the possibility that we will experience severe losses due to the continued deterioration in the performance of residential mortgage-backed securities and collateralized debt obligations;
MBIA’s insurance operations are principally conducted through MBIA Insurance Corporation and its subsidiaries (“MBIA Corp.”). MBIA Corp. issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public-purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and pools of corporate and asset-backed bonds, and bonds backed by other revenue sources such as corporate franchise revenues, both in the new issue and secondary markets. Additionally, MBIA Corp. has insured credit default swaps primarily on pools of collateral, which it considered part of its core financial guarantee business. The financial guarantees issued by MBIA Corp. provide an unconditional and irrevocable guarantee of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that MBIA Corp. has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon such acceleration by MBIA Corp.
On February 25, 2008, the Company announced that it has ceased insuring new credit derivative contracts except in transactions related to the reduction of existing derivative exposure. In addition, the Company announced that it has suspended the writing of all new structured finance business for approximately six months.
MBIA’s municipal services operations consisted of the activities of MuniServices and Capital Asset. As a result of the sale of MuniServices and Capital Asset, the Company no longer reports municipal services operations and the assets, liabilities, revenues and expenses of these entities have been reported within discontinued operations for 2006 and 2005 in accordance with Statement of Financial Accounting Standards No. (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” See “Note 15: Discontinued Operations” in the Notes to Consolidated Financial Statements for information relating to the Company’s discontinued operations.
The Company’s results of operations for the years ended December 31, 2007, 2006 and 2005 are discussed in the “Results of Operations” section included herein.
Prior to the fourth quarter of 2007, MBIA Corp. and its insurance subsidiaries had triple-A financial strength ratings with stable outlook from Standard and Poor’s Corporation (“S&P”), Moody’s Investors Service, Inc. (“Moody’s”), Fitch, Inc. (“Fitch”) and Rating and Investment Information, Inc. Following the recent stress in the collateralized debt obligations (“CDOs”) and mortgage sectors and the increased risk that more underlying credit ratings of transactions insured by MBIA will be downgraded by S&P, Moody’s and Fitch, the three major rating agencies took the following actions:
On January 15, 2008, S&P announced that it had revised its surveillance assumptions for U.S. RMBS, in particular that it increased the expected loss assumption for 2006 vintage subprime collateral to 19% from 14%. The change in assumptions was driven by negative trends in monthly performance data for subprime mortgages as well as certain macroeconomic factors driving U.S. home prices.
On December 14, 2007, Moody’s released ratings announcements concerning a number of financial guarantee insurers, including MBIA Corp., resulting from Moody’s reassessment of such insurer’s capital adequacy. Moody’s affirmed MBIA Corp.’s insurance financial strength at “Aaa” but changed its outlook for MBIA Corp. to “negative” from “stable” while confirming the outlook of three of MBIA Corp.’s competitors as “stable”. Moody’s indicated that this action reflected the stress to MBIA Corp. from its mortgage-related exposures, as well as the steps already taken, and likely to be taken, by MBIA Corp. to strengthen its capital position. Moody’s also indicated that MBIA Corp.’s current capitalization was below the target Aaa level, and would be close to the minimum Aaa level under Moody’s stress scenario. Moody’s further indicated that while it believed that the investment by Warburg Pincus, as described in the “Capital Resources-Capital Strengthening Plan” section under “Warburg Pincus Agreement,” would address MBIA Corp.’s estimated shortfall in hard capital, the negative outlook reflects uncertainty concerning the performance of MBIA Corp.’s insured portfolio and the ultimate resolution of its total capital plan. In addition, Moody’s stated that it will evaluate any changes in MBIA Corp.’s governance, strategy and risk management made in response to the material stress faced by MBIA Corp. on its mortgage-related exposures. Moody’s stated in its announcement that it expected to revise MBIA Corp.’s outlook to “stable” to the extent MBIA Corp. executed an overall capital plan that reestablished a robust capital position.
On January 31, 2008, Moody’s published its preliminary views about the financial guarantee insurance industry. It stated that its estimate of the capital needed to support the mortgage-related risk of some guarantors has risen significantly, and that some existing firms may be unable to restore financial strength to levels consistent with a Aaa rating, which could possibly lead them to pursue a more narrow business focus or enter into runoff. Moody’s indicated that a Aaa guarantor needs an adequate level of capital, a risk management and underwriting framework commensurate with that capital, and a viable business plan. Moody’s suggested that if any
one of these characteristics were judged by it to be inadequate, it would expect to lower the guarantor’s rating. Moody’s added that the business orientation and underwriting guidelines of firms in this sector might require meaningful change in order to retain Aaa ratings.
On December 20, 2007, Fitch placed the AA ratings of MBIA Inc. and AAA ratings of MBIA Corp. and its subsidiaries on rating watch negative pending MBIA Inc.’s raising additional capital, while confirming the outlook of two of MBIA Corp.’s competitors as “stable.” In its press release, Fitch identified a shortfall of approximately $1 billion and stated that “If at any time during the next four-to-six weeks, MBIA is able to obtain capital commitments and/or put in place reinsurance or other risk mitigation measures, on top of the $1 billion capital commitment the company received from Warburg Pincus, that would help improve MBIA’s Matrix result at an ‘AAA’ rating stress, Fitch would anticipate affirming MBIA’s ratings with a Stable Rating Outlook.” Fitch also noted that if MBIA Inc. was unable to obtain capital commitments or put into place reinsurance or other risk mitigation measures to address its capital shortfall in the noted timeframe, Fitch would expect to downgrade MBIA Corp.’s insurer financial strength ratings by one notch to “AA+.”
On February 5, 2008, Fitch placed the AAA insurer financial strength ratings of MBIA Corp. and its insurance affiliates, the AA ratings of MBIA Corp.’s Surplus Notes and the AA long-term debt rating of MBIA Inc. on rating watch negative. Fitch announced that it was updating certain modeling assumptions in its ongoing analysis of the financial guaranty industry, specifically related to exposures to structured finance collateralized debt obligations (“SF CDOs”). Fitch expects that simulated capital model losses and expected losses will increase materially for MBIA Corp. due to its exposure to SF CDOs and that these losses may be inconsistent with its AAA rating standards for financial guarantors. Fitch noted that MBIA’s addition of $1.5 billion of new capital with a further $500 million equity investment through a rights offering backstopped from Warburg Pincus “may not be sufficient to address the necessary capital needed to maintain MBIA’s ‘AAA’ insurer financial strength rating.”
MBIA Inc.’s and MBIA Corp.’s current financial strength ratings from the major rating agencies are summarized below:
In addition to its announced capital strengthening plan, on February 25, 2008, the Company announced its intention to reorganize its insurance operations in a manner that would provide public finance and structured finance insurance from separate operating entities. This reorganization is expected to be completed within the next five years. See “Note 29: Subsequent Events” in the Notes to Consolidated Financial Statements for a discussion of the reorganization of the insurance operations.
Significant changes to any variables on which the loss factor is based, over an extended period of time, would likely result in an increase or decrease in the Company’s loss factor with a corresponding increase or decrease in the amount of the Company’s loss and LAE provision. For example, as external and internal statistical data are applied to the various sectors of the Company’s insured portfolio, a shift in business written toward sectors with high default rates would likely increase the loss factor, while a shift toward sectors with low default rates would likely decrease the loss factor. Additionally, increases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or decreases in statistical recovery rates and in the Company’s actual recovery experience would likely increase the Company’s loss factor. Conversely, decreases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or increases in statistical recovery rates and in the Company’s actual recovery experience would likely decrease the Company’s loss factor.
Given the increased level of specific case basis losses recorded in the last several years, if none of the other variables used in deriving the loss factor had changed, the Company’s loss factor would approximate 22% on a cumulative basis through December 31, 2007, which would have generated loss and LAE of $162 million, $152 million and $159 million for the years ended December 31, 2007, 2006 and 2005, respectively. Another variable that changed over the last several years, however, and that affects the determination of the loss factor is the mix of business among different sectors. During this period, the Company has ceased writing business in certain sectors in which loss experience has been high relative to its total portfolio, such as tax liens, lower rated high-yield collateralized bond obligations, manufactured housing and certain direct corporate obligations, which offset the impact that the higher case basis incurred activity would have on the loss factor. Excluding actual loss experience incurred in the sectors listed above and the reserves established for RMBS exposure in 2007 in addition to its loss factor, the Company’s cumulative loss factor through December 31, 2007 would approximate 7%, which would have generated loss and LAE of $51 million, $48 million and $51 million for the years ended December 31, 2007, 2006 and 2005, respectively. Also mitigating the impact of higher case basis incurred activity is the improvement in the overall credit quality of the insured portfolio, with a greater percentage of the insured portfolio rated A or above over the past few years, as well as a decline in the number of issues on the Company’s caution lists.
Considering all of the assumptions used in the assessment of the adequacy of the loss factor, including the higher case basis incurred activity in 2007 and 2005 and the offsetting effect of observed changes in the variables described above, the Company believes that its current loss factor of 12% continues to represent a reasonable estimate of losses that have or are probable to occur as a result of credit deterioration in the Company’s insured portfolio but which have not yet been specifically identified and applied to specific insured obligations. In addition, the Company believes that the amount of unallocated loss reserves recorded on its balance sheet at December 31, 2007 are adequate to cover specific losses that may develop from its existing insured portfolio.
Loans reported as delinquent as of December 31, 2007 were assumed to default over the first six months of the projection period at rates that increase commensurate with the number of days past due (the “Roll Rate Default Methodology”). We assumed default rates of 45%, 60% and 100% for loans within a 30-day, 60-day and 90-day and over past due period, respectively. For loans that were not reported as delinquent as of December 31, 2007, a conditional default rate (“CDR”) was used to forecast losses beginning in month seven of the forecast. A CDR is an estimate of the percent of performing loans in a pool of loans that are expected to default during a given time period. For 2007 vintage transactions with more limited performance history, the assumed default rate was equal to the greater of the one- or three-month average CDR and a default rate determined using the Roll Rate Default Methodology. These CDRs were assumed to decrease over time at rates and over periods of time that vary by transaction vintage and underlying loan performance. Servicer advances for delinquent loans were assumed to be zero and all defaulted loans were assumed to result in a total loss of principal after a six-month liquidation period.
In addition, for transactions secured by home equity lines of credit (“HELOCs”), the model considered borrower draws and repayment rates. For HELOCs, the current three-month average draw rate was used to project future line draws. For HELOCs and transactions secured by fixed rate closed-end second mortgages, the three-month average conditional repayment rate (“CRR”) was used to project voluntary principal repayments. A one-month average CRR was used when a three-month was not available. Cash flows also assumed a constant basis spread between floating rate assets and floating rate insured debt obligations (the difference between Prime and LIBOR interest rates, minus any applicable fees). For all transactions, cash flows considered allocations and other structural aspects of a transaction, including managed amortization periods, rapid amortization periods and claims against MBIA’s insurance policy consistent with such policy’s terms and conditions.
The assumptions and cash flow structure referenced above resulted in a forecasted cumulative collateral loss that was added to existing actual cumulative collateral losses. The resulting estimated net claims on MBIA’s insurance policies were discounted to a net present value reflecting MBIA’s obligation to pay claims over time and not on an accelerated basis. The above assumptions represent MBIA’s best estimate of how transactions will perform over time. However, additional case basis loss and LAE reserves of approximately $270 million would be required in the event of a six-month increase in the forecasted CDR beyond our current estimates followed by a twelve-month lengthening of the period during which CDR rates are assumed to decrease.
amount of principal outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. Accordingly, deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. When an MBIA-insured obligation is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company. Installment premiums are earned on a straight-line basis over each installment period, generally one year or less. As the outstanding principal of an installment-based policy is paid down by the issuer of an MBIA-insured obligation, less premium is collected and recognized by the Company. Both upfront and installment premium recognition methods recognize premiums over the term of an insurance policy in proportion to the remaining outstanding principal balance of the insured obligation.
The effect of the Company’s upfront premium earnings policy is to recognize greater levels of upfront premiums in the earlier years of each policy insured, thus matching revenue recognition with exposure to the underlying risk. Recognizing premium revenue on a straight-line basis over the life of each policy without allocating premiums to the sinking fund payments would materially affect the Company’s financial results. Premium earnings would be more evenly recorded as revenue throughout the period of risk than under the current method, but the Company does not believe that the straight-line method would appropriately match premiums earned to the Company’s exposure to the underlying risk. Therefore, the Company believes its upfront premium earnings methodology is the most appropriate method to recognize its upfront premiums as revenue. The premium earnings methodology used by the Company is similar to that used throughout the financial guarantee industry. However, premium revenue recognition is subject to change as a result of the FASB project described in the “Results of Operations-Insurance Operations-Losses and Loss Adjustment Expenses” section included herein.
The Company maintains an ongoing review of its valuation models and has formal procedures for the approval and control of data inputs. See “Note 26: Fair Value of Financial Instruments” in the Notes to Consolidated Financial Statements for additional information on the various types of instruments entered into by MBIA and a comparison of carrying values as reported in the Company’s balance sheet to estimated fair values.
The Company’s financial instruments categorized as assets primarily comprise investments in debt and equity instruments. The majority of the Company’s debt and equity investments are accounted for in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS 115 requires that all debt instruments and certain equity instruments be classified in the Company’s balance sheet according to their purpose and, depending on that classification, be carried at either amortized cost or fair market value. The majority of the Company’s financial assets are valued using an independent pricing service, which uses observable market-based inputs when available. If a security cannot be priced by the pricing service, the Company receives a direct dealer quote which is used as the basis for recording fair value. Adverse credit market conditions during the second half of 2007 caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing service and dealers. Equity investments outside the scope of SFAS 115 are accounted for under cost or equity method accounting principles. Other financial assets that require fair value reporting or disclosures within the Company’s notes to the financial statements are valued based on underlying collateral or the Company’s estimate of discounted cash flows.
management to exercise judgment as to whether an investment is impaired based on market conditions and trends and the availability of relevant data. See “Note 12: Investment Income and Gains and Losses” in the Notes to Consolidated Financial Statements for further information regarding other-than-temporary losses recorded in net income.
The Company’s financial instruments categorized as liabilities primarily consist of obligations related to its asset/liability products and conduit segments within the Company’s investment management services operations, and debt issued for general corporate purposes. These liabilities are typically recorded at their face value adjusted for premiums or discounts. The fair values of such instruments are generally not reported within the Company’s financial statements, but rather disclosed in the accompanying notes. However, the carrying values of financial liabilities which qualify as part of fair value hedging arrangements under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, are adjusted in the Company’s balance sheet to reflect those risks being hedged. MBIA has instituted cash flow modeling techniques to estimate the value of its liabilities that qualify as hedged obligations under SFAS 133 based on current market data. Financial liabilities that the Company has elected to fair value under SFAS 155, “Accounting for Certain Hybrid Financial Instruments” or that require fair value reporting or disclosures within the Company’s notes to its financial statements are valued based on underlying collateral, the Company’s estimate of discounted cash flows or quoted market values for similar transactions.
In determining the fair value, we use various valuation approaches with priority given to observable market prices when they are available. Market prices are generally available for traded securities and market standard credit default swaps but are less available or unavailable for highly-customized credit default swaps. Most of the derivative contracts we insure are structured credit derivative transactions that are not traded and do not have observable market prices. Typical market credit default swaps are standardized, liquid instruments that reference tradable securities such as corporate bonds that also have observable prices. These market standard credit default swaps also involve collateral posting, and upon a default of the reference bond, can be settled in cash.
In contrast, our insured credit default swap contracts do not contain the typical CDS market standard features as described above but have been customized to replicate our financial guarantee insurance policies. Our insured derivative instruments provide protection on a specified or managed pool of securities or CDS with a deductible or subordination level. We are not required to post collateral, and upon default, we make payments on a “pay-as-you-go” basis after the subordination in a transaction is exhausted.
Our payment obligations after a default vary by deal and by insurance type. There are three primary types of policy payment requirements:
Historically, there has not been a market for the transfer of such highly structured insured credit derivative contracts, in part because of the contractual differences noted above. As a result, we believe there are no relevant third party “exit value” market observations for these contracts. If we were to affect a transfer of these contracts, we believe the most likely counterparties would be other financial guarantee insurers and reinsurers. In the absence of an actual financial market, we value these insured credit derivatives at the estimated amount that financial guaranty insurers with comparable credit ratings as us would require to assume these contracts. Since there are no active market transactions in our exposures, we generally use vendor-developed and proprietary models, depending on the type and structure of the contract, to estimate the fair value of our derivative contracts. In limited instances, we do execute transactions with reinsurers that reduce our exposure to insured credit derivatives. In those instances, we consider the transactions to be good indicators of fair value when the transaction is negotiated independently of other transactions and when it is executed at or near the measurement date. In such cases, the premiums we pay to the reinsurers are used to fair value the derivative contract, after adjusting for reinsurance contract terms that differ from our underlying insured credit derivative.
As a result of our decision in February 2008 to not insure credit derivative instruments and the potential that other market participants stop insuring credit derivative contracts, coupled with the lack of exchange transactions in the current market place, it may become more difficult to obtain observable market inputs for our valuations in the future. As a result, the assumptions about market participants or their assumptions that are used in estimating fair value may change in the future. We will continually monitor these developments as conditions warrant.
The BET was developed and published by Moody’s and provides an alternative to simulation models in estimating a probability distribution of losses on a diverse pool of assets. The model that we use has been modified from the Moody’s version as described below. The distribution of expected losses can then be applied to a specific transaction structure in order to size the expected losses of different risk exposure tranches within a structured transaction. We use the BET model, together with the market price for the underlying collateral to estimate fair value of our insured credit derivatives.
Collateral in the portfolio is generally considered on an average basis instead of modeling each piece of collateral separately
Correlation is modeled using a diversity score, which is calculated based on rules regarding industry or sector concentrations
Credit spreads - These are obtained from market data sources published by third parties (e.g. CMBX index spreads, dealer spread tables for the collateral similar to assets within our transactions) as well as collateral-specific spreads provided by trustees or obtained from market sources. If observable market credit spreads are not available for the underlying reference obligations, then a market spread is used that most closely resembles the underlying reference obligations, considering asset class, credit quality rating and maturity of the underlying reference obligations. This data is obtained from recognized sources and is reviewed on an ongoing basis for reasonableness and applicability to our derivative portfolio.
We use the following spread hierarchy in determining which source of spread to use, with the rule being to use CDS spreads where available. If not available, then we use cash security spreads.
2. Sector specific spreads (such as CMBX index spreads or dealer provided spread tables by asset class and rating)
Over time the data inputs can change as new sources become available or existing sources are discontinued or are no longer considered to be the most appropriate. It is the objective of the Company to move to higher levels on the hierarchy whenever possible, but it is sometimes necessary to move to lower priority inputs because of discontinued data sources or assessments that the higher priority inputs are no longer considered to be representative of market spreads for a given type of collateral. This can happen, for example, if transaction volume falls so a previously used spread index is no longer viewed as being reflective of current market levels.
If collateral-specific spreads are not available, the Weighted Average Rating Factor (“WARF”) is used to determine the credit rating which is used to determine the appropriate spread. This is a 10,000 point scale designed by Moody’s where lower numbers indicate better ratings. Because the difference in default probability between AA1 and AA2 is much less than between B1 and B2, the ratings are not spaced equally on this scale. The WARF is obtained from the most recent trustee’s report or calculated by us based on the credit ratings of the collateral in the transaction. In determining WARF, Moody’s ratings are used for collateral if they are available, and if not, then S&P and then Fitch ratings are used.
The aggregate market value of the entire collateral pool is specified by market spreads. The BET model uses market inputs (collateral spreads, diversity score and recovery rates) along with the transaction structure and subordination level to allocate value between the different tranches of the transaction. There can often be several tranches, including multiple subordinated tranches, and the BET can allocate values to each tranche. We only use the value ascribed to the most senior tranche that is insured by us. The level of subordination below our exposure or credit tranche is a very significant factor that affects the estimated fair values of our exposure as subordination below our exposure absorbs all losses in the transaction’s underlying portfolio before any claim is made on our insurance policy. Most of our insured structured credit derivatives have subordination at inception of the transaction that is in excess of that required for the most senior triple-A rating within a transaction.
The following table presents the net par outstanding as of December 31, 2007 and the related income statement net gain or loss for the year ended December 31, 2007 by fair value technique of all insured credit derivatives within our insurance portfolio.
Our investment management services operations and corporate operations enter into OTC derivatives, such as interest rate swaps, currency swaps, credit default swaps and total return swaps, which predominately trade in liquid markets. We mark these derivatives using industry standard models developed by vendors. The following table presents the net notional value outstanding as of December 31, 2007 and the related income statement net gain or loss for the year ended December 31, 2007 by fair value technique of all credit and other derivatives within the Company’s investment management services portfolio and corporate operations.
For further information regarding our derivative portfolio, see the “Market Risk” section included herein.
Under SFAS 142, “Goodwill and Other Intangible Assets,” goodwill and intangible assets with indefinite lives are tested for impairment at least annually. This test includes a two-step process aimed at determining the amount, if any, by which the carrying value of a reporting unit exceeds its fair value and should be charged as an expense through net income.
The following table presents highlights of the Company’s consolidated financial results for 2007, 2006 and 2005. Items listed under “Other per share information (effect on net income)” are items that we commonly identify for the readers of our financial statements because they are a by-product of the Company’s operations or due to general market conditions beyond the control of the Company.
Consolidated revenues from continuing operations decreased to a loss of $283 million in 2007 compared with income of $2.7 billion in 2006. The decline in insurance revenues resulted from a $3.6 billion loss on financial instruments at fair value and foreign exchange which was primarily the result of adverse changes in the fair value of the Company’s insurance credit derivative portfolio and an adjustment to the Company’s carrying value of its investment in Channel Reinsurance Ltd. (“Channel Re”), partially offset by a mark-to-market gain on the Company’s Money Market Committed Preferred Custodial Trust (“CPCT”) securities facility. The investment management services operations’ revenues increased primarily due to an increase in interest income resulting from growth in the asset/liability products segment, higher fees in the advisory services segment due to growth in assets under management and an increase in gains on financial instruments at fair value and foreign exchange due to gains on total return swaps resulting from declines in underlying bond prices. Consolidated expenses from continuing operations increased 77% to $2.8 billion in 2007 from $1.6 billion in 2006. This increase was principally due to an increase in loss and LAE incurred in the insurance operations reflecting $614 million of specific case basis reserves and $200 million of non-specific unallocated reserves related to MBIA’s prime, second-lien RMBS exposure. In addition, investment management services’ interest expense increased due to growth in the asset/liability products segment, commensurate with the increase in interest income. The Company recorded a net loss for 2007 of $1.9 billion compared with net income of $819 million for 2006. Net loss per diluted share was $15.17 for 2007 compared with net income per diluted share of $5.99 for 2006.
Gross premiums written (“GPW”), net premiums written (“NPW”) and net premiums earned for the last three years are presented in the following table:
NPW, which represents gross premiums written net of premiums ceded to reinsurers, increased 10% to $892 million in 2007 from $815 million in 2006. The increase in 2007 was a result of the increase in GPW and a reduction in premiums ceded to reinsurers. Premiums ceded to reinsurers from all insurance operations as a percentage of GPW were 11% and 12% for 2007 and 2006, respectively. Reinsurance enables the Company to cede exposure and comply with its single risk and other credit guidelines, although the Company continues to be primarily liable on the insurance policies it underwrites.
Net premiums earned include scheduled premium earnings as well as premium earnings from refunded issues. Net premiums earned in 2007 of $856 million was slightly higher versus 2006 due to a 6% increase in scheduled premiums earned, offset by a 25% decrease in refunded premiums earned. The increase in scheduled premiums earned resulted from an increase in business written and lower refunding activity in 2007.
During 2007, total net par insured rated A or above, before giving effect to MBIA’s guarantee, was 82% compared with 77% during 2006 and 81% during 2005. These percentages reflect a change in the mix of business written during each year. At December 31, 2007, 83% of the Company’s outstanding net par insured was rated A or above before giving effect to MBIA’s guarantee compared with 81% at December 31, 2006. The following table presents the credit quality distribution of MBIA’s outstanding net par insured as of December 31, 2007 and 2006. 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, a MBIA equivalent rating is used.
Global structured finance net par insured rated A or above, before giving effect to the Company’s guarantee, represented 78% of global structured finance business written by the Company during 2007, compared with 71% during 2006 and 69% during 2005. At December 31, 2007, 80% of the outstanding global structured finance net par insured was rated A or above before giving effect to the Company’s guarantee, up from 78% as of December 31, 2006.
INVESTMENT INCOME The Company’s insurance-related net investment income for the last three years and ending investment asset balances at amortized cost as of December 31, 2007 and 2006 are presented in the following tables:
The Company’s insurance-related pre-tax net investment income, excluding net realized gains and losses, decreased 1% in 2007 to $573 million from $581 million in 2006. After-tax net investment income also decreased 1% in 2007 as the proportion of taxable investments remained relatively consistent with 2006. The decline in pre-tax net investment income reflects a decrease in average invested assets in 2007 compared with 2006 as well as an $11 million decrease in investment income related to Northwest Airlines’ enhanced equipment trust certificates, which the Company received in connection with a remediation and subsequently sold in the second quarter of 2007. See the Risk Management section for additional information on the Northwest Airlines’ enhanced equipment trust certificates. However, pre-tax net investment income benefited from a $16 million increase in VIE interest income. VIE interest income is generated from interest bearing assets held by such entities and supports the payment of interest expense on debt issued by these entities.
Excluding interest income related to VIEs and the Northwest Airlines’ enhanced equipment trust certificates and interest received on reimbursed expenses, insurance-related net investment income decreased 1% on a pre-tax and after-tax basis in 2007 compared with 2006. These decreases were attributable to a decline in average invested assets as a result of dividends paid from MBIA Corp. to MBIA Inc. in December 2006 and April 2007 and claim payments made in the fourth quarter of 2006 to call two MBIA-insured transactions. Average investment yields decreased slightly in 2007 compared with 2006. Ending asset balances at amortized cost, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, were $10.1 billion and $9.6 billion at December 31, 2007 and 2006, respectively. Tax-exempt investments represented 58% and 55% of ending asset balances, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, at December 31, 2007 and 2006, respectively.
In 2006, the Company’s insurance-related net investment income, excluding net realized gains and losses, increased 18% to $581 million from $493 million in 2005. After-tax net investment income increased 16% in 2006 as the proportion of taxable investments remained relatively consistent with 2005. Growth in pre-tax investment income reflects an increase in consolidated VIE interest income of $34 million. Additionally, pre-tax investment income for 2006 included $17 million related to Northwest Airlines’ enhanced equipment trust certificates and $6 million related to non-recurring interest on reimbursed expenses received in connection with the remediation of a private label credit card securitization, with no comparable amounts recorded in 2005.
amortized cost, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, were $9.6 billion and $9.9 billion at December 31, 2006 and 2005, respectively. Tax-exempt investments represented 55% and 54% of ending asset balances, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, at December 31, 2006 and 2005, respectively.
Approximately two-thirds of the mark-to-market loss in 2007 on the insured credit derivatives portfolio resulted from wider spreads for commercial mortgage-backed securities and residential mortgage-backed securities collateral and the remaining one-third was primarily due to ratings downgrades of the collateral comprising insured credit derivatives for multi-sector CDO structures.
is required to be recorded on the Company’s balance sheet at fair value. The gain was due to an increase in the differential between the Company’s credit default swap spreads and the yield applicable to the CPCT facility.
In 2006, the Company recorded net gains on financial instruments at fair value and foreign exchange of $1 million. The net gains in 2006 were largely due to foreign exchange gains related to the sale of foreign securities offset by derivative losses on deals that were terminated early. In 2005, the Company recorded net losses on financial instruments at fair value and foreign exchange of $4 million. The 2005 net losses primarily resulted from the reversal of gains recorded in prior years on credit derivatives as transactions approach their maturity and that terminated in 2005, net of foreign currency gains.
In July 2002, MBIA Corp., together with Wells Fargo Bank N.A. in its capacity as trustee, filed suit in Delaware federal district court against Royal Indemnity Corporation (“Royal”) to enforce insurance policies that Royal issued guaranteeing vocational loans originated by SFC. MBIA Corp. insured eight securitizations that were collateralized by the SFC vocational student loans guaranteed by Royal. On April 2, 2007, MBIA announced that MBIA Corp. reached an agreement with Royal to settle its outstanding litigation against Royal related to SFC. The District Court in Delaware entered a final judgment in the case implementing the settlement on March 30, 2007. In the second quarter of 2007, under the terms of the settlement Royal paid an amount sufficient to repay the approximately $362 million of outstanding par amount of the bonds insured by MBIA as well as to reimburse MBIA for a portion of
In July 2006, Eurotunnel petitioned the Paris Commercial Court for protection from its creditors under a safeguard procedure, a new French reorganization statute with limited similarities to a U.S. Chapter 11 reorganization. On August 2, 2006, the commercial court granted Eurotunnel protection under the safeguard procedure. On January 15, 2007, following approval of a safeguard plan by its creditors, bondholders, vendors and employees, the commercial court approved the safeguard plan and ordered the implementation of the safeguard plan. On June 28, 2007, Eurotunnel implemented the safeguard plan.
Under Eurotunnel’s safeguard plan, holders of Eurotunnel senior debt received cash in full for their claims and, accordingly, MBIA’s exposure to Eurotunnel senior debt was reduced to zero. Additionally, MBIA recovered claim payments it had made with respect to Eurotunnel senior debt. Under the safeguard plan, holders of Eurotunnel Tier 1A debt received cash in full for their claims and, on June 29, 2007, Fixed-Link Finance 2, B.V. (“FLF2”) used that cash to repay all of its outstanding notes and to reimburse MBIA for the 18 million British pound claim payment it made in the first quarter of 2007. MBIA’s exposure to Eurotunnel through FLF2 and to FLF2 debt was reduced to zero. Under the safeguard plan, holders of Eurotunnel Tiers 1 and 2 debt received cash in full for their claims and holders of Eurotunnel Tier 3 debt received approximately 62% of their claims in cash. Fixed-Link Finance, B.V. (“FLF1”) will use the cash received on account of its Tiers 1, 2 and 3 claims to make scheduled interest payments through February 1, 2009, at which time all available cash will be used to repay FLF1’s outstanding notes in order of priority. As a result of this development, S&P raised its ratings on the FLF1 Class A and B notes to AAA/Stable, noting that the recoveries of the Class A and B notes are wholly secured by cash. The Class A and B notes are pari passu with the Class G notes guaranteed by MBIA and recoveries of the Class G notes are also wholly secured by cash. Accordingly, although FLF1 no longer owns any Eurotunnel debt, MBIA remains exposed to FLF1 through February 1, 2009. At December 31, 2007, MBIA’s exposure to FLF1 debt on account of the Class G notes was approximately $759 million in net par outstanding. MBIA has not paid and does not expect to pay any claims with respect to its exposure to FLF1. The Company believes that it will not incur an ultimate loss on its Eurotunnel exposure and, therefore, has not established a case basis loss reserve for this credit.
MBIA’s Insured Portfolio Management (“IPM”) Division is responsible for monitoring MBIA insured issues. The level and frequency of MBIA’s monitoring of any insured issue depends on the type, size, rating and performance of the insured issue. If IPM identifies concerns with respect to the performance of an insured issue it may designate such insured issue as “Caution List-Low,” “Caution List-Medium” or “Caution List-High.” The designation of any insured issue as “Caution List-Medium” or “Caution List-High” is based on the nature and extent of these concerns and requires that an increased monitoring and, if needed, a remediation plan be implemented for the related insured issue.
Included in the Company’s case basis reserves are both loss reserves for insured obligations for which a payment default has occurred and MBIA has already paid a claim and also for which a payment default has not yet occurred but a claim is probable and estimable in the future. At December 31, 2007, case basis reserves consisted of the following:
When MBIA becomes entitled to the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment, it records salvage and subrogation as an asset. Such amounts are included in the Company’s balance sheet within “Other assets.” As of December 31, 2007 and 2006, the Company had salvage and subrogation assets of $108 million and $180 million, respectively. The decrease in salvage and subrogation assets principally resulted from collections of salvage amounts due to the
On April 18, 2007, the FASB issued an Exposure Draft (“ED”) entitled “Accounting for Financial Guarantee Insurance Contracts”, an interpretation of SFAS 60, with a 60-day comment period. The comment period ended on June 18, 2007. On September 4, 2007, the FASB Board held a public roundtable meeting with respondents to the ED to discuss significant issues raised in the comment letters. Since the roundtable, the FASB Board re-deliberated on some of the issues raised. The ED clarifies how SFAS 60 applies to financial guarantee insurance contracts issued by insurance enterprises, including the methodologies to account for premium revenue and claim liabilities, as well as related disclosures. The proposals contained in the ED are not considered final accounting guidance until the FASB completes its due process procedures and issues a final statement, which could differ from the ED. Under the ED or the re-deliberated meetings, MBIA would be required to recognize premium revenue by applying a fixed percentage of premium to the amount of exposure outstanding at each reporting period (referred to as the level-yield approach). The proposed recognition approach for a claim liability would require MBIA to recognize a claim liability when there is an expectation that a claim loss will exceed the unearned premium revenue (liability) on a policy basis based on the present value of expected cash flows. Additionally, the ED would require MBIA to provide expanded disclosures relating to factors affecting the recognition and measurement of financial guarantee contracts.
Due to certain continuing rights MBIA possesses with respect to the Certificates, MBIA recorded the Certificates and the related financing on its balance sheet under the requirements of SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The Certificates were included within “Short-term investments” and the related financing was included within “Payable for investments purchased” on the Company’s consolidated balance sheets. During the second quarter of 2007, MBIA no longer possessed its continuing rights with respect to the Certificates and, therefore, removed the Certificates and related financing from its consolidated balance sheet as of June 30, 2007.
As of December 31, 2007, the aggregate amount of insured par ceded by MBIA to reinsurers under reinsurance agreements was $79.7 billion. Additionally, the Company has other reimbursement agreements not accounted for as reinsurance, primarily with a reinsurer rated AA- by S&P and Aa3 by Moody’s, covering $4.1 billion of insured par. The following table presents the percentage of outstanding par ceded to and reinsurance recoverable from reinsurers by rating levels as of December 31, 2007:
Channel Re is a reinsurer of MBIA. Additionally, MBIA owns a 17.4% equity interest in Channel Re. In June 2007, S&P revised its outlook on Channel Re from negative to stable. In February 2008, S&P placed Channel Re’s AAA rating on CreditWatch with negative implications. In February 2008, Moody’s downgraded Channel Re to Aa3 from Aaa, with negative outlook. For the year ended December 31, 2007, the Company expects that Channel Re will report negative shareholder’s equity on a GAAP basis as a result of fair valuing its insured credit derivatives. As a result, in the fourth quarter of 2007, the Company recorded an adjustment to the carrying value of its equity ownership interest in Channel Re from $85.7 million at September 30, 2007 to zero. As of December 31, 2007, the Company had $708.2 million of derivative assets related to credit derivatives ceded to Channel Re and a $13.1 million reinsurance recoverable from Channel Re. The Company has assessed Channel Re’s ability to pay these amounts to MBIA if they were to be settled and has concluded that Channel Re had sufficient liquidity supporting its business to settle such amounts, inclusive of approximately $495 million that Channel Re had on deposit in trust accounts as of December 31, 2007 for the benefit of MBIA. Although the trusts limit the potential for Channel Re to default on its obligations to MBIA, there can be no assurance that Channel Re will not default on its obligations to MBIA that exceed the amounts already established in the trust accounts. If, in the future, MBIA determines that Channel Re does not have sufficient liquidity to settle its obligations to MBIA, MBIA will record reserves against such amounts.
Several of the Company’s other financial guarantee reinsurers, including RAM Reinsurance Company, Ltd. (“RAM”), Ambac Assurance Corporation, XL Financial Assurance Ltd. and XL Capital Assurance Inc., have had their credit ratings either downgraded or put on negative watch by one or more of the major rating agencies between December 2007 and February 2008. RAM has deposited $104 million of assets in a trust for the benefit of MBIA as of December 31, 2007. Although there was no material impact on the Company for any of the rating agency actions through February 2008 relating to its reinsurers, a further downgrade of one or more of the Company’s reinsurers could increase the amount of capital required to maintain MBIA Corp.’s triple-A ratings and may require the establishment of reserves against any receivables due from the such reinsurers.
Annually, MBIA reviews its insurance-related expenses to determine if there have been any changes in its business or cost structure that would materially change the amount of costs accounted for as policy acquisition costs. If so, the Company conducts a policy acquisition cost study to determine the amount of insurance costs that relate to acquiring new non-derivative insurance policies and that are deferrable under GAAP. MBIA completed its latest study in July 2005 and expects to complete a study during 2008. If, as a
MBIA will recognize a premium deficiency if the sum of the expected loss and LAE and unamortized policy acquisition costs exceed the related unearned premiums. If MBIA was to have a premium deficiency that is greater than unamortized acquisition costs, the unamortized acquisition costs would be reduced by a charge to expense and a liability would be established for any remaining deficiency. Although GAAP permits the inclusion of anticipated investment income when determining a premium deficiency, MBIA currently does not include this in making its determination.
Financial guarantee insurance companies use the expense ratio (expenses divided by net premiums earned) as a measure of expense management. The decrease in the expense ratios presented in the preceding table are principally due to a lower level of operating expenses in 2007 and higher levels of operating expenses during 2006 and 2005.
INTEREST EXPENSE Interest expense from MBIA’s insurance operations, which primarily consists of interest related to debt issued by consolidated VIEs, the financing of the Northwest Airlines Pass Through Trust 2000-1G certificates and agreements accounted for as deposits, increased to $82 million in 2007 from $76 million in 2006. The increase primarily related to a $16 million increase in interest expense associated with consolidated VIEs, offset by an $8 million decrease in interest related to the Northwest Airlines Pass Through Trust 2000-1G certificates. For 2006, interest expense increased 193% compared with 2005 due to additional VIEs being consolidated by the Company during 2005 and the financing of the Northwest Airlines Pass Through Trust 2000-1G certificates in 2006. Interest expense related to consolidated VIEs was $74 million, $58 million and $25 million in 2007, 2006 and 2005, respectively.
beneficiary. The Company would be required to consolidate VIEs if it was determined to be the primary beneficiary of the VIEs. The primary beneficiary is the entity that will absorb the majority of the expected losses, receive the majority of the expected residual returns, or both, of a VIE. The Company conducts consolidation analyses under the provisions of FIN 46(R) upon the inception of its guarantees to the third-party SPVs and upon the occurrence of certain reconsideration events.
The Company consolidates certain third-party VIEs as a result of financial guarantees provided by the insurance operations. Third-party VIEs’ assets and liabilities are primarily reported in “Investments held-to-maturity” and “Variable interest entity floating rate notes,” respectively, on the face of the Company’s balance sheet. The assets and liabilities of these VIEs each totaled $1.4 billion at December 31, 2007 and $1.5 billion at December 31, 2006. Revenues and expenses related to third-party VIEs are primarily recorded in “Net investment income” and “Interest expense”, respectively, on the Company’s statements of operations and substantially net to zero. Consolidation of such VIEs does not increase MBIA’s exposure above that already committed to in its insurance policies. Additionally, consolidation of the insured VIEs does not affect the capital ratios, debt covenants, dividends or credit ratings of the Company.
The Company consolidated two VIEs in the third quarter of 2004 and a third VIE in the fourth quarter of 2006 that were established in connection with the securitizations of Capital Asset tax liens and to which the Company provided financial guarantees. In December 2006, the Company sold its interest in all of these consolidated VIEs. MBIA held a variable interest in these entities, which resulted from its insurance policies, and had determined that it was the primary beneficiary under FIN 46(R).
The Company’s $130.6 billion CDO portfolio comprised 19.2% of the Company’s total insured net par of $678.7 billion as of December 31, 2007. The Company’s aggregate CDO book is diversified by vintage and collateral type. Ninety percent of this exposure, or $117.3 billion, was insured via credit default swaps. The distribution of the Company’s insured CDO and related instruments portfolio by collateral type is presented in the following table:
Multi-Sector CDOs are transactions that include a variety of structured finance asset classes in their collateral pools. As of December 31, 2007, $30.1 billion, or approximately 4%, of the Company’s total insured net par outstanding of $678.7 billion and 23% of the Company’s $130.6 billion CDO portfolio insured net par outstanding, was comprised of Multi-Sector CDOs. The collateral in the Company’s Multi-Sector CDOs includes ABS (e.g. securitizations of auto receivables, credit cards, etc.), CMBS, CDOs and various types of RMBS including prime and subprime RMBS.
Within the multi-sector CDOs, the next four tables will show further breakdowns of the collateral composition and ratings of sub-prime RMBS collateral, non-sub-prime RMBS collateral, and CDOs of ABS collateral by vintage year. CDOs of ABS may contain exposure to various types of collateral, including RMBS.
For the Multi-Sector CDO portfolio, the collateral composition is presented in the following table. The collateral level detail for each year insured was calculated using a weighted average of the net par written for deals closed during that particular year. The total collateral amount of the portfolio exceeds the net par written as a result of credit enhancement (such as overcollateralization and subordination) and reinsurance.
The table does not provide collateral level detail on 38 CDOs totaling $2.3 billion of net par. Three deals, with $756 million of net par, contain European Mezzanine ABS assets and other collateral, and were closed in 2005 and 2006. In addition, 35 deals represent insurance sold to investors for CDO tranches in their portfolios (secondary market insurance executions). The deals total $1.57 billion of net par and all were insured prior to 2005. In addition, all 35 deals were rated triple-A at the time MBIA wrote insurance on them.
All figures represent MBIA’s insured net par outstanding as of December 31, 2007. Data was gathered from several third party sources such as trustee reports, Intex, Bloomberg and rating agency websites; therefore, amounts and distributions may differ depending on data source and interpretation. Collateral ratings are current as of February 1, 2008.
Below IG (Investment Grade) denotes collateral credit ratings of BBB- or below.
During the latter half of 2007, the Multi-Sector portfolio experienced stress related to the U.S. subprime mortgage crisis. During the fourth quarter of 2007, the Company downgraded its internal ratings of twelve insured tranches of Multi-sector CDOs (totaling net par exposure of $11.8 billion).
As of December 31, 2007, the majority of the Investment Grade Corporate CDO exposure had triple-A rated subordination below MBIA’s exposure and the Company had not experienced any material credit deterioration to this book. These transactions are typically structured to benefit from credit enhancement sized to a triple-A (or a multiple of triple-A) level of credit protection before consideration is given to the guarantee by the Company. The Company’s net exposure to Investment Grade Corporate CDOs represents 33% of the Company’s CDO exposure and approximately 6% of the Company’s total net insured portfolio. The Company’s Investment Grade Corporate CDO exposure references pools of predominantly investment grade corporate credits (approximately 96% of gross par); some of these pools may also include limited exposure to other asset classes, including structured finance securities (including RMBS and CDO collateral). Most Investment Grade Corporate CDOs are structured for asset coverage with a deductible.
The Company’s exposure to Structured CMBS Pools comprised about 4.8% of the Company’s total insured net par as of December 31, 2007. These transactions are pools of CMBS that are structured with a first loss deductible sized to a Triple-A (or a multiple of Triple-A) level of credit protection before consideration is given to the wrap provided by the Company. The credit protection sizing is a function of the underlying collateral ratings and the structural attributes. Most Structured CMBS Pools are structured for asset coverage with a deductible. The CMBS securities in the pool are either cash assets or (more typically) securities referenced synthetically. Each pool consists of CMBS securities drawn from a range of different CMBS securitizations, which in turn are backed by a diverse pool of loans secured by commercial real estate properties. The Company’s Structured CMBS Pools are static, meaning that the pool cannot be changed through its life.
The Company’s CRE CDO exposure comprised about 1.6% of the Company’s total insured net par as of December 31, 2007. CRE CDOs are managed pools of CMBS, CRE whole loans, B-Notes, mezzanine loans, REIT debt and other securities (including, in some instances, buckets for RMBS and CDOs) that allow for reinvestment during a defined time period. The structures benefit from typical CDO structural protections such as cash diversion triggers, collateral quality tests and manager replacement provisions. Furthermore, MBIA’s claims paying obligations are for current interest & ultimate principal. As with the Company’s other CDOs, these transactions generally are structured with Triple-A, or a multiple of Triple-A credit support protection before the Company’s guarantee.
In 2007, investment management services’ revenues of $1.8 billion increased 49% over 2006. Excluding net realized gains from investment securities and net gains on financial instruments at fair value and foreign exchange, revenues of $1.6 billion increased 35% over 2006. The increase in revenues was attributable to growth in the Company’s asset/liability products segment, primarily due to investment agreement and medium-term note issuance, and the advisory services segment. Advisory services’ revenues were favorable compared to 2006 as a result of growth in managed assets, particularly in municipal investment pool balances where assets under
Net realized gains from investment securities in the investment management services operations were $1 million in 2007 compared with net realized gains of $6 million in 2006 and net realized gains of $1 million in 2005. Net realized gains in the investment management services operations are generated from the ongoing management of its investment portfolios. In addition, in 2007, the Company recorded a $6.2 million write-down of its investment in Hudson-Thames Capital Limited (“Hudson-Thames”), a structured investment vehicle (“SIV”) managed by our advisory services segment and a total $20 million write-down of investments in two structured finance assets, one of which is a SIV managed by a third party and the other is an uninsured CDO.
As of December 31, 2007, ending assets under management were $63.3 billion, slightly lower compared with the 2006 year-end level. Conduit ending assets included in assets under management at December 31, 2007 totaled $4.2 billion compared with $4.1 billion at December 31, 2006. Average assets under management increased 18% to $66.0 billion in 2007 from $56.0 billion in 2006. As of December 31, 2006, ending assets under management were $63.5 billion, 30% above the 2005 year-end level. Average assets under management in 2006 increased 14% to $56.0 billion from $49.2 billion in 2005.
Advisory services’ pre-tax income, excluding realized gains and losses from investment securities and gains and losses on financial instruments at fair value and foreign exchange, totaled $17.9 million in 2007, down 19% from 2006. Third-party ending assets under management were $22.1 billion and $28.5 billion at December 31, 2007 and December 31, 2006, respectively. The market values of assets related to the Company’s insurance and corporate investment portfolios managed by the investment management services operations at December 31, 2007 were $10.7 billion, slightly up from the balance at December 31, 2006 of $10.5 billion. In 2006, advisory services’ pre-tax income, excluding realized gains and losses from investment securities and gains and losses on financial instruments at fair value and foreign exchange, totaled $22.1 million, up 13% over 2005.
Through the advisory services segment, MBIA Asset Management was the investment manager of the SIV named Hudson-Thames, acting under an investment management agreement and at the direction of an independent board of directors. Launched at the end of 2006, Hudson-Thames had $2 billion of assets at its peak. As of December 31, 2006, MBIA invested $8.7 million in the capital notes of Hudson-Thames, which it subsequently increased to $15.8 million by the third quarter of 2007. During the summer of 2007, adverse conditions in the structured finance and SIV markets inhibited Hudson-Thames from issuing new senior notes (primarily commercial paper) to repay maturing notes. During the fourth quarter of 2007, at the direction of the Hudson-Thames board of directors, all of the remaining assets of Hudson-Thames were sold, all of its senior liabilities were fully paid, and in December 2007, Hudson-Thames ceased operations. Overall results for 2007 reflect the impairment of MBIA’s capital notes and unreimbursed expenses, which combined totaled $8.2 million, of which $3.7 million was recorded in the fourth quarter 2007.
The objective of Hudson-Thames was to issue senior notes (commercial paper and medium-term notes) and invest the proceeds in high quality eligible assets to earn a net interest margin. Junior notes, which served as capital in the structure, were also issued to investors who would earn the excess interest spread after paying the interest expense on senior notes and program expenses. The program operated under strict asset/liability management guidelines and was permitted (and expected) to purchase assets with longer maturities than those of the liabilities issued, and to operate over time by funding maturing senior notes partially with maturing assets and partially by issuing new senior notes.
Beginning in August 2007, adverse conditions in the asset-backed commercial paper markets, in particular the SIV market, prevented Hudson-Thames from issuing new senior notes to repay maturing notes. At the direction of Hudson-Thames’ board of directors, all of the remaining assets of Hudson-Thames were sold and in December 2007 Hudson-Thames ceased operations.
A subsidiary of MBIA Asset Management is the program manager for three CDOs totaling $0.7 billion in par amount as of December 31, 2007. A CDO is a managed investment vehicle which purchases a portfolio of diversified assets funded by issuance of debt and equity, the repayment and return of which are linked to the performance of the assets. The CDOs managed by MBIA consist of a variety of asset classes as underlying collateral, including corporate and asset-backed securities. Three additional CDOs, totaling $2.0 billion in par amount, for which MBIA was the manager matured during 2007.
At the inception of each CDO, or upon the adoption of FIN 46(R) in the case of CDOs issued prior to the adoption of FIN 46(R), the Company conducted consolidation analyses and the Company concluded that while the CDOs met the definition of VIEs, MBIA was not the primary beneficiary and, therefore, need not consolidate them. The Company’s variable interest is limited to the management fee and the Company believes that there are no possible scenarios under which it would consolidate the VIEs. Had the Company concluded that consolidation was warranted, the impact to its December 31, 2007 balance sheet would have been an increase in the Company’s assets of $0.7 billion, or 2%, and a corresponding increase in liabilities and shareholders’ equity. These increases would not have been expected to result in any impact on the Company’s debt covenants, capital ratios or credit ratings.
Net realized losses from investment securities in the corporate operations were $5.0 million in 2007 compared with net realized gains of $3.8 million in 2006 and net realized losses of $1.0 million in 2005. Net realized gains and losses for the years ended December 31, 2007, 2006 and 2005 were generated from the ongoing management of the investment portfolios. However, in the second and third quarter of 2007, the Company realized $9.6 million and $0.9 million of impairment losses, respectively, on a subprime mortgage-oriented investment.
In the first half of 2007, the corporate operations recorded insurance recoveries of $6.4 million, which represented recoveries received on the Company’s directors’ and officers’ insurance policy. These insurance recoveries reimbursed the Company for a portion of the expenses incurred by the Company in connection with the regulatory investigations and the related private securities and derivative litigations. No additional recoveries were received in the third and fourth quarters of 2007. However, the Company is pursuing additional recoveries under its directors’ and officers’ insurance policy.
The corporate operations incurred interest expense of $81 million, $81 million and $91 million for the years ended December 31, 2007, 2006 and 2005, respectively. The decrease in interest expense in 2006 compared with 2005 resulted from the retirement of $100 million of debt in the fourth quarter of 2005.
MBIA’s tax policy is to optimize after-tax income by maintaining the appropriate mix of taxable and tax-exempt investments. In general, the effective tax rate fluctuates from time to time as the Company manages its investment portfolio on an after-tax total return basis. The effective tax rate, including tax related to discontinued operations, was a benefit of 37.3% and a provision of 28.3% and 29.9% for the years ended December 31, 2007, 2006 and 2005, respectively. The benefit in 2007 was a result of the net loss from operations for 2007. The higher tax rate in 2005 compared with 2006 was primarily due to the accrual of regulatory penalties, which are not deductible for purposes of calculating the Company’s Federal income taxes.
The increase in the long-term debt to capital ratio reflects the large net losses on financial instruments at fair value and foreign exchange recorded in 2007, which resulted in a substantial decline in shareholders’ equity.
In the fourth quarter of 2007, deterioration in the RMBS and CDO sectors resulted in the major rating agencies reassessing the capital adequacy ratios of financial guarantors to reflect deterioration in the expected performance of transactions within the financial
Capital generation from the maturing of existing transactions and a decrease in the number of new transactions consummated has reduced our rating agency capital requirement by a range of approximately $250 million to $500 million, depending on the rating agency, in the fourth quarter of 2007.
On January 9, 2008, the Company announced an anticipated reduction in its quarterly shareholder dividends. On February 25, 2008, the Company’s Board of Directors approved the elimination of MBIA Inc. shareholder dividends. The elimination of MBIA Inc. shareholder dividends is expected to preserve approximately $174 million of capital on an annualized basis.
The Company is exploring the purchase of reinsurance covering a diversified portion of MBIA’s portfolio, which, if it occurs, is expected to reduce our rating agency capital requirements by up to $200 million and is expected to occur in the near term.
On February 1, 2007, the Company’s Board of Directors authorized the repurchase of common stock up to $1 billion under a new share repurchase program, which superseded the previously authorized program. As of December 31, 2007, the Company repurchased 10 million shares under the program at an average price of $66.30 per share. The Company’s ability to repurchase common stock is largely dependent on the amount of dividends paid by MBIA Corp. to MBIA Inc. Repurchases of 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 believe that share repurchases can be an appropriate deployment of capital in excess of amounts needed to maintain the triple-A claims-paying ratings of MBIA Corp. and support the growth of MBIA’s businesses.
The Company has available various facilities, such as lines of credit and equity-based facilities, which further support its claims-paying resources. In aggregate, we believe our claims-paying resources are more than adequate to support our business risks. At December 31, 2007, MBIA Corp. maintained a $450 million limited recourse standby line of credit facility with a group of major banks to provide funds for the payment of claims in excess of the greater of $500 million of cumulative claims, net of recoveries, or 5% of average annual debt service with respect to U.S. public finance transactions. The agreement is for a ten-year term, which expires in March 2015.
Cash needs at the parent holding company level are primarily for dividends to its shareholders, interest payments on its debt and operating expenses. Sources of cash at the parent holding company level primarily consist of dividend payments from MBIA Corp. and MBIA Asset Management, investment income and the issuance of debt. Additionally, the parent company maintains excess cash and investments to ensure it is able to meet its ongoing short-term and long-term cash requirements. As of December 31, 2007, the parent company had $434 million of cash and investments available for general corporate liquidity purposes. The parent company also has access to a $500 million revolving credit facility, as described below, which may be used for general corporate purposes. Combining its current cash, investments and credit facility with anticipated dividends from its operating subsidiaries, for the year ended December 31, 2008, we project that the parent company will have access to $1.5 billion of cash and investments, compared to annualized cash needs of approximately $160 million.
Investment agreements issued by the asset/liability products segment generally provide for collateral posting or termination in the event of a downgrade of MBIA Corp.’s credit ratings. The maximum collateral posting would occur at a single-A financial strength rating by Moody’s or S&P, and the maximum terminations would occur at a triple-B financial strength rating by Moody’s or S&P. Based on the asset portfolio as of December 31, 2007, the maximum collateral posting requirement at a single-A financial strength rating would be $12.4 billion and free collateral at a triple-B financial strength rating would be $9.4 billion. As of December 31, 2007, the Company’s collateral posting requirement totaled $7.4 billion and free collateral totaled $19.3 billion based on MBIA Corp.’s triple-A financial strength rating. We believe that the liquidity position of the asset/liability products segment is adequate to meet these requirements related to investment agreements under stress scenarios.
During 2007, net cash used by investing activities was $6.3 billion compared with $4.8 billion during 2006. The increase of $1.5 billion was primarily due to the purchase of fixed-maturity investments related to growth in the investment management services operations’ asset/liability products program.
The available-for-sale investment portfolio provides a high degree of liquidity, since it comprises readily marketable high-quality fixed-income securities and short-term investments. At December 31, 2007 and 2006, the fair value of the consolidated available-for-sale investment portfolio was $37.0 billion and $31.9 billion, respectively, as presented in the following table:
The increase in the amortized cost of the insurance operations’ available-for-sale investments at December 31, 2007 compared with December 31, 2006 was the result of positive cash flows from operations, partially offset by dividend payments to MBIA Inc. in April 2007. The increase in the amortized cost of available-for-sale investments in the investment management services operations was the result of growth in the Company’s asset/liability products segment. Corporate investments decreased at December 31, 2007 compared with December 31, 2006 due to the repurchase of common stock under our share repurchase program and dividend payments to MBIA Inc. shareholders, partially offset by dividends received from the insurance operations.
The weighted-average credit quality of the Company’s fixed-income portfolios has been maintained at double-A since its inception. The quality distribution of the Company’s fixed-income investment portfolios, excluding short-term investments, based on ratings from Moody’s as of December 31, 2007 is presented in the following table. Alternate ratings sources, such as S&P, have been used for a small percentage of securities that are not rated by Moody’s.
MBIA’s consolidated investment portfolio includes investments that are insured by various financial guarantee insurers (“Insured Investments”), including investments insured by MBIA Corp. (“MBIA Insured Investments”). At December 31, 2007, Insured Investments at fair value, excluding conduit segment investments,
represented $8.1 billion or 20% of total investments, of which $2.5 billion or 6% of total investments were insured by MBIA Corp. Conduit investments represented $4.3 billion or 10% of total investments and were all insured by MBIA Corp.
The distribution of the Company’s Insured Investments by financial guarantee insurer as of December 31, 2007 is presented in the following table.
During January and February of 2008, several of the financial guarantee insurers listed in the preceding table have been downgraded by one or more of the rating agencies. A downgrade of a financial guarantee insurer will likely have an adverse affect on the fair value of investments insured by the downgraded financial guarantee insurer. If MBIA 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 MBIA guarantee of the MBIA Insured Investments in the consolidated investment portfolio, at December 31, 2007, based on the actual or estimated underlying ratings (i) the weighted-average rating of the investment portfolio would be in the Aa range, (ii) the weighted-average rating of just the MBIA Insured Investments in the investment portfolio would be in the A range and (iii) less than 1% of the investment portfolio would be rated below investment grade.
Conduit programs involve the use of rating agencies in assessing the quality of asset purchases and in assigning ratings to the various programs funded through the conduits. All transactions currently funded in the conduits had an underlying rating of at least investment grade by Moody’s and S&P prior to funding. The weighted-average underlying rating for transactions currently funded in the
conduits was A+ by S&P and A1 by Moody’s at the time such transactions were funded. MBIA estimates that the current weighted-average underlying rating of all outstanding conduit transactions was A+ by S&P and A1 by Moody’s at December 31, 2007.
The following table summarizes the Company’s future estimated cash payments relating to contractual obligations as of December 31, 2007. Estimating these payments requires management to make estimates and assumptions regarding these obligations. Estimates and assumptions used by management are described below the following table. Since these estimates and assumptions are subjective, actual payments in future periods may vary from those reported in the following table. For information on the Company’s financial guarantee exposure see “Note 20: Net Insurance In Force” in the Notes to Consolidated Financial Statements.
Investment agreements, commercial paper, medium-term notes, variable interest entity floating rate notes, securities sold under agreement to repurchase and long-term debt include principal and interest and exclude premiums or discounts. 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. Gross insurance claim obligations represent the future value of payments MBIA expects to make, before estimated recoveries and reinsurance, under actual or probable insurance policy claims. The discounted value of such actual or estimated claims, after estimated recoveries, is reported as case basis reserves within “Loss and loss adjustment expense reserves” on the Company’s consolidated balance sheet.
In January and February 2008, the Company has observed a further widening of market spreads and credit quality ratings downgrades of certain tranches within MBIA’s insured CDOs. As a result of the further market spread widening and the deterioration of asset credit quality ratings, the Company could suffer additional mark-to-market losses in the first quarter of 2008 and in subsequent quarters, although the ultimate amount of such losses will depend on future market developments. As changes in fair value can be caused by factors unrelated to the performance of MBIA’s business and credit portfolio, including general market conditions and perceptions of credit risk, as well as market use of credit derivatives for hedging purposes unrelated to the specific referenced credits in addition to events that affect particular credit derivative exposure, the application of fair value accounting may cause the Company’s earnings to be more volatile than would be suggested by the underlying performance of MBIA’s business operations and credit portfolio.
The following tables reflect sensitivities to changes in credit spreads, rating migrations and recovery rates. Each table stands on its own and should be read independently of each other.
Sensitivity to changes in credit spreads can be estimated by projecting a hypothetical instantaneous shift in credit spread curves. The following table presents the estimated pre-tax change in fair value and the cumulative estimated net fair value of the Company’s credit derivatives portfolio of instantaneous shifts in credit spreads as of December 31, 2007. Estimated changes in fair value are calculated using the valuation methods described in the “Critical Accounting Estimates” section included herein. Contracts for which fair value is calculated using specific dealer quotes or actual transaction prices are excluded from the following table as the Company is unable to obtain data necessary to model hypothetical changes in such contracts.
MBIA’s insurance of structured credit derivatives typically remain in place until the maturity of the derivative. The Company does, however, periodically establish positions which offset its insurance positions in the reinsurance market, in which contracts also typically remain in place until the maturity of the insurance contract. Any difference between the price of the initial transaction and the offsetting transaction will result in gains or losses. With respect to MBIA’s insured structured credit derivatives, in the absence of credit impairment, the cumulative gains and losses should reverse over time. Additionally, in the event of the termination and settlement of a contract prior to maturity, any resulting gain or loss upon settlement will be recorded in the Company’s financial statements. In February 2008, the Company has decided not to insure derivatives in the future, except in transactions that are intended to reduce its overall exposure to insured derivatives. This may result in termination of certain existing contracts prior to maturity.