18,962 square feet of office space (3,813 square feet of which is subleased) for our mortgage insurance regional offices, service centers and on-site offices throughout the U.S. The leases for this space expire between 2009 and 2012;
Approximately 6,600 square feet of office space for our international financial guaranty operations in London. The lease for this space expires in 2012;
Approximately 500 square feet of office space for our mortgage insurance operations in Hong Kong. The lease for this space expires in 2009;
Our two data centers (Dayton and Philadelphia) serve as one another’s disaster recovery sites and support all of our businesses. In addition, we have established business continuity recovery plans for our offices in London, New York and Philadelphia.
(1) Diluted net income per share and average share information in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share.” Amounts reflect the inclusion of shares underlying contingently convertible debt, which was redeemed on August 1, 2005. See Note 21 of Notes to Consolidated Financial Statements.
(4) Reflects the 2004 and 2005 recaptures of previously ceded business.
(5) Total assets as of December 31, 2006, have been adjusted for amounts previously reported in other assets. See Note 2 of Notes to Consolidated Financial Statements.
Our financial guaranty segment mainly insures and reinsures credit-based risks. Financial guaranty insurance typically provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due.
Public Finance. Insurance of public finance obligations, including tax-exempt and taxable indebtedness of states, counties, cities, special service districts, other political subdivisions and tribal finance and for enterprises such as airports, public and private higher education and health care facilities, project finance and private finance initiative assets in sectors such as schools, healthcare and infrastructure projects. The issuers of public finance obligations we insure are typically rated investment-grade without the benefit of our insurance;
Reinsurance. Reinsurance of domestic and international public finance obligations, including those issued by sovereign and sub-sovereign entities, as well as reinsurance of structured finance and financial solutions obligations.
We provide these products and services mainly through Radian Asset Assurance Inc., our principal financial guaranty subsidiary (“Radian Asset Assurance”) and through Radian Asset Assurance Limited (“RAAL”), an insurance subsidiary of Radian Asset Assurance authorized to conduct financial guaranty business in the United Kingdom and, subject to compliance with the European passporting rules, other European Union jurisdictions.
C-BASS is an unconsolidated, less than 50%-owned investment that is not controlled by us. We and MGIC Investment Corporation (“MGIC”) each own 46% of C-BASS, with the remaining interests owned by the management of C-BASS. Historically, C-BASS has been principally engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages.
Beginning in February 2007 and continuing through approximately the end of March 2007, the subprime mortgage market experienced significant turmoil. After a period of relative stability that persisted during April, May and through approximately late June, market dislocations recurred and then accelerated to unprecedented levels beginning in approximately mid-July 2007. During the five month period from February 1, 2007 through June 30, 2007, C-BASS’s financial statements included the payment of approximately $290.3 million to satisfy lenders’ margin calls on loans to C-BASS, which it handled with its available liquidity.
On July 17, 2007, C-BASS completed its acquisition of Fieldstone Investment Corporation (“Fieldstone”), a mortgage banking company that originated, sold, and invested primarily in non-conforming single family residential mortgage loans, for approximately $187 million, including closing costs. C-BASS used approximately $90 million in cash to fund this acquisition.
On July 19, 2007, in order to support C-BASS’s liquidity position, we and MGIC, each entered into a $50 million unsecured revolving credit facility agreement with C-BASS that is payable on demand and was scheduled to expire December 31, 2007.
On July 20 and 23, 2007, C-BASS drew down the entire $50 million on each facility ($100 million in total.)
Prior to July 29, 2007, a number of qualified buyers showed a strong interest in C-BASS, and both we and MGIC received multiple preliminary indications of interest above C-BASS’s book value. Due diligence was ongoing until July 29, 2007 when the increase in margin calls over the prior few days significantly jeopardized C-BASS’s liquidity position, resulting in a withdrawal of all interested buyers at that time.
On July 30, 2007, in accordance with the terms of our credit facility with C-BASS, we demanded full and immediate payment of all amounts owed to us under the credit facility. This amount currently remains outstanding. Amounts drawn under this facility bear interest at a rate of one-month London Interbank Offered Rate (“LIBOR”) at the date the amount is drawn plus 2.875%. If the loan is called for payment, but remains unpaid as currently is the case, the facility bears interest at LIBOR plus 6.875%. In addition, a 0.375% facility fee is payable to us and MGIC.
Sale of Litton Loan Servicing LP (“Litton”). Since July 31, 2007, with the cooperation of its lenders, including us and MGIC, C-BASS has been working with its financial advisor and potential investors, to evaluate strategic alternatives for securing additional liquidity. As a result of that process, on September 27, 2007, C-BASS agreed to sell to Goldman Sachs substantially all of its interest in Litton for approximately $430 million in order to avoid bankruptcy. As a condition to this sale, on November 16, 2007, the C-BASS employees, lenders and creditors, including us, entered into an agreement (the “Override Agreement”) establishing (i) the terms for the distribution of the consideration from the sale, among all interested parties and (ii) an agreement among the outstanding lenders and creditors to continue to forebear from exercising any recourse rights under their existing obligations with C-BASS. There are certain agreements and covenants contained in the Override Agreement and to the extent C-BASS were to breach one of those agreements or covenants, C-BASS may have to seek bankruptcy protection.
In December 2007, C-BASS completed the sale of Litton to Goldman Sachs. In connection with this sale, Goldman Sachs also paid a nominal amount for the option to purchase from the current owners of C-BASS, including us, 45% of the equity of C-BASS for approximately $5 million. We estimated that this option had a fair value of $0 at December 31, 2007.
Emerging Issues Task Force (“EITF”) No. 98-13, “Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee” (“EITF No. 98-13”), requires that when the recognition of equity losses reduces our equity investment to zero, we should continue to report our share of equity method losses in our income statement and should apply those equity method losses to our other investments in or loans to C-BASS. During the fourth quarter, operating results at C-BASS were negative due to a continuation of valuation reductions in their whole loan and securities portfolio. As a result of the additional losses at C-BASS, and continued application of APB Opinion No. 18 and EITF No. 98-13, we recorded a full write-off of our $50 million credit facility as of December 31, 2007. The ultimate collectibility of this facility is uncertain.
Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets that it generally purchases at deep discounts from national financial institutions and major retail
corporations and subsequently seeks to collect. In addition, Sherman originates credit card receivables through its subsidiary CreditOne and has a variety of other similar ventures related to consumer assets.
On September 19, 2007, we sold to Sherman Capital, L.L.C. (“Sherman Capital”), an entity owned by the management of Sherman: (1) all of our preferred interests in Sherman and (2) 1,672,547 Class A Common Units in Sherman, representing approximately 43.4% of our total common interests in Sherman, for a cash purchase price of approximately $277.6 million, plus a future contingent payment. The amount of the contingent payment, if any, will depend on the extent that Sherman Capital’s after-tax return on 1,425,335 of the Class A Common Units acquired in the transaction exceeds approximately 16% annually. The contingent payment is payable to us on December 31, 2013 or earlier upon the closing of a sale of Sherman. We recorded a gain of $181.7 million on the sale of our interest in Sherman.
We expect to pay total mortgage insurance claims (including second-liens) of approximately $200 million in the first quarter of 2008 and approximately $1 billion in total in 2008. While we and the mortgage lenders have recently tightened our underwriting guidelines considerably, the early performance of business written in 2006 and much of 2007 has been poor, providing early evidence that this business will likely be unprofitable. Until these books of business have sufficiently seasoned, we expect to continue to experience poor results in our traditional mortgage insurance business. These results have been, and will likely continue to be, exacerbated by the deteriorating domestic housing market that has existed throughout 2007 and is predicted to continue into 2009 and possibly beyond.
In response to current market conditions, we implemented changes to our underwriting criteria in the fourth quarter of 2007, and we are in the process of adjusting our pricing to improve our risk/reward posture and to generate appropriate returns on new business. The most important change to our underwriting criteria is the adoption of a declining market policy in which we reduce the maximum loan-to-value (“LTV”) that we will insure by 5% in any region of the U.S. that experiences a decline in value based on the most recent data produced by the Office of Federal Housing Enterprise Oversight. Based on this recent data, approximately 60% of the U.S. is experiencing declines and we are correspondingly reducing risk by reducing our maximum LTVs in these areas. In addition, in the third quarter of 2007, we made significant changes to our Alt-A guidelines by restricting our exposure to various combinations of reduced documentation and high-LTV loans. Although others in the
industry have announced similar changes to pricing and underwriting standards, it is possible that our underwriting and pricing changes may negatively affect our business volume, growth of new insurance written and insurance in force. However, we believe these changes are necessary to improve our risk profile, and we have begun to see improvement in our fourth quarter mix of business as a result of these changes, our corporate-wide focus on prime business and the industry-wide shift to higher quality credit.
In addition to Smart Home, we transfer a substantial portion of the risk we write on loans originated by certain lender-customers to captive reinsurance companies affiliated with such lender-customers. We had approximately 53 active captive reinsurance agreements in place at December 31, 2007. As of December 31, 2007, approximately 41.6% of our primary risk in force was subject to captive reinsurance. This percentage can be volatile as a result of increases or decreases in the volume of structured transactions, which are not typically eligible for captive reinsurance arrangements. Although the amount of losses we expect to incur in our mortgage insurance business is uncertain at this point, in most reasonable stress scenarios, we would expect to receive significant reinsurance recoveries from Smart Home and captive reinsurance, beginning in 2009.
Despite our poor operating results for the year, we are encouraged by recent positive trends in the mortgage insurance market. Market turmoil has led to a tightening of our customers’ mortgage underwriting standards, which should result in better performing books of mostly prime business in the future. We also are seeing a continued increased demand for our traditional mortgage insurance product as alternative products, such as 80-10-10 mortgages, which were a common alternative to mortgage insurance in 2005 and 2006, have declined significantly due to higher interest rates and diminished liquidity available in the origination and secondary markets for these products. We also believe that the private mortgage insurance market has benefited from the tax deductibility for eligible borrowers of mortgage insurance premiums and an increase in the number of low down payment mortgage loans purchased by the GSEs. As a result of these positive trends, our primary new insurance written increased by 42.4% in 2007 compared to 2006. This increase reflects a 59.0% increase in new insurance written generated by our traditional flow business.
twelve months ended December 31, 2006. This increase was due to a decline in refinancing activity from the high levels in 2005 and 2006, mainly due to home price depreciation, tighter underwriting standards and an overall decrease in the lending capacity among mortgage originators. The persistency rate for structured products during the twelve months ended December 31, 2007 was 69.2% compared to 77.7% for our flow business. We expect that persistency rates will continue to remain at elevated levels for as long as the current disruption in the housing and mortgage credit markets continues to persist.
NIMS. The $604 million of risk in force associated with NIMS at December 31, 2007, representing 1.3% of our total risk in force, comprises 37 deals with an average notional balance of $16 million ($59 million at origination) and a total notional balance of $704 million. The average expiration of our existing NIMS transactions is approximately two years. In the fourth quarter of 2007, as a risk mitigation initiative, we purchased, at a discount to par, some of the NIMS bonds that we insure, thereby contributing to the reduction in our overall risk on NIMS. In 2008, we have continued to purchase the NIMS bonds that we have insured in instances where we believe the repurchase may reduce our ultimate loss.
The loans underlying the NIMS bonds that we insure began to show significant deterioration toward the end of the second quarter of 2007, leading to more delinquencies occurring earlier than we had expected. These loans have continued to deteriorate throughout 2007. NIMS are subject to derivative accounting and as a result, at December 31, 2007, we have a cumulative unrealized loss of approximately $434 million related to NIMS bonds. Of this amount, approximately $377.0 million represents the present value of our total expected principal credit losses related to NIMS bonds. As of December 31, 2007, we have paid only $14.9 million in claims related to NIMS, and expect to pay the majority of the expected claims beginning in 2010. We ceased writing new NIMS business during the second quarter of 2007 and do not anticipate writing NIMS business in the future as we implement a business model focused primarily on traditional mortgage insurance.
Second-Lien Mortgages. In addition to insuring first-lien mortgages, to a lesser extent, we also provided primary or modified pool insurance on second-lien mortgages (“second-liens”). The second-lien products have been especially susceptible to the disruption in the housing market and the subprime mortgage market. In the first quarter of 2006, we significantly reduced the amount of new second-liens business written in a first-loss position. In the first quarter of 2007, we ceased writing new second-lien business of any kind, and have no intention of writing second-lien business in the future.
As of December 31, 2007, our total exposure to second-liens was approximately $925 million or approximately 2.0% of our total mortgage insurance risk in force. Of our total exposure to second-liens, approximately 48% represents a seasoned segment of our portfolio comprising transactions written in 2005 or earlier, generally with prime collateral or in which we are in a second-loss position. As a whole, this portion of our second-lien portfolio continues to perform generally within our expectations. The remaining 52% of our total exposure to second-liens relates to two groups of transactions that have been particularly affected by the disruption in the subprime market. We expect that a significant portion of our total future losses with respect to second-liens will come from these two groups of transactions.
The first of these groups, representing approximately $404 million of exposure or 44% of our total exposure to second-liens, comprises two structured transactions entered into in late 2005 and early 2006. Claims paid during 2007 have included a significant number of claims from the first of these transactions, covering the first 10% of aggregate losses on a pool of subprime second-lien mortgages. We split losses with our counterparty under this transaction on a 50-50 basis. As discussed in prior quarters, we began experiencing a significant increase in filed claims from this transaction during the third quarter of 2006 and have paid approximately $71.4 million in net claims on this transaction as of December 31, 2007. At December 31, 2007, our net exposure remaining under this transaction was $8.2 million or approximately half of the $16.5 million in gross remaining exposure. In addition to this transaction, we also have a supplemental policy on the same pool of mortgages that covers certain losses in excess of the 10% aggregate stop-loss. Based on delinquency and loss patterns to date, we currently expect cumulative losses on the entire pool of mortgages covered by these two transactions to be
over 20%, resulting in future losses to us of approximately $239 million. We are working with our counterparty to attempt to satisfy all claims issues in a fair way that mitigates overall losses as much as possible.
The second of the two groups, representing approximately $77 million of exposure or 8% of our total exposure to second-liens, comprises a series of transactions entered into in the second half of 2006 and early 2007. Our risk under these transactions represents 5% of cumulative losses, attaching at 10% of cumulative losses and detaching at 15% of cumulative losses. Although our cumulative losses related to this transaction were minimal at December 31, 2007, the early delinquency and third-party claim patterns for this transaction have been far worse than our initial expectations. As a result, we currently assume that the cumulative losses related to this transaction will exceed our exposure limit, resulting in future losses to us equal to our total exposure of approximately $77 million.
We expect that our second-lien book of business will be almost entirely paid down by 2010. As a result, we expect that much of the approximate $413 million in projected future losses resulting from this product will be incurred over that time period. Against these losses, we expect to earn an additional $66.6 million in premiums over the remaining life of the portfolio. Losses in our second-lien portfolio are particularly sensitive to changes in home prices, and therefore, we cannot be certain that actual losses in our second-lien portfolio will not differ materially from our projections.
Although losses with respect to our second-lien business, much like in our traditional first-lien mortgage insurance business, will be incurred and paid over time as delinquencies develop and claims are filed, the net present value of the expected future losses and expenses above expected future premiums and existing reserves on the second-lien business has been recorded in 2007 as a $195.6 million premium deficiency reserve. The accounting principle governing this is discussed below in “Critical Accounting Policies-Reserve for Losses”.
Credit Default Swaps. In our mortgage insurance business, we sell protection on residential mortgage-backed securities (“RMBS”) through credit default swaps both domestically and internationally. In 2007, few attractive opportunities were available to write this business both before and following the disruption in the mortgage credit markets. As a result, we did not write any new credit protection on RMBS in credit default swap form in 2007, compared to $32 million in notional value written in 2006.
As of December 31, 2007, our total exposure to domestic credit default swaps on RMBS was $212 million. These exposures were rated between A and BBB at origination, and were written between May 2005 and January 2006, with most of the exposure originated in 2005. Credit default swaps in our mortgage insurance business are subject to derivative accounting, requiring determinations of gain or loss of the fair value of such derivative instruments. As of December 31, 2007, we had incurred a cumulative unrealized loss for these transactions of approximately $84 million. Of the $212 million of risk in force, based on an observation of performance to date, we expect to ultimately incur credit losses of approximately $32 million, and could incur an additional $48 million. We do not believe that we will ultimately have credit losses on the remaining $132 million of the $212 million in exposure.
The widening of credit spreads during 2007 resulted in a loss in the fair value of derivative instruments in our financial guaranty business of approximately $841 million, $550 million of which is related to our synthetic corporate CDO exposure. We believe the portion of this mark related to our synthetic corporate CDO exposure is almost entirely spread driven and does not represent material deterioration in the credit quality of such portion of our insured financial guaranty portfolio or the erosion of the underlying collateral. As a result, provided that the credit quality of this business remains strong, this loss in fair value should reverse over time as the transactions mature or sooner if credit spreads tighten. Of the remaining $291 million of market value losses, $203 million is attributed to our exposure to CDO subprime RMBS and CDO CMBS as discussed in more detail below.
Despite the difficult business environment, there have been limited, selective opportunities in the direct public finance and structured products markets. In addition, despite the difficult operating environment, we experienced strong growth in both facultative and treaty reinsurance business during 2007.
The overall credit performance of our financial guaranty portfolio showed some deterioration, but remained strong during 2007 given market conditions. We established a $100 million allocated non-specific reserve for the one direct market-value transaction remaining in our financial guaranty portfolio during 2007. This credit is discussed below under “CDO Subprime RMBS Exposure” and in detail below under “Results of Operations-Financial Guaranty-Year Ended December 31, 2007 compared to Year Ended December 31, 2006-Provision for Losses.” In addition, we increased our allocated non-specific reserve for asset-backed RMBS transactions that we insure, representing $182.8 million in aggregate par outstanding, by an aggregate $23.0 million due to performance deterioration of these transactions.
Included in our Non-CDO RMBS exposure is subprime RMBS exposure, which is spread among 149 transactions with the largest individual exposure being $47.2 million. 65.4% of our financial guaranty Non-CDO subprime RMBS exposure has been assumed as reinsurance, while 34.6% has been insured directly, with no new Non-CDO subprime RMBS having been written directly since 2004. The following table provides additional information regarding our Non-CDO RMBS exposure as of December 31, 2007:
* Ratings are based on our ratings estimate of the collateral using rating agency models and methodologies to the extent available.
(1) As of December 31, 2007, we had approximately $169 million of exposure to home equity lines of credit (including $25 million to subprime and $79 million to Alt-A), all of which was assumed from our primary financial guaranty reinsurance customers.
We have no direct financial guaranty exposure to Non-CDO RMBS tranches that were downgraded or placed on negative watch by Moody’s Investor Service (“Moody’s”) or Standard & Poor’s Ratings Service (“S&P”) during their rating actions on RMBS transactions between July 2007 and January 2008.
CDO Subprime RMBS Exposure. We have limited subprime RMBS exposure through three directly-insured CDOs of ABS with an aggregate net par outstanding of $752.1 million (or 0.7% of financial guaranty’s total net par outstanding as of December 31, 2007). Two of these transactions, with net par outstanding of $502.1 million and $150 million, respectively, are currently rated AAA by S&P, with ratings of A- and AAA, respectively, under our internal ratings. The $502.1 million transaction was placed on negative watch by S&P on January 30, 2008.
Moody’s and S&P took multiple rating actions that affected RMBS and CDOs of ABS between July 2007 and January 2008. As of December 31, 2007, 18 RMBS credits and four CDOs of ABS credits representing $114.3 million (or 18.3%) of the $625.9 million collateral pool underlying our $502.1 million CDO of ABS transaction had been downgraded. The total subordination in this transaction equals $126.8 million. No collateral has been downgraded or is on negative watch or review for possible downgrade in the transaction with $150 million exposure. The following table provides additional information regarding these two transactions:
(1) Of the RMBS collateral included in the $502.1 million and $150.0 million transactions, approximately 42.5% and 15.8% of this collateral, respectively, represents subprime RMBS.
CDO CMBS Exposure. We have approximately $1.8 billion in exposure to CMBS through four synthetic insured CDOs. These four CDOs, each of which is currently rated AAA by both Moody’s and S&P, contain 127 triple-A rated CMBS tranches (the “CMBS Obligations”) that were issued as part of 88 securitizations (the “CMBS Securitizations”). The following table provides additional information regarding our CMBS exposure as of December 31, 2007:
Net (Loss) Income. We incurred a consolidated net loss for 2007 of $1,290.3 million or $16.22 per share (diluted), compared to net income of $582.2 million or $7.08 per share (diluted) for 2006. The decrease in earnings for 2007 was mainly due to the significant disruption in the housing and mortgage credit markets during 2007, which has impacted all of our business segments. In particular, our results for 2007 were negatively impacted by the impairment of our investment in C-BASS, a significant decrease in the change in fair value of derivative instruments, a significant increase in the provision for losses in both our financial guaranty and mortgage insurance segments and a premium deficiency for our second-lien product. These results have been partially offset by the gain on the sale of a portion of our interest in Sherman during the third quarter of 2007, an income tax benefit due to the losses incurred, a decrease in other operating expenses and an increase in net investment income.
Net Premiums Written and Earned. Consolidated net premiums written for 2007 were $1,184.9 million, a $72.9 million or 6.6% increase from $1,112.0 million for 2006. Consolidated net premiums earned for 2007 were $1,038.6 million, a $22.8 million or 2.2% increase from $1,015.8 million earned for 2006. As discussed above, the current mortgage and housing cycle has had a positive impact on the production and retention environment for private mortgage insurance. As a result, our mortgage insurance business experienced an increase in flow business written during 2007, reflecting an increase in demand for our traditional mortgage insurance product in the current uncertain housing market. Partially offsetting this increase in premiums written in our mortgage insurance business was a year over year decrease in premiums written in our financial guaranty business as a result of the difficult business production environment, particularly for our public finance business, resulting from the disruption in the credit markets and corresponding widening of credit spreads on Radian Asset Assurance. The year over year increase in premiums earned was mainly due to an increase in premiums earned on our primary mortgage insurance business, mortgage insurance credit derivatives, international mortgage business and our financial guaranty public finance business. This increase was partially offset by a decrease in premiums earned from our financial guaranty structured products business.
Net Investment Income. Net investment income for 2007 was $256.1 million, a $21.8 million or 9.3% increase from $234.3 million in 2006. This increase was mainly due to an increase in investable assets as a result of positive cash flows and the $200 million draw down from our credit facility during the third quarter of 2007 and higher yields in our investment portfolio.
Net Gains on Securities. Net gains on securities for 2007 were $53.6 million, compared to $40.8 million for 2006. Included in 2007 was $1.7 million of losses related to changes in the fair value of hybrid securities and trading securities. Also included in net gains on securities for 2007, was a $37.9 million net gain related to the sale of hybrid securities. Included in 2006 was a $21.4 million pre-tax gain resulting from the sale of our remaining interest in Primus Guaranty, Ltd. (“Primus”) in the first quarter of 2006. The 2007 and 2006 net gains were partially offset by approximately $9.4 million and $10.6 million of losses on investment securities that were other-than-temporarily impaired in 2007 and 2006, respectively. See “Investments” below in this Item 7.
Change in Fair Value of Derivative Instruments. For 2007, the change in fair value of derivative instruments was a net loss of $1.3 billion, compared to a net gain of $16.1 million for 2006. The decrease in the change in fair value of derivative instruments in 2007 was mainly a result of a $841 million increase in the cumulative unrealized loss on financial guaranty derivatives due to significant credit spread widening and a $427 million increase in the cumulative unrealized loss related to our NIMS portfolio, which is primarily credit related as discussed above. Partially offsetting these decreases is a gain related to the value of the put options on our money market custodial preferred securities, (“CPS”) of approximately $35 million. The $16.1 million gain for 2006 was due primarily to the tightening of spreads and included a $17.2 million charge related to the termination of a financial guaranty contract.
Other Income. Other income decreased to $11.7 million for 2007 from $20.9 million for 2006, mainly due to a decrease in fee income from affiliates and a decrease in mortgage insurance contract underwriting income as a result of less demand for this business.
Other Operating Expenses. Other operating expenses were $192.2 million for 2007 compared to $242.6 million for 2006. Included in 2007 operating expenses is $14.0 million of expenses related to our terminated merger with MGIC. Excluding these items, the decrease in other operating expenses was mainly due to foreign exchange gains and a decrease in employee costs, consulting costs, software expense, and depreciation expense on office equipment.
Interest Expense. Interest expense of $53.0 million for 2007 increased $4.9 million or 10.2% from $48.1 million for 2006. These amounts reflect interest on our long-term debt and other borrowings and include the impact from interest rate swaps that we entered into in 2004. The interest rate swaps effectively convert the interest rate on our 5.625% Senior Notes due 2013 to a variable rate based on a spread over the LIBOR. Included in interest expense for 2007 was $4.2 million of interest related to the $200 million that we drew down from our unsecured revolving credit facility on August 15, 2007. See Note 7 of Notes to Consolidated Financial Statements for a discussion of the interest calculation on amounts drawn under this facility.
Income Tax (Benefit) Provision. We recorded an income tax benefit of $778.6 million for 2007 and an income tax provision of $231.1 million for 2006. The consolidated effective tax rate was 37.6% for 2007, compared to 28.4% for 2006. The higher effective tax rate for 2007 reflects the losses incurred during 2007 and an increase in the ratio of income generated from tax-advantaged investment securities compared to income generated from operations. The tax rate for 2006 reflects an allocation of the reversal of prior years’ tax exposures that expired June 30, 2006.
Net Income. Net income for 2006 was $582.2 million or $7.08 per share (diluted), compared to $522.9 million or $5.91 per share (diluted) for 2005. Diluted net income per share for 2005 reflects the inclusion of 2.2 million shares, underlying our contingently convertible debt, which was redeemed in its entirety on August 1, 2005. Including these shares in the calculation of diluted net income per share resulted in a reduction in diluted net income per share of $0.13 for 2005. In addition, the results for 2005 reflect an immediate reduction in net income of $4.1 million or $0.04 per share (diluted) related to a recapture of business by one of our financial guaranty reinsurance customers following a downgrade of the financial strength ratings of Radian Asset Assurance by Moody’s in May 2004 (referred to herein as the “2005 recapture”). See Note 2 of Notes to Consolidated Financial Statements for more information regarding this recapture, including the financial impact to us. Net income increased for 2006 mainly due to an increase in net investment income, change in fair value of derivative instruments, equity in net income of affiliates and a decrease in the provision for losses, partially offset by an increase in other operating expenses, interest expense and the provision for income taxes.
Net Gains on Securities. Net gains on securities for 2006 were $40.8 million, compared to $36.6 million for 2005. This increase was mainly due to the $21.4 million pre-tax gain resulting from the sale of our remaining interest in Primus in the first quarter of 2006. Partially offsetting this increase was approximately $10.6 million of losses on investment securities that were other-than-temporarily impaired in 2006. Net gains on securities for 2005 included a $3.3 million loss on the sale of a partial interest in Sherman and a $3.2 million loss from a complete write-down of our investment in SBF Participacoes Ltda., a Brazilian insurer that we acquired in connection with our acquisition of the financial guaranty business in 2001.
Change in Fair Value of Derivative Instruments. For 2006, the change in fair value of derivative instruments was a net gain of $16.1 million, compared to a net gain of $9.2 million for 2005. In 2005 we applied a refined model for valuing corporate CDOs, which indicated that we had incurred a $50.8 million loss on one transaction at December 31, 2005. See “Results of Operations-Financial Guaranty-Year Ended December 31, 2006 Compared to Year Ended December 31, 2005-Changes in Fair Value of Derivative Instruments” below. The 2006 amount includes an additional $17.2 million charge related to a payment made in March 2006 in connection with the termination of this same transaction. In addition, although credit spreads tightened slightly in 2006, we experienced a year over year decrease in the change in fair value of derivative instruments resulting from the shorter duration of a large portion of the contracts.
Net Premiums Written and Earned. Net premiums written for 2007 were $955.1 million, a $106.0 million or 12.5% increase from $849.1 million for 2006. Net premiums earned for 2007 were $843.5 million, a $31.5 million or 3.9% increase compared to $812.0 million for 2006. Net premiums written in 2007 were positively impacted by the uncertain credit markets in 2007, which led to increased production in our traditional flow business. Included in net premiums earned for 2007 is a $17.0 million positive adjustment as a result of the refinement in our process for estimating premiums receivable and the unearned premium thereon. Net premiums earned for 2007 also were positively impacted by increases in premiums earned from NIMS and international business, partially offset by a decrease in premiums earned from our second-lien business due to a lesser amount of business originated in 2006 and 2007. Premiums earned from all our non-traditional products (including derivatives) were $112.6 million for 2007, compared to $96.9 million for 2006. We anticipate modest growth in mortgage insurance earned premiums from our traditional flow business for 2008 as insurance in force continues to grow.
Net Gains on Securities. Net gains on securities in our mortgage insurance business were $39.9 million for 2007, compared to $30.2 million for 2006. Included in 2007 were losses related to changes in the fair value of hybrid securities and trading securities of $1.9 million and net gains related to the sale of hybrid securities of approximately $26.2 million. Included in net gains on securities for 2006 is an allocation of net gains on securities to the mortgage insurance segment, most of which came from the sale of our remaining interest in Primus. The 2007 and 2006 amounts also include approximately $9.4 million in losses related to the write-down of other-than-temporarily impaired securities.
Change in Fair Value of Derivative Instruments. The change in the fair value of derivative instruments was a loss of $531.8 million for 2007, compared to a gain of $3.7 million for 2006. The decrease in 2007 compared to 2006 was mainly due to the $427.0 million mark-to-market loss on our NIMS book, approximately $377.0 million of which represents the present value of estimated credit losses on this business as discussed above. In addition to NIMS, RMBS credit default swaps in our domestic mortgage insurance business resulted in an additional
negative mark of approximately $83.6 million. Our international credit default swap business resulted in an additional negative mark of $2.6 million during the year, which we do not consider to be credit related.
Policy Acquisition Costs. Policy acquisition costs were $67.8 million for 2007, compared to $65.0 million for 2006. During 2007, amortization expense was impacted by an increase in persistency rates and updates to our loss ratios assumptions, both of which affected the rate at which deferred policy acquisition costs were amortized. During 2006, our persistency rates decreased, which resulted in an increase in previously recorded amortization expense.
Interest Expense. Interest expense attributable to our mortgage insurance business for 2007 was $27.9 million compared to $26.6 million for 2006. The 2007 amount includes interest on our long-term debt and other borrowings that was allocated to the mortgage insurance segment as well as the impact of interest-rate swaps.
Income Tax (Benefit) Provision. We recorded an income tax benefit of $429.9 million for 2007 and an income tax provision of $102.3 million for 2006. The effective tax rate was 38.2% for 2007 compared to 26.6% for 2006. The higher effective tax rate for 2007 reflects the losses incurred during 2007 and an increase in the ratio of income generated from tax-advantaged investment securities compared to income generated from operations. The tax rate for 2006 reflects an allocation of the reversal of prior years’ tax exposures that expired June 30, 2006.
Net Investment Income. Net investment income attributable to our mortgage insurance business for 2006 was $138.3 million, an increase of $20.0 million or 16.9%, compared to $118.3 million for 2005. Investment income for 2006 reflects an increase in interest income on bonds due to higher investment balances, higher overall interest rates and an increase in dividend income on private equity investments.
Change in Fair Value of Derivative Instruments. The change in the fair value of derivatives was a gain of $3.7 million for 2006, compared to a gain of $4.1 million for 2005. The 2006 change in the fair value of derivatives includes changes in the fair value of embedded options in convertible securities held in the investment portfolio of $13.4 million, offset by $7.0 million of change in fair value of derivative instruments related to NIMS. When convertible securities with embedded options carried at unrealized gains are sold, it has the effect of reclassifying the unrealized gain from the change in fair value of derivative instruments to gains on securities. See Note 2 of Notes to Consolidated Financial Statements.
Policy Acquisition Costs. Policy acquisition costs were $65.0 million for 2006, compared to $62.9 million for 2005. The 2006 amount includes the amortization of commissions relating to international business. This increase was also the result of the acceleration of the amortization of policy acquisition costs of $4.7 million and $5.1 million in 2006 and 2005, respectively, due to a decrease in the persistency rates.
Interest Expense. Interest expense attributable to our mortgage insurance business for 2006 was $26.6 million compared to $24.2 million for 2005. Both periods include interest on our long-term debt, including the impact of interest-rate swaps, allocated to the mortgage insurance segment.
Direct primary insurance in force was $143.1 billion at December 31, 2007, compared to $113.9 billion at December 31, 2006 and $109.7 billion at December 31, 2005. The increase in primary insurance in force was mainly attributable to a single structured transaction written as modified pool insurance in the first quarter of 2007, a significant increase in flow business generated throughout 2007 and increased persistency rates.
(1) Includes 2,595, 1,161 and 452 defaults at December 31, 2007, December 31, 2006 and December 31, 2005, respectively, where reserves have not been established because no claim payment is currently anticipated.
(2) Includes 20,193, 13,309 and 3,699 defaults at December 31, 2007, December 31, 2006 and December 31, 2005, respectively, where reserves have not been established because no claim payment is currently anticipated.
The default and claim cycle in the mortgage insurance business begins with our receipt of a default notice from the insured. Generally, the insured notifies us of a default within 15 days after the loan has become 60 days past due. For reporting and internal tracking purposes, we do not consider a loan to be in default until the loan has been in default for 60 days.
The total number of loans in default, including second-liens, increased to 96,203 at December 31, 2007, from 67,173 at December 31, 2006 and 57,088 at December 31, 2005. The average loss reserve per default at December 31, 2007 was $13,986, compared to $9,725 and $10,444 at December 31, 2006 and 2005, respectively. Primary and pool defaults at December 31, 2007 included 2,595 and 20,193 defaults, respectively, on loans where reserves have not been established because no claim payment is currently anticipated. At December 31, 2006, primary and pool defaults included 1,161 and 13,309 defaults, respectively, on loans where reserves have not been established. At December 31, 2005, primary and pool defaults included 452 and 3,699 defaults, respectively, on loans where reserves have not been established. Excluding those defaults without a related reserve, the average loss reserve per default was $18,327, $12,395 and $12,518 at December 31, 2007, 2006 and 2005, respectively.
A higher proportion of new delinquencies in 2007 are from loans in California and Florida, which would indicate that claims paid in those states will likely increase, perhaps significantly in 2008.
(1) Does not include amounts related to expected future losses that are included in the reserve for second-lien premium deficiency.
(1) Related to ceded losses on captive transactions and Smart Home.
Net (Loss) Income. Our financial guaranty segment’s net loss for 2007 was $440.2 million, compared to $136.1 million of net income for 2006. The decrease for 2007 was mainly due to a significant decrease in change in fair value of derivative instruments, an increase in the provision for losses and a decrease in earned premiums. These decreases in income were partially offset by a decrease in other operating expenses, an increase in net investment income, higher net gains on securities and a tax benefit due to the pretax loss.
Net Premiums Written and Earned. Our financial guaranty segment’s net premiums written for 2007 were $229.8 million, a $33.1 million or 12.6% decrease compared to $262.9 million for 2006. The decrease in net premiums written in 2007 compared to 2006 was attributable to the difficult business environment, particularly for our public finance business, resulting from the disruption in the credit markets and corresponding widening of the credit spreads of Radian Asset Assurance. Net premiums earned for 2007 were $195.1 million compared to $203.8 million for 2006. The decrease in premiums earned for 2007 mainly relates to less earned premium from corporate credit derivative products due to our negotiated termination of certain transactions in 2007 and lower trade credit reinsurance premiums, as this business continues to run off. Premiums earned in 2007 were positively impacted by an additional $11.5 million in refundings from our public finance products compared to 2006. Included in net premiums earned for 2007 were refundings of $23.3 million compared to $11.8 million for 2006.
(1) Amounts recorded related to the immediate impact of the 2005 recapture. See Note 2 of Notes to Consolidated Financial Statements.
Net Investment Income. Net investment income attributable to our financial guaranty business was $107.7 million for 2007, compared to $95.9 million for 2006. The 2007 amount reflects an increase in investment balances and higher yields.
Net Gains on Securities. Net gains on securities were $12.5 million for 2007, compared to $7.8 million for 2006. Included in the net gains on securities for 2007 was $11.7 million related to the sale of hybrid securities. The 2006 amount includes an allocation of the gain on the sale of our remaining interest in Primus, partially offset by approximately $1.2 million in losses related to the write-down of other-than-temporarily impaired investment securities.
We established an allocated non-specific reserve of $50 million during each of the last two quarters of 2007 ($100 million in total, representing our total exposure) related to a 2003 BBB-rated credit in which we provide market-value and credit support for an extendable commercial paper program. This program is supported by ABS, including RMBS collateral. On October 24, 2007, the principal placement agent for this program advised us that the commercial paper was not purchased at its most recent roll date. As a result, the commercial paper extended by its terms for six months during which time the underlying assets must be liquidated to repay the paper. As a result of ongoing deterioration in the ABS markets, the sale of these assets have not been sufficient to repay the maturing commercial paper and total losses have exceeded our exposure to this credit. We began
paying claims on this credit in January 2008 and have paid claims equal to our total exposure of $100 million on this transaction. This credit represents the only direct market-value transaction remaining in our financial guaranty portfolio.
There is one credit at December 31, 2007 for which we have not allocated a specific reserve that, without a positive change, may default in the near-term and could potentially result in a claim. Based on currently available information, we expect that any claim from this credit, should one arise, would range from a minimal amount up to slightly above 50% of the $52 million in total par outstanding. The potential amount of any claim is not estimable at this point, in part, because of the availability of a number of strategic alternatives currently under consideration and other mitigating factors that could reduce or delay any payment from us. In addition, remediation efforts have added substantial additional collateral security for the insured obligation, which could reduce the amount of any claim we may be required to pay. We continue to collect and analyze additional information regarding that transaction.
Interest Expense. Interest expense was $19.8 million for 2007, compared to $16.6 million for 2006. Both periods include interest on our long-term debt and other borrowings, including the impact of interest-rate swaps, which was allocated to the financial guaranty segment.
Income Tax (Benefit) Provision. We recorded an income tax benefit of $265.6 million for 2007 and an income tax provision of $40.9 million for 2006. The effective tax rate was 37.6% for 2007, compared to 23.1% for 2006. The higher effective tax rate for 2007 reflects the losses incurred during 2007 and an increase in the ratio of income generated from tax-advantaged investment securities compared to income generated from operations. The tax rate for 2006 reflects an allocation of the reversal of prior years’ tax exposures that expired June 30, 2006.
Net Premiums Written and Earned. Net premiums written and earned for 2006 were $262.9 million and $203.8 million, respectively, compared to $223.1 million and $211.8 million, respectively, for 2005. Net premiums written and earned for 2005 reflect a reduction of $54.7 million and $4.5 million, respectively, related to the 2005 recapture. Net premiums written and earned in 2006 were significantly impacted by the run-off in the trade credit reinsurance line of business. For 2006, trade credit reinsurance accounted for 1.7% and 10.5% of financial guaranty’s net premiums written and earned, respectively, down from 15.7% and 23.3%, respectively, of financial guaranty’s net premiums written and earned for 2005 (12.6% and 22.8%, respectively, excluding the impact of the 2005 recapture).
Net Gains on Securities. Net gains on securities were $7.8 million for 2006, compared to $10.7 million for 2005. The 2006 amount includes an allocation of the gain on the sale of our remaining interest in Primus, partially offset by approximately $1.2 million in losses related to the write-down of other-than-temporarily impaired investment securities. Included in 2005, is a $3.2 million loss on the write-down of our interest in SBF Participacoes Ltda.
Income Tax (Benefit) Provision. The effective tax rate was 17.7% for 2006, compared to 23.2% for 2005. The tax rate for 2006 reflects an allocation of the reversal of prior years’ tax exposures that expired June 30, 2006. The lower tax rate also reflects an overall increase in the ratio of income generated from tax-advantaged securities compared to income generated from operations.
The gross par (net present value) originated by our financial guaranty segment in 2007, 2006 and 2005 is as follows:
We have various contractual obligations that are recorded as liabilities in our Consolidated Financial Statements. Other items, including payments under operating lease agreements and pension liabilities, are not recorded on our consolidated balance sheets as liabilities but represent a contractual commitment to pay.
(2) The timing of these potential payments is uncertain given the nature of the obligation.
Financial Accounting Standards Board Interpretation No. 48 (“FIN No. 48”) Liability. As of December 31, 2007, our expected payment for significant contractual obligations includes approximately $76.3 million of gross
Investment Commitments. As part of the non-investment-grade allocation component of our investment program, we have committed to invest $55 million in alternative investments that are primarily private equity structures. At December 31, 2007, we had unfunded commitments of $24.5 million. These commitments have capital calls over a period of at least six years, and certain fixed expiration dates or other termination clauses.
Letters of Credit. We also utilize letters of credit to back assumed reinsurance contracts, medical insurance policies and an excise tax-exemption certificate used for ceded premiums from our domestic operations to our international operations. These letters of credit are with various financial institutions, have terms of one-year and will automatically renew unless we elect otherwise. The letters of credit outstanding at December 31, 2007 and 2006 were $10.8 million and $15.5 million, respectively.
Radian Asset Assurance and RAAL are parties to a Capital Maintenance Agreement pursuant to which Radian Asset Assurance has agreed to maintain RAAL’s capital at a level not less that 350% of the equivalent of the required margin of solvency pursuant to the regulations of the Financial Services Authority, RAAL’s U.K. regulator, and to ensure that at all times RAAL has sufficient cash resources for the timely honoring of its contractual obligations. Radian Asset Assurance is not required to make any payments that would cause it to be in breach of its own minimum capital requirements, and certain payments by Radian Asset Assurance pursuant to this agreement are specifically subject to the prior approval of the New York Superintendent of Insurance.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of asset-backed (including mortgage-backed) securities. To allow our customers to comply with these regulations, we typically are required, depending on the amount of credit enhancement we are providing, to provide (1) audited financial statements for the insurance subsidiary participating in these transactions or (2) a full and unconditional holding-company level guarantee for our insurance subsidiaries’ obligations in such transactions. To date, Radian Group has guaranteed two structured transactions for Radian Guaranty with approximately $363.6 million of remaining credit exposure.
Funding of Rabbi Trusts. Under our change of control agreements with our executive officers, upon a change of control of Radian Group Inc. or Radian Asset Assurance, as the case may be, we are required to fund an irrevocable rabbi trust to the extent of our obligations under these agreements. The total maximum amount that we would be required to place in trust is approximately $16.6 million as of December 31, 2007.
As a provider of credit enhancement, in the normal course of business, we enter into arrangements with special purpose entities (“SPEs”). SPEs are corporations, trusts or partnerships that are established for a limited purpose. SPEs, by their nature, are generally not controlled by their equity owners, as the establishing documents generally govern all material decisions. There are two different accounting frameworks applicable to SPEs: the qualifying SPE (“QSPE”) framework under SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities”, (“SFAS No. 140”) and the variable interest entity (“VIE”) framework as provided by FIN No. 46 (R) “Consolidation of Variable Interest Entities,” (“FIN No. 46R”). The applicable framework depends on the nature of the entity and our relation to that entity.
The QSPE framework is applicable when an entity transfers (sells) financial assets to an SPE meeting certain criteria defined in SFAS 140. These criteria are designed to ensure that the activities of the entity are essentially predetermined at the inception of the vehicle and that the transferor of the financial assets cannot exercise control over the entity and the assets therein. Entities meeting these criteria are not consolidated by the transferor, or other counterparties, as long as they do not have the unilateral ability to liquidate or to cause the entity to no longer meet the QSPE criteria.
Our interests in QSPEs may be accounted for as insurance contracts or financial guaranty derivatives. For insurance contracts with QSPEs, we record reserves for losses and loss adjustment expenses, and for derivative interests in QSPEs, we record changes in the fair value as a corresponding asset or liability. We do not record the underlying assets or liabilities of QSPEs on our balance sheet.
SPEs and VIEs are a significant part of our non-traditional mortgage insurance products as well as our financial guaranty business. Our primary involvement with SPEs relates to transactions in which we provide a financial guaranty to one or more classes of beneficial interest holders in the SPE. Underlying collateral in the SPEs includes residential and commercial mortgages, consumer receivables, securities and other financial assets sold to a SPE and repackaged into securities or similar beneficial interests. SPEs may also be used to create securities with a unique risk profile desired by investors and as a means of transferring risk, such as our Smart Home transactions. We consolidate those VIEs in which we are the primary beneficiary. See Note 17, “Variable Interest Entities” in the Notes to Consolidated Financial Statements for a complete discussion of VIEs. For additional information regarding
exposure to our mortgage insurance and financial guaranty products see “Business-Mortgage Insurance” and “Business-Financial Guaranty” sections detailed in Item 1 of Part I of this report.
Certain other SPEs do not meet the requirements of a QSPE, because all their activities are not sufficiently limited or they have entered into certain non-qualifying transactions. In some circumstances, a QSPE may not be exempt from consolidation if we have the unilateral ability to make significant changes to the QSPE. We follow the criteria under FIN No. 46R in determining whether we should consolidate such entities.
Participants in the entity acquire or sell interests in the entity.
NIMS-We provided credit enhancement on NIMS bonds. A NIMS bond represents the securitization of a portion of the excess cash flow and prepayment penalties from a mortgage-backed security comprised mostly of subprime mortgages. The majority of this excess cash flow consists of the spread between the interest rate on the mortgage-backed security and the interest generated from the underlying mortgage collateral. Historically, issuers of mortgage-backed securities would have earned this excess interest over time as the collateral aged, but market efficiencies enabled these issuers to sell a portion of their residual interests to investors in the form of NIMS bonds. Typically, the issuer retained a significant portion of the residual interests, which was subordinated to the NIMS bond in a first-loss position, so that the issuer would suffer losses associated with any shortfalls in residual cash flows before the NIMS bond experienced any losses. NIMS bonds have largely been susceptible to the disruption in the housing market and the subprime mortgage market during 2007. See “Overview of Business Results-Mortgage Insurance-NIMS” for information regarding our total loss expectations with respect to NIMS. Our NIMS are generally structured as QSPEs. There are certain circumstances and triggers outside of our control, however, that would give us the ability to call some or all of the outstanding NIMS bonds. The effective control that we attain if the call option is triggered, renders the QSPE a VIE under FIN No. 46R. We then assess whether we are required to consolidate the VIE. At December 31, 2007, there were six such transactions that required consolidation, but such consolidation had an immaterial impact to our consolidated financial statements.
Each transaction begins with the formation of an unaffiliated, offshore reinsurance company. We then enter into an agreement with the Smart Home reinsurer to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of loans. Each class relates to the loss coverage levels on the reinsured portfolio and is assigned a rating by one or more of the three major rating agencies. We do not hold any of the credit-linked notes issued as part of this structure; as such we have no significant variable interests in the structures and are not subject to consolidation under FIN No. 46R. See “Overview of Business Results -Mortgage Insurance-Traditional Mortgage Insurance” above for further discussion.
Our involvement with SPEs has a significant role in our financial guaranty business as a guarantor of beneficial interests held by third party investors. The guarantees are generally financial guarantees of principal and interest payments to beneficial interest holders. Our guarantees are generally issued on highly rated senior securities issued by these SPEs and are not designed to absorb a significant portion of the variability created by the assets in the SPEs. Accordingly, we do not consolidate these SPEs. An increase in losses within the SPE structure is not an event that would require us to reconsider consolidation under FIN No. 46R. However, if any of the trigger events discussed above were to occur and we were required to reconsider our variable interests in the SPE, there is an increased risk that we may be required to consolidate some of these SPEs. This is primarily due to the deterioration in subordination of the underlying collateral that has occurred since our initial determination, made at inception of the VIEs, that we were not the primary beneficiary.
Effective January 1, 2007, we began classifying convertible securities (including the fixed-maturity component of securities previously classified as available for sale and the derivative component previously classified as available for sale and trading securities) as hybrid securities. Hybrid securities generally combine both debt and equity characteristics. Prior to 2007, the changes in fair value of the fixed-maturity component of these securities were recorded in our consolidated statements of changes in common stockholders’ equity through accumulated other comprehensive income or loss and the changes in fair value of the derivative component of these securities were recorded as a gain or loss in our consolidated statements of income. In accordance with SFAS No. 155, effective January 1, 2007, all changes in the fair value of the entire convertible security are now recorded as net gains or losses on securities in our consolidated statements of income. Our transition adjustment related to the adoption of SFAS No. 155 increased retained earnings at January 1, 2007 by $9.8 million, and reduced accumulated other comprehensive income by the same amount. The transition amount includes unrealized gains of $14.1 million (net of tax) and unrealized losses of $4.3 million (net of tax) related to convertible securities at December 31, 2006.
For securities in our investment portfolio, we conduct a quarterly evaluation of declines in market value of the securities to determine whether the decline is other-than-temporary. If a security’s fair value is below the cost basis, and it is judged to be an other-than-temporary decline, the cost basis of the individual security is written down to fair value through earnings as a realized loss and the fair value becomes the new basis for the security. During 2007, we recorded approximately $4.3 million of charges related to declines in the fair value of securities (primarily small cap value stocks) considered to be other-than-temporary. During 2006, we recorded $10.6 million of charges related to declines in the fair value of securities considered to be other-than-temporary. There were no such charges in 2005. At December 31, 2007, 2006 and 2005, there were no other investments held in the portfolio that were determined to be other-than-temporarily impaired.
Other invested assets consist of approximately $2.2 million of residential mortgage-backed securities and $20.6 million of alternative investments that are primarily private equity investments, including an investment in a fund sponsored and co-managed by C-BASS that invests in real estate related securities. During 2007, we recorded a $5.1 million loss considered to be other-than-temporary on our investment in this fund. Other invested assets are carried under the cost method or under the equity method.
Our evaluation of market declines for other-than-temporary impairment is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors about the security and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by management in its impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential
The unrealized losses of 12 months or greater duration as of December 31, 2007 on our investments in U.S. Treasury obligations were caused by interest rate movement. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
The unrealized losses of 12 months or greater duration as of December 31, 2007 on our investments in tax-exempt state and municipal securities were caused primarily by interest rate movement. Certain securities, mainly those insured by monoline insurance companies, experienced credit spread widening during 2007 as a result of recent events in the subprime residential mortgage market. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
The unrealized losses of 12 months or greater duration as of December 31, 2007 on the majority of the securities in this category were caused by market interest rate movement. We believe that credit quality did not impact security pricing due to the relative high quality of the holdings (i.e., the majority of the securities were highly-rated governments and government agencies or corporate issues with minimum ratings of single-A). Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
We act mainly as a holding company for our insurance subsidiaries and do not have any significant operations of our own. Dividends from our subsidiaries, which include amounts received from our affiliates (C-BASS and Sherman), and permitted payments to us under our tax- and expense-sharing arrangements with our subsidiaries, along with income from our investment portfolio, are our principal sources of cash to pay stockholder dividends and to meet our obligations. These obligations include our operating expenses, taxes and interest and principal payments on our long-term debt and other borrowings. The payment of dividends and other distributions to us by our insurance subsidiaries is limited by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In addition, although we have expense-sharing arrangements in place with our principal operating subsidiaries that require those subsidiaries to pay their share of holding company-level expenses, including interest expense on long-term debt and other borrowings, these expense-sharing arrangements may be changed at any time by the applicable state insurance departments. Our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the rating agencies for us to maintain our ratings. If the cash we receive from our subsidiaries pursuant to tax- and expense-sharing arrangements is insufficient for us to fund our obligations, or our subsidiaries require more capital, we may be required to seek additional capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all.
Our liquidity needs over the next 12 months include funds for the payment of dividends on our common stock, debt service payments on our outstanding long-term debt and other borrowings, claim payments on our insured obligations, operating expenses, payment of amounts related to the termination of our pension plan and potentially, to fund a payment on account related to the IRS investigation described above. We expect to fund these requirements with available cash and amounts received under our expense-sharing arrangements or as dividends from our insurance operating subsidiaries, subject to regulatory requirements, which may include dividends from working capital, all of which we expect to be sufficient to make such payments for at least the next 12 months. We have the ability to draw an additional $200 million under our existing credit facility (discussed below) to support our short-term liquidity needs and could, if necessary, seek to sell all or a portion of our remaining interest in Sherman, subject to the existing option with Sherman’s management, although we cannot be certain that we would be able to sell our interest in Sherman on favorable terms, if at all.
Based on our current intention to pay quarterly common stock dividends of $0.02 per share and assuming that our common stock outstanding remains constant at 80,412,974 shares at December 31, 2007, we would require approximately $6.4 million to pay our quarterly dividends for the next 12 months. We will also require approximately $57.3 million annually to pay the debt service on our outstanding long-term debt and other borrowings, including the $200 million that we have drawn down from our existing credit facility.
months. In the likely event that claim payment obligations and operating expenses exceed the operating cash flows generated by our insurance operating subsidiaries, we believe that we have the ability to fund any excess from sales of short-term investments maintained at the operating company. In the event that we are unable to fund excess claim payments and operating expenses through the sale of short-term investments, we may be required to incur unanticipated capital losses or delays in connection with the sale of less liquid securities held by us. At December 31, 2007, the parent company had cash and liquid investment securities of $123.5 million.
In February 2005, the SEC declared effective our $800 million universal shelf registration statement. On June 7, 2005, we issued under the shelf registration statement $250 million of unsecured senior notes at a price of 99.822% of their principal amount. These notes bear interest at the rate of 5.375% per annum, payable semi-annually on June 15 and December 15. The notes mature on June 15, 2015. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed. We used a portion of the proceeds from the sale of the notes to redeem at par, on August 1, 2005, all $219.3 million in aggregate principal amount outstanding of our 2.25% Senior Convertible Debentures due 2022. We used the balance of the proceeds for general corporate purposes.
In May 2001, we issued $250 million of 7.75% debentures due June 1, 2011. Interest on the debentures is payable semi-annually on June 1 and December 1. We have the option to redeem some or all of the debentures at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed.
On August 15, 2007, we drew down $200 million in principal amount under this facility. The amount drawn down bears interest at a rate equal to LIBOR plus 20 basis points (which resets periodically) as specified by the credit facility. We contributed $100 million of the proceeds of the draw down to Radian Asset Assurance to support the risk written in our financial guaranty business. The remaining $100 million will be used for general corporate purposes. Although we had no immediate need for additional liquidity, in light of current market conditions, we drew on the facility to provide us with greater financial flexibility and adequate liquidity for the long-term. After the draw down, the remaining credit available under the facility is $200 million.
In September 2003, Radian Asset Assurance completed a transaction for $150 million of money market committed preferred custodial trust securities, pursuant to which it entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), our wholly-owned subsidiary. Radian Asset Securities in turn entered into a series of three perpetual put options on its own preferred stock (on substantially identical terms to the Radian Asset Assurance preferred stock). The counterparties to the Radian Asset Securities put options are three trusts established by two major investment banks. The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more of the put options and the corresponding exercise of one or more corresponding Radian Asset Securities put options.
If the Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired, and investors, through their equity investment in the Radian Asset Securities preferred stock, would have rights to the assets of Radian Asset Assurance as an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholders’ claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of our claims, through EFSG, as the owner of the common stock of Radian Asset Assurance. If all the Radian Asset Assurance put options were exercised, Radian Asset Assurance would receive up to $150 million in return for the issuance of its own perpetual preferred stock, the proceeds of which would be usable for any purpose, including the payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock.
Each trust (See Note 8 of Notes to Consolidated Financial Statements) is restricted to holding high-quality, short-term commercial paper investments to ensure that it can meet its obligations under the put options. To fund these investments, each trust issued its own auction market perpetual preferred stock. On September 5, 2007, Fitch downgraded its rating of the trusts to “BBB+” from “A.” As a result of this downgrade, the maximum spread over LIBOR payable by us for maintenance of these options increased to 300 basis points from 200 basis points. Because sufficient auction clearing bids have not been made, the reset auction rate for the options has reset at this maximum rate, resulting in a $1.5 million increase in the annual cost to us of maintaining these options. Each trust remains rated “A” by S&P. The initial costs to issue this facility were recorded as a reduction to additional paid-in capital.
The following table reconciles net income to cash flows from operations for the years ended December 31, 2007, 2006 and 2005 (in thousands):
Cash flows from operations for 2007 decreased from the comparable period of 2006. This decrease was mainly due to an increase in claims paid, purchases of trading securities and lower distributions from affiliates. We expect that net income will be less than cash flows from operations during the next 12 months.
We also may purchase shares on the open market to meet option exercise obligations and to fund 401(k) matches and purchases under our Employee Stock Purchase Plan and may consider additional stock repurchase programs in the future.
of our common stock for approximately $22.8 million, (4) dividends paid in 2007 of $6.4 million and (5) a $21.2 million adjustment for the adoption of FIN No. 48. Offsetting these was the proceeds from the issuance of common stock under incentive plans of $25.3 million.
SEC guidance defines Critical Accounting Policies as those that require the application of management’s most difficult, subjective, or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods. In preparing our Consolidated Financial Statements, management has made estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. In preparing these financial statements, management has utilized available information including our past history, industry standards and the current economic environment and housing environment, among other factors, in forming its estimates and judgments, giving due consideration to materiality. Actual results may differ from those estimates. In addition, other companies may utilize different estimates, which may impact comparability of our results of operations to those of companies in similar businesses. A summary of the accounting policies that management believes are critical to the preparation of our Consolidated Financial Statements is set forth below.
Our model differentiates between prime and other products and takes into account the different loss development patterns and borrower behavior that is inherent in these products, whether we are in a first- or second-loss position and whether there are deductibles on the loan. We use actuarial projection methodologies to produce a range of reserves by product and a midpoint for each product based on historical factors such as ultimate claim rates and claim severity.
The following table shows the mortgage insurance range of loss and LAE reserves, as determined by our actuaries, and recorded reserves for losses and LAE, as of December 31, 2007 and 2006:
At December 31, 2007, we had case reserves and LAE reserves on financial guaranty policies of $33.3 million. Of this amount, $22.5 million was attributable to a single manufactured housing transaction originated and serviced by Conseco Finance Corp. We have a high degree of certainty that we will suffer losses with respect to this insured obligation equal to the amount reserved, which equals the total amount of the remaining insured obligation. The case and LAE reserves also include $10.0 million attributable to 22 reinsured obligations on which our total par outstanding is $26.5 million. These reserves are established based on amounts conveyed to us by the ceding companies and confirmed by us. We do not have any reasonable expectation that the ultimate losses will deviate materially from the amount reserved. The remaining $0.8 million represents LAE reserves attributable to seven insured obligations, partially offset by salvage recoveries on six other insured obligations.
At December 31, 2007, 16 credits were included in our allocated non-specific reserves of $141.3 million, including $100.0 million related to a BBB-rated structured finance credit discussed above. See “Results of Operations-Financial Guaranty-Year Ended December 31, 2007 Compared to December 31, 2006” for more information regarding this credit. We expect that we will suffer losses with respect to these insured obligations approximately equal to the amount reserved of $141.3 million. These credits have a gross par amount of $362.3 million.
Our unallocated non-specific loss reserve at December 31, 2007, was $49.2 million. The range between the unallocated non-specific reserves that would have resulted from applying the highest and lowest default factors generated by any of the three models was approximately $25 million to $67 million, which we believe provides a reasonably likely range of expected losses.
At each balance sheet date, we also evaluate both the model-generated default factors and our unallocated non-specific reserves against management’s subjective view of qualitative factors to ensure that the default factors and the unallocated non-specific reserves represent management’s best estimate of the expected losses on our portfolio of credits for which we have not established a case reserve or an allocated non-specific reserve. These qualitative factors include existing economic and business conditions, overall credit quality trends resulting from industry, geographic, economic and political conditions, recent loss experience in particular segments of the portfolio, changes in underwriting policies and procedures and seasoning of the book of business. The macroeconomic factors that we evaluate are outside of our control and are subject to considerable variability. The company-specific factors that we evaluate also require us to make subjective judgments. In addition, a significant change in the size of our portfolio underlying the unallocated non-specific reserves, such as through the expiration of policies or the refunding or recapture of insured exposures, could require an adjustment to the default factors or our level of unallocated non-specific reserves. Our estimates of our reserves for losses and LAE for our financial guaranty segment’s other lines of business, mainly trade credit reinsurance, depend upon the receipt of accurate information on claims and loss estimates from ceding companies. In addition, a reserve is included for losses and IBNR, on trade credit reinsurance. As the business is now in run-off, the receipt of information from ceding companies is likely to be more sporadic and the setting of reserves will be more reliant on management estimates. We use historical loss information and make inquiries to the cedants of known events as a means of validating our loss assumptions.
Setting the loss reserves in both business segments involves significant reliance upon estimates with regard to the likelihood, magnitude and timing of a loss. The models and estimates we use to establish loss reserves may not prove to be accurate, especially during an extended economic downturn. We cannot be certain that we have correctly estimated the necessary amount of reserves or that the reserves established will be adequate to cover ultimate losses on incurred defaults.
All our derivative instruments are recognized in our consolidated balance sheets as either assets or derivative liabilities, depending on the rights or obligations under the contracts. The interest-rate swaps that we have entered into qualify as hedges and are accounted for as fair value hedges. Our forward foreign currency contracts, credit protection in the form of credit default swaps and certain financial guaranty contracts within
We account for NIMS as derivatives under SFAS No. 133. As a result of the severe disruption in the subprime mortgage market, we refined our methodology for valuing NIMS in the third quarter of 2007 consistent with our increased loss expectations for this product. Prior to the third quarter, we valued our NIMS bonds by evaluating recent premium levels and the present value of future estimated cash flows. When we determined that a NIMS bond was not performing in accordance with our expectations, we estimated a claim amount that we would be required to pay on each bond. Refinement to our model addresses the potential vulnerability of all NIMS bonds under current market conditions, including those performing within our expectations. Our refined methodology uses market-based roll rates and internally developed loss assumptions and, we estimate losses in each securitization underlying a NIMS bond. We then project prepayment fees on the underlying collateral in each securitization, incorporating actual and historical prepayment experience. The estimated loss and prepayment speeds are used to estimate the cash flows for each underlying securitization and NIMS bond, and ultimately, to produce the projected credit losses for each NIMS bond at legal maturity. In addition to expected credit losses, the fair value for each NIMS bond is approximated by incorporating further loss stresses, future expected premiums from the NIMS bond, and an estimated rate of return that a counterparty would require in assuming the exposure from us. This required rate of return is evaluated based on market rates of return implied by available market indices on mortgage-backed securities of similar underlying credit risk. Changes in our estimated fair value marks are recorded as a gain/loss on derivatives and paid losses are recorded as a realized loss. Because NIMS guarantees are not market traded instruments, considerable judgment is required in estimating fair value. The use of different assumptions and/or methodologies could have a significant effect on estimated fair values.
In February 2006, the FASB issued SFAS No. 155, an amendment of SFAS Nos. 133 and 140. As discussed above in “Investments” we adopted SFAS No. 155 on January 1, 2007. Accordingly, securities that were previously classified as available for sale and trading securities on our consolidated balance sheets were reclassified to hybrid securities on our consolidated balance sheets on the date of adoption and as provided by SFAS No. 155, we elected to record convertible securities at fair value and changes in the fair value are recorded as net gains or losses on securities.
Costs associated with the acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. Because SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs, amortization of these costs for each underwriting-year book of business is charged against revenue in proportion to estimated gross profits over the estimated life of the policies using the guidance provided by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” This includes accruing interest on the unamortized balance of deferred policy acquisition costs. Estimates of expected gross profit including persistency and loss development assumptions for each underwriting year and product type used as a basis for amortization are evaluated regularly, and the total amortization recorded to date is adjusted by a charge or credit to the statement of income if actual experience or other evidence suggests that earlier estimates should be revised. Considerable judgment is used in evaluating these factors when updating the assumptions. The use of different assumptions would have a significant effect on the amortization of deferred policy acquisition costs.
In the third quarter of 2007, we initially established a $155 million reserve for premium deficiency on our second-lien business. In accordance with SFAS No. 60, our second-lien business is considered to be a separate product due to the fact that the business is managed separately, priced differently from our traditional products and the customer base is different from that of our traditional products. SFAS No. 60 requires a premium deficiency reserve if the net present value of the expected future losses and expenses exceeds expected future premiums and existing reserves. We reassess our expectations for premiums and losses and expenses for our second-lien business each quarter and update our premium deficiency accordingly. In the fourth quarter of 2007, the second-lien deficiency increased by approximately $41 million as a result of further deterioration in the performance of our second-lien portfolio.
We provide for income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). As required under SFAS No. 109, our deferred tax assets and liabilities are recognized under the liability method which recognizes the future tax effect of temporary differences between the amounts recorded in the Consolidated Financial Statements and the tax bases of these amounts. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled.
In June 2006, the FASB issued FIN No. 48. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.
In September 2006, the FASB issued SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS No. 158”). SFAS No. 158 requires us to recognize the funded status of a benefit plan-measured as the difference between plan assets at fair value (with limited exceptions) and the benefit obligation-in our consolidated balance sheets. For a pension plan, the benefit obligation is the projected benefit obligation; for any other postretirement benefit plan, such as a retiree health care plan, the benefit obligation is the accumulated postretirement benefit obligation. SFAS No. 158 also requires us to recognize as a component of accumulated other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. Amounts recognized in accumulated other comprehensive income, including the gains or losses, prior service costs or credits, and the transition asset or obligation remaining, are adjusted as they are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of those statements. In addition, SFAS No. 158 requires us to measure defined benefit plan assets and obligations as of the date of our fiscal year-end statement of financial position (with limited exceptions), and to disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. Employers with publicly traded equity securities are required to initially recognize the funded status of a defined benefit postretirement plan, provide the required disclosures and to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position. We adopted this statement effective December 31, 2006. The implementation of SFAS No. 158 did not have a material impact on our Consolidated Financial Statements. See Note 12 of Notes to Consolidated Financial Statements.
addresses diversity in practice in quantifying financial statement misstatements and the potential for the build up of improper amounts on the balance sheet. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. Management has reviewed the SAB in connection with our consolidated financial statements for the current and prior periods, and has determined that its adoption did not have an impact on any of these financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 (i) defines fair value, (ii) establishes a framework for measuring fair value in GAAP and (iii) expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007. We adopted SFAS No. 157 effective January 1, 2008 and are currently evaluating the impact of adoption, which could be material, on our consolidated financial statements. In accordance with SFAS No. 157, we will be required to incorporate into the fair value of our derivative instruments an adjustment that reflects the credit quality of Radian Group Inc. When valuing debt and derivative liabilities, a widening of the obligor’s credit spread results in a reduction of the fair value of the liabilities. Radian’s credit spread has widened substantially since the beginning of 2007. Between January 1, 2007 and February 29, 2008, Radian’s 5-year credit default swap spreads increased by 998 basis points, from 37 basis points to 1,035 basis points. In accordance with FSP SFAS No. 157-2 “Effective Date of FASB Statement No. 157,” we have elected to defer the effective date of SFAS No. 157 for nonfinancial assets and liabilities until January 1, 2009.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin (“ARB”) No. 51” (“SFAS No. 160”). The objective of SFAS No. 160 is to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in consolidated financial statements by establishing accounting and reporting standards. These standards require: (i) the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; (ii) the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income, (iii) changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently; (iv) when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value and (v) entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. Management currently is considering the impact of the adoption of SFAS No. 160.
In September 2005, Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”), was issued. This SOP provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The adoption of SOP 05-1 on January 1, 2007, did not have a material impact on our Consolidated Financial Statements.
The EITF reached a consensus on EITF Issue No. 06-5, “Accounting for Purchases of Life Insurance-Determining the Amount that Could be Realized in Accordance with FASB Technical Bulletin No. 85-4” (“EITF No. 06-5”). EITF No. 06-5 addresses (i) whether a policyholder should consider any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the amount that could be realized under the insurance contract in accordance with Technical Bulletin No. 85-4, (ii) whether a policyholder should consider the contractual ability to surrender all of the individual-life policies (or certificates in a group policy) at the same time in determining the amount that could be realized under the insurance contract in accordance with Technical Bulletin No. 85-4, “Accounting for Purchases of Life Insurance” and (iii) whether the cash surrender value component of the amount that could be realized under the insurance contract in accordance with Technical Bulletin No. 85-4 should be discounted in accordance with APB Opinion No. 21, “Interest on Receivables and Payables”, when contractual limitations on the ability to surrender a policy exist. EITF No. 06-5 is effective for fiscal years beginning after December 15, 2006. The impact as a result of our adopting EITF No. 06-5 effective January 1, 2007, was not material to our consolidated financial statements.
In May 2007, the FASB issued FSP FIN No. 48-1, “Definition of Settlement in FASB Interpretation No. 48” (“FSP FIN No. 48-1”) which clarifies when a tax position is considered settled under FIN No. 48. FSP FIN No. 48-1 is applicable at the adoption of FIN No. 48, which was January 1, 2007 for us and did not have a material impact on our tax position at December 31, 2007.
PricewaterhouseCoopers LLP, an independent registered public accounting firm, was retained to audit Radian Group Inc.’s (“Radian’s”) Consolidated Financial Statements. The accompanying report of PricewaterhouseCoopers LLP is based on its audit, which it is required to conduct in accordance with the standards of the Public Company Accounting Oversight Board (U.S.), and which includes the consideration of Radian’s internal control over financial reporting to establish a basis for reliance thereon in determining the nature, timing and extent of audit tests to be applied.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of changes in common stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Radian Group Inc. and its subsidiaries (the “Company”) at December 31, 2007, and the results of their operations and their cash flows for the year ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the Index appearing under Item 15 as of and for the year ended December 31, 2007 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because a material weakness in internal control over financial reporting related to management not maintaining a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles commensurate with the Company’s financial reporting requirements as of December 31, 2007. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. The material weakness referred to above is described in Management’s Report on Internal Control over Financial Reporting included in Item 9a. We considered this material weakness in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 consolidated financial statements and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements. The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in management’s report referred to above. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Our financial guaranty segment provides credit-related insurance coverage through credit default swaps and certain other financial guaranty contracts to meet the needs of customers and counterparties in a wide variety of domestic and international markets on a direct and assumed basis related to public finance bonds and structured finance obligations. In 2005, we placed our trade credit reinsurance line of business into run-off.
Until September 30, 2004, our financial guaranty business also included our ownership interest in Primus Guaranty, Ltd. (“Primus”), a Bermuda holding company and parent to Primus Financial Products, LLC, a provider of credit risk protection to derivatives dealers and credit portfolio managers on individual investment-grade entities. In September 2004, Primus issued shares of its common stock in an initial public offering. We sold a portion of our shares in Primus as part of this offering. In 2005 and during the first quarter of 2006, we sold all of our remaining interest in Primus, recording a pre-tax gain of $2.8 million in 2005 and a pre-tax gain of $21.4 million in 2006.
Determinations of ratings by the rating agencies are affected by a variety of factors, including macroeconomic conditions, economic conditions affecting the mortgage insurance and financial guaranty industries, changes in regulatory conditions, competition, underwriting, risk management assessment, investment losses, earnings volatility, the perceived need for additional capital, if necessary, and the ability to raise capital and the perceived instability in the ongoing franchise value of participants in these industries.
Our principal operating subsidiaries had been assigned the following ratings as of the date of this report:
(1) Fitch continues to rate us and our subsidiaries despite our request to Fitch on September 5, 2007 that Fitch immediately withdraw all of its ratings for us and our subsidiaries.
(2) Each Moody’s rating for our mortgage insurance subsidiaries is currently under review for possible downgrade.
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of all wholly-owned subsidiaries. Companies in which we, or one of our subsidiaries, own interests ranging from 20% to 50%, are accounted for in accordance with the equity method of accounting (see Note 4). All intercompany accounts and transactions, and intercompany profits and losses, have been eliminated.
In December 2003, the Financial Accounting Standards Board (“FASB”) revised FASB Interpretation No. 46 (“FIN No. 46R”), “Consolidation of Variable Interest Entities”, which addresses consolidation by business enterprises of variable interest entities. FIN No. 46R has not had a material impact on our Consolidated Financial Statements. We regularly monitor our variable interest entities for possible consolidation.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. While the amounts included in our consolidated financial statements include our best estimates and assumptions, actual results may vary.
In our financial guaranty business, insurance premiums are earned in proportion to the level of amortization of insured principal over the contract period or over the period that coverage is provided. Unearned premiums
Credit enhancement fees on derivative contracts are included in premiums written and are earned over the period that credit protection is provided.
In the mortgage insurance segment, reserves for losses generally are not established until we are notified that a borrower has missed two consecutive payments. LAE consists of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. We maintain an extensive database of claim payment history and use models, based on a variety of loan characteristics, including the status of the loan as reported by its servicer, and macroeconomic factors such as regional economic conditions that involve significant variability over time, as well as more static factors such as the estimated foreclosure period in the area where the default exists, to help determine the likelihood that a default will result in a claim (referred to as the “claim rate”), the amount that we will pay if a default becomes a claim (referred to as “claim severity”) and based on these estimates, the appropriate loss reserve at any point in time.
With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for delinquent loans in the early stage of delinquency are more volatile in nature than for loans that are in the later stage of delinquency. As the delinquency proceeds toward foreclosure, there is more certainty around these estimates as a result of the aged status of the delinquent loan, and adjustments are made to loss reserves to reflect this updated information. If a default cures (historically, a large percentage of defaulted loans have cured before going to claim, although this rate has fallen significantly during 2007 as a result of the deteriorating housing market), the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. We do not specifically reserve for defaults that we believe to have occurred but that have not been reported to us on a timely basis by lending institutions or for loans that we believe have cured but that have not been reported to us on a timely basis. We believe this number would not be material. All estimates are continually reviewed and adjustments are made as they become necessary.
As mentioned above, we generally do not establish reserves for loans that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second-loss position, we calculate what the reserve would have been if there had been no deductible. If the existing deductible is greater than the reserve amount for any given default, we do not establish a reserve for the default. See “Reserve for Second-Lien Premium Deficiency” below for an exception to this general principle.
Because of the ambiguities in the application of SFAS No. 60 to our loss reserving policy, we do not believe that SFAS No. 60 alone provides sufficient guidance for our reserving policy, particularly with respect to establishing non-specific reserves before an insured event is reported. As a result, we and other members of the financial guaranty industry, supplement the principles of SFAS No. 60 with those of SFAS No. 5, “Accounting for Contingencies,” which calls for the establishment of reserves when it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. We also rely by analogy on SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” and the Emerging Issues Task Force (“EITF”) Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which state that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5. Establishing non-specific reserves for credits that have not yet defaulted is a practice followed by the entire financial guaranty industry, although there may be differences in the specific methodologies used by other financial guarantors in establishing and classifying these reserves. We believe that our financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that credit-based insurance involves a gradual deterioration of credit over time. However, because of the lack of specific accounting literature comprehensively addressing the unique attributes of financial guaranty contracts, the accounting principles applicable to our loss reserving policy are subject to change.
Our financial guaranty insurance contracts provide an unconditional and irrevocable guaranty to the holder of a financial obligation that, upon payment default by the insured obligor, we will pay the full amount of principal and interest on an insured obligation when due. Our financial guaranty reinsurance contracts provide for reimbursement to the primary insurer under a reinsured financial guaranty contract when the primary insurer is obligated to pay principal and interest on an insured obligation. The following description of our financial guaranty loss reserving policy relates only to non-derivative financial guaranty contracts provided through financial guarantees of direct and assumed insurance business.
We establish loss reserves on our financial guaranty contracts based on the estimated cost of settling claims, including associated LAE, adjusted for estimated recoveries under salvage or subrogation rights. Our financial guaranty loss reserves are comprised of specific reserves (which we refer to as “case reserves”) and non-specific reserves.
We record non-specific reserves to reflect the deterioration of insured credits that have not yet defaulted. We determine this deterioration in two ways. First, we record non-specific reserves for losses when we identify through our surveillance procedures or, in the case of reinsurance, after we confirm information provided by the primary insurer regarding, specific significant deterioration events that have occurred with respect to specific insured credits that have not yet defaulted. We refer to this category of our non-specific reserves as “allocated non-specific reserves.” Second, because we believe that inherent deterioration begins immediately and continues over time on our remaining portfolio, we also record non-specific reserves for other losses, on a portfolio basis. We refer to this category of non-specific reserves as “unallocated non-specific reserves.”
Our unallocated non-specific reserves are established over time by applying expected default factors to the premiums earned during each reporting period on each credit for which we have not established a case reserve or an allocated non-specific reserve. The expected frequency and severity of losses for each credit is generated from three sources-two that are published by major rating agencies and one that is generated by a proprietary internal model-based on the product class, published rating and term to maturity for each credit. We set the expected life-time losses for each credit at a point in the range between the highest and lowest expected life-time loss factors generated by the rating agency and internally generated models. The default rates published by rating agencies tend to be very low because we mainly insure investment-grade obligations that, historically, have a very low probability of default. Although the default rate is low, the amount of losses upon default can be very high because we tend to insure large financial obligations. Because of the low incidence of losses on financial guaranty obligations, it is also very difficult to estimate the timing of losses on our insured obligations for which we have not yet established a case reserve or allocated non-specific reserve. The default factors for the year ended December 31, 2007 approximated 10% of earned premiums on public finance credits and 15% of earned premiums on structured finance credits. The default factors for the years ended December 31, 2006 and 2005 approximated 10% of earned premiums on public finance credits and 20% of earned premiums on structured finance credits. As a result of favorable loss development, we were able to lower the default factor for structured finance credits in 2007.
depending on the size of the necessary case reserve and the adequacy of the remaining non-specific reserve with respect to the other credits in our portfolio. In addition, establishing case reserves may require a provision beyond what is then included in non-specific reserves. Establishing reserves can reduce our net income when unallocated non-specific reserves are increased, when allocated non-specific reserves are established in an amount that exceeds unallocated non-specific reserves, or when case reserves are established in an amount that exceeds non-specific reserves. Conversely, a reduction of reserves, due to improved economic conditions or a cure of a default with respect to a specific credit for which a case reserve has been established, or otherwise, can lead to an increase in our net income.
We periodically evaluate our estimates for losses and LAE and adjust such reserves based on our actual loss experience, mix of business and economic conditions. Changes in total estimates for losses and LAE are reflected in current earnings. We believe that our total reserves for losses and LAE are adequate to cover the ultimate cost of all claims net of reinsurance recoveries. Setting the loss reserves in both business segments involves significant reliance upon estimates with regard to the likelihood, magnitude and timing of a loss. The models and estimates we use to establish loss reserves may not prove to be accurate, especially during an extended economic downturn. Ultimate losses and LAE may differ materially from amounts currently recorded. All changes in these estimates are recorded in the period in which such changes are identified.
We periodically review and evaluate the future profitability of each separate product line in our mortgage insurance segment. We evaluate premiums of first-lien and second-lien categories separately for this assessment. Our second-lien business is considered to be a separate product line. The business is managed separately, priced differently from our traditional products and the customer base is different from that of our traditional products. While second-lien performance was consistently below expectations and had begun to deteriorate further in 2006, it became apparent in the third quarter of 2007 that future premiums would not be sufficient to cover future losses and expenses. In the third quarter of 2007, we established a reserve for premium deficiency on our second-lien business. We established a premium deficiency reserve since we believe that the net present value of the expected future losses and expenses will exceed expected future premiums and existing reserves. To calculate the premium deficiency, we project future premiums and losses for our second-lien business on a deal-by-deal basis, using historical results to help determine future performance for both repayments and claims. An estimated expense factor is then applied, and the result is discounted using an applicable rate of return, which was 4.03% at December 31, 2007. This net present value, less any existing reserves, is recorded as a premium deficiency and the reserve is updated on a quarterly basis based on actual results for that quarter, along with updated deal level projections.
Trading securities, hybrid securities, NIMS bonds, credit default swaps and financial guaranty derivative contracts are recorded at fair value as described in Notes 15 and 16. All derivative instruments and contracts are recognized on our consolidated balance sheets as either assets or derivative liabilities, depending on the rights or obligations provided under the contracts. The interest-rate swaps that we have entered into qualify as hedges and are accounted for as fair value hedges at December 31, 2007. All changes in fair value of derivatives, other than for the interest-rate swaps, are included in the statements of income. Credit default swaps and certain other derivative contracts with a positive fair value are included in other assets on our consolidated balance sheets. See Note 15 for further discussion.
In February 2006, the FASB issued SFAS No. 155, an amendment of SFAS Nos. 133 and 140. As discussed below in “Investments”, we adopted SFAS No. 155 on January 1, 2007. Accordingly, securities that were previously classified as available for sale and trading securities on our consolidated balance sheets were reclassified to hybrid securities on our consolidated balance sheets on the date of adoption and as provided by SFAS No. 155, we elected to record convertible securities at fair value and changes in the fair value are recorded as net gains or losses on securities.
Costs associated with the acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs. Amortization of these costs is charged against earnings in proportion to estimated gross profits over the estimated life of the policies using the guidance provided by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” This amount includes accrued interest on the unamortized balance of deferred policy acquisition costs. Estimates of expected gross profit, which consider persistency and loss development assumptions for each underwriting year and product type, are evaluated regularly, and the total amortization recorded is adjusted by a charge or credit to our consolidated statements of income if actual experience or other evidence suggests that earlier estimates should be revised. Considerable judgment is used in evaluating these estimates and the assumptions on which they are based. The use of different assumptions could have a significant effect on the amortization of deferred policy acquisition costs. In 2007, an increase in persistency rates was largely offset by increased loss rates, resulting in no material change in estimate. In 2006 and 2005, as a result of the decrease in the persistency rate, we accelerated the amortization of
Deferred policy acquisition costs in the financial guaranty business are comprised of those expenses that vary with, and are principally related to, the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses, offset by commission income on premiums ceded to reinsurers. Acquisition costs are deferred and amortized over the period in which the related premiums are earned for each underwriting year. The amortization of deferred policy acquisition costs is adjusted regularly based on the expected timing of both upfront and installment-based premiums. The estimation of installment-based premiums requires considerable judgment, and different assumptions could produce different results. Total deferred acquisition costs for financial guaranty amortized during 2007, 2006 and 2005 was $45.4 million, $46.6 million and $53.0 million, respectively.
As noted under “Reserve for Losses” above, the FASB is considering changing materially the accounting model used by the financial guaranty industry for deferred policy acquisition costs.
Assets and liabilities denominated in foreign currencies are translated at year-end exchange rates in accordance with SFAS No. 52, “Foreign Currency Translation”. Operating results are translated at average rates of exchange prevailing during the year. Unrealized gains and losses, net of deferred taxes, resulting from translation are included in accumulated other comprehensive income in stockholders’ equity. Gains and losses resulting from transactions in foreign currency are recorded in current period net income.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments classified as available for sale are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. Investments classified as trading securities and derivatives are reported at fair value, with unrealized gains and losses reported as a separate component of
Radian is the beneficiary of insurance policies on the lives of certain of our current and past officers and employees. We have recognized the amount that could be realized upon surrender of the insurance policies in other assets in our consolidated balance sheets. At December 31, 2007 and 2006, the amount of company-owned life insurance totaled $65.5 million and $62.5 million, respectively.
In December 2004, the FASB issued SFAS No. 123R (“SFAS No. 123R”), “Share-Based Payment”, which requires compensation cost related to share-based payment transactions to be recognized in an issuer’s financial statements. The compensation cost, with limited exceptions, is measured based on the grant-date fair value of the equity or liability instrument issued. In October 2005, the FASB issued Staff Position No. SFAS No. 123(R)-2, “Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R),” to provide guidance on the application of the term “grant date” in SFAS No. 123R. In accordance with this Staff Position, the grant date of an award shall be the date the award is approved by our board of directors if, at such time, (i) the recipient of the award does not have the ability to negotiate the key terms and conditions of the award and (ii) the key terms of the award are expected to be communicated to the recipients within a relatively short time period after the date of approval. SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-
On January 1, 2006, we adopted SFAS No. 123R using a modified prospective application as permitted by SFAS No. 123R. Accordingly, prior period amounts have not been restated. Under this application, we are required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Compensation cost is recognized over the periods that an employee provides service in exchange for the award. See Note 11.
Despite this recapture, this primary insurer customer renewed its reinsurance treaty with us on substantially the same terms. In March 2005, without cost to or concessions by us, this customer waived all of its remaining recapture rights with respect to the May 2004 downgrade by Moody’s. There are no remaining recapture rights with respect to the May 2004 downgrade by Moody’s.
We account for guarantees under FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guaranties, including Indirect Guaranties of Indebtedness of Others.” This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This Interpretation also incorporates, without change, the guidance in FIN No. 34, “Disclosure of Indirect Guaranties of Indebtedness of Others,” which was superseded. The Interpretation was applied to our guaranty of the performance of Sherman under a $25 million revolving credit facility that expired in December 2007.
In April 2006, the FASB issued FASB Staff Position (“FSP”) No. FIN No. 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)” (“FSP FIN No. 46(R)-6”), which addresses how a reporting enterprise should determine the variability to be considered in applying FASB
In September 2006, the SEC released Staff Accounting Bulletin (“SAB”) No. 108 (“SAB No. 108”). This release expresses the SEC’s views regarding the process of quantifying financial statement misstatements and addresses diversity in practice in quantifying financial statement misstatements and the potential for the build up of improper amounts on the balance sheet. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. Management has reviewed the SAB in connection with our consolidated financial statements for the current and prior periods, and has determined that its adoption did not have an impact on any of these financial statements.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of APB No. 51” (“SFAS No. 160”). The objective of SFAS No. 160 is to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in consolidated financial statements by establishing accounting and reporting standards. These standards require that: (i) the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; (ii) the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; (iii) changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently; (iv) when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value and (v) entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. Management currently is considering the impact and disclosure requirements that may result from the adoption of SFAS No. 160.
In April 2007, the FASB issued FSP FIN No. 39-1, an amendment of FASB Interpretation No. 39, “Offsetting of Amounts Related to Certain Contracts” (“FSP FIN No. 39-1”). FSP FIN No. 39-1 replaces the terms “conditional contracts” and “exchange contracts” with the term “derivative instruments” and permits a reporting entity to offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement that have been offset in the statement of financial position. FSP FIN No. 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. We plan to adopt FSP FIN No. 39-1 in the first quarter of 2008 and are currently considering the impact, if any, that may result from the adoption.
The EITF reached a consensus on EITF Issue No. 06-4, “The Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (“EITF No. 06-4”). EITF No. 06-4 addresses whether the postretirement benefit associated with an endorsement split-dollar life insurance arrangement is effectively settled in accordance with SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and APB Opinion No. 12, “Omnibus Opinion-1967”, upon entering into such an arrangement. EITF No. 06-4 is effective for fiscal years beginning after December 15, 2007. Management currently is evaluating the impact, if any, on our consolidated financial statements. We will adopt EITF No. 06-4 in the first quarter of 2008.
The EITF reached a consensus on EITF Issue No. 06-5, “Accounting for Purchases of Life Insurance-Determining the Amount that Could be Realized in Accordance with FASB Technical Bulletin No. 85-4” (“EITF No. 06-5”). EITF No. 06-5 addresses (i) whether a policyholder should consider any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the amount that could be realized under the insurance contract in accordance with Technical Bulletin No. 85-4, (ii) whether a policyholder should consider the contractual ability to surrender all of the individual-life policies (or certificates in a group policy) at the same time in determining the amount that could be realized under the insurance contract in accordance with Technical Bulletin No. 85-4, “Accounting for Purchases of Life Insurance” and (iii) whether the cash surrender value component of the amount that could be realized under the insurance contract in accordance with Technical Bulletin No. 85-4 should be discounted in accordance with APB Opinion No. 21, “Interest on Receivables and Payables”, when contractual limitations on the ability to surrender a policy exist. EITF No. 06-5 is effective for fiscal years beginning after December 15, 2006. The impact as a result of our adopting EITF No. 06-5 effective January 1, 2007, was not material to our Consolidated Financial Statements.
For the years ended December 31, 2007, 2006 and 2005, we did not sell any fixed-maturity investments classified as held to maturity.
The change in unrealized gains and losses recorded in accumulated other comprehensive income consisted of (in thousands):
The unrealized losses of 12 months or greater duration as of December 31, 2007 on the majority of the securities in this category were caused by market interest rate movement. Certain securities, mainly those issued by financial firms with exposure to subprime residential mortgages experienced spread widening during 2007. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities had been in a continuous unrealized loss position at December 31, 2006.
C-BASS is an unconsolidated, less than 50%-owned investment that is not controlled by us. Historically, C-BASS has been principally engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages. Beginning in February 2007 and continuing through approximately the end of March 2007, the subprime mortgage market experienced significant turmoil. After a period of relative stability that persisted during April, May and through approximately late June, market dislocations recurred and then accelerated to unprecedented levels beginning in approximately mid-July 2007. As a result, C-BASS ceased purchasing mortgages and mortgage securities and its securitization activities in the third quarter of 2007, and sold its loan servicing platform to Goldman Sachs in the fourth quarter of 2007. In connection with this sale, Goldman Sachs paid a nominal amount for the option to purchase from the current owners of C-BASS, including us, 45% of the equity of C-BASS for approximately $5 million. We estimated that this option had a fair value of $0 at December 31, 2007.
We account for our investment in C-BASS under the equity method of accounting in accordance with Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (“APB Opinion No. 18”). During the third quarter of 2007, C-BASS incurred a loss of $935 million and in accordance with APB Opinion No. 18, we recognized our portion of losses of approximately $441 million. This resulted in a reduction in our equity investment in C-BASS from $468 million to $27 million at September 30, 2007. In addition to the recognition of losses, we completed an impairment analysis which resulted in the charge-off of the remaining carrying value of $27 million in the equity investment in C-BASS at September 30, 2007.
On July 19, 2007, in order to support C-BASS’s liquidity position, we entered into a $50 million unsecured revolving credit facility agreement with C-BASS that is payable on demand and was scheduled to expire December 31, 2007. On July 20 and 23, 2007, C-BASS drew down the entire $50 million on this facility. On July 30, 2007, in accordance with the terms of our credit facility with C-BASS, we demanded full and immediate payment of all amounts owed to us under the credit facility. These amounts currently remain outstanding. Amounts drawn on this facility bear interest at a rate of one-month London Interbank Offered Rate (“LIBOR”) at the date the amount is drawn plus 2.875%. If the loan is called for payment, but remains unpaid as currently is the case, the facility bears interest at LIBOR plus 6.875%. In addition, a 0.375% facility fee is payable to us.
EITF No. 98-13, “Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee” (“EITF No. 98-13”), requires that when the recognition of equity losses reduces our equity investment to zero, we should continue to report our share of equity method losses in our income statement and should apply those equity method losses to our other investments in C-BASS. As a result of the additional losses at C-BASS, and continued application of APB Opinion No. 18 and EITF No. 98-13, we recorded a full write-off of our $50 million credit facility with C-BASS. The ultimate collectibility of this loan is uncertain.
As restructured, we were granted an option to purchase, effective July 1, 2006:
4.17% of the Class A Common Units outstanding after the reclassification, which represented 3.92% of the common equity interests in Sherman prior to the reclassification; and
On September 22, 2006, we paid $65.3 million to an entity controlled by Sherman’s management team in connection with the exercise of our restructured option. The purchase price consisted of approximately $44.8 million for the Class A Common Units and approximately $20.5 million for the Preferred Units.
2007 Sale of Partial Interest. On September 19, 2007, we sold to Sherman Capital, L.L.C. (“Sherman Capital”), an entity owned by the management of Sherman: (1) all of our preferred interests in Sherman and (2) 1,672,547 Class A Common Units in Sherman, representing approximately 43.4% of our total common interests in Sherman, for a cash purchase price of approximately $277.6 million, plus a future contingent payment. The amount of the contingent payment, if any, will depend on the extent that Sherman Capital’s after-tax return on 1,425,335 of the Class A Common Units acquired in the transaction exceeds approximately
16% annually. The contingent payment is payable to us on December 31, 2013 or earlier upon the closing of a sale of Sherman. We recorded a gain of $181.7 million on the sale of our interest in Sherman.
The following tables show selected financial information for C-BASS and Sherman for the years ended December 31, 2007 and 2006:
C-BASS’s management is expected to issue audited financial statements for 2007 by the end of March 2008, that are required to be included in this Form 10-K. The summarized C-BASS financial information for 2007 included in this report will be updated, if required, at the time those audited financial statements are included in this Form 10-K, and it is possible that adjustments may be material. Because the carrying value of our investment in C-BASS has been fully written down, we do not expect that any change to the summarized C-BASS financial information will have a material impact on our consolidated financial statements.
Radian Guaranty entered into ten-year variable quota share treaties in each of the years 1994 through 1997 to reinsure its primary risk originated in each of these years and a portion of its pool risk written in 1997. The term of each treaty was 10 years and was non-cancelable by either party except under certain conditions. Under the terms of the treaties, Radian Guaranty ceded premiums to the reinsurer based on 15% of the premium received on the covered business. Radian Guaranty was entitled to receive a commission ranging from 30% to 32% of the premium paid under the treaty provided that certain loss rates were not exceeded. In return for the payment of the ceded premium, Radian Guaranty received variable quota-share loss relief at levels ranging from 7.5% to 15.0% based upon the loss ratio on the covered business. The treaties also included underwriting-year excess coverage that entitled Radian Guaranty to receive 8% of the premium written on the covered business under each treaty at the end of the fourth, seventh and tenth years to the extent that this amount was greater than the total amount previously received under the variable quota-share coverage provision of the treaty. Premiums were payable to the reinsurer on a quarterly basis net of commissions due and any losses calculated under the variable quota-share coverage.
the tenth year of the 1997 treaty. In December 2006, Radian Guaranty terminated the remaining variable quota-share reinsurance treaty, as allowed under the terms of the treaty.
We and other companies in the mortgage insurance industry participate in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically establishes a reinsurance company that assumes part of the risk associated with the portfolio of that lender’s mortgages insured by us on a flow basis (as compared to mortgages insured in structured transactions, which typically are not eligible for captive reinsurance arrangements). In return for the reinsurance company’s assumption of a portion of the risk, we cede a portion of the mortgage insurance premiums paid to us to the reinsurance company. In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development, such as losses brought on by significant national or regional downturns in the real estate market. Until recently, losses under most captive reinsurance treaties have not approached a level requiring payment to us. However, in the current credit environment in which losses have increased significantly, it is likely that many captive reinsurance treaties relating to the 2006 through 2007 insured mortgage portfolios will attach and require payment to us from the captive reinsurer. Ceded losses recoverable from such captives began to be booked in the fourth quarter of 2007, and should accelerate throughout 2008, although most cash recoveries are not expected until 2009 and later. Depending on market conditions, captive reinsurance could serve as a significant source of reinsurance recoveries for us beginning in 2009. We also offer, on a limited basis, “quota share” captive reinsurance agreements under which the captive reinsurance company assumes a pro rata share of all losses in return for a pro rata share of the premiums collected.
The captive reinsurers are typically required to maintain minimum capitalization equal to 10% of the risk assumed. Risk ceded under captive reinsurance arrangements at December 31, 2007, and 2006, was $2.8 billion and $2.4 billion, respectively. For the years ended December 31, 2007, 2006 and 2005, Radian Guaranty had ceded premiums written of $138.7 million, $116.2 million and $91.8 million, respectively, and ceded premiums earned of $134.6 million, $116.6 million and $90.7 million, respectively, under these various captive reinsurance arrangements. Ceded losses in 2007 were $3.9 million. In 2006 and 2005, ceded losses were not significant.
We protect against losses in excess of our expectations on some of the risk associated with non-prime and riskier products by reinsuring this business through Smart Home transactions. In 2004, we developed Smart Home as a way to effectively transfer risk from our portfolio to investors in the capital markets. Smart Home mitigates our risk against catastrophic loss, concentrated positions and riskier products. As a result, Smart Home arrangements are important in managing our risk profile, especially in the non-prime market. Approximately 5% and 10% of our primary mortgage risk in force was included in Smart Home arrangements at December 31, 2007 and 2006, respectively. In these transactions, we reinsure the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions.
We establish reserves to provide for the estimated losses from claims and LAE on defaults (or delinquencies) reported.
The following tables present information relating to our mortgage insurance reserves and LAE (in thousands):
The following tables present information relating to our financial guaranty reserves and LAE (in thousands):
generated by any of the three models was approximately $25 million to $67 million, which we believe provides a reasonably likely range of expected losses.
We discount financial guaranty case reserves arising from defaults that involve claim payments over an extended period of time. The discount rate corresponds to our statutory investment yield of 4.40% in 2007 and 4.36% in 2006. Discounted liabilities at December 31, 2007, were $9.2 million, net of discounts of $3.1 million, compared to discounted liabilities of $9.9 million, net of discounts of $4.2 million, at December 31, 2006. We do not discount our non-specific reserves.
The following table shows our case and non-specific reserves for losses and loss adjustment expenses for our financial guaranty business, and case reserves and incurred but not reported (“IBNR”) related to the non-financial guaranty businesses included in our financial guaranty segment as of the indicated dates (in thousands):
The composition of our long-term debt and other borrowings at December 31, 2007 and December 31, 2006 was as follows:
Our unsecured revolving credit facility requires us to maintain a consolidated net worth of at least $2 billion. In addition, under the credit facility, our senior debt ratings, as provided by S&P and Moody’s, may not (1) at the same time be lower than A-for S&P and A3 for Moody’s, or (2) be lower than either BBB for S&P or Baa2 for Moody’s. At December 31, 2007 and 2006, we were in compliance with all debt covenants.
If the Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired, and investors, through their equity investment in the Radian Asset Securities preferred stock, would have rights to the assets of Radian Asset Assurance as an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholders’ claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of ours, through EFSG, as the owner of the common stock of Radian Asset Assurance. If all the Radian Asset Assurance put options were exercised, Radian Asset Assurance would receive up to $150 million in return for the issuance of its own perpetual preferred stock, the proceeds of which would be usable for any purpose, including the payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock.
The aggregate fair value of the put options, is recorded as an asset or derivative liabilities and changes in the fair value of the put options are recorded as a change in fair value of derivatives. At December 31, 2007 we recorded an asset of approximately $35 million and a change in fair value of derivatives of approximately $32 million. Prior to the fourth quarter of 2007, the value of the put options and the put premium were immaterial to our consolidated financial statements.
The components of our consolidated income tax (benefit) provision are as follows (in thousands):
The reconciliation of taxes computed at the statutory tax rate of 35% for 2007, 2006 and 2005, to the (benefit) provision for income taxes is as follows (in thousands):
We believe that our deferred tax assets will more likely than not be fully realized in future periods and, therefore, we have not established a valuation allowance with respect to such assets.
Cumulative T&L bonds purchased and subsequent redemptions are reflected in the balance of prepaid federal income taxes on our consolidated balance sheets. During 2007, we redeemed approximately $15.3 million of T&L bonds, net of current year T&L bonds purchased. Prepaid federal income taxes include T&L bonds of $793.5 million and $808.7 million at December 31, 2007 and 2006, respectively.
We have taken a position in various jurisdictions that we are not required to remit taxes with regard to the income earned on our investment in certain partnership interests. Although we believe that these tax positions are likely to succeed if adjudicated in a court of last resort, measurement under FIN No. 48 of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Over the next twelve months, additional taxable income or taxable losses may be generated from these investments, which would require increases or decreases in our calculations of potential state and local taxes, including any penalty and interest thereon. An estimate of the taxable income or loss, the character of such income or loss and its impact to the current income taxes payable over the next 12-month period cannot be reasonably made at this time.
The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of residual interests in REMICs and has proposed adjustments to us denying the
(1) Our U.S. federal corporation income tax returns filed for calendar years 2000 through 2004 are currently being examined by the Internal Revenue Service (“IRS”). The IRS may also open the 1999 tax year for examination under Internal Revenue Code Section 6501(e) (“IRC Section 6501(e)”). With regard to the 1999 calendar year, we have agreed to extend the statute of limitations for the assessment of tax to June 30, 2008. The extension of the statute of limitations is contingent upon the IRS’s successful application of the provisions of IRC Section 6501(e). With regard to calendar years 2000 through 2003, we have also agreed to extend the statute of limitations for the assessment of tax to June 30, 2008. All such statute of limitation extensions, including the 1999 calendar year extension, have limited the scope of the examinations to the recognition of certain tax benefits that were generated through our investment in a portfolio of residual interests in Real Estate Mortgage Investment Conduits (“REMICs”).
surplus at December 31, 2007 of $10.3 million and $26.1 million, respectively. In addition, without the prior approval of the Pennsylvania Insurance Commissioner, an insurer only may pay dividends during any 12-month period in an aggregate amount less than or equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus, or (ii) the preceding year’s statutory net income. In accordance with this test, no amounts would be available for dividends from Radian Guaranty and Radian Insurance in 2008. Radian Insurance has not paid any dividends to Radian Guaranty, its immediate parent company. Radian Guaranty paid $150.9 million of dividends in 2007 and transferred its investment in Sherman of $104 million in 2007 to Radian Group.
Amerin Guaranty’s ability to pay dividends on its common stock is restricted by certain provisions of the insurance laws of Illinois. The insurance laws of Illinois establish a test limiting the maximum amount of dividends that may be paid from unassigned surplus by an insurer without prior approval by the Illinois Insurance Commissioner. Under this test, Amerin Guaranty may pay dividends during any 12-month period in an aggregate amount less than or equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus, or (ii) the preceding year’s statutory net income. In accordance with this test, Amerin Guaranty would not be able to pay a dividend in 2008 without prior regulatory approval.
The FSA requires insurance companies to maintain minimum capital, calculated with reference to gross written premiums. RAAL’s equity shareholder’s funds and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
Radian Guaranty’s statutory net (loss) income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 was as follows:
In March 2008, Radian Group contributed $15 million to Amerin Guaranty in order for them to be in compliance with Illinois insurance regulations.
Radian Insurance’s statutory net (loss) income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 was as follows:
The differences between the statutory net income and surplus and the consolidated net income and equity presented on a GAAP basis, represent differences between GAAP and Statutory Accounting (“STAT”) for the following reasons:
(g) Under STAT, SFAS No. 123R is not applicable. SFAS No. 123R has been adopted for our GAAP financial statements.
(h) Under STAT, change in fair value of derivatives is not recorded, except for changes associated with known credit losses. Any loss payments that are made are included in the provision for losses.
We have an equity compensation plan, the Radian Group Inc. Equity Compensation Plan (the “Plan”), under which we may provide grants of incentive stock options, non-qualified stock options, restricted stock, stock appreciation rights (referred to as “SARs”), performance shares and phantom stock. To date, all awards granted under the Plan have been in the form of non-qualified stock options, restricted stock and phantom stock. The Plan provides for the grant of all options (other than incentive stock options to holders of 10% of our voting shares) at an option price per share equal to 100% of the market price of our common stock on the date of grant. The Plan authorizes the issuance of up to 9,400,000 shares of our common stock, of which there are approximately 175,254 shares remaining available for grants under the Plan as of December 31, 2007. Officers and other employees (of Radian or its affiliates) are eligible to participate in the Plan. Non-employee directors are also eligible to participate in the Plan, but are not permitted to receive grants of incentive stock options.
We elected to apply the short-cut method in accounting for the windfall of tax benefits under SFAS No. 123R. Should future offsets to the windfall as a result of cancellations, expirations or exercise shortfalls exceed the balance of $25.6 million at December 31, 2007, the excess would be reflected in the Consolidated Statements of Income.
(1) Beginning in 2006, with the adoption of SFAS No. 123R, the expected life of stock options granted was based on the simplified method. Stock options have historically been granted with a vesting period of three or four years, expiring over seven or 10 years.
for non-employee directors, the grantee’s departure from the board of directors;
The amount of cash received from the exercise of stock options for the years ended December 31, 2007 and 2006 was approximately $25.3 million and $26.9 million, respectively, and the related tax benefit was approximately $8.9 million and $9.4 million, respectively. The total intrinsic value of options exercised, at the
We generally issue shares from unissued reserved shares for exercises with an exercise price less than the treasury stock repurchase price and from treasury stock when the exercise price is greater than the treasury stock repurchase price.
The table summarizes information regarding fully vested share options as of December 31, 2007 and 2006:
The weighted average fair value per share of the stock options granted during the years ended December 31, 2007, 2006 and 2005 was $7.03, $16.61 and $17.43, respectively.
The following table summarizes information concerning outstanding and exercisable options at December 31, 2007:
The Compensation Committee may issue shares of our common stock under a grant of restricted stock under the Plan. The shares underlying a grant are issued in consideration for services rendered having a value, as determined by our board of directors, at least equal to the par value of the common stock. If a grantee’s relationship with us terminates while the shares are subject to restrictions imposed by the Compensation Committee, the restricted stock grant will terminate with respect to all shares that are subject to restrictions, and such shares must be immediately returned to us. While shares are subject to restrictions, a grantee may not sell, assign, transfer, pledge or otherwise dispose of the shares of our common stock, except to a successor grantee in the event of the grantee’s death. All restrictions imposed under a restricted stock grant lapse after the applicable restriction period or as the Compensation Committee may determine. Each share of restricted stock is granted at full value with no exercise price.
The Compensation Committee may grant phantom stock awards under the Plan, which entitle grantees to receive shares of our common stock on a date (referred to in the Plan as the conversion date) established by the Compensation Committee. The phantom stock may be subject to further vesting restrictions as the Compensation Committee determines. Unless otherwise provided in a grant letter, if a grantee’s relationship with us terminates during any period in which vesting restrictions apply, the phantom stock grant terminates as to all shares covered by the grant as to which vesting restrictions have not lapsed and such shares will be forfeited. Our practice to date has been to grant fully vested phantom stock to directors with a conversion date upon the termination of the director’s relationship with us. In addition, we are also using phantom stock to fund awards issued under our Performance Share Plan adopted in 2005. See “Performance Shares” below. Each share of phantom stock is granted at full value with no exercise price. All phantom stock will be paid in whole shares of our common stock, with fractional shares paid in cash. At December 31, 2007, there were approximately 787 dividend-equivalent phantom stock shares accrued that were not included in the total number of outstanding shares. The amount recorded as stock-based compensation expense related to phantom stock for the years ended December 31, 2007, 2006 and 2005 was $(3.4) million, $1.2 million and $3.1 million, respectively. The negative expense in 2007 relates to the reversal of previously recorded expense due to declines in the market price of our common stock.
The following are assumptions used in our calculation of ESPP compensation expense during 2007:
We have a Performance Share Plan (the “Program”). The Program is intended to motivate our executive officers by focusing their attention on critical financial indicators that measure our success. The performance share awards granted pursuant to the Program are funded by equity awards under the Plan. We are currently using phantom stock grants to fund awards under the Program. The Compensation Committee grants performance share awards to eligible participants with respect to performance periods of overlapping durations. Both the first and second performance periods under the Program are three-year periods that began on January 1, 2005 and January 1, 2006, respectively.
At the beginning of each performance period, a target number of performance shares are established for each participant in the Program. The performance shares are denominated in shares of common stock and are settled in common shares. The maximum payout under any performance share award is 250,000 shares of common stock. The amount of stock-based compensation expense related to performance shares for the years ended December 31, 2007 and 2006 was $(3.6) million and $3.2 million, respectively. The negative expense in 2007 relates to the reversal of previously recorded expense due to declines in the market price of our common stock.
Retirement benefits are a function of the years of service and the level of compensation. Assets of the plan are allocated as follows:
provide certain active participants in the Pension Plan with yearly cash “transition credits” (initially for up to five years, if employed by Radian during this time) under the Savings Plan equal to a fixed percentage of their eligible pay, calculated based on a formula that takes into account their age and years of completed vesting service as of January 1, 2007.
In addition to providing pension benefits, we provide certain healthcare and life insurance benefits to our retired employees who were hired before January 1, 1990, under a postretirement welfare plan (the “Postretirement Welfare Plan”). Until its curtailment on August 31, 2002, EFSG had a plan that provided certain healthcare benefits for retired employees (the “EFSG Postretirement Medical Plan”). The expense for postretirement benefit costs for 2007 was $32,500 as compared to $33,600 for 2006, and $34,800 for 2005. We accrue the estimated cost of retiree medical and life benefits over the period during which employees render the service that qualifies them for benefits.
In 2006, we implemented FASB issued Statement No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS No. 158”). SFAS No. 158 requires us to recognize the funded status of a benefit plan-measured as the difference between plan assets at fair value (with limited exceptions) and the benefit obligation-in our consolidated balance sheets. For a pension plan, the benefit obligation is the projected benefit obligation; for any other postretirement benefit plan, such as a retiree health care plan, the benefit obligation is the accumulated postretirement benefit obligation. SFAS No. 158 also requires us to recognize as a component of accumulated other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit
cost. Amounts recognized in accumulated other comprehensive income, including the gains or losses, prior service costs or credits, and the transition asset or obligation remaining, are adjusted as they are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of those statements. In addition, SFAS No. 158 requires us to measure defined benefit plan assets and obligations as of the date of our fiscal year-end consolidated balance sheets (with limited exceptions), and to disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. Employers with publicly traded equity securities were required to initially recognize the funded status of a defined benefit postretirement plan, to provide the required disclosures and to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position.
Weighted average assumptions used to determine net pension and net periodic postretirement benefit obligation at December 31, 2007 and 2006 were as follows:
The Citigroup Pension Discount Curve is constructed beginning with a U.S. Treasury par curve that reflects the entire Treasury and Separate Trading of Registered Interest and Principal Securities market. From the Treasury curve, Citibank produces a double-A corporate par curve by adding option-adjusted spreads that are drawn from the double-A corporate sector of the Citigroup Broad Investment-Grade Bond Index. Finally, from the double-A corporate par curve, Citigroup derives the spot rates that constitute the Pension Discount Curve. For payments beyond 30 years we extend the curve assuming that the discount rate derived in year 30 is extended to the end of the plan’s payment expectations.
In August and September 2007, two purported stockholder class action lawsuits, Cortese v. Radian Group Inc. and Maslar v. Radian Group Inc., were filed against Radian Group Inc. and individual defendants in the U.S. District Court for the Eastern District of Pennsylvania. The complaints, which are substantially similar, allege that we were aware of and failed to disclose the actual financial condition of C-BASS prior to our declaration of a material impairment to our investment in C-BASS. On January 30, 2008, the Court ordered that the cases be consolidated into In re Radian Securities Litigation and appointed the Institutional Investors Iron Workers Local No. 25 Pension Fund (“Iron Workers”) and the City of Ann Arbor Employees’ Retirement System (“Ann Arbor”) Lead Plaintiffs in the case. Iron Workers and Ann Arbor are represented by the law firm of Coughlin Stoia Geller Rudman & Robbins LLP, which has been appointed Lead Counsel, and the Law Offices of Bernard M. Gross, which has been appointed Liaison Counsel. A consolidated complaint is due to be filed by March 17, 2008. While it is still very early in the pleadings stage, we do not believe that the allegations in the consolidated cases have any merit, and we intend to defend against this action vigorously.
We also utilize letters of credit to back assumed reinsurance contracts, medical insurance policies and an excise tax-exemption certificate used for ceded premiums from our domestic operations to our international operations. These letters of credit are with various financial institutions, have terms of one-year and will automatically renew unless we specify otherwise. The letters of credit outstanding at December 31, 2007 and 2006 were $10.8 million and $15.5 million, respectively.
Our mortgage insurance business utilizes its underwriting skills to provide an outsourced underwriting service to its customers. We give recourse to our customers on loans we underwrite for compliance. Typically, we agree that if we make a material error in underwriting a loan, we will remedy, indemnify, make whole, repurchase, or place additional mortgage insurance coverage on the loan. During 2007, we processed requests for remedies on less than 1% of the loans underwritten and sold a number of loans previously acquired as part of the remedy process. We paid losses for sales and remedies from reserves in 2007 of approximately $4.5 million. Providing these remedies means we assume some credit risk and interest-rate risk if an error is found during the limited remedy period in the agreements governing our provision of contract underwriting services. Rising mortgage interest rates or an economic downturn may expose the mortgage insurance business to higher losses. In 2006, we had provisions for contract underwriting remedies of $5.7 million. In 2007, our provisions were approximately $3.2 million and our reserve at December 31, 2007, was $2.0 million. We closely monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis.
The commitment for non-cancelable operating leases in future years has not been reduced by future minimum sublease rental payments aggregating approximately $24.2 million. A portion of these payments relates to subleases to our affiliates.
(1) Diluted net (loss) income per share and average shares outstanding per SFAS No. 128, “Earnings Per Share.”
(4) The results reflect a significant decrease in the change in fair value of derivative instruments due to the significant disruption in the housing and mortgage markets, primarily reflected in NIMS related losses and significant credit spread widening.
The fair value of our financial instruments and derivative contracts is best determined from market pricing when available; otherwise, fair value is based on estimates using present value or other valuation methodologies. We currently define fair value as the current amount that would be exchanged between two willing parties, other than in a forced liquidation. Considerable judgment is required to interpret available market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount we could realize in a current market exchange. The use of different market assumptions or estimation methodologies may have an effect on the estimated fair value amounts.
The majority of derivatives that we enter into relate to financial guarantees in our financial guaranty segment, and to a lesser extent, the mortgage insurance segment. These financial guarantees are accounted for as derivatives under SFAS No. 133 as they do not qualify for the financial guarantee exception. The derivative financial guaranty contracts are guarantees provided on structured pools of credit default swaps or other obligations that we intend to remain in place for the entire term of the contracts. Our financial guaranty derivative portfolio primarily consists of corporate pooled CDOs, NIMS and non-corporate CDOs backed by various asset classes such as RMBS, CMBS, Trust Preferred Securities, credit card and auto loan receivables. These financial guaranty derivatives are described in more detail below.
(1) The fair value of the put options on CPS. Prior to 2007, this amount was immaterial to the consolidated financial statements.
Our 2007 net loss of $1,340.7 million was mainly a result of an $841 million increase in the cumulative unrealized loss on financial guaranty derivatives due to significant credit spread widening and a $427 million increase in the cumulative unrealized loss related to our NIMS portfolio, which is primarily credit related. Credit spreads have continued to widen in the first quarter of 2008. Partially offsetting these decreases is a gain related to the value of the put options on our CPS.
Terms of the interest-rate swap contracts at December 31, 2007 were as follows (dollars in thousands):
(a) The December 31, 2007 six-month LIBOR forward rate at the next swap payment date plus 87.4 basis points.
combination of variable interests, that will either (i) absorb of majority of the VIE’s expected losses, (ii) receive a majority of the VIE’s expected residual returns, or (iii) both. To determine if we are the primary beneficiary of a VIE, we review, among other factors, the VIE’s design, capital structure, contractual terms, which interests create or absorb variability and related party relationships, if any. Additionally, we may calculate our share of the VIE’s expected losses and expected residual returns based upon the VIE’s contractual arrangements and/or our position in the VIE’s capital structure.
The following is a summary of our exposure to the NIMS underlying trust assets at December 31, 2007:
At December 31, 2007, we were not primary beneficiaries of the NIMS trust underlying securitized assets. As such, we were not required to consolidate any of the assets underlying the NIMS trust. We continue to monitor these transactions and structures for possible consolidation considerations and triggers under FIN No. 46R. The total assets related to those underlying NIMS trusts were $35.2 billion.
Financial Guaranty-Our involvement with variable interest entities has a significant role in our financial guaranty business as a guarantor of beneficial interests held by third party investors. The guarantees may be in the form of pool policies issued to cover losses on underlying mortgage loans due to defaults or financial guarantees of principal and interest payments to beneficial interest holders. In certain of these VIEs, we could potentially be the primary beneficiary of the entity’s variable interests through our participation in the VIE and certain beneficial interests. Consequently we would be required to consolidate the assets and liabilities of the VIE.
The following table sets forth our total assets and maximum exposure to loss associated with our significant financial guaranty variable interests in VIEs as of December 31 for the years indicated:
Since September 2002, our board of directors has authorized five separate repurchase programs, including the current 6.0 million share program, for the repurchase, in the aggregate, of up to 21.5 million shares of our common stock on the open market. At December 31, 2007, approximately 20.4 million shares under these programs for a total cost of approximately $1.0 billion, including 0.4 million shares during the 2007 at a cost of approximately $22.8 million. The board did not set an expiration date for the current program. All share repurchases made to date were funded from available working capital and were made from time to time depending on market conditions, share price and other factors.
The reconciliation of segment net (loss) income to consolidated net (loss) income is as follows:
For each of the years ended December 31, 2007, 2006 and 2005, our domestic net premiums earned were $1,009.3 million, $970.0 million, and $959.0 million, respectively, and our net premiums earned attributable to foreign countries were approximately $29.3 million, $45.8 million, and $59.7 million, respectively. Because a significant amount of our trade credit reinsurance was written internationally, international net premiums earned from trade credit reinsurance business has declined over the past few years as existing business runs off and new business is not originated. In addition, long-lived assets located in foreign countries were immaterial for the periods presented.
Basic net income per share is based on the weighted average number of common shares outstanding, while diluted net income per share is based on the weighted average number of common shares outstanding and common share equivalents that would arise from the exercise of stock options. Diluted shares included our senior convertible debentures until they were redeemed on August 1, 2005, see Note 7.