This Annual Report includes statements that may constitute "forward-looking statements" within the meaning of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Words such as "believes," "anticipates," "expects," "intends" and "plans" and future and conditional verbs such as "will," "should," "would," "could" and "may" and similar expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements. The Company cautions that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. Important factors that could cause its results to differ, possibly materially, from those indicated in the forward-looking statements include, but are not limited to, those discussed under "Item 1. Business-Forward-Looking Statements" and "Item 1A. Risk Factors."
Financial Security Assurance Holdings Ltd. ("FSA Holdings" or, together with its subsidiaries, the "Company") is a holding company incorporated in the State of New York. The Company, through its insurance company subsidiaries, engages in providing financial guaranty insurance on public finance obligations in domestic and international markets. Historically, the Company also provided financial guaranty insurance on asset-backed obligations. In addition, the Company historically issued FSA-insured guaranteed investment contracts and other investment agreements ("GICs"), as well as medium term notes to municipalities and other market participants through its Financial Products ("FP") segment.
The Company conducted its GIC business through its non-insurance subsidiaries FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the "GIC Subsidiaries"). FSACM conducted substantially all the Company's GIC business since April 2003, following its receipt of an exemption from the requirements of the Investment Company Act of 1940. When the GIC Subsidiaries sold GICs, they loaned the proceeds to FSA Asset Management LLC ("FSAM"), which invests the funds in fixed-income obligations that satisfy the Company's investment criteria. The Company's affiliates ceased issuing GICs in November 2008 in contemplation of the sale of the Company to Assured Guaranty Ltd. ("Assured"). FSAM wholly owns FSA Portfolio Asset Limited ("FSA-PAL"), a U.K. company that invests in non-U.S. securities.
For the year ended December 31, 2008, the Company had gross premiums written of $690.4 million, of which approximately 88% related to insurance of public finance obligations and approximately 12% related to insurance of asset-backed and other non-public finance obligations. The Company also had realized gains on credit derivatives of $126.9 million in 2008. At December 31, 2008, the Company had net par outstanding of $408.5 billion, of which approximately 75% represented insurance of public finance obligations and approximately 25% represented insurance of asset-backed and other non-public finance obligations. At December 31, 2008, the Company had $16.4 billion principal amount of FP segment debt.
FSA's exposure to mortgage-backed obligations with deteriorating credit performance was the primary driver of loss expense in the Company's financial guaranty segment which have increased from $31.6 million as of December 31, 2007 to $1,877.7 million as of December 31, 2008, despite the fact that the Company has no material exposures to collateralized debt obligations ("CDOs") of asset-backed securities ("ABS") that include RMBS, which caused severe losses for a number of other financial guarantors. The full extent of credit losses in the mortgage sector, and the extent to which they may affect the Company, will not be known for several years. The Company is also closely
The Company is affected by conditions in the financial markets and general economic conditions, primarily domestic, but also international.
When the GIC Subsidiaries sold a GIC, they loaned the proceeds to FSAM. The terms governing FSAM's repayment of those proceeds to the GIC Subsidiaries match the payment terms under the related GIC. FSAM invests the proceeds in securities and enters into derivative transactions to convert any fixed-rate assets and liabilities into London Interbank Offered Rate ("LIBOR")-based floating rate assets and liabilities. Most of FSAM's assets consist of residential mortgage-backed securities ("RMBS") that have suffered significant market value declines and, in more limited cases, credit deterioration resulting in a shareholders' deficit for FSAM at December 31, 2008. The market value declines of FSAM's assets subject FSAM to significant liquidity risk insofar as the GICs are in most cases subject to redemption or collateralization upon the downgrade of FSA below certain thresholds, with a significant number of GICs subject to redemption or collateralization should FSA be downgraded below Aa3 by Moody's (FSA's current Moody's rating) or below AA- by S&P. Dexia had previously announced its intention to assume the credit and liquidity risk associated with the Company's FP business, and provided significant support to the FP business in the course of 2008.
In February 2009, Dexia entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia, (the "FSAM Risk Transfer Transaction"). Each of the agreements executed under the FSAM Risk Transfer Transaction directly affect (1) FSAM and (2) the entities that absorb the risks created by FSAM. These agreements provide for the (i) elimination of FSA's guaranty of repayment of FSAM's borrowings under the credit facilities provided by Dexia's bank subsidiaries; (ii) elimination of FSA's guaranty of certain of FSAM's investments; and (iii) increase in the credit facilities provided to FSAM by Dexia's bank subsidiaries from $5 billion to $8 billion.
(2)Represents the reversal of eliminations related to intercompany note between FSAM and the GIC Subsidiaries. In the table above, the carrying value of the note receivable from FSAM represents net realizable value, in accordance with accounting principles generally accepted in the United States of America ("GAAP") in effect at December 31, 2008. Statement of Financial Accounting Standards ("SFAS") No. 160, "Noncontrolling Interests in Consolidated Financial Statements" ("SFAS 160"), became effective January 1, 2009 and may be applicable to the deconsolidation of FSAM. The Company is currently evaluating the impact of SFAS 160 on the Company's financial statements in 2009 as SFAS 160 may materially affect the method of valuing the carrying amount of the GIC entities' notes receivable from FSAM at the February 2009 deconsolidation date.
Obligations insured by the Company are generally awarded ratings on the basis of the financial strength ratings given to the Company's insurance company subsidiaries by the major securities rating agencies. During 2007 and 2008, the global financial crisis that began in the U.S. subprime residential mortgage market transformed the financial guaranty industry. By the end of November 2008, all of the monoline guarantors that had been rated Triple-A at the beginning of the year had been downgraded in varying degrees by Moody's, and all but two had been either downgraded or placed on negative outlook or negative credit watch by S&P and Fitch, reducing the number of active providers of financial guaranty insurance while calling into question the durability of financial guaranties in general. On December 31, 2008, the Company was rated Triple-A (negative credit watch) by S&P and Fitch and
Aa3 (developing outlook) by Moody's. Prior to November 2008, the Company's insurance company subsidiaries, as well as the obligations they insured, had been awarded Triple-A ratings by the three major rating agencies. Rating agencies raised concerns about the stability of FSA's rating during the second half of 2008. The rating agencies stated that their actions regarding FSA were based in part upon concerns regarding the prospects for new business originations by financial guarantors, as well as uncertainty about future support for FSA. As a result of the recent ratings actions, FSA's market opportunities were severely limited beginning in the second half of 2008 and its long-term opportunities remain unclear. These developments, combined with illiquidity in the capital markets, led to a marked reduction in FSA's production in the second half of 2008.
The following table shows the current ratings of the Company and its four main competitors at March 13, 2009, by each of the rating agencies:
office to oversee bond insurers. The cost of buying protection in the credit default swap ("CDS") market on monoline names rose significantly during 2008.
In the fourth quarter of 2007, Berkshire Hathaway Assurance Company ("BHAC") commenced operations as a financial guaranty insurer. Given BHAC's affiliation with Triple-A rated Berkshire Hathaway Company, BHAC has the potential to be a significant competitor to the Company in the public finance sector but has to date insured transactions only on an opportunistic basis. Another new monoline competitor, Municipal and Infrastructure Assurance Corporation ("MIAC"), commenced operations in October 2008, intending to focus on municipal and infrastructure finance. National Public Finance Guaranty Corp. ("NPFG"), an affiliate of MBIA Insurance Corporation, commenced operations in February 2009, intending to focus on municipal finance. In addition, Ambac Assurance Corporation has announced an intention to establish an affiliate, Everspan Financial Guaranty Corp, that will engage in municipal financial guaranty insurance. There are proposals for Congress to establish a federally chartered bond insurer, and for states and pension funds to establish bond insurers, in each case to address the public sector demand for bond insurance. Any such Federal, state or pension fund sponsored bond insurer would likely prove to be a significant competitor to the Company.
The credit crisis that began in 2007 followed several years of seemingly benign credit conditions, during which delinquency and default rates were comparatively low across the residential mortgage, consumer finance and corporate finance credit markets. Beginning in 2005, credit spreads were tight, indicating that investors were relatively undiscriminating about risk, and structures of some asset-backed securities were based on loss assumptions that have proven to be too optimistic. This was particularly true in the RMBS sector and with CDOs of ABS that contain a high percentage of RMBS. During these years, FSA maintained its underwriting and pricing standards, even though this meant declining to insure certain transactions.
In 2007 and 2008, mortgage performance deteriorated rapidly, exceeding the most conservative historical loss expectations. For the first time since the Great Depression, year-over-year home prices declined across the entire United States, not just regionally. As projected losses on subprime and other RMBS increased, some mortgage lenders failed, and rating agencies downgraded many mortgage-related securities. This included a large amount of CDOs of ABS. In the home equity line of credit ("HELOC") market, which generally involves prime borrowers, projected losses rose to unprecedented levels. In the first quarter of 2008, these borrowers began to default at much higher rates, a trend which continued through the year.
In 2008, the Company established 38 new case reserves, primarily for first and second lien RMBS insured transactions. Loss provisions, primarily those related to the insured RMBS portfolio, reflect the assumption that economic stress in the U.S. economy will continue for the foreseeable future. Loss expense for the year ended December 31, 2008 was $1,877.7 million, related primarily to increases in loss estimates on RMBS transactions.
strong. The Company's originations since mid-2008 have been limited, primarily due to market conditions and concerns regarding rating agency actions.
Net income decreased in both the financial guaranty and FP segments. In the financial guaranty segment, higher losses related to insured RMBS transactions and negative fair-value adjustments for credit derivatives were primarily responsible for producing negative segment results. In the FP segment, the loss was largely due to OTTI charges. The Company no longer has the intent to hold such securities to maturity, due to Dexia's Purchase Agreement covenant to retain the FP operations and segregate or separate the FP operations from the Company's financial guaranty operations. As a result, the Company was required to record an OTTI charge for all assets in the Portfolio in an unrealized loss position at December 31, 2008.
In order to understand the results of operations reported in accordance with GAAP, the discussion that follows explains certain fair-value adjustments that cause volatility in reported earnings. While there is also volatility in reported earnings due to reserves and other economic gains and losses, management typically views fair-value adjustments that are not indicative of expected loss separate from its core operating results in making its decisions. For discussion of the Company's fair value methodology, see Note 3 to the consolidated financial statements in Item 8.
Fair-value adjustments for credit derivatives in the insured portfolio: Fair-value adjustments for credit derivatives in the insured portfolio include credit impairments representing estimated economic losses as well as non-economic fair-value adjustments expected to reverse to zero over time. In 2008, the Company estimated credit impairments of $152.4 million pre-tax. At December 31, 2008, the non-economic portion of fair-value adjustments for credit derivatives in the insured portfolio of $592.6 million had no effect on insurance company statutory equity or claims-paying resources, and rating agencies generally do not take these unrealized gains or losses into account for evaluating FSA's capital adequacy. At December 31, 2008, all of the credit derivatives in the insured portfolio were categorized as Level 3 in the SFAS 157 fair value hierarchy.
Fair-value adjustments for instruments with economically hedged risks: The majority of the Company's economic hedges relate to FP segment interest rate derivatives used to convert the fixed interest rates of certain assets to dollar-denominated floating rates based on the London Interbank Offered Rate ("LIBOR"). Without hedge accounting or a fair-value option, SFAS 133 requires the marking to fair value of each such derivative in income without the offsetting mark to fair value on the risk it is intended to hedge. The one-sided valuations for economically hedged risks that do not qualify for hedge accounting and unhedged credit risk valuations for securities in the trading portfolio cause volatility in the consolidated statements of operations and comprehensive income. Management views fair-value adjustments on economically hedged risks together with the fair-value adjustments on the hedging items in order to analyze and manage hedge inefficiency, regardless of the prescribed accounting treatment. For assets within the trading portfolio, net income reflects both the economic effect of hedged economic risks related to interest and foreign exchange rates, and non-economic changes in fair value related to credit spreads. At December 31, 2008, the majority of derivative instruments were categorized as Level 3 in the SFAS 157 fair value hierarchy.
The Company established a tax valuation allowance of $2.5 billion in 2008 against deferred tax assets attributable to FP segment net unrealized losses.
Shareholders' equity under GAAP ("book value") was negative $5.2 billion at December 31, 2008, compared with positive $1.6 billion at December 31, 2007. The decline in 2008 was primarily the result of mark-to-market losses in the FP segment, losses incurred in the financial guaranty segment and negative fair-value adjustments for credit derivatives.
The Company employs the non-GAAP measure present value originations ("PV originations") to describe the economic value of the Company's new business originations in a given period. PV originations are the sum of the non-GAAP measures PV financial guaranty originations and PV net interest margin ("NIM") originated in the FP segment and represents the Company's measure of business production in a given period. PV financial guaranty originations, PV NIM originated and PV originations are based on estimates of, among other things, prepayment speeds of asset-backed securities. PV financial guaranty originations is a measure of gross origination activity and does not reflect premiums ceded to reinsurers or the cost of CDS or other credit protection, which may be considerable, employed by the Company to manage its credit exposures.
The Company's insurance policies, including credit derivatives, are generally non-cancelable and remain outstanding for years from date of inception, in some cases 30 years or longer. Accordingly, PV financial guaranty originations, as distinct from earned premium or realized gains (losses) on credit derivatives, represents amounts to be realized in the future.
Year-to-year comparisons of PV financial guaranty originations are affected by the application of a different discount rate each year. The discount rates employed by the Company for this purpose were 4.92%, 4.86%, and 5.07% for 2008, 2007 and 2006 originations, respectively.
For a reconciliation of gross premiums written to the non-GAAP measure PV Financial Guaranty Originations, see "-Financial Guaranty Segment-PV Financial Guaranty Originations."
The FP segment produces NIM, which is a non-GAAP measure, rather than insurance premiums. Like installment premiums, PV NIM originated in a given period is expected to be earned and collected in future periods.
FP segment debt is issued at or converted into LIBOR-based floating rate obligations, with proceeds invested in or converted into LIBOR-based floating rate investments intended to result in profits from a higher investment rate than borrowing rate. FP NIM represents the difference between the current period investment revenue and borrowing cost, net of the economic effect of derivatives used to hedge interest rate and currency risk.
PV NIM originated represents the difference between the present value of estimated interest to be received on investments and the present value of estimated interest to be paid on liabilities issued by the FP segment, net of transaction expenses and the expected results of derivatives used to hedge interest rate risk. The Company's future positive interest rate spread estimate generally relates to contracts or security instruments that extend for multiple years.
Net interest income and net interest expense are reflected in the consolidated statements of operations and comprehensive income but are limited to current period earnings. As the GICs and the assets they fund extend beyond the current period, management considers the PV NIM originated to be a useful indicator of future FP NIM to be earned.
2008 vs. 2007: In the financial guaranty segment, negative operating earnings for the year ended December 31, 2008 were due to increased loss expense driven by increased net RMBS loss estimates, as well as higher public finance losses, credit impairments on the Company's insured CDS and insured net interest margin securitizations ("NIMs") portfolio and realized losses related to its investment in Syncora Guarantee Re Ltd. ("SGR") (formerly XL Financial Assurance Ltd.) and investments in Lehman Brothers. Higher upfront premiums in the first half of 2008 and $804.3 million of 2008 capital contributions to the financial guaranty segment increased the General Investment Portfolio's invested asset balance, which increased net investment income. Premiums earned and realized gains (losses) of credit derivative fees, collectively, also increased.
Net premiums earned are broken down into two major categories: premiums earned on refundings and accelerations and premiums earned on new and recurring insured obligations. Refundings may vary significantly from year to year as they are affected by the interest rate environment. In periods of declining interest rates, issuers generally seek to refinance their obligations. In cases where an issuer defeases or calls an outstanding obligation insured by the Company, all unearned premiums are accelerated and recognized in current earnings. Accelerations also include premiums earned on ceded contracts that have been commuted or terminated.
At the same time, public finance originations and premiums earned had steadily increased over the past several years. In the second half of 2008, however, the Company's new originations in the public finance sector were restricted due to the ratings changes in the second half of 2008, including Moody's downgrade of FSA's rating to Aa3, as well as a decline in market acceptance of financial guaranties.
The Company employs reinsurance to manage single-risk limits and maintain capacity to write new business. Due to the 2008 downgrades of certain reinsurers, the Company has and may continue to re-assume ceded exposure. In 2008, net premiums earned included $28.5 million resulting from commutations or cancellations of reinsurance contracts. This primarily resulted in a ratio of ceded premiums written to gross premiums written of 5% in 2008, compared to 38% in 2007 and 2006.
In 2008, the Company had net realized losses of $6.7 million, which included a $36.1 million loss on the sale of its investment in SGR preferred stock and an OTTI charge of $6.0 million for several municipal bonds, offset in part by realized gains on sales of assets. Realized losses from the General Investment Portfolio were $1.9 million in 2007 and $8.3 million in 2006.
In consultation with the Securities and Exchange Commission (the "SEC"), members of the financial guaranty industry have collaborated to develop a presentation of credit derivatives issued by financial guaranty insurers that is more consistent with that of non-insurers. The tables below illustrate the current required presentation with prior period balances reclassified to conform to the current presentation. The reclassifications do not affect net income or equity, although they do affect various revenue, asset and liability line items. Changes in fair value are recorded in "net change in fair value of credit derivatives" in the consolidated statements of operations and comprehensive income. The "realized gains (losses) and other settlements" component of this income statement line includes premiums received and receivable on written CDS contracts and premiums paid and payable on
purchased contracts. If a credit event occurred that required a payment under the contract terms, this line item would also include losses paid and payable to CDS contract counterparties due to the credit event and losses recovered and recoverable on purchased contracts.
The Company's insured portfolio includes other contracts accounted for as derivatives, including (a) insured interest rate swaps entered into by the issuer in connection with the issuance of certain public finance obligations ("IR swaps") and (b) insured NIM securitizations and other financial guaranty contracts that guarantee risks other than credit risk, such as interest rate basis risk, issued after January 1, 2007 ("FG contracts with embedded derivatives").
Summary of the Net Change in the Fair Value of Credit Derivatives
(1)Includes amounts which in prior periods were classified as premiums earned. Considerable judgment is necessary to interpret the data to develop the estimates of fair value. Under the SFAS 157 fair value hierarchy, all credit derivative valuations are categorized as Level 3. (For a description of the SFAS 157 fair value hierarchy, see Note 3 to the consolidated financial statements in Item 8.) Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair-value amounts.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is the case with most of the Company's CDS contracts because these contracts are not traded, then the determination of fair value is based on internally developed estimates. The Company's methodology for estimating the fair value of a CDS contract incorporates all the remaining future premiums to be received over the life of the CDS contract, discounted to present value using the current LIBOR swap rate, which conforms to market practice, and multiplied by the ratio of the current exit value premium to the contractual premium. The estimation of the current exit value premium is derived using a unique
credit-spread algorithm for each defined CDS category that utilizes various publicly available credit indices, depending on the types of assets referenced by the CDS contract and the length of the contract. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, if available, performance of underlying assets, changes in internal credit assessments or rating agency-based shadow ratings, and the level at which the deductible has been set. Estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions. For more information regarding the Company's valuation process, see "Credit Derivatives in the Insured Portfolio" in Note 3 to the consolidated financial statements in Item 8.
(1)Upon the adoption of SFAS 157, $40.9 million pre-tax, or $26.6 million after-tax, was recorded as an adjustment to beginning retained earnings related to credit derivatives.
•CDS contracts are neither held for trading purposes (i.e., a short-term duration contract written for the purpose of generating trading gains) nor used as hedging instruments. Instead, they are
written with the intent to provide protection for the stated duration of the contract, similar to the Company's intent with regard to a financial guaranty contract.
•FSA is not entitled to terminate CDS and realize a profit on a position that is "in the money." A counterparty to a CDS contract written by FSA generally is not able to force FSA to terminate a CDS that is "out of the money."
Credit derivatives in the asset-backed portfolio represent 71.2% of total asset-backed par outstanding. The Company has grouped CDS contracts by major category of underlying instrument for purposes of internal risk management and external reporting. The tables below summarize the credit rating, net par outstanding and remaining weighted-average life ("WAL") for the primary components of the Company's CDS portfolio.
(6)Primarily infrastructure obligations and European mortgage-backed securities. Also includes $375.2 million and $421.4 million at December 31, 2008 and 2007, respectively, in U.S. RMBS net par outstanding. All U.S. RMBS exposures were rated Triple-B or higher. Includes certain pooled corporate obligations. For the sensitivity of CDS contracts that would result from an increase of one basis point in market credit spreads, see "
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2008, 2007 and
Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2008, 2007 and
At December 31, 2008, Dexia Holdings Inc. ("Dexia Holdings") owned over 99% of outstanding FSA Holdings shares; the only other holders of FSA Holdings common stock were directors of FSA Holdings who owned shares of FSA Holdings common stock or economic interests therein under the Company's Director Share Purchase Program.
The Company is a subsidiary of Dexia Holdings which, in turn, is owned 90% by Dexia Crédit Local S.A. ("Dexia Crédit Local") and 10% by Dexia S.A. ("Dexia"). Dexia is a Belgian corporation primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia.
The Company conducted its GIC business through its non-insurance subsidiaries FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the "GIC Subsidiaries"). FSACM conducted substantially all the Company's GIC business since April 2003, following its receipt of an exemption from the requirements of the Investment Company Act of 1940. When the GIC Subsidiaries sold GICs, they loaned the proceeds to FSA Asset Management LLC ("FSAM"), which invests the funds in fixed-income obligations that satisfy the Company's investment criteria. FSAM wholly owns FSA Portfolio Asset Limited ("FSA-PAL"), a U.K. company that invests in non-U.S. securities.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the "HSR Act") and the rules promulgated thereunder by the Federal Trade Commission (the "FTC"), the Acquisition may not be consummated until notifications have been given and certain information has been furnished to the FTC and the Department of Justice (the "DOJ") and specified waiting period requirements have been satisfied. The HSR Act waiting period expired on January 21, 2009. In addition, under the insurance holding company laws and regulations applicable to the insurance subsidiaries of the Company and Assured, before a person can acquire control of a U.S. insurance company, prior written approval must be obtained from the insurance commissioner of the state where the insurer is domiciled. Assured has informed the Company that Assured filed applications with the insurance departments of the States of New York and Oklahoma and the U.K. Financial Services Authority; that the applications to the New York Insurance Department and the U.K. Financial Services Authority have been approved; and that it has made pre-acquisition filings regarding the potential competitive impact of the acquisition, which are deemed to have been approved. Dexia has informed the Company that it has filed an application with the U.K. Financial Services Authority in connection with its acquisition of Assured common shares pursuant to the Purchase Agreement, which has been approved, and that it has filed disclaimers of control with the insurance departments of the states of Maryland, New York, and Oklahoma.
When the GIC Subsidiaries sold a GIC, they loaned the proceeds to FSAM. The terms governing FSAM's repayment of those proceeds to the GIC Subsidiaries match the payment terms under the related GIC. FSAM invests the proceeds in securities and enters into derivative transactions to convert any fixed-rate assets and liabilities into London Interbank Offered Rate ("LIBOR")-based floating rate assets and liabilities. Most of FSAM's assets consist of residential mortgage-backed securities ("RMBS") that have suffered significant market value declines and, in more limited cases, credit deterioration resulting in a shareholders' deficit for FSAM at December 31, 2008. The market value declines of FSAM's assets subject FSAM to significant liquidity risk insofar as the GICs are in most cases subject to redemption or collateralization upon the downgrade of FSA below certain thresholds,
As a result of the significant decline in asset value and the November 2008 cessation of issuing GICs, the GIC business changed from a business model managed by the Company focused on attaining positive net interest margin, to a run-off business managed by Dexia seeking to minimize liquidity risk and optimize asset recovery values.
In February 2009, Dexia entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia (the "FSAM Risk Transfer Transaction"). Each of the agreements executed under the FSAM Risk Transfer Transaction directly affect (1) FSAM and (2) the entities that absorb the risks created by FSAM. These agreements provide for the (i) elimination of FSA's guaranty of repayment of FSAM's borrowings under the credit facilities provided by Dexia's bank subsidiaries; (ii) elimination of FSA's guaranty of certain of FSAM's investments; and (iii) increase in the credit facilities provided to FSAM by Dexia's bank subsidiaries from $5 billion to $8 billion.
Obligations insured by the Company are generally awarded ratings on the basis of the financial strength ratings given to the Company's insurance company subsidiaries by the major securities rating agencies. On December 31, 2008, the Company was rated Triple-A (negative credit watch) by S&P and Fitch Ratings ("Fitch") and Aa3 (developing outlook) by Moody's. Prior to the third quarter of 2008,
During 2007 and 2008, the global financial crisis that began in the U.S. subprime residential mortgage market transformed the financial guaranty industry. By the end of November 2008, all of the monoline guarantors that had been rated Triple-A at the beginning of the year had been downgraded in varying degrees by Moody's, and all but one had been either downgraded or placed on negative outlook or negative credit watch by S&P and Fitch. FSA and the Company's other insurance company subsidiaries were among the last companies to be affected, and were rated "Triple-A/stable" by all three rating agencies until July 2008. Rating agencies raised concerns about the stability of FSA's rating during the second half of 2008, and Moody's lowered FSA's Aaa rating to Aa3 (developing outlook) in November. These developments, combined with illiquidity in the capital markets, led to a marked reduction in FSA's production in the second half of 2008.
The Company has refinanced certain poorly performing transactions by employing refinancing vehicles to raise funds, prepay the claim obligations and take control of the assets. These refinancing vehicles are consolidated with the Company and considered part of the financial guaranty segment.
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. In contemplation of this change, FSACM, FSA Capital Markets Services, LLC and FSAM became direct subsidiaries of a newly formed subsidiary, FSA Financial Products Inc. ("FSA Financial Products"), in December 2008. Previously they had been direct subsidiaries of FSA Holdings. FSA Financial Products is owned by FSA Holdings.
In the third quarter of 2008, to address FP segment liquidity requirements, Dexia entered into an agreement to provide a $5 billion committed, unsecured, standby line of credit (the "First Dexia Line of Credit") to FSAM. At December 31, 2008, FSAM had $1.3 billion in draws outstanding under the First Dexia Line of Credit. In addition, on November 13, 2008, the Company entered into two new agreements with Dexia and its affiliates in support of its FP business, which provide additional protection through a $3.5 billion collateral swap facility and a $500 million capital facility to cover economic losses beyond the $316.5 million of pre-tax loss estimated at the end of June 2008. In February 2009, Dexia increased the credit facilities provided to FSAM from $5 billion to $8 billion. At March 2, 2009, the outstanding amount drawn by the Company had increased to $2.7 billion.
The Company consolidates the results of certain variable interest entities ("VIEs"), which include FSA Global Funding Limited ("FSA Global") and Premier International Funding Co. ("Premier"). FSA
The Company's management believes that the assets held by FSA Global and Premier, including those that are eliminated in consolidation, are beyond the reach of the Company's creditors, even in bankruptcy or other receivership. Substantially all of the assets of FSA Global are pledged to secure the repayment, on a pro rata basis, of FSA Global's notes and its other obligations.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 25). The preparation of financial statements in conformity with GAAP requires management to make extensive estimates and assumptions that affect the reported amounts of assets and liabilities in the Company's consolidated balance sheets at December 31, 2008 and 2007, the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2008, 2007 and 2006 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments, the determination of other-than-temporary impairment ("OTTI"), the deferral and amortization of policy acquisition costs and taxes. Actual results may differ from those estimates.
The consolidated financial statements include the accounts of FSA Holdings and its direct and indirect subsidiaries, (collectively, the "Subsidiaries"), principally including:
•the "FP Investment Portfolio," consisting of the investments supporting the GIC liabilities, which are primarily designated as available-for-sale, but in some cases are classified as trading; and
•the "VIE Investment Portfolio," consisting of the investments supporting the VIE liabilities, which are designated as available-for-sale;
•the "General Investment Portfolio," consisting of the investments held by FSA, FSA Holdings and other subsidiaries not included in the other portfolios and which are designated as available-for-sale.
Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged with derivatives or are economically hedged but do not qualify for hedge accounting is reflected as a separate component of shareholders' equity, net of tax, unless deemed to be OTTI. OTTI is reflected in earnings as a realized loss. The unrealized gain or loss attributable to the hedged risk on investments that qualify as fair-value hedges is recorded in the consolidated statements of operations and comprehensive income in "net interest income on financial products segment."
Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. The cost of securities sold is based on specific identification of each security.
Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at fair value. Amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less are included in short-term investments.
VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. Auction Rate Securities are long-term securities with interest rate reset features and are traded in the marketplace through a bidding process. The cash flows related to these securities are presented on a gross basis in the consolidated statements of cash flows.
Effective January 1, 2009, the Company's recognition of premium revenue will change due to the adoption of Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standard ("SFAS") No. 163, "Accounting for Financial Guarantee Insurance Contracts" ("SFAS 163"), as described in "-Recently Issued Accounting Standards that are Not Yet Effective."
The Company establishes a case reserve for the present value of the estimated loss, net of subrogation recoveries, when, in management's opinion, the likelihood of a future loss on a particular insured obligation is probable and reasonably estimable at the balance sheet date. When an insured obligation has met the criteria for establishing a case reserve and that transaction pays a premium in installments, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue. Typically, a case reserve is determined using cash flow or similar models that represent the Company's estimate of the net present value of the anticipated shortfall between (1) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (2) anticipated cash flow from and proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. The estimated loss, net of recovery, on a transaction is discounted using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established and is not subsequently adjusted. In certain situations where cash flow models are not practical, a case reserve represents management's best estimate of expected loss.
The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by
Since the non-specific reserve contains the inherent losses of the portfolio, when a case reserve adjustment is deemed appropriate, whether the result of adverse or positive credit developments, accretion or the addition of a new case reserve, a full transfer is made between the non-specific reserve and the case reserve balances with no effect to income. The adequacy of the non-specific reserve balance is reviewed periodically and at least annually. Such analyses are performed to quantify appropriate adjustments that may be either charges or benefits on the consolidated statements of operations and comprehensive income.
Cash collateral received from derivative counterparties is netted with derivative receivables from the same counterparties when the right of offset exists under master netting agreements.
Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are recorded at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities resulting from translating investments
Asset-backed and, to a lesser extent, public finance transactions insured by the Company may employ special purpose entities ("SPEs") for a variety of purposes. A typical asset-backed transaction, for example, employs an SPE as the purchaser of the securitized assets and as the issuer of the insured obligations. SPEs are typically owned by transaction sponsors or charitable trusts, although the Company may have an ownership interest in some cases. The Company generally maintains certain contractual rights and exercises varying degrees of influence over SPE issuers of FSA-insured obligations.
The Company is required to consolidate SPEs that are considered VIEs where the Company is considered the primary beneficiary.
In considering the significance of its interest in a particular VIE, the Company considers the extent to which both the variability it absorbs from the VIE and the Company's exposure to that VIE are material to the Company's own financial statements. The Company believes that its surveillance categories are an appropriate measure to use for identification of VIEs in which the Company absorbs other than insignificant variability. VIEs selected for this purpose are related to risks classified as surveillance Category IV, defined as "demonstrating sufficient deterioration to indicate that material credit losses are possible even though not yet probable" or risks classified as surveillance Category V, defined as "transactions where losses are probable." The Company believes that VIE-related risks classified as surveillance Categories IV and V are VIEs in which the Company absorbs a significant portion of the variability created by the particular VIE. For a more detailed description of the surveillance categories used by the Company, see Note 9.
VIEs in which the Company holds a significant variable interest, but which are not consolidated, have been aggregated according to principle line of business for the purpose of disclosing the nature and extent of the Company's exposure to such VIEs. The Company aggregates such VIEs according to principle line of business to appropriately reflect the VIE risk and reward characteristics in an aggregated manner. The table below displays the Company's exposure to these VIEs at December 31, 2008.
(1)Represents the net par outstanding that corresponds to insured bonds issued by VIEs. FSA's interest in these non-consolidated VIEs is included in "losses and loss adjustment expenses" and "credit derivatives" in the Company's balance sheet.
The Company has consolidated certain VIEs for which it has determined that it is the primary beneficiary. The table below shows the carrying value and classification of the consolidated VIE assets and liabilities in the Company's financial statements:
FSA has provided financial guarantee insurance contracts on the assets held and the notes issued by FSA Global Funding and, as such, FSA is exposed to the risk of non-payment of the assets held by FSA Global Funding. In addition, aside from the financial guarantee insurance contracts provided by FSA, there are no arrangements, either explicit or implicit, which could require the Company to provide financial support to the VIEs.
Under SFAS No. 123, "Share-Based Payment" (revised 2004), the Company recorded $1.2 million and $1.0 million in additional after-tax expense related to the Dexia Employee Share Plans in 2007 and 2006, respectively. There was no expense recorded in 2008.
In October 2008, the FASB issued FSP No. FAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active" ("FSP 157"). FSP 157 clarifies the application of SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), in an inactive market, without changing its existing principles. The FSP was effective immediately upon issuance. The adoption of FSP No. FAS 157-3 did not have an effect on the Company's financial position or results of operations or cash flows.
The Company adopted SFAS 157, effective January 1, 2008. SFAS 157 addresses how companies should measure fair value when required to use fair value measures under GAAP. SFAS 157:
•defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework for measuring fair value;
In February 2007 the FASB issued SFAS 159. SFAS 159 provides an option to elect fair value as an alternative measurement for selected financial assets and financial liabilities not previously recorded at fair value. The Company adopted SFAS 159 on January 1, 2008 and elected fair value accounting for certain FP segment debt and certain assets acquired in refinancing FSA-insured transactions not previously carried at fair value. For more information regarding the fair value option, see Note 4.
The Company applied its valuation methodologies for its assets and liabilities measured at fair value to all of the assets and liabilities carried at fair value effective January 1, 2008, whether those instruments are carried at fair value as a result of the adoption of SFAS 159 or in compliance with other authoritative accounting guidance. The Company has fair value committees to review and approve valuations and assumptions used in its models. These committees meet quarterly prior to the Company issuing its financial statements.
Fair value is based upon pricing received from dealer quotes or alternative pricing sources with reasonable levels of price transparency, internally developed estimates that employ credit-spread algorithms or models that use market-based or independently sourced market data inputs, including yield curves, interest rates, volatilities, debt prices, foreign exchange rates and credit curves. In addition to market information, models also incorporate instrument-specific data, such as maturity date.
The transition adjustment in connection with the adoption of SFAS 157 was an increase of $26.6 million after-tax to beginning retained earnings, which relates to day one gains that had been deferred under EITF 02-03.
The following table summarizes the components of the fair-value adjustments included in the consolidated statements of operations and comprehensive income:
(3)Represents fair-value adjustments on the assets that economically defease the Company's liability for deferred compensation plans ("DCP") and supplemental executive retirement plans ("SERP").
•Level 1-inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
•Level 2-inputs to the valuation methodology include quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
•Level 3-inputs to the valuation methodology are unobservable and significant drivers of the fair value measurement.
A financial instrument's categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
Inputs refer broadly to the assumptions that market participants use in pricing assets or liabilities, including assumptions about risk. Inputs may be observable or unobservable.
•Observable inputs are inputs that reflect assumptions market participants would use in pricing the asset or liability, developed based on market data obtained from independent sources.
•Unobservable inputs are inputs that reflect the assumptions management makes about the assumptions market participants would use in pricing the asset or liability, developed based on the best information available in the circumstances.
•The market approach uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities. Valuation techniques consistent with the market approach often use market multiples derived from a set of comparables or matrix pricing. Market multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering both quantitative and qualitative factors specific to the measurement. Matrix pricing is a mathematical technique used principally to value certain securities without relying exclusively on quoted prices for the specific securities but comparing the securities to benchmark or comparable securities.
•The income approach converts future amounts, such as cash flows or earnings, to a single present amount, or a discounted amount. Income approach techniques rely on current market expectations of future amounts. Examples of income approach valuation techniques include present value techniques, option-pricing models that incorporate present value techniques, and the multi-period excess earnings method.
The following is a description of the valuation methodologies the Company uses for financial instruments including the general classification of such instruments within the valuation hierarchy.
The fair value of bonds in the General Investment Portfolio is generally based on quoted market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. If quoted market prices are not available, the valuation is based on pricing models that use dealer price quotations, price activity for traded securities with similar attributes and other relevant market factors as inputs, including security type, rating, vintage, tenor and its position in the capital structure of the issuer. Assets in this category are primarily categorized as Level 2.
For short-term investments in the General Investment Portfolio, which are those investments with a maturity of less than one year at time of purchase, the carrying amount approximates fair value. These short-term investments include money-market funds and other highly liquid short-term investments, which are categorized as Level 1 on the valuation hierarchy, and foreign government and agency securities, which are categorized as Level 2.
The trading portfolio is comprised of U.K. pound sterling-denominated inflation-linked bonds for which fair value is based on broker quotes that are derived from their internally-developed models that use observable market inputs to the extent possible. The investments are classified as Level 3.
The Company considers all such agreements to be a normal part of its financial guaranty insurance business but, for accounting purposes, these contracts are deemed to be derivative instruments and therefore must be recorded at fair value, with changes in fair value recorded in the consolidated statements of operations and comprehensive income in "net change in fair value of credit derivatives."
Significant assumptions that, if changed, could result in materially different fair values include:
•the assumed credit spread attributable to credit risk of the underlying referenced obligations exclusive of funding costs,
•the reference credit index used, which includes a market correlation factor for pooled corporate CDS contracts, and
Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, if available, performance of underlying assets, changes in internal credit assessments or rating agency-based shadow ratings, and the level at which the deductible has been set. Estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions.
recoveries). The attachment points for each of the Company's CDS contracts vary, as the deductibles are negotiated on a contract-by-contract basis.
In the ordinary course, the Company does not post collateral to the counterparty as security for the Company's obligation under CDS contracts. As a result, the Company receives a smaller fee than it would for a CDS contract that required the posting of collateral. In order to calculate the exit value premium for CDS that do not require collateral to be posted, the Company applies a factor (the "non-collateral posting factor") to the indicated market premium for CDS contracts that require collateral to be posted. The non-collateral posting factor was 70% for the year ended December 31, 2008.
For each of these types of CDS contracts, the price the Company charges when entering into such contract sometimes differs from the fair value determined by the Company's fair value model at the time when the Company enters into the CDS contract. The Company refers to this difference as the "initial model adjustment," and is not an indicator of a day one gain. The initial model adjustment is needed because of differences between the CDS contract being valued and the reference index. The initial model adjustment is calculated at the inception of a CDS contract in order to calibrate the indicated model fair value of the CDS contract to the contractual premium rate on the trade date.
Pooled Corporate CDS Contracts: A pooled corporate CDS contract insures the default risk of a pool of referenced corporate entities. As there is no observable exchange trading of bespoke pooled corporate CDS, the Company values these contracts using an internal pricing model that uses the mid-point of the bid and ask prices (the "mid-market price") of dealer quotes on specific indexes as inputs to its pricing model, principally the Dow Jones CDX for domestic corporate CDS ("DJ CDX")
Prices quoted for these tranches do not represent perfect pricing references, but are the only relevant market-based information available for this type of non-traded contract. The recent market volatility in the index tranches has had a significant impact on the estimated fair value of the Company's portfolio of pooled corporate CDS.
Investment-Grade Pooled Corporate CDS Contracts: The Company applies quoted prices to its investment-grade pooled corporate CDS contracts ("IG CDS") by stratifying its IG CDS contracts into four maturity bands: less than 3.5 years; 3.5 to 5.5 years; 5.5 to 7.5 years; and 7.5 to 10 years. Within the maturity bands, further distinction is made for contracts that have a significantly higher starting attachment point (usually 30% or higher).
The CDX North America IG Index ("CDX IG Index") is comprised of prices sourced from 125 North American investment grade CDS quoted (each, an "Index CDS") and is supported by at least 10 of the largest CDS dealers. In addition to the full capital structure, the CDX IG Index also provides price quotes for various tranches delineated by attachment and detachment points: 0 to 3%; 3 to 7%; 7 to10%; 10 to 15%; 15 to 30% and 30 to 100%. Approximately every six months, a new "series" of the CDX IG Index is published ("on-the-run") based on a new grouping of 125 Index CDS, which changes the composition of the 125 Index CDS of older ("off-the-run") series. Each quarter, the Company compares the composition of the 125 Index CDS in both the on-the-run and off-the run series of the CDX IG Index to the CDS pool referenced by the Company's IG CDS contracts (the "reference CDS pool") and uses the average of the series of the CDX IG Index and the comparable iTraxx Index that most closely relates to the credit characteristics of the Company's IG CDS contracts, mainly the Weighted-Average Rating Factor ("WARF"), of the Company's IG CDS contracts. The Company also remodels each of its contracts to determine if the credit quality remains Super Triple-A and compares the WARF of the index to the WARF of each of the Company's IG CDS contracts. A "Super Triple-A" credit rating indicates a level of first-loss protection generally exceeding 1.3 times the level required by a rating agency for a Triple-A rating. WARF is a 10,000 point scale developed by Moody's that is used as an indicator of collateral pool risk. A higher WARF indicates a lower average collateral rating.
The Company's IG CDS contracts typically attach at 10% or higher. The following table indicates FSA's typical attachment points and total tranche widths:
To calculate the weighted average price for the entire tranche width of the Company's IG CDS (the "total tranche width"), a price is obtained for each quoted tranche comprising the total tranche width, and the sum of the weighted average prices is divided by the total tranche width. The price for each quoted tranche is the mid-market of the quoted price for that tranche, weighted by the width of that tranche. The following table illustrates the calculation of the weighted-average price of the Company's IG CDS contracts with a maturity of up to 3.5 years, given quoted CDX IG tranche prices of 332 basis points, 83.5 basis points and 68.4 basis points for the 10 to 15%, 15 to 30%, and 30 to 100% tranches, respectively.
(a)determines the weighted average of the mid-market prices for the applicable tranches by (1) multiplying the mid-market price for each tranche by the tranche width and (2) dividing the total amount derived by the total tranche width, using CDX IG and iTraxx quoted prices; and then
Below is an example of the pricing algorithm that is applied to the Company's domestic IG CDS contracts with durations of 3.5 to 5.5 years, assuming an average IG calibration factor of 296%, to determine the exit premium value as of December 31, 2008:
The Company applies a factor to the quoted prices (the "HY calibration factor"). The HY calibration factor is intended to calibrate the index price to each of the Company's pooled corporate high-yield CDS contracts, which reference pools of entities that are typically of higher average credit quality than those reflected in the CDX HY Index. The HY calibration factor is determined for each HY CDS contract by calibrating the WARF of the index so that it approximately equals the WARF of each HY CDS contract. To do so, the Company recalculates the index price after removing from the index the reference obligations that have the lowest ratings. This recalculated index price is then divided by the unadjusted index to arrive at the HY calibration factor. At December 31, 2008, the HY calibration factor applied to the Company's HY CDS contracts ranged from 28% to 100% of the WARF of the index.
Approximately every six months, a new "series" of the CDX HY Index is published ("on-the-run") based on a new grouping of 100 single name CDS, which changes the composition of the Index of older ("off-the-run") series. The Company compares the composition of the Index in both the on-the-run and off-the run series of the HY index to each CDS pool (i.e., "reference entities" or companies included in each contract) referenced by the Company's contracts (the "reference CDS pool"). Based on that comparison, the Company determines which of the actively quoted series most
To arrive at the exit value premium that is applied to each of the Company's CDS contracts in a given maturity band, the non-collateral posting factor is applied to the weighted-average market price determined for that maturity band.
•Each quarter, the average of the series of the CDX HY or iTraxx that most closely relates to the credit characteristics of the CDS contracts in the Company's portfolio is used. In some cases it may be the most recently published series of those indices, but in other cases, it may be the previously published series to the extent that it is still being published.
As with pooled corporate CDS, there is no observable exchange trading of CDS of funded CDOs and CLOs. The price of protection charged by a CDS writer is based on the "credit spread component" of the "all-in credit spread" of funded CLOs, as quoted by underwriter participants. As the all-in credit spread for a given CLO may not always be observable in the market, the CDS writer often utilizes an index, published by an underwriter participant, such as the "all-in" London Interbank Offered Rate ("LIBOR") spread for Triple-A rated cash-funded CLOs (the "Triple-A CLO Funded Rate") as published by J.P. Morgan Chase & Co. The Triple-A CLO Rate is an all-in credit spread that includes both a funding and credit spread component.
The determination of the exit value premium is summarized as follows:
The Company determined the fair value of the CPS by estimating the fair value of a floating rate security with an estimated market yield reflective of the underlying committed preferred security structure and the relevant coupon based on the capped auction rate.
Other liabilities and minority interest include payables for securities purchased and derivative obligations. For receivable for securities sold and payable for securities purchased, the carrying amount is cost, which approximates fair value because of the short maturity.
benchmark securities and weighted average expected lives. In addition, the valuation of the fair-valued liabilities includes an adjustment to reflect the credit quality of FSA that represents the impact of changes in market credit spreads on these liabilities. The fair-valued liabilities are categorized as Level 3 in the valuation hierarchy. See Note 4 for a description of the FP segment debt for which the Company elected fair value option.
Mortgage loans in the portfolio of assets acquired in refinancing transactions are carried at the lower of cost or market on an aggregate basis. At December 31, 2008, such investments were carried at their market value of $13.8 million. The mortgage loans are classified as Level 3 of the fair value hierarchy as there are significant unobservable inputs used in the valuation of such loans. An indicative dealer quote is used to price the non-performing portion of these mortgage loans. The performing loans are valued using management's determination of future cash flows arising from these loans, discounted at the rate of return that would be required by a market participant. This rate of return is based on indicative dealer quotes.
Level 3 assets were 38.9% of total assets at December 31, 2008. Level 3 liabilities were 37.7% of total liabilities at December 31, 2008.
(1)Realized and unrealized gains/(losses) from changes in values of Level 3 financial instruments represent gains/(losses) from changes in values of those financial instruments only for the periods in which the instruments were classified as Level 3.
(4)Reported in net interest income from financial products segment if designated in a qualifying fair-value hedging relationship, or net realized gains (losses) from financial products segment if determined to be OTTI.
(9)Reported in net interest income from financial products segment if designated in a qualifying fair-value hedging relationship, or net realized and unrealized gains (losses) on derivative instruments if not so designated.
(2)Excludes $1.3 billion of draws on the First Dexia Line of Credit outstanding at December 31, 2008. 4. FAIR VALUE OPTION
The Company adopted SFAS 159 effective January 1, 2008. SFAS 159 provides an option to elect fair value as an alternative measurement for selected financial assets and financial liabilities not previously carried at fair value. The fair-value option may be applied to single eligible instruments, is irrevocable and is applied only to entire instruments and not to portions of instruments. For a discussion of the Company's valuation methodologies, see Note 3.
The Company's fair value elections were intended to mitigate the volatility in earnings that had been created by recording financial instruments and the related risk management instruments on a different basis of accounting, to eliminate the operational complexities of applying hedge accounting or to conform to the fair value elections made by the Company in 2006 under its International Financial Reporting Standards reporting to Dexia. The requirement, under SFAS 157, to incorporate a reporting entity's own credit risk in the valuation of liabilities which are carried at fair value, has created additional volatility in earnings as credit risk is not hedged. The following table provides detail regarding the Company's elections by consolidated balance sheet line at January 1, 2008.
The following table presents the pre-tax changes in fair value included in the consolidated statements of operations and comprehensive income for the year ended December 31, 2008, for items for which the SFAS 159 fair value election was made.
The table above includes gains of approximately $1.4 billion for the year ended December 31, 2008, that are attributable to changes in the Company's own credit spread.
The following table reflects the aggregate fair value and the aggregate remaining contractual principal balance outstanding at December 31, 2008, for certain assets acquired in refinancing transactions and FP segment debt for which the SFAS 159 fair value option has been elected.
(1)Includes $33.8 million of loans that are 90 days or more past due.
(2)The fair-value adjustment for FP segment debt considers interest rate, foreign exchange rates and the Company's own credit risk.
The following table summarizes the components of the net investment income generated by the General Investment Portfolio:
The credit quality of fixed-income securities in the General Investment Portfolio based on amortized cost was as follows:
(2)Includes U.S. Treasury obligations which comprised 7.4% of the portfolio as of December 31, 2008.
The General Investment Portfolio includes bonds insured by FSA ("FSA-Insured Investments") that were acquired in the ordinary course of business. Of the bonds included in the General Investment Portfolio at December 31, 2008, 6.6% were insured by FSA and 28.6% were insured by other monolines. All of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA guaranty, was in the Single-A range. These assets are included in the Company's surveillance process and, at December 31, 2008, no loss reserves were anticipated on any of these assets. See Note 26 for more information.
The following table shows the gross unrealized losses and fair value of bonds in the General Investment Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
(3)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $3.8 million, or 37.6% of its amortized cost.
(1)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $0.2 million, or 7.7% of its amortized cost.
(2)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $0.5 million, or 6.9% of its amortized cost.
(1)Stated maturities for mortgage-backed securities of three to 30 years at December 31, 2008 and of four to 30 years at December 31, 2007.
(2)Stated maturities for asset-backed securities of one to 15 years at December 31, 2008 and of one to 15 years at December 31, 2007. Proceeds from sales of long-term bonds from the General Investment Portfolio during 2008, 2007 and 2006 were $4,011.4 million, $3,568.2 million and $1,637.3 million, respectively. Proceeds from maturities of bonds for the General Investment Portfolio during 2008, 2007 and 2006 were $519.2 million, $189.2 million and $163.3 million, respectively. Gross gains of $51.8 million, $5.6 million and $0.9 million and gross losses of $52.2 million, $7.5 million and $5.8 million were realized on sales in 2008, 2007 and 2006, respectively.
Bonds and short-term investments at an amortized cost of $10.0 million and cash of $1.8 million at December 31, 2008 and bonds and short-term investments at an amortized cost of $10.1 million and cash of $1.8 million at December 31, 2007, were on deposit with regulatory authorities as required by insurance regulations.
The following table sets forth the FP Investment Portfolio fixed income securities based on ratings:
(1)Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2008. Rating agencies continue to monitor the ratings on the residential mortgage-backed securities closely, and future adverse rating actions on these securities may occur.
(1)Amortized cost includes fair value adjustments recorded as OTTI and hedge accounting adjustments.
(1)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $32.2 million, or 30.1% of its amortized cost.
(2)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $21.3 million, or 32.1% of its amortized cost.
(3)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $6.3 million, or 18.0% of its amortized cost. For the year ended December 31, 2008, the OTTI charge in the FP Investment Portfolio was $8,397.9 million and was recorded in net realized gains (losses) from financial products segment. The amount of the OTTI charge recorded in the statement of operations and comprehensive income is not necessarily indicative of management's estimate of economic loss, but instead represents the write-down to current fair-value. Historically, the Company had the ability and intent to hold the FP Segment Investment Portfolio to maturity. However, the Company no longer has the intent to hold such securities to maturity, due to Dexia's agreement under the Purchase Agreement to retain the FP
operations and segregate or separate the FP operations from the Company's financial guaranty operations. As a result, the Company is required to record an OTTI charge for all assets in the Portfolio in an unrealized loss position at December 31, 2008.
The amortized cost and fair value of the available-for-sale securities in the FP Investment Portfolio are shown below by contractual maturity. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. At December 31, 2008, the estimated weighted average expected life of the FP Investment Portfolio was 7.0 years.
(2)Stated maturities for mortgage-backed securities of one to 39 years as of December 31, 2008 and of two to 39 years as of December 31, 2007.
The amortized cost and fair value of available-for-sale bonds and short-term investments in the VIE Investment Portfolio by contractual maturity are shown below. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
(1)Stated maturities for asset-backed securities of one to 23 years at December 31, 2008 and of two to 24 years at December 31, 2007.
Proceeds from maturities of bonds for the VIE Investment Portfolio during 2007 and 2006 were $165.9 million and $24.7 million, respectively. There were no maturities for the VIE Investment Portfolio in 2008.
In the normal course of business, the Company may hold securities purchased under agreements to resell. A portion of these securities may be pledged to the Company's investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). However, such securities generally may not be rehypothecated by the investment agreement counterparty. The Company also pledges investments held in the FP Investment Portfolio to investment agreement counterparties. At December 31, 2008, $6,120.5 million of the assets held in the FP Investment Portfolio, together with related accrued interest, were pledged as collateral to investment agreement counterparties.
At December 31, 2008, the Company had received $1,057.9 million of collateral from counterparties to reduce its net derivative exposure to such parties.
The bonds within the refinanced asset portfolio all have contractual maturities of less than five years. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
(1)The amount of the discount at December 31, 2007 for the gross and net case reserves was $14.5 million and $3.3 million, respectively. The table below presents certain assumptions inherent in the calculations of the case and non-specific reserves:
During 2008, loss and loss adjustment expenses was $1,877.7 million. The increase for the year was driven primarily by deteriorating credit performance in home equity lines of credit ("HELOCs"), Alt-A closed end second lien mortgage securities ("CES"), Option adjustable rate mortgage loan ("Option ARMs"), Alt-A first lien and public finance transactions. "Alt-A" refers to borrowers whose credit falls between prime and subprime. In addition, the net non-specific reserves increased by $54.5 million for the year. Management's current reserve estimates assume loss levels for transactions backed by second-lien mortgage products will remain at their peaks until mid-2009 and slowly recover to more normal rates by mid-2010. For first-lien mortgage transactions, where losses take longer to develop than in second-lien mortgage transactions, peak conditional default rates are assumed to continue until mid-2010 and then decline linearly over 12 months to 25% of the peak, remain there for three years and then taper down to 5% of peak rates over several years.
The increase in losses paid is driven by payments on HELOC transactions. Generally, once the overcollateralization is exhausted on an insured HELOC transaction, the Company pays a claim if losses in a period exceed spread for the period, and, to the extent spread exceeds losses, the Company is reimbursed for any losses paid to date. In 2008, the Company paid net HELOC claims of $577.7 million. This brought the inception to date net claim payments on HELOC transactions to $625.3 million. There were no claims paid on most other classes of insured transactions through December 31, 2008. Most claim payments on Alt-A CES are not payable until 2037 or later. Option ARM claim payments are expected to occur between 2010 and 2012.
During 2006, the Company charged $23.3 million to loss expense, consisting of $17.8 million for originations of new business and $5.5 million related to accretion on the reserve for in-force business. Net case reserves decreased $0.7 million due primarily to loss payments and some improvement in CBO transactions, offset in part by the establishment of a new case reserve for a municipal health care transaction.
The Company assigns each insured credit to one of five designated surveillance categories to facilitate the appropriate allocation of resources to monitoring, loss mitigation efforts and rating the credit condition of each risk exposure. Such categorization is determined in part by the risk of loss and in part by the level of routine involvement required. The surveillance categories are organized as follows:
The tables below present the gross and net par and interest outstanding and deferred premium revenue in the insured portfolio for risks classified as described above:
Management periodically evaluates its estimates for losses and LAE and establishes reserves that management believes are adequate to cover the present value of the ultimate net cost of claims. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company's actual loss experience, its mix of business and economic conditions. However, because of the uncertainty involved in developing these estimates, the ultimate liability may differ materially from current estimates.
On November 26, 2002, the Company issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt.
On December 19, 2001, the Company issued $100.0 million of 67/8% notes due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
The Company's insurance policies typically guarantee the scheduled payments of principal and interest on public finance and asset-backed (including credit derivatives in the insured portfolio) obligations. The gross amount of financial guaranties in force (principal and interest) was $813.9 billion at December 31, 2008 and $833.2 billion at December 31, 2007. The net amount of financial guaranties in force was $611.4 billion at December 31, 2008 and $598.3 billion at December 31, 2007.
The par outstanding of insured obligations in the asset-backed insured portfolio includes the following amounts by type of collateral:
In connection with Dexia's acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. ("WMH"). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains Insurance Group, Ltd. ("White Mountains") for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains. While the Company had no legal liability in connection with the indemnity payment, the payment was treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a tax benefit of $16.5 million. In
At December 31, 2008 and 2007, the Company had a net deferred tax asset before valuation allowance of $3.3 billion and $0.4 billion, respectively. A valuation allowance is required when it is more likely than not that a portion or all of a deferred tax asset will not be realized. All evidence, both positive and negative, needs to be identified and considered in making the determination. Future realization of the existing deferred tax asset will depend on the Company's ability to generate sufficient taxable income of appropriate character (i.e., ordinary income versus capital gains) within the carryback and carryforward periods available under the tax law.
The economic conditions adversely affecting the Company did not fully materialize and the Purchase Agreement was not entered into until 2008 and, thus, the Company did not provide any valuation allowance on its net deferred tax assets at December 31, 2007.
1.The Company's unrealized capital and foreign exchange losses in the FP Investment Portfolio, if realized, would trigger capital losses which, for tax benefit purposes, could only be offset against capital gains. Capital losses could be carried back up to three years to offset capital gains realized in the prior three years and then carried forward for up to five years. Compelling negative evidence exists since there is no assurance that the Company could generate sufficient capital gains to offset these capital losses. Positive evidence exists if the Company were able to hold the FP Investment Portfolio to maturity, thus realizing only the losses due to impairment. The Company no longer definitively asserts that it has the ability and intent to hold the FP Investment Portfolio to maturity and has accordingly established a valuation allowance of $2.5 billion. A full valuation allowance of $3.0 billion was not established primarily because a portion of the loss is ordinary due to FSA's insurance of certain troubled FP assets and its ability to offset capital losses with gains on fair valued liabilities at FSA Global.
2.The $368 million tax benefit from loss reserves and $453 million from CDS would be realizable against future ordinary income. Negative evidence includes the uncertainty of selling financial guaranty policies in the future as well as the stability of the Company's credit rating by the three principal rating agencies. However, the Company has substantial streams of future premium earnings from its in force insured portfolio, with the total aggregating to approximately $3.5 billion at December 31, 2008. Even with the uncertainty of future business and the stability of the Company's credit rating, future premium revenues, coupled with investment income less expenses, are expected to be more than sufficient to offset current incurred losses, including credit derivatives losses. The Company's loss reserves represent the discounted value of future claims. Therefore, the accretion of losses to the undiscounted future value has also been taken into consideration, and the Company does not anticipate any significant additional loss trends. The Company expects future accretion on loss reserves of about $410.2 million. In addition, except for true credit losses, mark-to-market losses from CDS contracts will reverse over time. As the mark-to-market losses reverse, the deferred tax asset will also reverse. To the extent that true credit losses increase, the related mark-to-market losses will not fully reverse and the Company may not be able to offset such future losses against future ordinary income.
The Company treats its CDS contracts as insurance contracts for U.S. tax purposes. The current federal tax treatment of CDS contracts is an unsettled area of tax law. Market participants are generally treating CDS contracts for tax purposes as either: (1) notional principal contract ("NPC") derivative instruments, (2) guarantees, (3) insurance contracts, or (4) capital assets. The Company believes that it is more likely than not that its CDS contracts are either NPC or insurance contracts. Both receipts and payments arising from NPC and insurance contracts are characterized as ordinary income (although a termination of a CDS contract as an NPC may be treated as a capital transaction). Although the Company believes it is properly treating potential losses on its CDS contracts as ordinary, there are no assurances that the Internal Revenue Service ("IRS") will agree with the Company. Should the IRS disagree with the Company and characterize such losses, if any, as capital losses, the Company's ability to realize a related tax asset would be more limited, possibly leading to a reduction or elimination of the related deferred tax asset.
The Company believes that within the next 12 months, it is reasonably possible that unrecognized tax benefits for positions taken on previously filed tax returns will become recognized as a result of the expiration of statute of limitations for the 2005 tax year, which absent any extension, will close in September 2009.
employee compensation. Pension expense, which is funded annually, amounted to $6.8 million, $7.7 million and $7.5 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Performance shares issued prior to January 1, 2005 permitted the participant to elect, at the time of award, growth rates including or excluding realized and unrealized gains and losses on the investment portfolios. Performance shares issued after January 1, 2005 do not offer the option to include the impact of unrealized gains and losses on the investment portfolios. No payout occurs if the compound annual growth rate of adjusted book value and book value per outstanding share over specified three-year performance cycles is less than 7%, and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%.
The Dexia restricted stock component is a fixed plan, where the Company purchases Dexia shares and establishes a prepaid expense for the amount paid, which is amortized over 2.5-year and 3.5-year vesting periods. In 2008 and 2007, FSA purchased shares that economically defeased its liability for $3.8 million and $4.7 million, respectively. These amounts are being amortized to expense over the employees' vesting periods. For the years ended December 31, 2008, 2007 and 2006, the after-tax amounts amortized into income were $3.1 million, $2.7 million and $1.9 million, respectively.
The estimated final cost of these performance shares is accrued over the performance period. The after-tax benefit of $42.6 million for the year ended December 31, 2008 and expense of $40.0 million and $37.3 million for the years ended December 31, 2007 and 2006, respectively, was recorded for the performance shares. In 2008, the accrual for performance shares was completely written off to reflect the Company's performance, resulting in a benefit to income.
(1)Includes amounts that in prior periods were classified as premiums earned. The fair value of credit derivatives is reported in the balance sheet as "other assets" or "other liabilities and minority interest" based on the net gain or loss position with each counterparty. The unrealized component includes the market appreciation or depreciation of the derivative contracts, as discussed in Note 3.
The Company's typical CDS contract is different from CDS contracts entered into by parties that are not financial guarantors because:
•FSA is not entitled to terminate its CDS contracts and realize a profit on a position that is "in the money." A counterparty to a CDS contract written by FSA generally is not able to force FSA to terminate a CDS contract that is "out of the money."
CDS contracts in the asset-backed portfolio represent 71.2% of total asset-backed par outstanding. The Company has grouped CDS contracts by major category of underlying instrument for purposes of internal risk management and external reporting. The tables below summarize the credit rating, net par outstanding and remaining weighted average lives for the primary components of the Company's CDS portfolio. Net par outstanding in the table below is also included in the tables in Note 12.
(4)Net par outstanding represents the net maximum potential amount of future payments which the Company could be required to make.
The Company uses foreign currency contracts to manage the foreign exchange risk associated with certain foreign currency-denominated assets and liabilities. Gains or losses on the derivative instruments that are linked to the foreign currency denominated assets or liabilities being hedged are expected to substantially offset this variability.
In order for a derivative to qualify for hedge accounting, it must be highly effective at reducing the risk associated with the exposure being hedged. In order for a derivative to be designated as a hedge, there must be documentation of the risk management objective and strategy, including identification of the hedging instrument, the hedged item and the risk exposure, and how effectiveness is to be assessed prospectively and retrospectively. To assess effectiveness, the Company uses analysis of the sensitivity of fair values to changes in the risk being hedged, as well as dollar value comparisons of the change in the fair value of the derivative to the change in the fair value of the hedged item that is attributable to the risk being hedged. The extent to which a hedging instrument has been and is expected to continue to be effective at achieving offsetting changes in fair value must be assessed and documented at least quarterly. Any ineffectiveness must be reported in current-period earnings. If it is determined that a derivative is not highly effective at hedging the designated exposure, hedge accounting is discontinued.
An effective fair-value hedge is defined as one whose periodic change in fair value is 80% to 125% correlated with the change in fair value of the hedged item. The difference between a perfect hedge (i.e., the change in fair value of the hedge and hedged item offset one another so that there is zero effect on the consolidated statements of operations and comprehensive income, referred to as being "100% correlated") and the actual correlation within the 80% to 125% effectiveness range is the ineffective portion of the hedge. A failed hedge is one whose correlation falls outside of the 80% to 125% effectiveness range.
The inception-to-date net unrealized gain on derivatives (excluding accrued interest and collateral) in the FP segment of $1,278.4 million and $560.4 million at December 31, 2008 and 2007, respectively, is recorded in "other assets" or "other liabilities and minority interest," as applicable.
The Company obtains reinsurance to increase its policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Company reinsures portions of its risks with affiliated (see Note 24 for more information) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis.
The Company cedes approximately 23% of its gross par insured to a diversified group of reinsurers, including other monolines. Based on ceded par outstanding at December 31, 2008, 56.1% of FSA's reinsurers were rated Double-A- or higher at March 13, 2009. Some are still under review by rating agencies. The Company's reinsurance contracts generally allow the Company to recapture ceded business after certain triggering events, such as reinsurer downgrades. Included in the table below is $12,099 million in ceded par outstanding related to insured CDS.
Due to a liquidation order against Bluepoint, FSA is treating all reinsurance ceded to Bluepoint as cancelled as of the August 29, 2008 date of the liquidation order. Subsequent to September 30, 2008, in accordance with guidance obtained from the New York Insurance Department, FSA drew down from collateral maintained in trust by Bluepoint an amount equal to the net statutory basis unearned premium and case basis reserves and, as a result, FSA was able to take credit for such balances. In 2008, $9.4 million of earned premium related to this commutation.
The detailed balances that comprise "other assets" and "other liabilities and minority interest" at December 31, 2008 and 2007 are as follows:
Rent expense was $10.6 million in 2008, $10.2 million in 2007 and $10.7 million in 2006.
In connection with its financial guaranty business, the Company had outstanding commitments to provide guarantees of $4,639.4 million as of December 31, 2008. These commitments are typically short term and principally relate to primary and secondary public finance debt issuances. Commitments are contingent on the satisfaction of all conditions set forth in the contract. These commitments may expire unused or be cancelled at the counterparty's request. Therefore, the total commitment amount does not necessarily reflect actual future guaranteed amounts.
In November 2006, (i) the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs and other municipal derivatives and (ii) FSA received a subpoena from the SEC related to an ongoing industry-wide investigation concerning the bidding of municipal GICs and other municipal derivatives. Pursuant to the subpoenas the Company has furnished to the DOJ and SEC records and other information with respect to the Company's municipal GIC business. On February 4, 2008, the Company received a "Wells Notice" from the staff of the Philadelphia Regional Office of the SEC relating to the foregoing matter. The Wells Notice indicates that the SEC staff is considering recommending that the SEC authorize the staff to bring a civil injunctive action and/or institute administrative proceedings against the Company, alleging violations of Section 10(b) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") and Rule 10b-5 thereunder and Section 17(a) of the Securities Act of 1933, as amended. The Company has had ongoing discussions with the DOJ and the SEC. The ultimate loss that may arise from these investigations remains uncertain.
During 2008 nine putative class action lawsuits were filed in federal court alleging federal antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. These cases have been coordinated and consolidated for pretrial proceedings in the U.S. District Court for the Southern District of New York as MDL 1950, In re Municipal Derivatives Antitrust Litigation, Case No. 1:08-cv-2516 ("MDL 1950").
Five of these cases name both the Company and FSA: (a) Hinds County, Mississippi v. Wachovia Bank, N.A. (filed on or about March 13, 2008); (b) Fairfax County, Virginia v. Wachovia Bank, N.A. (filed on or about March 12, 2008); (c) Central Bucks School District, Pennsylvania v. Wachovia Bank N.A. (filed on or about June 4, 2008); (d) Mayor & City Counsel of Baltimore, Maryland v. Wachovia Bank N.A. (filed on or about July 3, 2008); and (e) Washington County, Tennessee v. Wachovia Bank N.A. (filed on or about July 14, 2008). Four of the cases name only the Company and also allege that the defendants violated state antitrust law and common law by engaging in illegal bid-rigging and market allocation, thereby depriving the cities of competition in the awarding of GICs and ultimately resulting in the cities paying higher fees for these products: (a) City of Oakland, California v. AIG Financial Products Corp. (filed on or about April 23, 2008); (b) County of Alameda, California v. AIG Financial Products Corp. (filed on or about July 8, 2008); (c) City of Fresno, California v. AIG Financial Products Corp. (filed on or about July 17, 2008); and (d) Fresno County Financing Authority v. AIG Financial Products Corp. (filed on or about December 24, 2008).
The Company and FSA also are named in five non-class actions originally filed in the California Superior Courts alleging violations of California law related to the municipal derivatives industry:
(d)County of San Mateo v. Bank of America, N.A. (filed on or about October 7, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-480664, removed to N.D. Cal. as Case No. 3:08-cv-4751, transferred to S.D.N.Y. as Case No. 1:09-cv-1196); and
These cases have been transferred to the S.D.N.Y. and consolidated with MDL 1950 for pretrial proceedings. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
behalf of rate payers, tax payers and citizens residing in Jefferson County, and alleges conspiracy and fraud in connection with the issuance of the County's debt. The complaint in this lawsuit seeks unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from this lawsuit. FSA was also named as a defendant in a second civil action regarding Jefferson County, Alabama, but was dismissed from such action in January 2009.
Because the majority of the Company's operations are conducted through FSA, the long-term ability of FSA Holdings to service its debt will largely depend on its ability to extract cash from FSA in the form of FSA's repurchase of its stock or receipt of dividends from FSA.
FSA Holdings paid dividends of $33.6 million in 2008, $122.0 million in 2007 and $530.0 million in 2006.
In June 2003, $200.0 million of CPS, money market committed preferred trust securities, were issued by trusts created for the primary purpose of issuing the CPS, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the "Preferred Stock") of FSA. There are four trusts, each with an initial aggregate face amount of $50 million. These trusts hold auctions every 28 days at which time investors submit bid orders to purchase CPS. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts, which represents the difference between the commercial paper yield and the winning auction rate (plus all fees and expenses of the trust). If an auction does not attract sufficient clearing bids, however, the auction rate will be subject to a maximum rate of 200 basis points above LIBOR for the next succeeding distribution period. Beginning in August 2007, the CPS required the maximum rate for each of the relevant trusts. FSA continues to have the ability to exercise its put option and cause the related trusts to purchase FSA Preferred Stock. The cost of the facility was $4.9 million, $1.8 million and $1.0 million for 2008, 2007 and 2006, respectively, and was recorded within other operating expenses. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts because it does not retain the majority of the residual benefits or expected losses.
Reconciliations of the Segments' Pre-Tax Operating Earnings (Losses) to Net Income (Loss)
GAAP income to operating earnings adjustments are primarily comprised of fair-value adjustments deemed to be non-economic. Such adjustments relate to (1) non-economic fair-value adjustments for credit derivatives in the insured portfolio, (2) non-economic impairment charges on investments, (3) fair-value adjustments for instruments with economically hedged risks and (4) fair-value adjustments attributable to the Company's own credit risk. Management believes that by making such adjustments the measure more closely reflects the underlying economic performance of segment operations.
•The Company invests short-term or cash assets in Dexia accounts and earns interest income on those accounts, which is recorded in the consolidated statements of operations and comprehensive income.
•A $3.5 billion collateral swap facility with Dexia in support of the FP business.
•The Company received dividends on its preferred stock investment in SGR until mid-2008, which was recorded in the consolidated statements of operations and comprehensive income and held two positions on the board of directors of SGR.
The table below summarizes amounts included in the financial statement captions resulting from various types of transactions executed with related parties, as well as outstanding exposures with related parties:
•a contingency reserve (rather than a non-specific reserve) is computed based on the following statutory requirements:
(1)Represents transactions with second-to-pay FSA-insurance that were previously insured by other monolines. Based on net par outstanding. Includes credit derivatives in the insured portfolio.