December 14, 2009, MBIA Corp. commenced an action in New York State Supreme Court, New York County, against Credit Suisse Securities (USA) LLC, DLJ Mortgage Capital, Inc. and Select Portfolio Servicing Inc. (collectively, “Credit Suisse”). The complaint seeks damages for fraud and breach of contractual obligations in connection with the procurement of financial guarantee insurance on the Home Equity Mortgage Trust Series 2007-2 securitization. On January 30, 2013, MBIA Corp. filed an amended complaint. The amended complaint alleges, among other claims, that Credit Suisse falsely represented: (i) the attributes of the securitized loans; (ii) that the loans complied with the governing underwriting guidelines; and (iii) that Credit Suisse had conducted extensive due diligence on and quality control reviews of the securitized loans to ensure compliance with the underwriting guidelines. The complaint further alleges that the defendants breached their contractual obligations to cure or repurchase loans found to be in breach of the representations and warranties applicable thereto and denied MBIA the requisite access to all records and documents regarding the securitized loans. An argument on both parties’ motions for partial summary judgment was held on November 15, 2016 and a decision is pending.
On July 23, 2008, the City of Los Angeles filed a complaint in the Superior Court of the State of California, County of Los Angeles, against a number of financial guarantee insurers, including MBIA. At the same time and subsequently, additional complaints against MBIA and nearly all of the same co-defendants were filed by various municipal entities and quasi-municipal entities, mostly in California. These cases are part of a coordination proceeding in Superior Court, San Francisco County, before Judge Curtis E. A. Karnow, referred to as the Ambac Bond Insurance Cases. In August of 2011, the plaintiffs filed amended versions of their respective complaints. The claims allege violation of California’s antitrust laws through maintaining a dual credit rating scale that misstated the credit default risk of certain issuers, thereby creating market demand for bond insurance. The plaintiffs also allege that the individual bond insurers participated in risky financial transactions in other lines of business that damaged each bond insurer’s financial condition, and failure to adequately disclose the impact of those transactions on their financial condition. The plaintiffs also assert common law claims of breach of contract and fraud. The non-municipal plaintiffs also allege a California unfair competition cause of action. Following an appeal of the dismissal of the plaintiff’s anti-trust claim under California’s Cartwright Act, the California Court of Appeal reinstated those claims against the bond insurer defendants on February 18, 2016. On April 8, 2016, Judge Mary E. Wiss recused and disqualified herself from further proceedings in the matter. On April 14, 2016, Judge Curtis E. A. Karnow was assigned to sit as the Coordination Trial Judge. On June 24, 2016, the defendants, including the MBIA parties, filed their answers to the complaints.
On November 2, 2015, Lynn Tilton and Patriarch Partners XV, LLC filed a complaint in New York State Supreme Court, Westchester County, against MBIA Inc. and MBIA Corp., alleging fraudulent inducement and related claims arising from purported promises made in connection with insurance policies issued by MBIA Corp. on certain collateralized loan obligations managed by Ms. Tilton and affiliated Patriarch entities, and seeking damages. The plaintiffs filed an amended complaint on January 15, 2016. On December 27, 2016, Justice Alan D. Scheinkman granted in part and denied in part MBIA’s motion to dismiss. On January 17, 2017, MBIA filed its answer. A scheduling order was entered on January 6, 2017 setting a Trial Readiness Conference for October 19, 2017.
National Public Finance Guarantee Corporation v. Padilla, Civ. No. 16-cv-2101 (D.P.R. June 15, 2016)
On June 15, 2016, National filed a complaint in federal court in Puerto Rico challenging the Puerto Rico Emergency Moratorium and Financial Rehabilitation Act (Law 21-2016 or the “Moratorium Act”) as unconstitutional under the United States Constitution. On June 22, 2016, National filed a motion for partial summary judgment on its claim that the Moratorium Act is preempted by the federal Bankruptcy Code. On July 7, 2016, the Puerto Rico defendants filed a motion to stay the case pursuant to the Puerto Rico Oversight, Management and Economic Stability Act (“PROMESA”), which was granted by the Court in August of 2016. The defendants filed their answer to the complaint on July 26, 2016. On November 15, 2016, the District Court denied National’s motion to lift the litigation stay granted pursuant to PROMESA. On January 11, 2017, the U.S. Court of Appeals for the First Circuit affirmed the denial of a separate plaintiff’s motion to lift the PROMESA stay in a related action challenging the Moratorium Act. Accordingly, the case remains stayed.
Refer to “Note 20: Commitments and Contingencies” for information about legal proceedings that occurred after December 31, 2016.