We and our subsidiaries currently lease office space in New York, New York; Norwalk, Connecticut; San Francisco, California; and London.
The following table presents our selected consolidated financial and operating data. The financial data set forth below for the years ended December 31, 2008, 2007, 2006, 2005 and 2004 are derived from our Consolidated Financial Statements. The financial data as of December 31, 2008, 2007 and 2006 and for the years ended December 31, 2008, 2007, 2006 and 2005 have been audited. The information set forth below should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in
References to the “Company,” “we,” “us” and “our” mean Syncora Holdings and, unless otherwise indicated, its subsidiaries.
Our operating business is conducted through Syncora Guarantee, which as a New York domiciled financial guarantee insurance company, is required to prepare financial statements in accordance with accounting practices prescribed by the National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures Manual and adopted by the State of New York (“NAIC SAP”) and that, under NAIC SAP all our guarantees are accounted for as insurance contracts. Accordingly, under NAIC SAP we account for all our guarantees as insurance contracts and, accordingly, recognize reserves for unpaid losses and loss adjustment expenses for all such contracts. For guarantees deemed to be insurance for GAAP, there is no difference between how we recognize reserves for insurance contracts under NAIC SAP and GAAP. As further discussed below, the adverse development of our reserves for unpaid losses and loss adjustment expenses, determined in accordance with NAIC SAP, is the principal factor affecting our regulatory solvency and potential regulatory intervention.
presenting the effect of the transactions comprising the 2008 MTA on our financial position and results of operations as of and for the year ended December 31, 2008. See “-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”.
During the third quarter of 2008, we recorded further significant adverse development relating to anticipated claims on our guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on our guarantees of RMBS which would have caused Syncora Guarantee to be unable to maintain its compliance with its $65 million minimum policyholders’ surplus requirement under New York Insurance Law as of September 30, 2008. However, at our request, the New York State Insurance Department (the “NYID”), pursuant to section 6903 of New York Insurance Law, granted Syncora Guarantee approval in connection with the preparation of its statutory financial statements for the quarter ended September 30, 2008 to release statutory-basis contingency reserves on policies that have been terminated and on policies on which we have established case basis reserves for losses and loss adjustment expenses, which differs from accounting practices prescribed by NAIC SAP. As a result of such approval, Syncora Guarantee reported policyholders’ surplus of $83.3 million at September 30, 2008. Absent such approval, Syncora Guarantee would have reported a policyholders’ surplus at September 30, 2008 of $19.1 million. Policyholders’ surplus is based on statutory-basis accounting practices which differ from GAAP. Such differences may be material. The aforementioned approval was also extended by the NYID in connection with the preparation of Syncora Guarantee’s statutory financial statements as of and for the year ended December 31, 2008. There can be no assurance that the NYID will continue to allow Syncora Guarantee to apply such practices.
The non-binding terms and conditions in the Letter of Intent provide that Syncora Guarantee and the Counterparties will commute or transfer to an affiliate of Syncora Guarantee, or cause their respective affiliates to commute or transfer to an affiliate of Syncora Guarantee, their respective CDS contracts and financial guarantee insurance contracts and in exchange Syncora Guarantee will pay to the Counterparties certain consideration to include, in the aggregate, (i) approximately $1.2 billion in cash consideration, (ii) common shares of Syncora Holdings, such shares to represent approximately 40% of the outstanding common shares of Syncora Holdings following the transaction, (iii) a $150 million short-term surplus note and a $475 million long-term surplus note, and (iv) additional consideration that may include an increase in the principal amount of, or interest rate on the, surplus notes, and cash consideration based on certain specified calculations. Such non-binding terms and conditions also provide that Syncora Guarantee will form a New York financial
guarantee insurance subsidiary (“Drop-Down Company”) to (a) reinsure, on a cut-through basis, certain of Syncora Guarantee’s public finance and selected global infrastructure in-force business, and (b) assume through consensual novations certain of Syncora Guarantee’s in-force guarantees of CDS business, in connection with which Syncora Guarantee would enter into a new swap contract with the respective counterparties to such guarantees to provide a financial guarantee that guarantees certain of the payments under such novated swap contract. Syncora Guarantee will capitalize Drop-Down Company with $185 million in equity and the purchase of two surplus notes of Drop-Down Company in the aggregate principal amount of $350 million. Such non-binding terms and conditions also contemplate certain closing conditions to the 2009 MTA, including the receipt of regulatory approvals and a process for selecting members of the Board of Directors of each of Syncora Guarantee, Syncora Holdings, and Drop-Down Company and certain of our officers.
All of the terms and conditions described above are subject to definitive documentation satisfactory to all of the parties. There can be no assurance that the parties will enter into such agreements in accordance with these terms and conditions or at all. In addition, consummation of the transactions contemplated by the 2009 MTA will be subject to various closing conditions and there can be no assurance that the transactions contemplated thereby will be consummated. In addition, we need to enter into settlement agreements with certain third-parties as part of the second phase of our strategic plan.
An additional element of the second phase of our strategic plan is the tender offer contemplated by the RMBS Transaction Agreement. On March 11, 2009, the Fund commenced a tender offer to acquire the RMBS Securities either in consideration for cash or for a certificate representing the uninsured cash flows of the tendered RMBS Securities and a cash payout. Subject to closing conditions, Syncora Guarantee will purchase class B shares of the Fund and receive certificates representing the insurance cash flows on all RMBS Securities acquired by the Fund for an amount not to exceed $375 million in the aggregate. If the minimum amount of RMBS Securities is successfully acquired, the tender offer would significantly reduce Syncora Guarantee’s exposure to residential mortgages. Consummation of the transactions contemplated by the RMBS Transaction Agreement is subject to various closing conditions and there can be no assurance that the transactions contemplated thereby will be consummated.
If the transactions contemplated by the 2009 MTA and the RMBS Transaction Agreement are not consummated, Syncora Guarantee is expected to continue to report a policyholders’ deficit and may therefore be subject to action by the NYID. See “Risk Factors-Risks Related to Our Company-We may be unable to close the 2009 MTA and the tender offer, which would have a material adverse effect on our financial condition and results of operations”, as well as below for a description of continuing risks and uncertainties affecting us.
Set forth below is a description of agreements comprising the 2008 MTA, as well certain summary financial information presenting the effect of the transactions comprising the 2008 MTA on our financial position and results of operations as of the Closing Date.
Under a registration rights agreement, dated as of August 5, 2008, by and among Syncora Guarantee, Syncora Guarantee Re and XL Capital, XL Capital agreed to provide Syncora Guarantee and Syncora Guarantee Re with two demand registration and unlimited piggyback registration rights with respect to the 8 million class A ordinary shares issued by XL Capital to Syncora Guarantee and Syncora Guarantee Re. Syncora Guarantee and Syncora Guarantee Re also agreed to hold such shares for a period of six months, which expired on February 5, 2009, and any sale of class A ordinary shares of XL Capital by Syncora Guarantee or Syncora Guarantee Re will be subject to a right of first offer in favor of XL Capital. In addition, pursuant to a letter dated July 29, 2008, from Syncora Holdings to the underwriters named in the underwriting agreement entered into by XL Capital for a public offering of its class A ordinary shares, Syncora Holdings agreed, and agreed to cause its subsidiaries to agree, to a six month lock-up period with respect to class A ordinary shares of XL Capital, which expired on January 29, 2009.
such letters of credit was approximately $15.2 million and $24.3 million, respectively, as of December 31, 2008.
In consideration for the releases and waivers agreed to by the Counterparties as part of the Master Transaction Agreement, Syncora Guarantee agreed to segregate an aggregate amount of $820 million in cash plus interest thereon, premiums paid by the Counterparties from July 28, 2008 through October 31, 2008 and any proceeds from the sale by the trust of the common shares of Syncora Holdings formerly owned by XL Capital (in the event such shares are sold) for the purpose of commuting, terminating, amending or otherwise restructuring existing agreements with the Counterparties pursuant to an agreement to be negotiated with the Counterparties, which agreement is contemplated by the Letter of Intent. At December 31, 2008, the carrying value of invested assets in the segregated account was approximately $837.6 million. Pursuant to the terms of the 2008 MTA, Syncora Guarantee agreed to certain restrictions on its ability to access the funds in the segregated account and to commute, terminate, amend or otherwise restructure policies and contracts to which it is a party. In the event that Syncora Guarantee becomes subject to a rehabilitation or liquidation proceeding, the funds shall no longer be separately held, segregated or limited in use for commutations or restructurings, and will be part of the general assets of Syncora Guarantee.
In addition to that discussed above, with the exception of the merger of Syncora Guarantee Re with and into Syncora Guarantee discussed below which was consummated on September 4, 2008, we executed the following transactions on or about the Closing Date:
discontinuance of Syncora Guarantee Re as a Bermuda corporation and continuance of Syncora Guarantee Re as a Delaware corporation, contribution by Syncora Holdings of all its ownership interests in Syncora Guarantee Re to Syncora Guarantee, which was followed by the merger of Syncora Guarantee Re with and into Syncora Guarantee on September 4, 2008, with Syncora Guarantee being the surviving company. Subsequent to the merger of Syncora Guarantee Re with and into Syncora Guarantee, our financial guarantee reinsurance segment ceased to exist.
Total expenses (consisting of legal, investment advisory, accounting and consulting fees) incurred in connection with the transactions comprising the 2008 MTA and the work through December 31, 2008 on the transactions contemplated by the Letter of Intent were approximately $55.5 million.
Represents effect of termination, commutation or elimination of certain reinsurance agreements and other arrangements between us and XL Capital.
Represents the effect of the commutation of certain retrocession agreements in place with non-affiliates.
Represents the effect of commuting the Old Master Facultative Reinsurance Agreement and entering into the New Master Facultative Agreement.
Represents the effect of the transfer by XL Capital of its shares of Syncora Holdings to Syncora Guarantee, as well as the amount of cash restricted pursuant to the agreement to hold an aggregate amount of $820.0 million in cash plus interest and premiums for the purpose of commuting, terminating, amending, or otherwise restructuring existing agreements with Counterparties.
Pursuant to section 6903 of the New York Insurance Law, the NYID has granted Syncora Guarantee approval, in connection with the preparation of its statutory basis financial statements as of and for the year ended December 31, 2008, to release statutory basis contingency reserves on terminated policies and policies on which Syncora Guarantee has established case basis reserves for losses and loss adjustment expenses, however, there can be no assurance that the NYID will continue to permit Syncora Guarantee to apply such accounting practices in the future. See “-Recent Developments.”
We continue to be materially exposed to risks associated with any continuing deterioration in the credit market sectors discussed above, as well as the spread of such deterioration to other sectors of the economy to which we have material business exposure, including commercial mortgage-backed securities (“CMBS”) and collateralized loan obligations (“CLOs”). The extent and duration of any continued deterioration of the credit markets is unknown, as is the effect, if any, on potential claim payments and the ultimate amount of losses we may incur on obligations we have guaranteed, and potential losses we may incur on our invested assets.
Establishment of case basis reserves for unpaid losses and loss adjustment expenses on our in-force insurance and reinsurance business and assessing the amount of anticipated claims and
recoveries on our in-force CDS contracts requires the use and exercise of significant judgment by management, including estimates regarding the likelihood of occurrence and amount of a loss on a guaranteed obligation. Actual experience may differ from estimates and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred and, in certain cases, will occur over many years in the future. Examples of these events include changes in the level of interest rates, credit deterioration of guaranteed obligations, and changes in the value of specific assets supporting guaranteed obligations. Both qualitative and quantitative factors are used in making such estimates. Any estimate of future costs is subject to the inherent limitation on management’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and claims will vary, perhaps materially, from any estimate. The most significant assumption underlying our estimate of ultimate losses on our guarantees of ABS CDOs and first lien RMBS transactions is our assumption regarding the expected cumulative loss on mortgage loan collateral supporting such securities. The most uncertain component of that assumption is the future performance of currently performing (non-delinquent) mortgage loan collateral. If the actual rate at which currently performing loans become delinquent is materially greater than assumed, there will be a material adverse effect on our estimate of ultimate losses on the aforementioned guarantees and, accordingly, our financial position and results of operations. Our estimate of ultimate losses on our guarantees of obligations supported by home equity line of credit (“HELOC”) and closed end second (“CES”) mortgage loan collateral is largely dependent on our default rate assumption. In this regard, we assumed that the default rate will begin to improve by early 2010. If actual loan performance improves later than assumed or does not improve as much as expected, there will be a material adverse effect on our ultimate losses on our guarantees of obligations supported by HELOCs and CES mortgage loan collateral and, accordingly, our financial position and results of operations. Our default assumptions for first lien RMBS transactions is based on current delinquent loans and analysis of historical defaults for loans with similar characteristics. A loss severity is applied to the first lien RMBS defaults ranging from 41-68% to determine the expected loss on the collateral in those transactions. We use traditional default and prepayment curves to model our unpaid losses. If loss severity is higher than the rates applied, there may be a material adverse effect on our ultimate losses. See Note 16 to the Consolidated Financial Statements for further information.
Our expected financial condition after the consummation of the transactions contemplated by the 2009 MTA and the tender offer is based on various assumptions concerning these transactions, including accounting and tax treatment. There can be no assurance that the assumptions will not differ materially from the ultimate treatment of such transactions and any differences may be material. In addition, while the transactions contemplated by the 2009 MTA and the related agreements and the tender offer were designed to improve our financial condition, we will continue to be subject to risks and uncertainties that could materially affect our financial position. Therefore, even if the transactions contemplated by the 2009 MTA and the tender offer are consummated, we may continue to report a policyholders’ deficit or not comply with the statutory minimum policyholders’ surplus, undergo additional restructuring and, in addition, we may become insolvent in the future.
See “Risk Factors” for additional risks that could materially adversely affect our results of operations, financial condition and liquidity.
In our opinion, the principal factors affecting our ability to continue as a going concern are (i) whether we are successful in consummating the transactions contemplated by the Letter of Intent and related transactions and the tender offer, as well as the effect on our financial condition from the consummation of such transactions, (ii) non-assertion by certain counterparties to our CDS contracts of a mark-to-market termination event, (iii) the risk of adverse loss development on our remaining in-force business after the successful consummation of the transactions contemplated by the Letter of Intent and related transactions and the tender offer that would cause Syncora Guarantee not to be in compliance with its $65 million minimum policyholders’ surplus requirement under New York Insurance Law, and (iv) the risk of intervention by the NYID as a result of the financial condition of Syncora Guarantee or the FSA UK as a result of Syncora Guarantee-UK’s financial condition.
The following charts illustrate our corporate structure before and after consummation of the transactions comprising the 2008 MTA, as well as after the consummation of transactions contemplated in the Letter of Intent:
Corporate Structure PRIOR to Consummation of Transactions Comprising the 2008 MTA
Corporate Structure AFTER Consummation of Transactions Contemplated by the Letter of Intent
Prior to the first quarter of 2008, we had maintained triple-A ratings from Moody’s, Fitch, and S&P and these ratings had been fundamental to our historical business plan and business activities. However, in response to deteriorating market conditions described above, the rating agencies have updated their analyses and evaluations of the financial guarantee insurance industry including us. As a result, our IFS ratings have been substantially downgraded by the rating agencies and the rating agencies have placed our IFS ratings on creditwatch/ratings watch negative or on review for further downgrade. Consequently, we suspended writing substantially all new business in January 2008.
Most recently, on March 9, 2009, Moody’s downgraded to “Ca” from “Caa1” the IFS ratings of Syncora Guarantee and Syncora Guarantee-UK, with the ratings placed on developing outlook and, on January 29, 2009, S&P downgraded to “CC” from “B” the IFS ratings of Syncora Guarantee and Syncora Guarantee-UK, with the ratings placed on negative outlook. Effective August 27, 2008, we terminated the agreement for the provision of ratings with Fitch. Since we have suspended writing
substantially all new business, we believe ratings from two agencies are sufficient. This follows numerous downgrades by each of S&P, Moody’s and Fitch since each of them first downgraded our triple-A ratings in the first quarter of 2008.
Effective the Closing Date, Syncora Guarantee Re redomesticated from Bermuda to Delaware and the ownership interests of Syncora Guarantee Re owned by Syncora Holdings were contributed by Syncora Holdings to Syncora Guarantee. On September 4, 2008 Syncora Guarantee Re merged with and into Syncora Guarantee, with Syncora Guarantee surviving the merger.
As of March 30, 2009, ten states have suspended Syncora Guarantee’s license placed an order of impairment against it or Syncora Guarantee voluntarily agreed to cease writing business in such state, though we anticipate that Syncora Guarantee will be able to continue to collect premiums on existing business in such states. Additional states may suspend Syncora Guarantee’s license to write new business in the future. See “Business-Regulation-United States.” As noted above, Syncora Guarantee has in any event suspended the writing of substantially all new business as of January 2008.
We charged premiums either on an upfront basis when the policy was issued or the contract was executed, or on an installment basis over the life of the applicable transaction.
See also “-Exposure to Residential Mortgage Market” below for information in regard to our exposure to residential mortgages, Note 6 to our Consolidated Financial Statements for information in regard to how our GAAP earnings are affected by the change in the fair value of our credit derivatives and “Risk Factors-Risks Related to Our Company”.
The following are certain financial measures management considers important in evaluating our financial condition:
We believe that Adjusted Shareholders’ Equity is an important metric to assist investors in understanding our current financial condition because: (i) by excluding the net credit derivative liability, the metric eliminates the benefit to our shareholders’ equity embedded therein from Non-Performance Risk, as defined and explained below, as well as eliminates the effect of other assumptions made by us in estimating the fair value of our CDS contracts which are not directly observable in the marketplace, and (ii) by including our best estimate of losses we expect to incur on our CDS contracts if we were to hold such CDS contracts to maturity and pay claims as they arise over the remaining life of such contracts, the metric presents our guarantees in insurance and derivative form on a consistent basis, which results in a more meaningful measure of our intrinsic value.
Historically, we evaluated our periodic sales performance based on a non-GAAP measure known as adjusted gross premiums. Adjusted gross premiums for any period equals the sum of: (i) upfront premiums written in such period, (ii) current installment premiums on business written in such period and (iii) expected future installment premiums on contracts written during such period that remain in force and for which there is a binding obligation on the part of the insured to pay the future installment premiums, discounted to present value at 7%, which we refer to as the present value of future installment premiums (“PVFIP”) on business written during such period. This measure adjusted for the fact, as described above, that upfront premiums are recorded in full as total premiums written at inception of the contract but future installment premiums are not. PVFIP is not reflected in our Consolidated Financial Statements. However, because we suspended writing substantially all new business in January of 2008, we no longer use this metric.
Historically, we measured our performance by using a metric referred to as operating earnings, a non-GAAP financial measure. Operating earnings represents net income, in accordance with GAAP, adjusted to exclude: (i) net realized gains (losses) on investments, (ii) net unrealized gains (losses) on credit derivatives, other than those losses caused by credit impairment, and (iii) earned premiums from refundings (see “-Critical Accounting Policies-Premium Revenue Recognition”). However, as a result of our current financial condition, we no longer believe this metric is relevant to the evaluation of our performance.
As of December 31, 2008, our total net direct exposure to RMBS aggregated approximately $8.7 billion, representing approximately 6.5% of our total in-force guaranteed net par outstanding at such date. The RMBS exposure consisted of various collateral types as set forth in the table below. The tables below also set forth our internal ratings, as well as the ratings of the rating agencies of the insured transactions at December 31, 2008. During the year ended December 31, 2008, we recorded an additional provision for losses and loss adjustment expenses after giving effect to reinsurance of approximately $1,789.8 million, on a present value basis, primarily to reflect adverse development on certain of such obligations. During the year ended December 31, 2007, we recorded a provision for losses and loss adjustment expenses after giving effect to reinsurance of $37.2 million on certain of such obligations. See Note 16 (a) to the Consolidated Financial Statements for detailed information regarding the basis of our estimates of losses and loss adjustment expenses with respect to the
As of December 31, 2008, we had 14 high-grade and 3 mezzanine ABS CDO guaranteed transactions in-force, with total net par outstanding of $14.2 billion. All of our indirect exposure to residential mortgages arises from CDOs in which our guarantees pertain to securities initially benefiting from higher than the minimum amount of subordination required under rating agency criteria in effect at the time of issue for a rating of “AAA,” based on S&P ratings. However, as a result of the actual levels of delinquencies, defaults and foreclosures on subprime mortgages substantially exceeding forecast levels, we now anticipate losses from these policies. As of December 31, 2008, our indirect subprime net exposure was approximately $4.4 billion based on the RMBS holdings within the ABS CDO collateral pools. In addition, the collateral pools of most of our ABS CDO transactions contain securities issued by other ABS CDOs. The indirect net exposure to other ABS CDOs was approximately $1.7 billion as of December 31, 2008 and a significant portion of the underlying collateral supporting these transactions consists of subprime RMBS. As our guarantees of ABS CDOs were issued in the form of CDS contracts, under GAAP, they are reported at fair value. At December 31, 2008 and 2007, we carried derivative liabilities relating to all of our CDS contracts of $787.2 million and $1,700.7 million, respectively, ($14,954.4 million and $1,700.7 million, respectively, before giving effect to Non- Performance Risk), of which $68.6 million and $1,511.7 million, respectively, ($11,209.3 million and $1,511.7 million, respectively, before giving effect to Non-Performance Risk), related to ABS CDOs. Non-Performance Risk is reflected in the fair value of our CDS contracts effective with the adoption of FASB No. 157, “Fair Value Measurements”, on January 1, 2008. Prior thereto, Non-Performance Risk was not reflected in the fair value of our CDS contracts. See “-Other Measures Used by Management to Evaluate Results of Operations and Financial Condition” and “Critical Accounting Policies and Estimates-Valuation of Credit Default Swaps” for a discussion of Non-Performance Risk. However, at December 31, 2008 and 2007, management’s best estimate of anticipated claims and recoveries on such CDS contracts, net of any recoveries anticipated from purchased credit derivatives, was $3,238.4 million and $645.1 million, respectively (see “-Anticipated Claims Payable and Anticipated Recoveries On CDS Contracts” below for detailed information regarding the basis of the estimate of such claims payments and recoveries and the sensitivity of assumptions underlying such estimate).
The following table presents the net par outstanding for our insured RMBS portfolio by type of collateral as of December 31, 2008:
Prime (2nd lien) mortgage loans are secured by second liens on one-to-four family residential properties. The underwriting standards used to underwrite prime mortgage loans are the standards applied to the most creditworthy borrowers and are generally acceptable to Fannie Mae and Freddie Mac. This category also includes Alt-A (2nd lien) loans.
Subprime (1st lien) mortgage loans are secured by first liens on residential properties to non-prime borrowers. The underwriting standards used to underwrite subprime mortgage loans are less stringent than the standards applied to the
The following table presents the net par outstanding and net case basis reserves for unpaid losses for our insured RMBS portfolio by year of origination (year the guarantee was underwritten and issued) as of December 31, 2008:
Also includes exposure considered to be “super senior” where the underlying credit support exceeds the “AAA” guidelines set by S&P.
The following table presents the net notional exposure of our guaranteed CDOs by type of referenced asset as of December 31, 2008:
An investment grade corporate CDO is a CDO that is collateralized by, or synthetically references, a bespoke portfolio or an index of debt to corporate entities rated investment grade, i.e. rated at least “BBB-” by S&P, “Baa3” by Moody’s and “BBB-” by Fitch or higher.
ABS CDOs secured primarily by “BBB” rated RMBS collateral at inception.
CDO includes ABS CDOs, CLOs, commercial real estate/CMBS CDOs, trust preferred securities CDOs, emerging markets CDOs and other CDOs.
The following table presents the net notional exposure of the referenced assets underlying our ABS CDO portfolio by rating as of December 31, 2008:
The following table presents ratings information for each of our 17 guaranteed ABS CDOs as of December 31, 2008:
S&P and Moody’s and the Company’s internal ratings current as of March 20, 2009. “/*-” indicates rating is on review for downgrade. “/*” indicates rating on watch developing. Internal ratings as of December 31, 2008.
The following table presents our CDO squared exposure as of December 31, 2008:
Expected claims and recoveries on our ABS CDO portfolio were estimated based on detailed cash flow modeling of expected quarterly cash flows for loans that are referenced in our ABS CDOs. ABS CDOs that we guarantee are highly complex structured transactions, the performance of which depends on a wide variety of factors outside of our control. Our estimate of claims and recoveries on these transactions was based on financial models, generated internally, to estimate future credit performance of the underlying assets, and to evaluate structures, rights and our potential obligations over time. The modeling of ABS CDOs requires analysis of both direct RMBS, as well as CDO collateral within the ABS CDOs, known as “inner securitizations,” and we do not consistently have access to all the detailed information necessary to project every component of each inner securitization. Therefore, in some cases we put greater reliance on the third party data sources and analytics which we are not able to independently verify. In addition, many of these financial models include, and rely on, a number of assumptions, many of which are difficult to estimate and are subject to change, and even small alterations in the underlying assumptions of the model can
have a significant effect on its results. Moreover, the performance of the securities we guarantee depends on a wide variety of factors which are outside our control, including the liquidity and performance of the collateral underlying such securities, the correlation of assets within collateral pools, the performance or non-performance of other transaction participants (including third-party servicers) and the exercise of control or other rights held by other transaction participants.
To develop the cash flow model for each guaranteed CDO, we begin by determining the expected cash flows for each security owned by the CDO. For each direct holding of an RMBS security (based on the CUSIP number obtained from the latest trustee report) we determined a cumulative loss projection based on characteristics of the mortgage loans in the collateral pool. We obtained information on the pool’s loan performance from “LPS”, a loan information database developed by LoanPerformance, a third party vendor. Projected future performance of each loan in the pool was determined by its characteristics as matched up against the performance of similar loans in the LPS historical database.
Prior to the 2008 MTA, including the merger of Syncora Guarantee Re with and into Syncora Guarantee (see “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”), the Company’s business activities were organized and managed in two operating segments: financial guarantee insurance and financial guarantee reinsurance. Following the 2008 MTA and the merger, the Company’s business is managed as one operating segment.
An understanding of our accounting policies for these items is of critical importance to understanding our Consolidated Financial Statements. The following discussion provides more
Amount is net of $22.0 million, representing the net present value of future installment premiums at December 31, 2008 with regard to certain of our guarantees on which case reserves are recorded at December 31, 2008.
Case basis reserves on insured business are established by us with respect to a specific policy or contract upon receipt of a claim notice or when management determines that (i) a claim is probable in the future based on specific credit events that have occurred and (ii) the amount of the ultimate loss that we will incur can be reasonably estimated. As specific case basis reserves are established we consider whether any changes are required to the assumptions underlying the calculation of unallocated reserves (which are discussed below) as a result of such activity. The amount of the case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that we expect to make, net of expected recoveries under salvage and subrogation rights. Case basis reserves are generally determined using cash flow models to estimate the net present value of the anticipated shortfall between (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) anticipated cash flow from the collateral
supporting the obligation and other anticipated recoveries. A number of quantitative and qualitative factors are considered when determining or assessing the need for a case basis reserve. These factors may include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured, the projected cash flow or market value of the assets that collateralize or secure the insured obligation, and the historical and projected loss rates on such assets. Other factors that may affect the actual ultimate loss include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. Such factors and our assessment thereof will be subject to the specific facts and circumstances associated with the specific insured transaction being considered for case reserve establishment. Case basis reserves are generally discounted at a rate reflecting the return on our investment portfolio during the period the case basis reserve is established. We believe this rate of return is an appropriate rate to discount our reserves because it reflects the rate of return on the assets supporting such business. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an upfront basis, we continue to record premium earnings on such policy over its remaining life, unless we have recorded a full limit loss with respect to such policy, in which case the remaining deferred premium revenue relating thereto is immediately reflected in earnings. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an installment basis, those premiums, if expected to be received prospectively, are considered a form of recovery.
Case basis reserves on financial guarantee reinsurance assumed are generally established by us upon quarterly current notifications from ceding companies. There historically has been no time lag between the time we record an assumed case basis reserve and the time our ceding companies record such reserves. For each notification of a ceded case basis reserve from our ceding companies, we conduct an examination of the basis of the ceding company’s reserve to ensure that we concur with the ceding company’s evaluation and conclusions. In certain instances, we may develop our own estimates of losses on assumed business. Except as discussed below, in all instances to date where we have assumed case basis reserves, we have concurred with the ceding companies’ evaluation and conclusions with respect to such reserves and, accordingly, there has been no difference between the amount of case basis reserves reported to us by our ceding companies and the amount we have recorded in our financial statements. During the year ended December 31, 2008, based on our own internal analysis, we recorded a provision for losses and loss adjustment expenses of $8.6 million relating to a reinsured guarantee covering a global infrastructure financing (see Note 16(d) to the Consolidated Financial Statements) and, in March 2009 we were advised by the ceding company that our share of the estimated reserve they had established was approximately $18.0 million. To date, we have not completed our assessment of the ceding company’s estimated reserve and, therefore, have not adjusted our provision to reflect the ceding company’s estimate.
We analyze the actual loss experience of companies comprising the industry annually. The analysis utilizes loss and premium data filed by the three largest companies in the financial guarantee insurance industry in Schedule P of their annual statutory financial statements. These statutory filings provide data for ten calendar years and exclude unallocated reserves. Information on unallocated reserves is obtained from Annual Reports filed with the Securities and Exchange Commission on Form 10-K and is combined with the Schedule P data to estimate ultimate loss ratios for each of the preceding ten years.
Our surveillance department focuses its review on monitoring the lower-rated bonds and potentially troubled bond sectors, which have included RMBS, CMBS, CDOs and CLOs. It tracks performance monthly to try to ensure that covenants have not been breached. Once a covenant is
breached we may have the right to put the transaction into rapid amortization so that all cash flow generated from that transaction is used to pay down principal and stay current with interest. Typically, we review periodically servicing and trustee reports to help track coverage levels, enhancement levels, delinquency levels, loss frequency, loss severity and total losses and compare these performance metrics with the metrics that were made available at the time the transaction was closed. If losses are above projections we will analyze the reasons for the deviation. In some cases it may be an indication of servicing problems where loans are delinquent and are not put into foreclosure in time to maximize recovery. Periodically, we audit servicers of loans and other assets supporting our insured obligations to better understand their servicing practices and to identify potential servicing problems, if any. Management believes that this is an important safeguard, as servicers are required to indemnify us against failure to adhere to the servicing standards set forth in the servicing agreements.
At December 31, 2008, the loss list consisted of 50 of our guarantees with remaining net par outstanding of $19.8 billion. Of these guarantees, 33 are insurance contracts on which we have recorded net case reserves for unpaid losses and loss adjustment expenses of $1.7 billion, and 17 are CDS contracts on which we have estimated we will incur anticipated claims
of $3.2 billion. At December 31, 2007, the loss list consisted of 21 of our guarantees with remaining net par outstanding of $10.3 billion. Of these guarantees, 9 are insurance contracts on which we have recorded net case reserves for unpaid losses and loss adjustment expenses of $135.6 million, and 12 are CDS contracts on which we have estimated we will incur anticipated claims of $645.1 million. The increase in net par outstanding on the loss list at December 31, 2008, as compared to December 31, 2007, resulted primarily from credit deterioration in our ABS CDO and RMBS exposures during 2008. See “-Anticipated Claims Payable and Anticipated Recoveries on CDS Contracts” and Note 16 of the Consolidated Financial Statements for further information.
Prior to suspending writing substantially all new business (See “-Overview of Our Business- Recent Developments”), we issued CDS contracts and entered into arrangements with other issuers of CDS contracts to assume, all or a portion, of the risks in the CDS contracts they issued (“back-to-back arrangements”) and, in certain cases, which are discussed in more detail below, we purchased back-to-back credit protection on all or a portion of the risk from the CDS contracts we issued or assumed. Such back-to-back arrangements were generally structured on a proportional basis. In connection with the transactions comprising the 2008 MTA, we terminated substantially all our back-to-back arrangements in the third quarter of 2008. See “-Overview of Our Business- Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”.
include commutations of CDS contracts. See “-Overview of Our Business-Description of the Transactions Contemplated by the Letter of Intent and Related Transactions”.
Level 2-Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and valuation drivers are observable in active markets.
The fair value of our in-force portfolio of CDS contracts other than CDS on ABS CDOs, which are discussed below, represents the net present value of the difference between the remaining unearned premiums that we originally charged for credit protection and our best estimate of what a financial guarantor of a comparable credit worthiness would hypothetically charge to provide the same protection as of the measurement date. The hypothetical nature of this exit value is representative of the lack of a principal market for our CDS contracts. In the absence of such a principal market, we believe other financial guarantors of comparable credit quality to Syncora Guarantee best represent the hypothetical exit market for our CDS contracts. Fair value is defined as the price at which an asset or a liability could be bought or transferred in a current transaction between willing parties. Fair value is determined based on quoted market prices, if available. Quoted market prices are available only on a limited portion of our in-force portfolio of CDS contracts. If quoted market prices are not available, fair value is estimated based on valuation techniques involving management’s judgment. In determining the fair value of our CDS contracts, we use various valuation approaches with priority given to observable market prices when they are available. Market prices are generally available for traded securities and market standard CDS contracts but are less available or unavailable for highly- customized CDS contracts. Most of our CDS contracts are highly customized structured credit derivative transactions that are not traded and do not have observable market prices. Due to the significance of unobservable inputs required to value such CDS contracts, they are considered to be Level 3 under the SFAS 157 fair value hierarchy.
Our payment obligations after a default vary by deal type. There are three primary types of policy payment requirements:
Our CDS contracts are structured to prevent large one-time claims upon a specified credit event and generally allow for payments over time (i.e. “pay as you go” basis) or at final maturity. Also, our CDS contracts are generally governed by a single transaction International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement relating only to that particular transaction/contract. Under most monoline financial guarantee standard termination provisions, there is no requirement for mark-to-market termination payments upon the early termination of a guaranteed CDS contract. However, substantially all of our CDS contracts provide for mark-to-market termination payments following the occurrence of events that are outside our control, such as Syncora Guarantee being placed into receivership or rehabilitation or a regulator taking control of Syncora Guarantee or Syncora Guarantee’s insolvency. Under current market conditions such termination payments would result in a substantial liability to us which would be substantially in excess of that currently recorded by us in accordance with SFAS 157 and our ability to pay. See “-Overview of Our Business-Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern, and Description of Our On-Going Strategic Plan.” An additional difference between our CDS contracts and the typical market standard CDS contracts is that, except in the circumstances noted above, there is no acceleration of the payment to be made under our CDS contracts unless we, at our option, elect to accelerate. Furthermore, by law, our guarantees are unconditional and irrevocable, and cannot be transferred to most other capital market participants as they are not licensed to write such business. However, through the purchase of back-to-back credit protection, the risk of loss (but not counterparty risk) on these contracts can be transferred to other financial guarantee insurance and reinsurance companies.
Description of Valuation Methodology Used by Us at December 31, 2008
levels not seen historically. These credit spreads reflect the lack of liquidity in the market and this liquidity premium historically has flowed directly to the CDS counterparty as the funding institution. Though we believe the actual premium percentage would be far below those seen in previous markets, with no observable market transactions to use as a benchmark, management has decided to set a floor on the premium percentage of 30%. This level is consistent with the bottom range of our historical premium pricing for CDS transactions. Under this approach, the financial guarantee CDS fee used for a particular contract in our fair value calculations represent a consistent percentage, period to period, of the credit spread determinable from the reference index value as of the measurement date. This results in a CDS fair value (before adjustment for Non-Performance Risk) that fluctuates in proportion with the reference index value.
For example, assuming that at the end of the previous reporting period the credit spread of a reference index was 100 basis points and the current market premium for a transaction that is priced off of that reference index was set at 30 basis points (30% of the reference index), if at the end of the current reporting period the reference index moved to 150 basis points (a 50% increase), the current market premium for such a transaction would be set at 45 basis points (also a 50% increase). Thus, the model indicates that we would need to receive an additional 15 basis points (45 bps currently less the 30 bps reported last period) for issuing a CDS on the reference obligation in the current reporting period. To compute the current period change in fair value we discount the product of the outstanding notional amount of the CDS and the contractual premium over the life of the reference obligation, using a counterparty discount rate and subtract from that, the discounted product of the outstanding notional amount of the CDS and calculated current market premium, over the life of the reference obligation using a Syncora-specific discount rate.
For CDS contracts issued on ABS CDOs, we utilize non-binding broker quotes on the underlying obligations to project principal and interest shortfalls and the timing of such shortfalls. We then discount the shortfalls using a Company-specific discount rate and net from this the discounted expected premium using a counterparty discount rate (based on the published credit spreads of the counterparty), to arrive at the fair value of the CDS. No adjustments have been made to third party broker quotes as these are intended to capture all elements of the fair value of the underlying securities.
In addition to that discussed above, the fair value of our CDS contracts reflects our Non-Performance Risk as implied by the market price of buying credit protection on Syncora Guarantee, by incorporating the spread on CDS contracts traded on Syncora Guarantee into the discount rate used (see “-Overview of Our Business-Other Measures Used by Management to Evaluate Results of Operations and Financial Condition” for a discussion of Non-Performance Risk). We estimate a discount rate for each CDS contract based on the swap rate and our credit spread for the duration that is the closest to the remaining weighted average life (“WAL”) of the obligation referenced in the CDS contract. Reflecting Non-Performance Risk in our estimate of the fair value of our CDS contracts was the only change in our valuation methodology caused by the adoption of SFAS 157. At December 31, 2008, the effect of reflecting our Non-Performance Risk in our estimate of the fair value of our CDS contracts was a reduction in our net derivative liability of approximately $14.2 billion. The spread on 10-year CDS contracts traded on Syncora Guarantee at December 31, 2008, was 60.16%. If the transactions contemplated by the Letter of Intent are consummated, specifically the commutations of CDS contracts with Counterparties (see “-Overview of Our Business-Description of the Transactions Contemplated by the Letter of Intent and Related Transactions”), the uncertainty associated with future adverse loss development on our guarantees will be reduced and management believes that, as a result, the cost of buying credit protection on Syncora Guarantee should decline. The effect of a decline in the cost of buying credit protection on Syncora Guarantee will increase our derivative liability on the remaining in-force CDS contracts; however, we believe that any such increase should be offset in part by the effect on our derivative liability from the aforementioned commutations. However, there can be no assurance that material adverse
the amount of subordination in our CDS contracts before liability attaches that would be required by a market participant in order for it to assume the risks in our contracts,
the actual amount of subordination in our CDS contracts before liability attaches,
price discovery resulting from discussions and negotiations with market participants or counterparties to our CDS contracts to transfer or commute the risks in any of our CDS contracts, and
With respect to items (viii) and (ix) above, in any price discovery involving a commutation of a CDS contract with our counterparty to the transaction, we considered our performance risk as implied by the market price of buying credit protection on Syncora Guarantee, when assessing the estimated fair value of our obligations to the counterparty under the contract.
The weight ascribed by us to the aforementioned factors in forming our best estimate of the fair value of our CDS contracts may vary under changing circumstances. In periods prior to July 1, 2007, we principally considered price indices published by nonaffiliated financial institutions in forming our best estimate of the fair value of our CDS contracts. The fair value of the guarantee was determined by multiplying the percentage change in the applicable credit price index or indices applicable to the assets referenced in the CDS contracts by the present value of the remaining expected future premiums to be received under the contract. We concluded that results from this calculation represented a reasonable estimate of the fair value of the Company’s CDS contracts at that time.
in instances where current market indices were reliable and available, our estimate of fair value was based on applying the percentage change in the applicable credit price index or indices applicable to the assets referenced in the CDS contracts to the present value of the remaining expected future premiums to be received under the contract, and
As of December 31, 2008 our consolidated investment portfolio consisted of debt securities, cash and cash equivalents (including restricted cash and cash equivalents) and equity securities. All of our investments in debt securities are considered available-for-sale and, accordingly, are carried at fair value. In addition, our equity securities are carried at fair value. As of December 31, 2008 and 2007, the carrying value of such investments was $3.6 billion and $2.7 billion, respectively. The fair values of our investments are based upon quoted market prices from nationally recognized pricing services or, in the absence of quoted market prices, dealer quotes or matrix pricing.
Premiums charged in connection with the issuance of our guarantees are received either upfront or in installments. Such premiums are recognized as written when due. Installment premiums written are earned ratably over the installment period, generally one to three months, which is consistent with the expiration of the underlying risk or amortization of the underlying insured par. Upfront premiums written are earned in proportion to the expiration of the related risk. The methodology employed to earn upfront premiums requires that such premiums be apportioned to individual sinking fund payments of a bond issue according to the bond issue’s amortization schedule. The apportionment is based on the ratio of the principal amount of each sinking fund payment to the total principal amount of the bond issue. After the premium is allocated to each sinking fund payment, such allocated premium is earned on a straight-line basis over the period of that sinking fund payment. As a result, for upfront premiums on amortizing insured obligations, premium revenue recognition will tend to be greater in the earlier periods of the transaction when there is a higher amount of risk or principal outstanding. The effect of our upfront premium earnings policy is that we recognize greater levels of upfront premiums in earlier years of each amortizing insured obligation. Recognizing premium revenue on a straight line basis over the life of each amortizing insured obligation without allocating premiums to the scheduled principal payments would materially change the amount of premium we recognize in a particular financial reporting period, but not over the life of the applicable policy. For upfront premiums on non-amortizing bullet maturity debt obligations, premium revenue recognition is recognized on a straight-line basis over the life of the underlying insured obligation. Deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk or principal of insured obligations. For both upfront and installment policies, ceded premium expense is recognized in earnings in proportion to and at the same time the related premium revenue is recognized. In addition, when an insured issue is retired early, is called by the issuer or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow (hereafter collectively referred to as “Refundings”), the remaining deferred premium revenue is earned at that time. Premiums earned for the years ended December 31, 2008, 2007 and 2006 include $130.6 million, $14.7 million, and $27.4 million, respectively, related to Refundings.
For the years ended December 31, 2008, 2007 and 2006, approximately 3%, 56% and 69%, respectively, of our gross premiums written were received upfront, and 97%, 44% and 31%, respectively, were received in installments.
See “Recent Accounting Pronouncements-Statement of Financial Accounting Standards (“SFAS”) No. 163, Accounting for Financial Guarantee Insurance Contracts-An interpretation of FASB Statement No. 60” for information regarding how SFAS 163 will change our premium revenue recognition and “Risk Factors-Rules relating to certain accounting practices in the
As we ceased writing substantially all new business in January of 2008 (see “-Overview of Our Business-Recent Developments”), costs incurred in connection with the acquisition of such new business that varied with and was directly related to the production of such business were deferred and amortized to expense in relation to earned premiums. These costs included direct and indirect expenses such as compensation costs of underwriting and marketing personnel and ceding commissions paid on assumed business. As of December 31, 2008 and 2007, we had deferred acquisition costs of $110.1 million and $108.1 million, respectively. Each year we conducted a study to estimate the amount of operating costs that varied with, and were directly related to, the acquisition of new business and therefore qualified for deferral. Ceding commissions received on premiums we cede to other reinsurers reduce acquisition costs. Such commissions are earned in relation to earned premium. In determining the recoverability of our deferred acquisition costs we consider expected losses and loss adjustment expenses, maintenance costs, unearned premiums, the anticipated present value of future premiums under installment contracts written, and anticipated investment income. Acquisition costs associated with credit derivative products are expensed as incurred. For policies reinsured with third parties we receive ceding commissions to compensate for acquisition costs incurred.
Deferred income tax assets and liabilities are established for the temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted rates in effect for the year in which the differences are expected to reverse. Such temporary differences relate principally to deferred ceding commissions, reserves for losses and loss adjustment expenses, deferred premium revenue, realized and unrealized gains and losses on investments and derivative financial instruments, statutory contingency reserves and net operating losses. A valuation allowance is recorded to reduce a deferred tax asset to the amount that is estimated to be more likely than not to be realized.
For the years ended December 31, 2008 and 2007, we recorded a charge of $1.7 billion and $137.6 million to establish a valuation allowance for our net deferred tax assets. The valuation allowance was calculated in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), which places primary importance on our operating results in the most recent three-year period when assessing the need for a valuation allowance. Our cumulative loss in the most recent three-year period as of December 31, 2008 and 2007, represented negative evidence sufficient to require a full valuation allowance under the provisions of SFAS 109. We intend to maintain a full valuation allowance for our net deferred tax assets until sufficient positive evidence exists to support reversal of all or a portion of the valuation allowance. Until such time, except for state, local and foreign tax provisions, we will have no net deferred tax assets. As of December 31, 2008, we had deferred tax assets before the valuation allowance of approximately $1.8 billion.
The following table presents summary consolidated statement of operations data for the years ended December 31, 2008, 2007 and 2006:
Discussion of Consolidated Results of Operations for the Years Ended December 31, 2008, 2007 and 2006
Comparison of Year Ended December 31, 2008 to Year Ended December 31, 2007. The increase in net loss available to common shareholders of $161.0 million for the year ended December 31, 2008, as compared to 2007 was primarily attributable to: (i) higher net losses and loss adjustment expenses of $1,728.5 million due primarily to adverse loss development relating to certain of our insured obligations supported by HELOC, CES and Alt-A mortgage collateral, (ii) higher net realized losses on investments of $237.9 million due primarily to other than temporary impairment charges during 2008 of $238.9 million, (iii) higher operating expenses of $131.9 million resulting primarily from substantially higher fees for professional services in connection with transactions comprising the 2008 MTA as well as ongoing restructuring efforts, a charge for the abandonment of certain leased office premises, an impairment charge related to our insurance licenses, and severance costs associated with the reduction of our workforce, (iv) a charge of $42.4 million related to the commutation of certain reinsurance agreements in connection with the 2008 MTA, (v) higher dividends on preferred shares of subsidiary of $1.9 million, offset in part by (vi) a net gain of $494.6 million attributable to the net change in fair value of derivatives during the year, as compared to a net loss of $1,295.0 million recorded in 2007, (vii) higher earned premiums of $110.7 million resulting primarily from Refundings, (viii) a $36.1 million gain on the redemption of the Series A
redeemable preferred shares of subsidiary, (ix) an increase in net investment income of $11.6 million reflecting an increase in average invested assets in 2008, as compared to 2007, (x) lower dividends of $ 8.4 million on the Syncora Holdings Series A Preference Shares, (xi) an increase in fee income of $3.3 million, (xii) lower net acquisition costs of $2.9 million, and (xiii) an income tax benefit of $2.7 million in 2008, as compared to income tax expense of $16.4 million in 2007.
Comparison of Year Ended December 31, 2007 to Year Ended December 31, 2006. The decrease in net income available to common shareholders of $1,341.9 million for the year ended December 31, 2007, as compared to 2006, was primarily attributable to: (i) higher net unrealized losses on CDS contracts of $1,331.6 million, resulting primarily from widening credit spreads on assets referenced in our in-force CDS contracts, particularly subprime mortgage loan assets in our guarantees of ABS CDOs (ii) higher net losses and loss adjustment expenses of $56.5 million primarily due to an increase reserves relating to certain of our guarantees supported by HELOC and CES mortgage loan collateral, (iii) higher operating expenses of $19.9 million resulting primarily from higher costs for compensation, legal and advisory services and public company expenses, (iv) an increase in income tax expense of $13.3 million primarily due to the establishment of a full valuation allowance in regard to our net deferred tax assets, (v) the semi-annual dividend of $8.4 million on the Syncora Holdings Series A Preference Shares, which were issued in April 2007, (vi) an increase in acquisition costs of $3.7 million primarily driven by a write-off of deferred acquisition costs of $3.1 million related to certain of our guarantees of obligations supported by HELOC and CES mortgage loan collateral on which we have recognized losses, as well as higher premium taxes resulting from growth in our in-force business, and (vii) a decrease in fee income of $2.2 million, offset in part by (viii) an increase in net investment income of $43.0 million reflecting an increase in average invested assets during 2007, as compared to 2006 (due to the issuance of the Syncora Holdings Series Preference Shares in April 2007 and operating cash flow), as well as higher yields on new money investments, (ix) higher earned premiums of $9.2 million due to the growth of our in-force business (in particular, our book of installment premium business), (x) a decrease in net realized losses on investments of $13.7 million, and (xi) a decrease of $4.4 million in dividends on preferred shares of subsidiary.
Guarantee premiums written during the period include: (i) premiums received upfront on insurance policies and CDS contracts written during the period, (ii) installment premiums due during the period on in-force insurance policies and CDS contracts that were written prior to the period, and (iii) installment premiums due during the period on insurance policies and CDS contracts written during the period. Guarantee premiums written during the period do not include installment premiums due in future periods. Accordingly, our guarantee premiums written during any period are a function of the type and volume of contracts we write (upfront versus installment), as well as prevailing market prices. We suspended substantially all new business production beginning in January 2008 as a result of downgrades of our IFS ratings by the rating agencies and material adverse effects on our results of operations and financial condition resulting from the deterioration in the credit markets and the mortgage market specifically beginning in the second half of 2007 that continued through 2008. See “-Overview of Our Business-Recent Developments” and “-Overview of Our Business-Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern, and Description of Our On-going Strategic Plan.”
Gross premiums written were $79.4 million in 2008, a decrease of $174.8 million or 68.8%, from $254.2 million recorded in 2007. The decrease consisted of lower upfront premiums written and lower installment premiums written. The decrease primarily resulted from the fact that we ceased writing substantially all new business in January of 2008. See “-Overview of Our Business-Recent Developments” and “-Overview of Our Business-Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern, and Description of Our On-going Strategic Plan.”
Gross premiums written were $254.2 million in 2007, a decrease of $75.1 million or 22.8%, from $329.3 million recorded in 2006. The decrease primarily consisted of a decrease in upfront premiums written in the public finance and infrastructure and utilities sectors, partially offset by the increase in installment premiums written in the CDO and asset-backed securities sector.
The majority of our financial guarantee reinsurance business is assumed from affiliates of FSA.
from FSA and a new business relationship with a third- party primary company. The amount of reinsurance ceded to us from affiliates of FSA and other third-party primary companies depends upon the type and amount of insurance that they write, their capital needs and other factors.
We managed our in-force business based on single-risk limits to avoid concentration in single names and to mitigate event risk. For transactions that exceeded our single-risk limits, we historically ceded the excess to XLI, XL Reinsurance America, Inc. (“XL RE AM”), an indirect wholly-owned subsidiary of XL Capital, or third-party reinsurers. Through these cessions, we were able to manage large single risks and reduce concentration in specific bond sectors, geographic regions, and to specific issuers. However, in connection with the 2008 MTA, we commuted substantially all our ceded reinsurance arrangements. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information.”
The following table presents, for the years ended December 31, 2008, 2007 and 2006, the amount of premiums ceded to XLI, XL RE AM, and other third-party reinsurers:
Ceded premiums in 2008 were $0.4 million, a decrease of $66.5 million, as compared to $66.9 million in 2007. The decrease is attributable to the commutation of substantially all our ceded reinsurance arrangements in connection with the 2008 MTA and to the reversal of accrued ceded premiums payable on an excess of loss agreement (“XOL”) with XLI. During the fourth quarter of 2007 we ceded the aggregate limit of losses available under the XOL and accrued the related ceded premiums that would be payable under the XOL over the period such losses were expected to be paid. In connection with the 2008 MTA, the XOL was commuted and these premium payments are no longer payable.
Ceded premiums in 2007 were $66.9 million, an increase of $55.6 million as compared to $11.3 million in 2006. The increase was largely attributable to the transfer of certain business back to Syncora Guarantee Re from XLI in connection with our IPO in 2006, offset in part by a decrease in cessions to XL RE AM in connection with the management of Syncora Guarantee’s single risk limits. Also, Syncora Guarantee Re ceded certain business to XLI in 2007 as part of overall capital management which resulted in Syncora Guarantee Re ceding $21.5 million of premiums to XLI.
The following table presents, for the years ended December 31, 2008, 2007 and 2006, the amount of earned premiums attributable to upfront and installment policies and contracts, and a reconciliation of guarantee premiums earned to net premiums earned:
Net premiums earned in 2008 were $279.4 million, an increase of $110.7 million or 65.6%, as compared to $168.7 million in 2007. Higher net premiums earned in 2008 are primarily due to an increase in earned premiums from Refundings during the period of $115.9 million and the decrease of premiums ceded as a result of the commutation of substantially all our ceded reinsurance agreements in connection with the 2008 MTA. Net premiums earned from Refundings were $130.6 million in 2008, as compared to $14.7 million in 2007. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information.”
Net premiums earned in 2007 were $168.7 million, an increase of $9.3 million or 5.8%, as compared to $159.4 million in 2006. The increase in guarantee premiums earned in 2007, as compared to 2006, was primarily due to the year over year growth of our in-force business (in particular, our book of installment business written). Earned premiums from Refundings were $14.7 million in 2007, as compared to $27.8 million in 2006.
Represents the quarterly average of the amortized cost of debt securities, short-term investments and cash and cash equivalents for the respective periods.
Effective yield represents net investment income as a percentage of average invested assets. The decrease in the effective yield was due to the maintenance of higher balances of cash and cash equivalents compounded by lower short-term interest rates.
Net realized losses on investments were $240.4 million, $2.5 million, and $16.2 million in 2008, 2007 and 2006, respectively. Net realized losses in 2008 were primarily attributable to other-than-temporary impairment charges of $238.9 million and portfolio management actions relating to the management of duration, yield and exposure to certain credit risks amounting to $1.5 million. The other-than-temporary impairment charge recorded during the year ended December 31, 2008, was due to our inability to assert that we have the intent and ability to hold securities in an unrealized loss position until they mature or recover in value. Our inability to make such assertion is due to the expectation that we will need to sell a significant amount of our invested assets to fund the transactions contemplated by the Letter of Intent if they are consummated. See “-Overview of Our Business-Recent Developments-Description of the Transactions Contemplated by the Letter of Intent and Related Transactions.”
Unrealized losses on derivatives in the table above reflect the reversal of the carrying value of derivative contracts which were settled or commuted, as well as the change in the fair value of our in-force CDS contracts during the period. Our net derivative liability at December 31, 2008, before Non- Performance Risk, was $14,954.4 million ($732.4 million after Non-Performance Risk), as compared to our net derivative liability at December 31, 2007 of $1,346.1 million (prior to the adoption of SFAS 157, we were not required to, and did not, reflect Non-Performance Risk in estimating the fair value of our CDS contracts). See “-Other Measures Used by Management to Evaluate Results of Operations and Financial Condition” for a discussion of Non-Performance Risk. The increase in our net derivative liability before Non-Performance Risk at December 31, 2008, as compared to our net derivative liability at December 31, 2007 primarily relates to an increase in our derivative liabilities associated with our CDS contract guarantees which reference ABS CDOs, CLOs, CDO of CDOs, preinsured CDOs, and synthetic CMBS CDOs. With the exception of ABS CDOs, the increase in such liabilities primarily relates to the widening of the ABX or CDX indices. In regard to our derivative liabilities associated with ABS CDOs, the increase primarily relates to lower broker quotes on the underlying referenced obligations. The aforementioned increase in our derivative liability at December 31, 2008, as compared to December 31, 2007, was partially offset by the reversal of the derivative liabilities associated with the Swaps with Merrill Lynch and MLI, which were terminated in connection with the 2008 MTA, as discussed above. For additional information see “-Overview of Our Business-Exposure to Residential Mortgage Market” and “-Critical Accounting Policies and Estimates-Valuation of Credit Default Swaps.”
Our net derivative liability at December 31, 2007 was $1,346.1 million, as compared to $51.1 million at December 31, 2006. The increase in our net derivative liability primarily related to an increase in our derivative liabilities associated with our CDS contract guarantees of ABS CDOs, which have significant exposure to the residential mortgage market, offset in part by an unrealized gain on the put option in the Syncora Guarantee Capital Facility. See “-Liquidity and Capital Resources.”
Net losses and loss adjustment expenses include current year net losses incurred and adverse or favorable development of prior year net losses and loss adjustment expenses reserves. See “-Critical Accounting Policies and Estimates-Reserves for Losses and Loss Adjustment Expenses.”
Represents the effect on our reserves for unpaid losses and loss adjustment expenses of commuting certain reinsurance agreements in connection with the 2008 MTA. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”.
Net losses and loss adjustment expenses in 2008 were $1,797.9 million, an increase of $1,728.5 million, as compared to $69.4 million recorded in 2007. The increase in net losses and loss adjustment expenses primarily resulted from adverse loss development on certain of our guarantees which are supported by HELOC, CES and Alt-A mortgage loan collateral. See Note 16 to our Consolidated Financial Statements for detailed information in regard to losses and loss adjustement expenses.
The decrease in acquisition costs resulted primarily from: (i) the absence of any write-off of deferred acquisition costs in 2008 due to the inability to recover such costs from the profits of the underlying business, as compared to 2007 in which we recorded a $3.1 million charge relating thereto, and (ii) the classification of certain costs as operating expenses in 2008, offset in part by (iii) lower amortization of deferred ceding commissions of $5.3 million resulting from the commutation of certain reinsurance agreements in connection with the 2008 MTA, and (iv) higher amortization of deferred acquisition costs of $8.3 million from Refundings, as compared to $2.7 million in 2007.
Amortization of acquisition costs were $20.0 million for the year ended December 31, 2007, an increase of $3.8 million, as compared to $16.2 million in 2006 (which included $2.7 million and $2.2 million, respectively, of accelerated amortization of deferred acquisition costs due to Refundings in 2007 and 2006). Excluding the impact of Refundings, the increase of $5.1 million primarily reflects a write-off of deferred acquisition costs of $3.1 million related to certain guarantees of obligations supported by HELOC and CES mortgage loan collateral on which we have recognized losses, as well as higher premium taxes resulting from growth in our in-force business.
Amortization of deferred ceding commission revenue for the year ended December 31, 2007 increased by $1.1 million, as compared to 2006, due to an increase in ceded premiums earned resulting from continued exposure management.
The loss on commutation of reinsurance agreements during the year ended December 31, 2008 of $42.4 million resulted from the transactions contemplated by the 2008 MTA. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information” for details. There were no losses on commutations of reinsurance agreements for the years ended December 31, 2007 and 2006.
Operating expenses were $98.9 million in 2007, an increase of $19.9 million, or 25.2%, as compared to $79.0 million in 2006. The increase in operating expenses in 2007, as compared to 2006, was primarily attributable to higher corporate expenses, professional fees and compensation costs.
For the year ended December 31, 2008, we reported an income tax benefit of $2.7 million, as compared to income tax expense of $16.4 million in 2007.
We concluded that future income forecasted to be generated is insufficient to cause the realization of our deferred tax assets within a reasonable period, thus a valuation allowance has been established against the entire deferred tax asset at December 31, 2008 and 2007. See Note 17 to the Consolidated Financial Statements included elsewhere herein for further details.
Because dividends on our Syncora Holdings Series A Preference Shares are non-cumulative and the declaration of such dividends are subject to the discretion of our Board of Directors, under GAAP such dividends can only be recognized when declared by our Board of Directors and may not be accreted ratably over each fiscal year. In addition, because the governing documents underlying the Syncora Holdings Series A Preference Shares provide for semi-annual dividends, dividends will only be recognized during the first and third quarters of each fiscal year, if declared by the Board of Directors. Our Board of Directors did not declare a dividend during the year ended December 31, 2008 or at any meeting thereafter to the filing date of this report. On August 5, 2008, Syncora Holdings entered into an undertaking with the NYID pursuant to which it agreed not to make any dividends or distributions to its shareholders during an eighteen month period beginning on that date without the NYID’s express written consent. See “-Liquidity and Capital Resources-Syncora Holdings Liquidity” and “Risk Factors-Risks Related to Ownership of Our Common Shares-We have agreed not to make any dividends or distributions to our shareholders for a period of time and failure by us to pay dividends on the Syncora Holdings Series A Preference Shares could have a material adverse effect on the common shareholders’ board representation.” During the year ended December 31, 2007 a semi- annual dividend of $8.4 million on the Syncora Holdings Series A Preference Shares was declared July 31, 2007 by our Board of Directors and paid on October 1, 2007 to shareholders of record of the Syncora Holdings Series A Preference Shares on September 28, 2007.
At December 31, 2008 and 2007, our total liquidity resources (including restricted cash) on a consolidated basis were $3.6 billion and $3.2 billion, respectively. For the year ended December 31, 2008, net cash used in operating activities and provided by financing activities was $1,758.6 million and $1,776.3 million, respectively. Net cash used in operating activities was primarily attributable to the transfer of $971.8 million to restricted cash for the benefit of the Counterparties and other ceding companies, as well as to gross paid claims on RMBS and public finance credits of $621.8 million. Net cash provided by financing activities was driven from proceeds received from XL Capital in connection with the 2008 MTA (see “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”), and the issuance of the aforementioned Series B Preferred Shares by Syncora Guarantee Re. Net cash provided by investing activities of $335.4 million for the year ended December 31, 2008, reflects the receipt of net proceeds from the sales of securities, scheduled maturities of debt securities, and reinvestment of such proceeds into short-term cash equivalents.
Syncora Holdings’ Board of Directors did not declare either a quarterly dividend with respect to its common shares or a semi-annual dividend with respect to the Syncora Holdings Series A Preference Shares. On August 5, 2008, Syncora Holdings entered into an undertaking with the NYID pursuant to which it agreed not to make any dividends or distributions to its shareholders during an eighteen month period beginning on that date without the NYID’s express written consent. Any future dividends will be subject to the discretion and approval of the Board of Directors, applicable law and regulatory and contractual requirements. If dividends on the Syncora Holdings Series A Preference Shares are not paid in an aggregate amount equivalent to dividends for six full quarterly periods, whether or not declared or whether or not consecutive, holders of the Syncora Holdings Series A Preference Shares will have the right to elect two persons who will then
Liquidity resources at Syncora Guarantee are primarily used to pay its operating expenses, claims, premiums for reinsurance and purchased credit derivatives, support in-force business, and pay dividends to us, as well as to make investments from time to time in its subsidiary, Syncora Guarantee-UK. Syncora Guarantee’s principal sources of liquidity resources are its portfolio of liquid assets and its net operating cash flow. Syncora Guarantee’s liquidity resources can be affected by the amount and timing of claim payments, changes in interest rates, as well as the other factors described under “-Overview of Our Business-Key Factors Affecting Our Results of Operations.” In addition, Syncora Guarantee’s liquidity resources will be materially affected if we are successful in consummating the transactions contemplated by the Letter of Intent.
In connection with the transactions comprising the 2008 MTA, we have placed certain restrictions on Syncora Guarantee’s liquidity resources. Syncora Guarantee agreed to hold in a segregated account an aggregate amount of $820 million in cash (plus interest thereon, premiums paid by the Counterparties from July 28, 2008 through October 31, 2008 and any proceeds from the sale by the trust of XL Capital’s common shares of Syncora Holdings, in the event such shares are sold) for the purpose of commuting, terminating, amending or otherwise restructuring existing agreements with the Counterparties pursuant to an agreement to be negotiated with the Counterparties. At December 31, 2008, the carrying value of invested assets in the trust was approximately $837.6 million. Pursuant to the 2008 MTA, Syncora Guarantee agreed to certain limitations on its access to the funds in the segregated account. In the event that Syncora Guarantee becomes subject to a rehabilitation or liquidation proceeding, the funds shall no longer be separately held, segregated or limited in use for commutations or restructurings, and will be part of the general
In regard to the direct financial guarantee business underwritten by Syncora Guarantee, our general practice was not to agree to ratings-based triggers which require the mandatory posting of collateral or which would otherwise have a material adverse impact on our liquidity position. However, from time to time we may elect to post collateral. The transactions which have ratings-based triggers usually require downgrades of several notches before such triggers are breached. Typical consequences for breach of such ratings-based triggers may include (a) loss or sharing of our voting/control rights or (b) optional termination by the counterparty which, if exercised, generally results in the loss of future premium. In many instances, these consequences can be cured by certain corrective actions taken by us at our option within stipulated time periods (with limited exceptions, usually 20 to 30 days). Because of the decline in Syncora Guarantee’s ratings, holders of our financial guarantees may elect to exercise their rights to terminate our financial guarantees thereby decreasing future premiums payable to us.
Certain outwards agreements under which Syncora Guarantee cedes business or transfers risk generally contain ratings-based triggers whereby if Syncora Guarantee is downgraded generally to a level of “AA/Aa2” to “A/A3,” which has occurred, depending upon the agreement, the reinsurer or counterparty has the right, but not the obligation, to terminate the agreement on a run-off basis.
Syncora Guarantee reported net cash provided by investing activities of approximately $337.4 million for the year ended December 31, 2008, an increase of $783.3 million, as compared to net cash used in investing activities of $445.9 million during 2007. The increase is primarily attributable to the redeployment of redemptions, maturities and coupon interest into cash and cash equivalents as we continue to focus on enhancing our liquidity. See “-Liquidity and Capital Resources” above.
It would be an event of default under most of the CDS contracts insured by Syncora Guarantee if Syncora Guarantee should become insolvent or placed into rehabilitation, receivership, liquidation or other similar proceedings by a regulator. If there were an event of default or termination event under the CDS contracts guaranteed by Syncora Guarantee, as a result of Syncora Guarantee’s insolvency or otherwise, while the event of default or determination event continued, in certain cases the holders of these CDS contracts may have the right to terminate the CDS contracts and to assert claims for termination payments from Syncora Guarantee, based on the market value of the CDS contracts at the time of termination. If Syncora Guarantee were required to make such payments, under current market conditions this amount would, in the aggregate, be significantly in excess of its ability to pay. See “-Overview of Our Business-Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern, and Description of Our On-Going Strategic Plan” and “Risk Factors-Risks Related to Our Company-If Syncora Guarantee should become subject to a regulatory proceeding or becomes insolvent, the holders of certain of the CDS contracts Syncora Guarantee has insured may assert the right to terminate the contracts and require Syncora Guarantee to pay them the termination values, which under current market conditions would be in excess of Syncora Guarantee’s resources.”
Historically, we managed our in-force portfolio of guaranteed obligations based on, and to comply with, regulatory and rating agency single-risk limits and internal credit guidelines. Single-risk limits are designed to avoid concentration in single names and to mitigate event risk and are calculated as a percentage of capital. For transactions that exceed these limits or guidelines, we generally transferred the excess to XLI, XL RE AM, or other third-parties through reinsurance or back-to-back derivative transactions. Generally, all such reinsurance is structured as facultative quota share reinsurance in which the reinsurer is liable to us for its quota share of the applicable policies that we issue, regardless of when the loss occurs. The back-to-back derivative transfers are structured in the same manner. Accordingly, related reserves for unpaid losses and loss adjustment expenses (including unallocated loss reserves) and the anticipated claims and recoveries, are transferred in accordance with such contracts. In connection with transactions comprising the 2008 MTA, we commuted substantially all retrocession agreements that we had in place. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”.
“AA Companies and others” means those firms (other than XLI) that have either an “AA” category rating from S&P and/or an “Aa” category rating from Moody’s or have an investment grade rating but do not have a financial enhancement rating from S&P.
Syncora Guarantee’s reinsurer’s are not required to post collateral to secure the reinsurance recoverables from them (but may elect to post collateral for their obligations in lieu of termination or in lieu of an increase in ceding commission allowance) and accordingly, we are subject to their credit risk. In these circumstances we have the right to terminate on a cut-off basis (meaning that the reinsurance coverage is terminated in full and the reinsurer generally is required to return unearned premium) or a run-off basis (meaning that the reinsurance coverage remains in place for existing policies ceded but no new obligations may be ceded to the reinsurer) at any time by written notice, if we choose to recapture the risk ceded to these reinsurers. As a result of any such recapture, we would cease to have reinsurance for the losses on the transactions formerly ceded to reinsurers.
Interest and fees payable under the Facility shall be determined based upon certain spreads over defined benchmarks, principally LIBOR.
In December 2004, Syncora Guarantee Re entered into a put option agreement and an expense reimbursement agreement (the “Asset Trust Expense Reimbursement Agreement”) with Twin Reefs Asset Trust (the “Asset Trust”). The put option agreement provided Syncora Guarantee Re (and after the merger of Syncora Guarantee Re with and into Syncora Guarantee, continues to provide Syncora Guarantee) with the irrevocable right to require the Asset Trust at any time and from time to time to purchase non-cumulative perpetual Series B Preferred Shares with an aggregate liquidation preference of up to $200 million. There is no limit to the number of times that Syncora Guarantee may exercise the put option, redeem the Series B Preferred Shares from the Asset Trust and exercise the put option again. Syncora Guarantee is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B Preferred Shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by Syncora Guarantee pursuant to the Asset Trust Expense Reimbursement Agreement. The put option agreement is perpetual but would terminate on delivery of notice by Syncora Guarantee on or after December 9, 2009, or under certain defined circumstances, such as the failure of Syncora Guarantee to pay the put option premium when due or bankruptcy. The premium payable by Syncora Guarantee is the sum of certain trustee and investment managers expenses, the distribution of income paid to holders of the pass-through trust securities, less the investment yield on the eligible assets purchased using the proceeds originally raised from the issuance of the pass-through securities. The eligible securities (which are generally high-grade investment securities) are effectively held in trust to be used to fund the purchase of any Series B Preferred Shares upon exercise of the put.
for any dividend period ending on or prior to December 9, 2009, one-month LIBOR plus 1.00% per annum, calculated on an actual/360 basis; and
The holders of the Series B Preferred Shares will not be entitled to any voting rights as shareholders of Syncora Guarantee and their consent will not be required for taking any corporate action. Subject to certain requirements, the Series B Preferred Shares may be redeemed, in whole or in part, at the option of Syncora Guarantee at any time or from time to time after December 9, 2009 for cash at a redemption price equal to the liquidation preference per share plus any accrued and unpaid dividends thereon to the date of redemption without interest on such unpaid dividends.
On February 11, 2008, Syncora Guarantee Re exercised the put option, for the first time since the inception of the facility, to issue $200 million of the Series B Preferred Shares which, if declared, by Syncora Guarantee Re’s Board of Directors, or subsequent to the merger, Syncora Guarantee’s Board of Directors, will pay monthly dividends as discussed above. On February 26, 2008, Syncora Guarantee Re’s Board of Directors declared dividends on the Series B Preferred Shares at the applicable rate for the next three monthly periods and on May 6, 2008, Syncora Guarantee Re elected to declare dividends on the Series B Preferred Shares at the required rate for the succeeding month. On July 25, 2008, Syncora Guarantee Re elected to declare dividends on the Series B Preferred Shares at the required rate for the July 2008 and August 2008 periods. Syncora Guarantee did not declare dividends on the Series B Preferred Shares for any period after August 2008 through the date hereof.
On February 27, 2007, the Board of Directors of Syncora Guarantee Re approved: (i) an extraordinary dividend of $15.0 million on Syncora Guarantee Re Series A Preferred Shares, and (ii) a reduction in the stated value of the remaining outstanding Syncora Guarantee Re Series A Preferred Shares by a corresponding amount. Payment of the extraordinary dividend and the reduction in the stated value of the Syncora Guarantee Re Series A Preferred Shares occurred on March 30, 2007. This transaction was accounted for as a redemption of the preferred shares. In connection with the 2008 MTA, Syncora Holdings purchased all the outstanding Syncora Guarantee Re Series A Preferred Shares in exchange for $2.9 million and contributed them to Syncora Guarantee. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information”. In connection with the merger of Syncora Guarantee Re with Syncora Guarantee, such shares were cancelled.
The following table presents our long-term contractual obligations and related payments as of December 31, 2008, due by period:
The Company is liable under an information technology outsourcing agreement that it entered into with International Business Machines Corporation (“IBM”) on October 1, 2006. Pursuant to the agreement IBM will: (i) provide the Company with all its information technology hardware, (ii) provide all support services to maintain such hardware and provide for efficient disaster recovery, (iii) develop a transition plan for the Company’s systems from its existing hardware to new hardware, and (iv) maintain the Company’s technology at a level that allows the Company to take advantage of technological advances. In consideration for these services the Company is obligated to pay IBM approximately $4.0 million per annum for the five year term of the contract. Expense incurred by the Company under this agreement was $5.3 million, $4.6 million and $0 million for the years ended December 31, 2008, 2007 and 2006, respectively.
The timing and ultimate amount of the claims payments, net of anticipated recoveries before giving effect to reinsurance, could differ materially from our estimated amounts. For information regarding the estimates for unpaid loss and loss expenses as well as factors affecting potential payment patterns of reserves for actual and potential claims related to our different lines of business, see “-Critical Accounting Policies and Estimates” above.
As of December 31, 2008 and 2007, we did not have any off-balance sheet arrangements that were not accounted for or disclosed in the Consolidated Financial Statements. See “-Liquidity and Capital Resources-Syncora Guarantee Capital Facility” above and Note 9 to our Consolidated Financial Statements.
Statement of Financial Accounting Standards (“SFAS”) No. 163, Accounting for Financial Guarantee Insurance Contracts-An interpretation of FASB Statement No. 60
applying a fixed percentage of the premium to the amount of outstanding exposure at each reporting date (referred to as the level-yield approach). In addition, in regard to financial guarantee insurance contracts where premiums are received in installments SFAS 163 requires that an insurance enterprise recognize an asset for the premium receivable and a liability for the unearned premium revenue at inception of a financial guarantee insurance contract and, that such recognition should be based on the following:
We expect that the initial effect of applying SFAS 163 will be material to our financial statements. In particular, we expect that implementation of SFAS 163 will cause us to de-recognize our reserves for unallocated losses and loss adjustment expenses and preclude us from providing such reserves in the future (see Note 16 to the Consolidated Financial Statements).
SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years. In addition, beginning the third quarter of 2008, we are required to make certain disclosures describing the Company’s guarantees that are being closely monitored as a result of deterioration or other adverse developments (see Note 16 to the Consolidated Financial Statements).
In October 2006, the FASB issued proposed FASB Staff Position EITF 03-6-a, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.” This FASB Staff Position (“FSP”) addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing basic earnings per share (“EPS”) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, “Earnings Per Share.” A share-based payment award that contains a non-forfeitable right to receive cash when dividends are paid to common shareholders irrespective of whether that award ultimately vests or remains unvested shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be included in the computation of basic EPS pursuant to the two-class method. Under the terms of our restricted stock awards, grantees are entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return such dividends in the event the unvested awards are forfeited in the future. Accordingly, this FSP will have an effect on our EPS calculations. The FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of this FSP. Early application is not permitted.
SFAS No. 161, “Disclosures About Derivative Instruments and Hedging Activities-An Amendment of FASB Statement No. 133”
At December 31, 2008, our consolidated fixed-income portfolio consisted of debt securities and cash and cash equivalents with a carrying value of $3.6 billion and $2.7 billion, respectively. Our debt securities are designated as available for sale in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” The fixed-income portfolio is reported at fair value in accordance with SFAS 115, and the change in fair value is reported as part of accumulated other comprehensive income. Short-term investments consist of securities with maturities equal to or greater than 90 days but less than one year at time of purchase.
As of December 31, 2008, the top 10 corporate holdings, which exclude government guaranteed and government sponsored enterprises, represented approximately 9.0% of the total fixed-income portfolio and approximately 51.9% of all corporate holdings. At December 31, 2008, none of our corporate holdings exceeded 1.9% of our total fixed-income portfolio (including debt securities, short-term investments and cash and cash equivalents).
Our fixed-income portfolio is exposed to interest rate risk. Interest rate risk is the price sensitivity of a fixed-income security to changes in interest rates. We manage interest rate risk by setting duration targets for our investment portfolio, thus mitigating the overall economic effect of interest rate risk. We remain nevertheless exposed to interest rate risk since the assets are marked-to-market, thus subject to market conditions, while liabilities are accrued at a static rate. The hypothetical case of an immediate 100 basis point adverse parallel shift in global bond curves at December 31, 2008 would have decreased the fair value of our fixed-income portfolio by approximately 1.8%, or $64.9 million.
The amortized cost and estimated fair value of debt securities available for sale as of December 31, 2008, by contractual maturity, are presented below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. See Note 6 to our Consolidated Financial Statements for additional information regarding our debt securities available for sale as of December 31, 2008.
We believe that these factors include, but are not limited to, those listed under “Risk Factors” as well as the following:
our ability to enter into or close the 2009 MTA and close the tender offer;
our ability to maintain minimum policyholders’ surplus even if we close the 2009 MTA and the tender offer;
decision by Syncora Guarantee’s regulators to take regulatory action such as rehabilitation or liquidation of Syncora Guarantee at any time due in part to Syncora Guarantee’s current failure to maintain minimum required policyholders’ surplus or positive statutory policyholders’ surplus;
impact on the composition of the Board of Directors of the non-payment of dividends on the Syncora Holdings Series A Preference Shares;
potential adverse developments at Drop-Down Company and recapture of business ceded to Drop-Down Company under the 2009 MTA;
the financial condition of Syncora Guarantee-UK and action by the FSA UK;
requirement of Syncora Guarantee to provide Syncora Guarantee-UK with sufficient funds to maintain its minimum solvency margin;
the interconnectedness of risks that affect the our reinsurance and insurance portfolio and our financial guarantee products;
termination payments related to less traditional products, including CDS contracts, possibly in excess of our current resources;
delisting from the NYSE and intended deregistration under the Exchange Act;
legislative or regulatory developments, including changes in tax laws and regulation of mortgages;
The accompanying consolidated financial statements and financial statement schedule have been prepared assuming that the Company will continue as a going concern. As described in Note 2 to the consolidated financial statements, following significant losses in 2007 the Company’s insurance subsidiary, Syncora Guarantee Inc. (“Syncora Guarantee”) had its ratings downgraded by the three major rating agencies, and as a consequence Syncora Guarantee suspended writing substantially all new business. Furthermore, Syncora Guarantee reported a statutory policyholders’ deficit at December 31, 2008. Failure to maintain minimum policyholders’ statutory capital and surplus permits the New York State Insurance Department to intervene in Syncora Guarantee’s operations and seek court appointment as rehabilitator or liquidator of Syncora Guarantee and, accordingly, there is substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to this matter are described in Note 5. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
As discussed in Note 6 to the consolidated financial statements, the Company adopted SFAS No. 157, “Fair Value Measurements” in 2008.
Adverse developments in the credit markets generally and the mortgage market specifically that began in the second half of 2007 and continued through 2008 have resulted in material adverse effects on the Company’s business, results of operations, and financial condition, including (i) significant adverse development of anticipated claims on the Company’s guarantees, under its credit default swap (“CDS”) contracts, of collateralized debt obligations (“CDOs”) of asset-backed securities (“ABS CDOs”) and significant adverse development of reserves for unpaid losses and loss adjustment expenses on the Company’s guarantees, under its insurance contracts, of residential mortgage-backed securities (“RMBS”), and (ii) downgrades of the insurance financial strength ratings of the Company’s operating subsidiaries by Moody’s Investors Service, Inc. (“Moody’s”), Fitch Ratings (“Fitch”) and Standard & Poor’s Ratings Services (“S&P”), which ratings had been fundamental to their ability to conduct business and which have caused the Company to cease writing substantially all new business since January of 2008, resulting in the loss of future incremental earnings and cash flow.
During the second quarter of 2008, the Company recorded a material increase in adverse development of anticipated claims on its guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on its guarantees of RMBS causing it to be unable to maintain
During the fourth quarter of 2008, the Company recorded a material increase in adverse development relating to anticipated claims on our guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on our guarantees of RMBS. As a result of the material adverse development relating to anticipated claims on the Company’s guarantees of ABS CDOs and reserves for unpaid losses and loss adjustment expenses on the Company’s guarantees of RMBS recorded during 2008, Syncora Guarantee reported a policyholders’ deficit of $2.4 billion as of December 31, 2008. Failure to maintain positive statutory policyholders’ surplus or non-compliance with the $65 million statutory minimum policyholders’ surplus requirement permits the New York Superintendent of Insurance (the “New York Superintendent”) to seek court appointment as rehabilitator or liquidator of Syncora Guarantee. As a result of this material adverse development, and in accordance with our previously disclosed strategic plan, effective as of March 5, 2009, Syncora Guarantee signed a non-binding letter of intent with certain of the Counterparties (the “Letter of Intent”) whereby the parties agreed to negotiate in good faith to seek to promptly agree on mutually agreeable definitive documentation, in the form of a master transaction agreement and related agreements (hereafter referred to collectively as the “2009 MTA”). In addition, pursuant to the RMBS Transaction Agreement, dated as of March 5, 2009 (the “RMBS Transaction
Agreement”), on March 11, 2009, the fund referenced therein (the “Fund”) commenced a tender offer to acquire certain residential mortgage-backed securities that are insured by Syncora Guarantee (the “RMBS Securities”). The 2009 MTA and tender offer represent the principal elements of the second phase of our strategic plan. The transactions contemplated by the Letter of Intent and the related transactions and the tender offer are described in Note 3.
The non-binding terms and conditions in the Letter of Intent provide that Syncora Guarantee and the Counterparties will commute or transfer to an affiliate of the Company, or cause their respective affiliates to commute or transfer to an affiliate of the Company, their respective CDS contracts and financial guarantee insurance contracts and in exchange Syncora Guarantee will pay to the Counterparties certain consideration to include, in the aggregate, (i) approximately $1.2 billion in cash consideration, (ii) common shares of Syncora Holdings, such shares to represent approximately 40% of the outstanding common shares of Syncora Holdings following the transaction, (iii) a $150 million short-term surplus note and a $475 million long-term surplus note, and (iv) additional consideration that may include an increase in the principal amount of, or interest rate on the, surplus notes, and cash consideration based on certain specified calculations. Such non-binding terms and conditions also provide that Syncora Guarantee will form a New York financial guarantee insurance subsidiary (“Drop-Down Company”) to (a) reinsure, on a cut-through basis, certain of Syncora Guarantee’s public finance and selected global infrastructure in-force business, and (b) assume through consensual novations certain of Syncora Guarantee’s in-force guarantees of CDS business, in connection with which Syncora Guarantee would enter into a new swap contract with the respective counterparties to such guarantees to provide a financial guarantee that guarantees certain of the payments under such novated swap contract. Syncora Guarantee will capitalize Drop-Down Company with $185 million in equity and the purchase of two surplus notes of Drop-Down Company in the aggregate principal amount of $350 million. Such non-binding terms and conditions also contemplate certain closing conditions to the 2009 MTA, including the receipt of regulatory approvals and a process for selecting members of the Board of Directors of each of the Syncora Holdings, Syncora Guarantee, and Drop-Down Company and certain officers of the Company.
An additional element of the second phase of the Company’s strategic plan is the tender offer contemplated by the RMBS Transaction Agreement. On March 11, 2009, the Fund commenced a tender offer to acquire the RMBS Securities either in consideration for cash or for a certificate representing the uninsured cash flows of the tendered RMBS Securities and a cash payout. Subject to closing conditions, Syncora Guarantee will purchase class B shares of the Fund and receive certificates representing the insurance cash flows on all RMBS Securities acquired by the Fund for an amount not to exceed $375 million in the aggregate. If the minimum amount of RMBS Securities is successfully acquired, the tender offer would significantly reduce Syncora Guarantee’s exposure to residential mortgages. Consummation of the transactions contemplated by the RMBS Transaction Agreement is subject to various closing conditions and there can be no assurance that the transactions contemplated thereby will be consummated.
If the transactions contemplated by the 2009 MTA and the RMBS Transaction Agreement are not consummated, Syncora Guarantee is expected to continue to report a policyholders’ deficit and may therefore be subject to action by the NYID. See Note 5 for a description of continuing risks and uncertainties affecting the Company.
Set forth below is a description of agreements comprising the 2008 MTA, as well as certain summary financial information presenting the effect of the transactions comprising the 2008 MTA on the Company’s financial position and results of operations as of the Closing Date.
The Master Transaction Agreement provided for the termination, commutation or elimination of certain reinsurance agreements, guarantees and other arrangements among the Company and XL Capital and certain of its subsidiaries, and between Syncora Guarantee and Syncora Guarantee Re, in exchange for a cash payment by XL Capital to the Company of $1.775 billion, the issuance and transfer of 8 million class A ordinary shares of XL Capital in the aggregate to Syncora Guarantee and Syncora Guarantee Re, and the transfer of XL Capital’s common shares of Syncora Holdings to a trust, the SCA Shareholder Entity, for the benefit of Syncora Guarantee until such time as an agreement between Syncora Guarantee and the Counterparties is reached, and thereafter the Syncora Holdings shares will be held for the benefit of the Counterparties. As a result of the transfer of the shares of Syncora Holdings to the SCA Shareholder Entity, XL Capital no longer has the right to vote, nominate directors to Syncora Holdings’ Board of Directors or any other rights. On the Closing Date, the four XL Capital-nominated directors on Syncora Holdings’ Board of Directors resigned. Pursuant to a shareholders agreement with the SCA Shareholder Entity, the trust has a number of rights including the right to vote the shares and to nominate to Syncora Holdings’ Board of Directors, such number of directors as would equal one nominee less than a majority (if Syncora Holdings’ Board of Directors consists of nine or fewer Directors) or two nominees less than a majority (if Syncora Holdings’ Board of Directors consists of ten or more Directors). Effective November 19, 2008, pursuant to the shareholder agreement, the SCA Shareholder Entity appointed four members to Syncora Holdings’ Board of Directors. The Company also entered into a registration rights agreement with the SCA Shareholder Entity providing for demand registration rights, a shelf registration if the Company is so eligible and piggyback registration rights. Until the
Under a registration rights agreement, dated as of August 5, 2008, by and among Syncora Guarantee, Syncora Guarantee Re and XL Capital, XL Capital agreed to provide Syncora Guarantee and Syncora Guarantee Re with two demand registration and unlimited piggyback registration rights with respect to the 8 million class A ordinary shares issued by XL Capital to Syncora Guarantee and Syncora Guarantee Re. Syncora Guarantee and Syncora Guarantee Re also agreed to hold such shares for a period of six months, which expired on February 5. 2009, and any sale of class A ordinary shares of XL Capital by Syncora Guarantee or Syncora Guarantee Re will be subject to a right of first offer in favor of XL Capital. In addition, pursuant to a letter, dated July 29, 2008, from Syncora Holdings to the underwriters named in the underwriting agreement entered into by XL Capital for a public offering of its class A ordinary shares, Syncora Holdings agreed, and agreed to cause its subsidiaries to agree, to a six month lock-up period with respect to class A ordinary shares of XL Capital, which expired on January 29, 2009.
The Company and XL Capital obtained approvals from the NYID and the Bermuda Monetary Authority (the “BMA”) for the Master Transaction Agreement and the transactions comprising such agreement. Other required approvals related to the Master Transaction Agreement have been received from the Delaware Department of Insurance. The NYID has also approved the Merrill Agreement and the transactions comprising such agreement.
On March 31, 2009, the Company entered into Amendment No. 3 and Waiver Agreement (“Amendment No. 3”) with the lenders under the Credit Agreement, whereby the Company agreed to collateralize the remaining letters of credit in an amount equal to 105% of the total letter of credit exposure as of such date, plus any accrued and unpaid interest and fees thereon, plus all other accrued and unpaid obligations of the account parties under the Credit Agreement. In consideration of the foregoing, the lenders under the Credit Agreement have agreed to permanently waive (i) the requirement that audited financial statements of each account party (other than Syncora Guarantee)
be delivered within 90 days of the end of the fiscal year (provided that such audited financial statements shall be delivered within 120 days of the end of the fiscal year); (ii) the requirement that audited financial statements as reported on by the independent public accountants not have a “going concern” or like qualification or exception nor any qualification or exception as to the scope of such audit; (iii) the covenant relating to Syncora Holdings’ ratio of total funded debt to total capitalization; (iv) the covenant relating to Syncora Holdings’ consolidated net worth; and (v) any defaults as a result of the account parties not satisfying the requirements waived in clauses (i) through (iv) above or certain other requirements set forth in the Credit Agreement (as more fully described in Amendment No. 3). The amount of letters of credit outstanding under the Credit Agreement and the amount of collateral posted by the Company in support of such letters of credit was approximately $15.2 million and $24.3 million as of the December 31, 2008, respectively.
The effect of the transactions comprising the 2008 MTA on the Company’s financial position and results of operations as of the Closing Date:
Represents the effect of the commutation of certain retrocession agreements in place with non-affiliates of the Company.
The Company continues to be exposed to certain significant risks and uncertainties that could materially adversely affect its results of operations, financial condition and liquidity, including the following:
Establishment of case basis reserves for unpaid losses and loss adjustment expenses on the Company’s in-force business and assessing the amount of anticipated claims and recoveries on the Company’s in-force CDS contracts requires the use and exercise of significant judgment by management, including estimates regarding the likelihood of occurrence and amount of a loss on a guaranteed obligation. Actual experience may differ from estimates and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred and, in certain cases, will occur over many years in the future. Examples of these events include changes in the level of interest rates, credit deterioration of guaranteed obligations, and changes in the value of specific assets supporting guaranteed obligations. Both qualitative and quantitative factors are used in making such estimates. Any estimate of future costs is subject to the inherent limitation on management’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and claims will vary, perhaps materially, from any estimate. The most significant assumption underlying the Company’s estimate of ultimate
Under a reinsurance agreement between Syncora Guarantee and Syncora Guarantee-UK (the “Treaty”), Syncora Guarantee has agreed to reinsure, on a quota share basis, up to 97% of the financial guarantee business written by Syncora Guarantee-UK. In the event that, among other things, either of the parties becomes insolvent or has a receiver appointed, the other party shall have the right to terminate the Treaty. In the event of such termination, Syncora Guarantee will forego the right to receive any future premiums and Syncora Guarantee-UK
Furthermore, in 2002, Syncora Guarantee-UK agreed with the FSA UK to maintain a minimum solvency margin at the greater of (i) $12.5 million or (ii) 200% of the FSA UK’s required minimum margin of solvency. Under a Surplus Maintenance Agreement, Syncora Guarantee agreed to provide Syncora Guarantee-UK with funds sufficient to maintain compliance with this test at all times. Syncora Guarantee-UK was in breach of its capital solvency margin as required by the FSA UK under U.K. GAAP by $4.4 million as of September 30, 2008 and $0.6 million as of December 31, 2008. Syncora Guarantee contributed $4.4 million to Syncora Guarantee-UK and has requested NYID approval to contribute another $1.0 million. The NYID has verbally notified Syncora Guarantee that, until the 2009 MTA is consummated, it will not permit the $1.0 million capital injection to be made. Syncora Guarantee could be required to provide additional contributions to Syncora Guarantee-UK and these amounts could be material. The payment of such funds will be subject to NYID approval. If the NYID does not approve capital contributions to Syncora Guarantee-UK, the FSA UK may take regulatory actions that adversely affect Syncora Guarantee’s financial position and results of operations, and may impact its ability to comply with its minimum policyholders’ surplus requirement.
In light of Syncora Guarantee’s significant statutory policyholders’ deficit and significant anticipated near term claim payments, Syncora Guarantee’s Board of Directors is currently considering a suspension of, and may, in the exercise of its fiduciary duties, determine that it will suspend claim payments in order to preserve its assets for the benefit of all policyholders. If suspended, there can be no assurance when or if claim payments would recommence, although Syncora Guarantee’s Board of Directors could subsequently decide to recommence claim payments. Any decision to suspend claim payments could have a number of material
The Company’s expected financial condition after the consummation of the transactions contemplated by the 2009 MTA and the tender offer is based on various assumptions concerning these transactions, including accounting and tax treatment. There can be no assurance that the assumptions will not differ materially from the ultimate treatment of such transactions and any differences may be material. In addition, while the transactions contemplated by the 2009 MTA and the tender offer were designed to improve our financial condition, the Company will continue to be subject to risks and uncertainties that could materially affect our financial position. Therefore, even if the transactions contemplated by the 2009 MTA and the tender offer are consummated, the Company may continue to report a policyholders’ deficit or not comply with the statutory minimum policyholders’ surplus, undergo additional restructuring and, in addition, the Company may become insolvent in the future.
As a result of uncertainties associated with the aforementioned factors affecting the Company’s ability to continue as a going concern, management has concluded that there is substantial doubt about the ability of the Company to continue as a going concern. The Company’s financial statements as of December 31, 2008 and 2007 and for the years ended December 31, 2008, 2007, and 2006 are prepared assuming the Company continues as a going concern and do not include any adjustment that might result from its inability to continue as a going concern.
Management is principally focused on: (i) seeking to successfully consummate the 2009 MTA and the tender offer, (ii) maintaining or enhancing the Company’s liquidity, and (iii) remediating troubled credits to minimize claim payments, maximize recoveries and mitigate ultimate expected losses. The Company currently anticipates that in connection with the 2009 MTA Syncora Guarantee will agree, except in certain limited circumstances, not to recommence writing any new business.
In seeking to reduce exposure to CDS contracts and other guaranteed products and otherwise improve the Company’s financial position and liquidity, the Company may from time to time, directly or indirectly, seek to purchase (on the open market or otherwise) or commute its guaranteed exposures. The amount of exposure reduced and the nature of any such actions will depend on market conditions, pricing levels, the Company’s cash position, and other considerations. On March 11, 2009, the Fund commenced a tender offer to acquire the RMBS Securities insured by Syncora Guarantee (see Note 3).
Prior to the IPO, certain expenses reflected in the Consolidated Financial Statements include allocations of corporate expenses incurred by XL Capital related to general and administrative services provided to the Company. These expenses were allocated based on estimates of the cost incurred by XL Capital to provide these services to the Company. Management believes that the methods used to estimate the costs allocated to the company are reasonable. All intercompany accounts and transactions have been eliminated in consolidation. However, these results do not necessarily represent what the historical consolidated financial position, results of operations and cash flows of the Company would have been if the Company had been a separate, stand-alone entity prior to the IPO.
In December 2006, the SEC contacted the Association of Financial Guaranty Insurers (“AFGI”), of which the Company is a member, and instructed the members thereof to recommend a uniform approach for presenting credit derivatives issued by financial guarantee insurance companies in their financial statements. The recommendation of AFGI was developed in consultation with the staff of the Office of the Chief Accountant of the Division of Corporate Finance of the Securities and Exchange Commission (the “SEC”) and has been adopted by the Company effective January 1, 2008 in accordance with the transition AFGI discussed with the SEC. The new presentation does not change the Company’s reported net income or shareholders’ equity, although it does change the presentation of revenues, expenses, assets and liabilities.
As a result of the Company’s adoption of this revised presentation, changes in fair value of the Company’s credit derivatives are recorded in the line item of the accompanying consolidated statement of operations entitled “Net change in fair value of credit derivatives” which is required to be classified in the revenue section of the statement of operations. This line item consists of two components, which are also separately presented in the statement of operations: (1) “Realized gains
and losses and other settlements” and (2) “Unrealized gains and losses”. The “Realized gains and losses and other settlements” component includes (i) net premiums received and receivable on issued credit derivatives, (ii) net premiums paid and payable on purchased credit derivatives, (iii) losses paid and payable to credit derivative counterparties due to the occurrence of a credit event and, (iv) losses recovered and recoverable on purchased credit derivatives due to the occurrence of a credit event. The “Unrealized gains and losses” component includes anticipated claims payable and anticipated recoveries, as well as all other changes in fair value. Also included in the aforementioned line items is the change in fair value of the put option relating to Syncora Guarantee’s capital facility. See discussion below and in Note 9.
All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of debt securities are determined on the basis of average cost. Investment income is recognized when earned.
The Company’s policy is to not invest in obligations which it insures, and there were no such obligations included in the Company’s investment portfolio as of December 31, 2008 or 2007.
Premiums charged in connection with the issuance of the Company’s guarantees are received either upfront or in installments. Such premiums are recognized as written when due. Installment premiums written are earned ratably over the installment period, generally one to three months, which is consistent with the expiration of the underlying risk or amortization of the underlying insured par. Upfront premiums written are earned in proportion to the expiration of the related risk. The methodology employed to earn upfront premiums requires that such premiums be apportioned to individual sinking fund payments of a bond issue according to the bond issue’s amortization schedule. The apportionment is based on the ratio of the principal amount of each sinking fund payment to the total principal amount of the bond issue. After the premium is allocated to each scheduled sinking fund payment, such allocated premium is earned on a straight-line basis over the period of that sinking fund payment. As a result, for upfront premiums on amortizing insured obligations, premium revenue recognition will tend to be greater in the earlier periods of the transaction when there is a higher amount of risk or principal outstanding. The effect of the Company’s upfront premium earnings policy is that the Company recognizes greater levels of upfront premiums in earlier years of each amortizing insured obligation. Recognizing premium revenue on a straight-line basis over the life of each amortizing insured obligation without allocating premiums to the scheduled principal payments would materially change the amount of premium the Company recognizes in a particular financial reporting period, but not over the life of the applicable
In addition, when an insured issue is retired early, is called by the issuer or is in substance paid in advance through a refunding accomplished by placing U.S. government securities in escrow (hereafter collectively referred to as a “Refunding”), the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company.
net of expected recoveries under salvage and subrogation rights. Case basis reserves are generally determined using cash flow models to estimate the net present value of the anticipated shortfall between (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) anticipated cash flow from the collateral supporting the obligation and other anticipated recoveries. A number of quantitative and qualitative factors are considered when determining or assessing the need for a case basis reserve. These factors may include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured, the projected cash flow or market value of any assets that collateralize or secure the insured obligation, and the historical and projected loss rates on such assets. Other factors that may affect the actual ultimate loss include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. Such factors and the Company’s assessment thereof will be subject to the specific facts and circumstances associated with the specific insured transaction being considered for case reserve establishment. Case basis reserves are generally discounted at a rate reflecting the return on the Company’s investment portfolio during the period the case basis reserve is established. The Company believes this rate of return is an appropriate rate to discount its reserves because it reflects the rate of return on the assets supporting such business. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an upfront basis, the Company continues to record premium earnings on such policy over its remaining life, unless it has recorded a full limit loss with respect to such policy, in which case the remaining deferred premium revenue relating thereto is immediately reflected in earnings. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an installment basis, those premiums, if expected to be received prospectively, are considered a form of recovery.
In assessing whether a loss is probable, the Company considers all available qualitative and quantitative evidence. Qualitative evidence may take various forms and the nature of such evidence will depend upon the type of insured obligation and the nature and sources of cash flows to fund the insured obligation’s debt service. For example, such evidence with respect to an insured special revenue obligation such as an obligation supported by cash flows from a toll road would consider traffic statistics such as highway volume and related demographic information, whereas an insured mortgage-backed securitization would consider the quality of the mortgage loans supporting the insured obligation including delinquency, default and foreclosure rates, loan to value statistics, market valuation of the mortgaged properties and other pertinent information. In addition, the Company will make qualitative judgments with respect to the amount by which certain other
structural protections built into the transaction are expected to limit the Company’s loss exposure. Examples of such structural protections may include: (i) rate covenants, which generally stipulate that issuers (i.e., public finance issuers) set rates for services at certain predetermined levels (i.e., water and sewer rates which support debt obligations supported by such revenues), (ii) springing liens, which generally require the issuer to provide additional collateral upon the breach of a covenant or trigger incorporated into the terms of the transaction, (iii) consultant call-in rights, which provide, under certain circumstances, for a consultant to be engaged to make certain binding recommendations, such as raising rates or reducing expenses, (iv) the ability to transfer servicing of collateral assets to another party, and (v) other legal rights and remedies pursuant to representations and warranties made by the issuer and written into the terms of such transactions. Quantitative information may take the form of cash flow projections of the assets supporting the insured debt obligation (which may include, in addition to collateral assets supporting the obligation, structural protections subordinate to the attachment point of the Company’s risk, such as cash reserve accounts and letters of credit), as well as (to the extent applicable) other metrics indicative of the performance of such assets and the trends therein. The Company’s ability to make a reasonable estimate of its expected loss depends upon its evaluation of the totality of both the available quantitative and qualitative evidence, and no one quantitative or qualitative factor is dispositive.
In addition to case basis reserves, the Company maintains an unallocated loss reserve for expected losses inherent in its in-force business (consisting of both financial guarantee insurance and reinsurance business) that it expects to emerge in the future. The Company’s unallocated loss reserves represent its estimated ultimate liability from claims expected to be incurred in the future under its in-force insured and reinsured policies less outstanding case basis reserves and cumulative paid claims to date on such policies. The Company’s unallocated reserves are estimated by management based upon an actuarial reserving analysis. The actuarial methodology applied by the Company is in accordance with Actuarial Standards of Practice No. 36, Determination of Reasonable Provision. The methodology applied is based on the selection of an expected ultimate loss ratio (“UELR”), as well as an expected loss emergence pattern (i.e., the expected pattern of the expiration of risk on insured and reinsured in-force policies). Salvage and subrogation recoveries are implicit in the Company’s selected UELR as such ratio is derived from industry loss experience, which is net of salvage and subrogation recoveries (i.e., from the liquidation of supporting or pledged collateral assets). The implicit inclusion of salvage and subrogation recoveries in the Company’s selected UELR is consistent with the Company’s explicit consideration of collateral support in the establishment of its case basis reserves. In May 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 163 (“SFAS 163”), Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”). SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008. Upon adoption of SFAS 163, the Company will no longer be able to record unallocated reserves and will be required to de-recognize its existing unallocated reserves. See “Recent Accounting Pronouncements” below.
The Company updates its estimates of losses and loss adjustment expense reserves quarterly and any resulting changes in reserves are recorded as a charge or credit to earnings in the period such estimates are changed. In connection therewith, the Company’s unallocated reserves are adjusted each period to reflect (i) any revisions to management’s estimated UELR, if any, and (ii) the underlying par risk amortization (or “loss development”) of the related insured and reinsured in-force business (i.e., loss emergence pattern). As stated above, the Company’s estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. As the Company establishes case basis reserves and pays claims it may, based on its judgment, reduce or increase the UELR used to determine unallocated reserves to reflect its best estimate of the Company’s expected ultimate loss experience. In addition, under the
Company’s accounting policy the Company may, based on its judgment, reduce unallocated reserves in response to significant case basis reserve and/or paid loss activity. The Company would only expect such reductions to occur in limited instances, such as economic events generating significant loss activity across a broad cross-section of its in-force portfolio. The Company has not viewed its case basis reserve and paid loss activity to date to warrant a reduction of its unallocated reserves. While material case basis reserves were established by the Company in 2007 and 2008, these reserves were concentrated in certain sectors of the Company’s financial guarantee portfolio and were associated with unprecedented credit-market events. As such, these events did not alter the Company’s perspective of the UELR associated with the remainder of the portfolio and the required level of unallocated reserves. Each quarterly period there is an interplay between case basis reserves, unallocated reserves and cumulative paid losses to date, such that the aggregate thereof represents management’s best estimate of the ultimate losses it expects the Company to incur on its in-force business. The process of establishing unallocated reserves and periodically revising such reserves to reflect the underlying par risk amortization and management’s current best estimate of ultimate losses will ultimately cause the cumulative loss experience over the life of a particular underwriting year’s business to equal the cumulative inception-to-date actual paid losses on such business.
The Company’s loss reserving policy, described above, is based on guidance provided in FASB Statement No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), SFAS 5, “Accounting for Contingencies” and analogies to Emerging Issues Task Force (EITF) 85-20, “Recognition of Fees for Guaranteeing a Loan.” SFAS 60 requires that, for short-duration contracts, a liability for unpaid claim costs relating to insurance contracts, including estimates of costs relating to incurred but not reported claims, be accrued when insured events occur. Additionally, SFAS 5, requires that a loss be recognized when it is probable that one or more future events will occur confirming that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated.
In the event of a Refunding, the remaining net amount of DAC with respect to refunded insured issue is recognized at such time.
In the normal course of business, the Company purchases reinsurance coverage principally to increase aggregate capacity, manage its risk guidelines and reduce the risk of loss on its in-force business. Reinsurance premiums ceded are earned over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded which is applicable to the unexpired term of reinsured policies in-force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provision is made for any estimated uncollectible reinsurance.
CDS contracts are derivative contracts which offer credit protection relating to a particular security or pools of securities which are specifically referenced in the CDS contract. Under the terms of a CDS contract, the seller of credit protection (the issuer of the CDS contract) makes a specified payment to the buyer of such protection (the CDS contract counterparty) upon the occurrence of one or more credit events specified in the CDS contract with respect to a referenced security or securities. The terms of the CDS contracts issued by the Company generally only require the
Company to make a payment upon the occurrence of one or more specified credit events after exhaustion of various levels of subordination or first-loss protection. In addition, pursuant to the terms of the Company’s CDS contracts, the Company is precluded from transferring such contracts to other market participants without the consent of the counterparty.
Securities or assets referenced in the Company’s in-force CDS contracts include structured pools of obligations, such as ABS CDOs, CLOs, corporate CDOs, CDOs of CDOs and CMBS. Such pools were rated investment-grade or better at the issuance of the CDS contract.
The fair value of the Company’s in-force portfolio of CDS contracts other than CDS on ABS CDOs, which are discussed below, represents the net present value of the difference between the remaining unearned premiums that the Company originally charged for credit protection and management’s best estimate of what a financial guarantor of a comparable credit worthiness would hypothetically charge to provide the same protection as of the measurement date. The hypothetical nature of this exit value is representative of the lack of a principal market for the Company’s CDS contracts. In the absence of such a principal market, the Company believes other financial guarantors of comparable credit quality to Syncora Guarantee best represent the hypothetical exit
Typical market CDS contracts are standardized, liquid instruments that reference tradeable securities such as corporate bonds that also have observable prices. These market standard CDS contracts also involve collateral posting, and upon a default of the referenced bond obligation, can be settled in cash. In contrast, the Company’s CDS contracts do not contain the typical CDS market standard features as described above but have been customized to replicate the Company’s financial guarantee insurance. The Company’s CDS contracts provide protection on specified obligations, such as those described above and, generally contain a some form of subordination prior to the attachment of the Company’s liability. The Company is not required to post collateral, and upon default, the Company generally makes payments on a “pay-as-you-go” basis after the subordination in a transaction is exhausted.
The basis of management’s estimate of the fair value of the Company’s CDS contracts at December 31, 2008 described above reflects the absence of observable transactions in the Company’s principal market. Should such transactions occur in the future, it may significantly affect the Company’s estimate of the fair value of its CDS contracts.
The following table sets forth the Company’s financial assets and liabilities related to credit derivatives that were accounted for at fair value as of December 31, 2008 by level within the fair value hierarchy of SFAS 157. As required by SFAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
The following table presents the changes in the net derivative asset (liability) balance for the year ended December 31, 2008:
Represents the change in fair value of the put option on Syncora Guarantee’s capital facility (see Note 9). The fair value of the option was determined principally based on an independent broker quote.
Includes losses paid and payable on issued CDS contracts net of losses recovered and recoverable on purchased contracts.
As of December 31, 2007, the Company’s estimate of the fair value of its in-force CDS contracts was based on the use of valuation techniques involving management judgment in regard to a number of factors, including:
the actual amount of subordination in the Company’s CDS contracts before liability attaches,
credit price indices, published by non-affiliated financial institutions, for the type(s), or similar types, of assets referenced in the Company’s CDS contracts (both in terms of type of assets and their credit rating),
The weight ascribed by management to the aforementioned factors in forming its best estimate of the fair value of the Company’s CDS contracts may vary under changing circumstances. In periods prior to July 1, 2007, management principally considered price indices published by nonaffiliated financial institutions in forming its best estimate of the fair value of the Company’s CDS contracts. The fair value of the guarantee was determined by multiplying the percentage change in the applicable credit price index or indices applicable to the assets referenced in the CDS
In forming management’s best estimate of the fair value of the Company’s CDS contracts subsequent to June 30, 2007, however, management concluded that limited reliance could be placed on price indices because events and conditions in the credit markets associated with subprime mortgage collateral and corporate loans resulted in limited or no transaction activity in many financial instruments since June 30, 2007 (including ABS CDOs, CLOs, RMBS, and other CDOs), causing financial institutions which publish the indices that management historically relied upon to estimate the fair value of the Company’s credit derivatives either to refrain from updating such indices or base changes in the indices partly on judgments in regard to estimated price levels and not actual executed trades. In addition, evidence suggested that the limited price information available in the marketplace in regard to such instruments was influenced by trades resulting from margin calls and liquidity issues that are generally not part of the risks associated with the Company’s business model or CDS contracts. As a result of the factors discussed above, the fair value of the Company’s credit defaults swaps at September 30, 2007 and December 31, 2007 were estimated by management primarily as follows:
in instances where current market indices were reliable and available, management’s estimate of fair value was based on applying the percentage change in the applicable credit price index or indices applicable to the assets referenced in the CDS contracts by the present value of the remaining expected future premiums to be received under the contract, and
revenue at inception of a financial guarantee insurance contract and, that such recognition should be based on the following:
In September 2006, the FASB issued SFAS 157 “Fair Value Measurements” (“SFAS 157”) which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This Statement is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, where the FASB previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within these fiscal years. The Company adopted the provisions of SFAS 157 on January 1, 2008. See Note 6 for disclosure of the effect on our financial position and results of operations of the adoption of SFAS 157 and Note 7 for certain other disclosures required under SFAS 157.
In October 2008, the FASB issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active: An Amendment of FASB Statement No. 157” (“FSP No. FAS 157-3”). FSP No. FAS 157-3 applies to financial assets within the scope of SFAS 157 for which other accounting pronouncements require or permit fair value measurements. FSP No. FAS 157-3 clarifies the application of SFAS 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is not active. The provisions are effective upon issuance, including prior periods for which financial statements have not been issued. The provisions of this FSP need not be applied to immaterial items. Since FSP No. FAS 157-3 only illustrates additional guidance in determining the fair value of a financial asset when the market for that financial asset is not active, FSP No. The Company adopted FAS 157-3 upon its issuance and if did not have any effect on the Company’s financial condition, results of operations or cash flows.
In September 2008, the FASB issued FSP No. FAS 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161” (“FSP No. FAS 133-1 and FIN 45-4”). FSP No. FAS 133-1 and FIN 45-4 require enhanced disclosures about credit derivatives and guarantees and amends FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to exclude derivative instruments accounted for at fair value under SFAS No. 133. The Company adopted FSP No. FAS 133-1 and FIN 45-4 for its financial statements prepared as of and for the year ended December 31, 2008. Since FSP No. FAS 133-1 and FIN 45-4 only requires additional disclosures concerning credit derivatives and guarantees, adoption of FSP No. FAS 133-1 and FIN 45-4 did not affect the Company’s financial condition, results of operations or cash flows.
In October 2006, the FASB issued proposed FASB Staff Position EITF 03-6-a, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.” This FASB Staff Position (“FSP”) addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing basic earnings per share (“EPS”) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, “Earnings Per Share.” A share-based payment award that contains a non-forfeitable right to receive cash when dividends are paid to common shareholders irrespective of whether that award ultimately vests or remains unvested shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be included in the computation of basic EPS pursuant to the two-class method. Under the terms of the Company’s restricted stock awards, grantees are entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return such dividends in the event the unvested awards are forfeited in the future. Accordingly, this FSP will have an effect on the Company’s EPS calculations. The FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of this FSP. Early application is not permitted.
In June 2007, the FASB ratified the consensus reached by the EITF on Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards.” EITF Issue No. 06- 11 requires that the tax benefit with respect to dividends or dividend equivalents for non-vested restricted shares or restricted share units that are paid to employees be recorded as an increase to additional paid-in-capital. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007, with early adoption permitted. The Company adopted EITF Issue No. 06-11 on January 1, 2008 and it did not have any effect on the Company’s financial statements.
The change in net unrealized gains consists of changes in the valuation of debt securities of $36.7 million, $38.3 million and $0.5 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Proceeds from sales of debt securities for the years ended December 31, 2008, 2007 and 2006 were $100.5 million, $91.5 million and $384.5 million, respectively.
The gross realized gains and gross realized (losses) for the years ended December 31, 2008, 2007 and 2006 were $2.1 million and ($242.5) million; $0.9 million and ($3.4) million; and $1.9 million and ($18.1) million, respectively.
Represents 8 million class A ordinary shares of XL Capital received by the Company in connection with the transactions comprising the 2008 MTA. See Note 4.
Syncora Guarantee Re was originally formed in 1998 as part of an investment venture between XL Capital and FSA and was initially capitalized through a series of transactions resulting in the issuance by Syncora Guarantee Re of its common shares to XLI, an indirect wholly owned subsidiary of XL Capital, for consideration of $221.0 million and the issuance by Syncora Guarantee Re of its Series A Redeemable Preferred Shares to FSA for consideration of $39.0 million. On December 7, 2004, Syncora Guarantee Re issued additional common shares to XLI in exchange for $125.0 million and on July 1, 2006 all of XL Capital’s direct and indirect ownership interest in Syncora Guarantee Re was contributed to Syncora Holdings. See Note 1. In addition, during 2006, Syncora Holdings contributed $298.1 million to Syncora Guarantee Re from the net proceeds of its IPO and in 2007, Syncora Holdings contributed $225.0 million to Syncora Guarantee Re from the net proceeds of its issuance of Series A Perpetual Non-Cumulative Preference Shares. See Note 21. There were no common or other shares of equity capital issued by Syncora Guarantee Re to Syncora Holdings in exchange for such contributions. Pursuant to Syncora Guarantee Re’s corporate bye-laws each share of common stock of Syncora Guarantee Re was entitled to three votes with respect to matters requiring a vote of shareholders and each share of the Series A Redeemable Preferred Shares were entitled to one vote. Accordingly, at December 31, 2007 and 2006 holders of Syncora Guarantee Re’s Series A Redeemable Preferred Shares as a group had approximately a 5% voting interest in Syncora Guarantee Re, respectively, whereas holders of Syncora Guarantee Re’s common shares had an approximate 95% voting interest, respectively.
Under Syncora Guarantee Re’s corporate bye-laws the Series A Redeemable Preferred Shares were originally structured to provide for: (i) a 5% fixed annual dividend, (ii) an annual participating dividend according to certain criteria including a formula based on the financial guarantee company industry average for dividends paid, and (iii) a payment upon redemption. Under Syncora Guarantee Re’s amended corporate bye-laws the Series A Preferred Shares may be redeemed by Syncora Guarantee Re: (i) at any time, in whole or in part, at its sole option; subject to certain limitations; or (ii) in whole but not in part, at any time after the tenth anniversary of the date of their initial issue. Dividends under the Series A Preferred Shares are cumulative. At any time after November 3, 2008, the holders may require Syncora Guarantee Re to redeem the Series A Preferred Shares. The Series A Preferred Shares may also be required to be redeemed upon the occurrence of a change of control.
On February 27, 2007, the board of directors of Syncora Guarantee Re approved: (i) an extraordinary dividend of $15.0 million on its Series A Redeemable Preferred Shares, and (ii) a reduction in the stated value of the remaining outstanding Series A Redeemable Preferred Shares by
a corresponding amount. Payment of the extraordinary dividend and the reduction in the stated value of the Series A Redeemable Preferred Shares occurred on March 30, 2007. Also, as a result of the reduction in stated value, dividends on the redeemable preferred shares were $0.8 million quarterly subsequent to March 31, 2007.
On February 11, 2008, Syncora Guarantee Re issued $200 million of non-cumulative perpetual Series B preferred shares (the “Series B Preferred Shares”) pursuant to the exercise of a put option under its capital facility. After the merger of Syncora Guarantee Re with and into Syncora Guarantee on September 4, 2008, the Series B Preferred Shares became preferred shares of Syncora Guarantee (see Notes 1 and 4). The Series B Preferred Shares have a par value of $120 per share and a liquidation preference of $100,000 per share. Holders of outstanding Series B Preferred Shares are entitled to receive, in preference to the holders of Syncora Guarantee’s common shares, cash dividends at a percentage rate per Series B Preferred Share as follows:
In accordance with GAAP, the aforementioned put option is required to be reported at fair value with changes in the fair value thereof reflected in the unrealized gains (losses) component of the “Net change in fair value of derivatives” line item of the Company’s statements of operations. For the year ended December 31, 2008, the Company recorded a net realized gain of $179.6 million and for the years ended December 31, 2007 and 2006, the Company recorded net unrealized gains (losses) of $104.6 million and $(2.3) million, respectively, relating to the put option. The increase in the value of the put option recorded at December 31, 2008 and 2007 reflects the trading value at such dates of the aforementioned pass-through securities which, in turn, reflects the market perception of credit risk associated with the Series B Preferred Shares.
At December 31, 2007, the fair value of the put option was $107.1 million, which is reflected in the Company’s consolidated balance sheet at such date in the line item entitled, “Derivative assets”. During the period from January 1, 2008 through to the effective date of the exercise of the put option, the Company recorded an incremental unrealized gain on the put option of $72.5 million and
the corresponding derivative asset at such date was $179.6 million. Upon the exercise of the put option, the Company reversed the derivative asset and correspondingly reduced the paid in capital of the Series B Preferred Shares that were issued pursuant to the exercise of the put option. The effect of these entries is to report the Series B Preferred Shares at their estimated fair value at the date of issuance. Accordingly, the carrying value of the Series B Preferred Shares at December 31, 2008 of $20.0 million represents the net proceeds received upon the issuance thereof less the reversal of the fair value of the put option on the date of exercise.
Effective July 1, 2007, Syncora Guarantee Re ceded certain business to XLI, aggregating approximately $3.7 billion of guaranteed par/notional exposure, under an existing facultative quota share reinsurance agreement. As a result of this transaction, on such date, Syncora Guarantee Re ceded premiums of $16.3 million to XLI, received a ceding commission allowance of $6.6 million from XLI, and recorded a liability to XLI of $9.7 million. In connection with the 2008 MTA discussed in Note 4, the aforementioned reinsurance agreement was commuted.
Effective August 4, 2006, certain subsidiaries of XL Capital indemnified the Company for all losses and loss adjustment expenses incurred in excess of its retained reserves at the effective date of the agreement relating to an insured project financing described in Note 16 (c). In consideration for the aforementioned indemnifications the Company was obligated to pay such affiliates approximately $9.8 million on an installment basis over the life of the aforementioned project financing. As the premium was due irrespective of any early termination of the underlying insurance transaction, the Company recorded a liability of approximately $7.0 million at the effective date of the indemnifications (representing the present value of the obligation discounted at 5.0%, which reflects the rate on Treasury obligations at that time with a term to maturity commensurate with that of the liability) and a corresponding deferred cost, which are reflected in the accompanying consolidated balance sheet as of December 31, 2007 in “reinsurance premiums payable” and “prepaid reinsurance premiums”, respectively. In connection with the 2008 MTA discussed in Note 4, the aforementioned indemnities were cancelled.
Effective August 4, 2006, XLA has undertaken to indemnify the Company for any diminution in value below their carrying value at June 30, 2006 of the notes and preferred shares described in Note 16, which notes and preferred shares were acquired in connection with the satisfaction of a claim under a financial guarantee insurance policy issued by Syncora Guarantee. In addition, pursuant to the aforementioned indemnity, XLA agreed to indemnify the Company for any costs arising out of any litigation or future claim in connection with the aforementioned insurance policy. See Note 16 for further information regarding amounts recovered or recoverable by the Company under the indemnity.
Effective November 1, 2002 and as amended and restated as of March 1, 2007, Syncora Guarantee was party to a facultative reinsurance arrangement (the “XL Re Treaty”) with XL Reinsurance America, Inc. (“XL RE AM”). Under the terms of the XL Re Treaty, XL RE AM agreed to reinsure risks insured by Syncora Guarantee under financial guarantee insurance policies up to the amount necessary for Syncora Guarantee to comply with single risk limitations set forth in Section 6904(d) of the New York Insurance Law. Such reinsurance was on an automatic basis prior to the effective date of the IPO and was on a facultative basis on and after the effective date of the IPO. The reinsurance provided by XL RE AM was on an excess of loss or quota share basis. The Company was allowed up to a 30% ceding commission (or such other percentage on an arm’s-length basis) on ceded premiums written under the terms of this agreement. In connection with the 2008 MTA described in Note 4, the XL RE Treaty was commuted.
The XLI guarantee agreement terminated with respect to any new business produced by Syncora Guarantee and ceded to Syncora Guarantee Re pursuant to the facultative quota share reinsurance agreement after the effective date of the IPO, but the guarantee remained in effect with respect to cessions under the agreement prior to the IPO. In connection with
The following table summarizes the non-affiliated and affiliated components of each line item in the consolidated statements of operations where applicable:
Deferred acquisition costs, net of deferred ceding commission revenue, as well as related amortization, as of and for the years ended December 31, 2008, 2007 and 2006 are as follows:
During the year ended December 31, 2007, the Company recorded a charge of $3.1 million to reduce deferred acquisition costs in regard to certain of its guarantees of obligations supported by HELOC and CES mortgage loan collateral to reflect the fact that the sum of expected losses and loss adjustment expenses, maintenance costs and unamortized policy acquisition costs on such guaranteed obligations exceeded the related unearned premiums, the anticipated present value of future premiums under installment contracts written, and anticipated investment income.
The Company enters into ceded reinsurance arrangements principally to increase aggregate capacity, manage its risk guidelines and to reduce the risk of loss on business written or assumed. This reinsurance includes the reinsurance arrangements with affiliates that are discussed in Note 10, as well as reinsurance arrangements with non-affiliated reinsurers. Reinsurance does not relieve the Company of its obligations under its guarantees. Accordingly, the Company is still liable under its guarantees in the event reinsuring companies do not meet their obligations to the Company under reinsurance agreements. The Company regularly monitors the financial condition of its reinsurers. For the years ended December 31, 2008, 2007, and 2006 there were no amounts provided by the Company for uncollectible reinsurance recoverable. The following tables set forth certain amounts ceded to affiliate and non-affiliate reinsurers as of and for the years ended December 31, 2008, 2007, and 2006.
On August 1, 2006, Syncora Holdings and certain of its subsidiaries entered into the Credit Agreement with a syndicate of banks, for which Citibank N.A. is the administrative agent. The Credit Agreement provided for a five-year letter of credit and revolving credit facility, which, prior to the Credit Agreement Amendment, provided for letters of credit of up to $250 million and up to $250 million of revolving credit loans with the aggregate amount of outstanding letters of credit and
The Company provides financial guarantee insurance and reinsurance to support public and private borrowing arrangements. Financial guarantee insurance guarantees the timely payment of principal and interest on insured obligations to third party holders of such obligations in the event of default by an issuer. The Company’s potential liability in the event of non-payment by the issuer of a guaranteed obligation represents the aggregate outstanding principal guaranteed under its policies and contracts and related interest payable at the date of default. In addition, the Company provides credit protection on specific assets referenced in its CDS contracts which consist of structured pools of corporate obligations (see Note 6). Under the terms of its CDS contracts, the seller of credit protection makes a specified payment to the buyer of credit protection upon the occurrence of one or more specified credit events with respect to a referenced obligation. The Company’s potential liability under its CDS contracts represents the notional amount of such swaps that it guarantees.
The Company seeks to limit its exposure to losses by maintaining a surveillance function which monitors such transactions throughout their lives. Additionally, the Company historically sought to mitigate credit risk by only underwriting investment-grade transactions, diversifying its portfolio and maintaining collateral requirements on asset-backed obligations, as well as through reinsurance.
As of December 31, 2008 and 2007, par and notional amounts of the Company’s guaranteed asset-backed obligations were supported by the following types of collateral:
In its asset-backed business, the Company historically considered geographic concentration as a factor in its underwriting process. However, the existence of first-loss protection in a typical asset-backed securitization, in addition to other factors, makes it difficult to attribute geographic exposure to deals collateralized by diversified pools of obligations. For asset-backed transactions, the Company considers the seller/servicer, industry and type of collateral to be more relevant measures of diversification.
As of December 31, 2008, the Company had insured 14 high-grade and 3 mezzanine ABS CDO transactions, with total net par outstanding of $14.2 billion. All of its indirect exposure to residential mortgages arises from CDOs in which its guarantees are with respect to securities having the benefit of higher than the minimum amount of subordination required under rating agency criteria, in effect at the time of issue for a rating of “AAA,” based on S&P ratings. However, as a result of the actual levels of delinquencies, defaults and foreclosures on subprime mortgages substantially exceeding forecast levels, the Company anticipates losses from these policies. As of December 31, 2008, the Company’s indirect subprime net exposure was approximately $4.4 billion based on the RMBS holdings within the ABS CDO collateral pools. The Company’s indirect net exposure to other ABS CDOs was approximately $1.7 billion as of December 31, 2008, and a significant portion of the underlying collateral supporting these transactions consists of subprime RMBS. In addition, the collateral pools of most of the Company’s ABS CDO transactions contain securities issued by other ABS CDOs (also known as CDOs of CDOs or CDOs squared).
The following table presents the net notional exposure of the Company’s guaranteed CDOs by rating as of December 31, 2008:
Ratings represent the lower of ratings by S&P or Moody’s as of February 2, 2009.
For the years ended December 31, 2008, 2007 and 2006, the Company recorded a provision for losses and loss adjustment expenses, after giving effect to reinsurance, of approximately $1,789.8 million, $37.2 million and $0, respectively, representing the net present value loss expected to be incurred in the future with respect to certain of its guarantees of obligations supported by HELOC and CES (second lien loans) mortgage loan collateral, as well as Alt-A (first lien) mortgage loan collateral in 2008. At December 31, 2008 and 2007, reserves for unpaid losses and loss adjustment expenses on such business, after giving effect to reinsurance, were $1,557.9 million and $37.2 million, respectively ($1,558.4 million and $216.7 million, respectively before giving effect to reinsurance).
The 2008 activity for losses and loss adjustment expenses reflects the recapture of previously ceded reserves as a result of the commutation of reinsurance agreements. In connection with the 2008 MTA discussed in Note 4, the Company commuted substantially all of its ceded reinsurance arrangements.
The loss amounts discussed above, before giving effect to reinsurance, represent: (i) all claims paid through the measurement date, plus the net present value of claims expected to be paid subsequent thereto, less (ii) recoveries received through the measurement date, the net present value of expected recoveries subsequent thereto, and the net present value of installment premiums due by the counterparties to such guarantees subsequent to the measurement date.
The total remaining par guaranteed by the Company with respect to the aforementioned guarantees supported by HELOC, CES and Alt-A collateral, net of carried case basis reserves but before reinsurance, aggregated approximately $3.7 billion ($3.7 billion after reinsurance) at December 31, 2008 and $2.4 billion ($2.2 billion after reinsurance) at December 31, 2007.
The Company’s estimates of losses on the aforementioned guarantees are based on assumptions and estimates extending over many years into the future. Such estimates are subject to the inherent limitation on management’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate. Among other things, the assumptions could be affected by an increase in unemployment, further decreases in house prices, increase in consumer costs, lower advance rates by lenders or other parties, lower than expected revenues or other events or trends. The Company’s estimates are determined based on an analysis of results of a cash flow model.
The Company bases its default assumptions for the second lien transactions (HELOCs and CESs) in large part on recent observed default rates and the current pipeline of delinquent loans. At December 31, 2007, the Company had assumed that the peak defaults would occur at the end of 2008 and decline to a steady-state by mid-2009. At December 31, 2008, the Company’s assumption is that the peak will occur in mid-2009 and continue until early 2010 with a return to steady-state by the end of 2010. Net losses will be greater if the time it takes the mortgage performance to stabilize is longer than currently anticipated.
The losses for the second lien transactions (HELOCs and CESs) are estimated based on a model using a constant default rate (“CDR”) curve. The model anticipates a CDR which would reflect the “rolling” of delinquent loans to loss over a four to seven month time horizon and then assumes a peak CDR plateau through March 2010 followed by a ramping down of CDR over 9 months. After the ramp down, the Company assumes a steady state CDR at a CDR rate well above historical norms until approximately year seven of the deal. By year seven of the deal, the Company assumes another step down to 0% CDR to reflect lower default rates due to seasoning offset by recoveries on previously charged-off loans, based on shape of the CDR curve for a similar product. The CDR is a function of several factors, one of which is the state of the economy and unemployment. If economic conditions
The Company’s default assumptions for the 1st lien transactions is based on current delinquent loans and analysis of historical defaults for loans with similar characteristics. A loss severity is applied to the 1st lien defaults ranging from 41-68% based upon actual loss severity observances and collateral characteristics to determine the expected loss on the collateral in those transactions. The Company uses traditional default and prepayment curves to model its unpaid loss.
The Company has exercised rights available to it in connection with certain RMBS it insured to require the sponsors of such securities to repurchase mortgage loans backing the securities that breached certain representations and warranties. In all or most instances the Company has recorded reserves for unpaid losses and loss adjustment expense on such insured RMBS. While the sponsors have, and may in the future, dispute the repurchase of all or a portion of these mortgages, if the Company is successful in enforcing its rights, whether through litigation or otherwise, it will reduce the ultimate losses expected by the Company on the aforementioned insured securities. As of December 31, 2008 and 2007, the amount of mortgages that the Company is seeking sponsors to repurchase aggregated approximately $771.0 million and $0, respectively. No assurance can be given: (i) that the Company will be successful in enforcing its rights to require sponsors to repurchase the mortgages discussed above, and (ii) in regard to the amount of the potential decrease in reserves for unpaid losses that the Company may be able to record if it is successful. Potential benefit associated with successfully requiring the sponsor to repurchase mortgages, as discussed above, has not been reflected in the Company financial statements.
The Company insured payment of scheduled debt service on sewer revenue warrants issued by Jefferson County, Alabama (the “County”) in 2002 and 2003 and, in addition, has provided a surety bond policy in connection therewith. As of December 31, 2008, the outstanding principal amount of such obligations, and the Company’s exposure thereto before giving effect to reinsurance and the Company’s reserves for losses thereon discussed below, was $1.1 billion (after giving effect to reinsurance and the Company reserves for losses thereon, the Company’s exposure was $1.0 billion). Such obligations are secured by a pledge of the net revenues of the County’s sewer system. However, the County’s sewer system is experiencing severe financial difficulties and in a filing dated February 27, 2008 pursuant to SEC Rule 15c2-12, the County stated it can provide no assurance that net revenues from the sewer system will be sufficient to enable the County to pay, on a timely basis, the scheduled principal and interest obligations of the sewer revenue warrants.
During the year ended December 31, 2008, the Company recorded a provision for losses and loss adjustment expenses, after giving effect to reinsurance, of $26.6 million relating to the warrants, which reflects its best estimate of its ultimate loss thereon. At December 31, 2008, the Company’s reserve for unpaid losses and loss adjustment expenses, after giving effect to reinsurance, on the warrants was $22.4 million ($25.6 million before giving effect to reinsurance).
The Company continues to monitor the aforementioned exposure and, as new information becomes available, it may be required to adjust its provision for loss reserves thereon in the future. Through March 30, 2009, the Company has paid gross claims in an aggregate amount of approximately $165.5 million relating to the warrants. In addition, the Company estimates
In connection with the 2008 MTA (see Note 4), the Company and XL Capital canceled the aforementioned indemnities and commuted the aforementioned reinsurance provided by affiliates of XL Capital in exchange for consideration payable to the Company by affiliates of XL Capital equal to the ceded reserves for unpaid losses and loss adjustment expenses. Also, during the year ended December 31, 2008, the Company decreased the aforementioned reserves from $74.0 million to $41.3 million. The total remaining par insured by the Company in connection with this transaction (net of applicable carried case reserves before reinsurance), which amortizes over the next 10 years, aggregated approximately $224.8 million at December 31, 2008 and $204.6 million at December 31, 2007.
During the year ended December 31, 2008, the Company recorded a provision for losses and loss adjustment expenses of $8.6 million after giving effect to reinsurance relating to a global infrastructure financing that it had reinsured and carried a reserve for unpaid losses and loss adjustment expenses on such reinsured transaction of the same amounts at December 31, 2008. Such reserves were based on assumptions and estimates extending over many years into the future. A claim of $0.9 million was paid on this reinsured transaction in December 2008. Management continues to monitor the exposure and will revise its loss estimate if necessary, as new information becomes available. The total remaining par insured by the Company in connection with this transaction (net of applicable carried case reserves before reinsurance), which amortizes over the next 20 years, aggregated approximately $105.0 million at December 31, 2008. In March 2009, the Company was advised by the ceding company that its share of the estimated reserve they had established on this transaction was approximately $18.0 million. To date, the Company has not completed its assessment of the ceding company’s estimated reserve and, therefore, the Company has not adjusted its provision to reflect the ceding company’s estimate. See Note 6.
During 2006, the Company also recorded a charge and carried a liability at December 31, 2006 of $5.0 million relating to a dispute in regard to certain claims made by parties associated with the transaction discussed above. Because the Company’s liability in regard to this dispute was fully indemnified by XLA pursuant to the indemnification discussed above and in Note 10, the Company also recorded a benefit during 2006 and carried a recoverable from XLA at December 31, 2006 of $5.0 million. During 2007, the Company settled the dispute for $3.9 million and, accordingly, reduced the liability and corresponding recoverable to zero.
The Company’s surveillance department also analyzes whether claims on the Company’s policies are probable. In some cases, the surveillance department will engage an outside consultant with appropriate expertise in the underlying collateral assets and respective industries to assist management in examining the underlying collateral and determining the projected loss frequency and loss severity. In such case, the surveillance department will use that information to run a cash flow model that includes enhancement levels and debt service to determine whether a claim is probable, possible or not likely.
The following table sets forth certain information in regard to the Company’s closely monitored credits as of December 31, 2008:
Syncora Guarantee Re, prior to the Closing Date, was not subject to any taxes in Bermuda on either income or capital gains under applicable Bermuda law. Effective on the Closing Date, Syncora Guarantee Re redomesticated from Bermuda to the State of Delaware and all the ownership interests in Syncora Guarantee Re, which were owned by Syncora Holdings, were contributed by Syncora Holdings to Syncora Guarantee, and on September 4, 2008 Syncora Guarantee Re merged with and into Syncora Guarantee, with Syncora Guarantee being the surviving company.
Syncora Guarantee is subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations, and effective on the Closing Date through September 4, 2008, Syncora Guarantee Re was subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The U.S. federal income tax liability is determined in accordance with the principles of the consolidated tax provisions of the Internal Revenue Code and Regulations. Syncora Guarantee has subsidiary and branch operations in certain international jurisdictions that are subject to relevant taxes in those jurisdictions. Syncora Guarantee files, and for the period it remained in existence Syncora Guarantee Re will file, a consolidated tax return with Syncora Holdings US Inc. (the U.S. common parent of the Syncora Holdings group) and its subsidiaries (which consists of Syncora Guarantee and Syncora Holdings US Inc.’s other U.S. based subsidiaries). Syncora Guarantee US Inc. maintains a tax sharing agreement with its subsidiaries, whereby the consolidated income tax liability is allocated among affiliates in the ratio that each affiliate’s separate return liability bears to the sum of the separate return liabilities of all affiliates that are members of the consolidated group. In addition, a complementary method is used which results in reimbursement by profitable affiliates to loss affiliates for tax benefits generated by loss affiliates.
On the effective date of the merger discussed above, Syncora Guarantee Re’s separate existence ceased and from that point forward it was no longer a member of the U.S. consolidated return group.
Management has concluded that results from operations forecasted to be generated in the future is more likely than not insufficient to offset net operating loss carry forwards and cause the realization of the deferred tax assets within a reasonable period, thus a valuation allowance has been established against the entire deferred tax assets of the Company at December 31, 2008 and December 31, 2007. The valuation allowance was calculated in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”) which places primary importance on the Company’s operating results in recent periods when assessing the need for a valuation allowance. The Company’s cumulative loss in recent periods represents negative evidence sufficient to require a full valuation allowance under the provisions of SFAS 109. The Company intends to maintain a full valuation allowance for its net deferred tax assets until sufficient positive evidence exists to support reversal of all or a portion of the valuation allowance. Until such time, except for state, local and foreign tax provisions, the Company will have no net deferred tax assets.
Following the August 5, 2008 ownership change, the Company has generated significant additional NOLs, and depending upon the Company’s operating performance in future periods, and may continue to generate additional NOLs. If the Company undergo an ownership change for purposes of Section 382 as a result of future transactions involving the Company’s common shares, including purchases or sales of shares between five-percent shareholders, the Company’s ability to utilize our NOLs and recognize certain built-in losses would be subject to further limitations under Section 382.
On October 21, 2008, Syncora Holding’s Board of Directors approved changes to Syncora Holdings’ bye-laws which were subsequently approved by the shareholders on February 9, 2009 to limit the transfer of shares prior to the expiration of certain time periods specified in the such bye-laws to preserve shareholder value and the value of certain tax assets primarily associated with net operating losses (NOLs) and built in losses under Section 382 of the Internal Revenue Code. The Company’s ability to use its NOLs and built in losses would be limited, if there was an “ownership change” under Section 382. This would occur if shareholders owning (or deemed under Section 382 to own) 5% or more of the Company’s stock increased their collective ownership of the aggregate amount of outstanding shares of Syncora Holdings by more than 50% over a defined period of time. The transfer restrictions in the bye-laws reduce the likelihood of an “ownership change” occurring as defined by Section 382.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“Fin 48”), on January 1, 2007. As of December 31, 2008 and 2007, respectively, the Company had no material unrecognized tax benefit and no adjustments to liabilities or operations were required.
The Company recognizes interest and penalties related to uncertain tax provisions in income tax expense which were zero for the years ended 2008, 2007 and 2006.
The Company’s income tax provisions for the years ended December 31, 2008, 2007, and 2006 are as follows:
Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years ended December 31, 2008, 2007 and 2006 is provided below:
In the ordinary course of business, the Company also receives subpoenas and other information requests from regulatory agencies or other governmental authorities. Although no action has been initiated against the Company, it is possible that one or more regulatory agencies or other governmental authorities may pursue action against it. As of March 30, 2009, Syncora Guarantee has had its license suspended, has had an order of impairment issued against it or has voluntarily agreed to cease writing business in ten states. If such an action is brought, it could materially adversely affect the Company’s business, results of operations and financial condition.
Set forth below is a description of certain legal proceedings to which the Company’s a party.
In December 2007 and January 2008, three lawsuits were commenced in the United States District Court for the Southern District of New York. On April 24, 2008, an order was entered consolidating these actions under the caption In re Security Capital Assurance Ltd. Securities Litigation. On August 6, 2008, the plaintiffs filed a consolidated amended complaint. The complaint names Syncora Holdings, XL Capital Ltd, XL Insurance Ltd, the principal underwriters for the secondary offering, the financial advisors for the preferred share offering, Paul S. Giordano, David P. Shea, Edward B. Hubbard, and Richard P. Heberton as defendants. The complaint includes
Syncora Guarantee is named as a defendant in related lawsuits, filed from April 2008 through October 2008, which have been consolidated for coordinated preliminary and pretrial proceedings under the caption In re Municipal Derivatives Antitrust Litigation, MDL No. 1950, currently pending in the United States District Court for the Southern District of New York. Syncora Guarantee was not named as a defendant in the consolidated amended complaint filed on August 22, 2008. The Company is named as a defendant in a number of complaints filed by California municipal entities against several providers and brokers of municipal derivatives. These complaints allege a conspiracy among the defendants to fix, raise, maintain or stabilize the price of, and to rig bids and allocate customers and market for, municipal derivatives in violation of Federal and/or California State antitrust law and California State common law. The complaints seek unspecified damages and other relief.
On August 28, 2008, a complaint was filed by Carnell E. Fowler, William Young, and Citizens for Sewer Accountability, on behalf of the State of Alabama, against Syncora Guarantee and many
On or around September 16, 2008, Syncora Guarantee, together with the trustee under the indenture for the Jefferson County, Alabama sewer warrants as well as Financial Guaranty Insurance Company, who also insures a portion of the warrants, commenced a lawsuit against the County and its current commissioners in the United States District Court for the Northern District of Alabama seeking, among other things, the appointment of a receiver over the County’s sewer system. A hearing on the plaintiff’s request for a receiver occurred on March 26, 2009. A decision on the emergency motion for the appointment of a receiver is currently pending. On September 25, 2008, the county filed a counterclaim against Syncora Guarantee and Financial Guaranty Insurance Company alleging negligence, breach of contract, fraud and fraudulent suppression. See Note 16 (b) for additional information.
On or around June 27, 2008, Syncora Guarantee filed suit against IndyMac Bank, F.S.B. in the United States District Court for the Southern District of New York seeking to specifically enforce the terms of a certain insurance and indemnity agreement to which they are parties. Subsequent to the filing of this suit, the Federal Deposit Insurance Corporation (“FDIC”) placed IndyMac Bank, F.S.B into conservatorship. We filed a proof of claim with the FDIC on October 10, 2008. This litigation has been stayed until June 2009 to allow the FDIC 180 days to determine whether to allow the proof of claim.
On February 5, 2009, Syncora Guarantee, together with co-plaintiffs U.S. Bank National Association and CIFG Assurance North America, Inc., filed suit in the Supreme Court of the State of New York, New York County, against GreenPoint Mortgage Funding, Inc. (“GreenPoint”), alleging that GreenPoint made misrepresentations and warranties in connection with a securitization of primarily home-equity mortgage loans originated by GreenPoint, and for which Syncora Guarantee acted as credit enhancer, and seeking damages and other relief for breach of contract.
The Company is a Bermuda corporation and, except as described below, neither it nor its non-United States subsidiaries have paid United States corporate income taxes on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the U.S. However, because definitive identification of activities which constitute being engaged in a trade or business in the United States is not provided by the Internal Revenue Code of 1986, regulations or court decisions,
there could be no assurance that the Internal Revenue Service would not contend that the Company or its non-United States subsidiaries are engaged in a trade or business or otherwise subject to taxation in the U.S. If the Company or its non-United States subsidiaries were considered to be engaged in a trade or business in the United States (and, if the Company or such subsidiaries were to qualify for the benefits under the income tax treaty between the United States and Bermuda and other countries in which the Company operates, such business were attributable to a “permanent establishment” in the U.S.), the Company or such subsidiaries could be subject to United States tax at regular tax rates on its taxable income that is effectively connected with its United States trade or business plus an additional 30% “branch profits” tax on such income remaining after the regular tax.
See also Note 5 for a description of continuing risks and uncertainties affecting the Company and other information.
The following estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data used to develop the estimates of fair value. Accordingly, the
Debt securities and equity investments: The fair values of the Company’s investments are based upon quoted market prices from nationally recognized pricing services or, in the absence of quoted market prices, dealer quotes or matrix pricing.
Syncora Holdings’ Board of Directors did not declare a quarterly dividend with respect to its common shares or a semi-annual dividend with respect to the Syncora Holdings Series A Preference Shares, as defined in Note 21, during the year ended December 31, 2008 or at any time thereafter through to the filing date of this report. On August 5, 2008, Syncora Holdings entered into an
undertaking with the NYID pursuant to which it agreed to not make dividends or distributions to its shareholders for eighteen months following such date without its express written consent. Any future dividends will be subject to the discretion and approval of the Board of Directors, applicable law and regulatory and contractual requirements. If dividends on the Syncora Holdings Series A Preference Shares are not paid in an aggregate amount equivalent to dividends for six full quarterly periods, whether or not declared or whether or not consecutive, holders of the Syncora Holdings Series A Preference Shares will have the right to elect two persons who will then be appointed as additional directors to the Board of Directors of Syncora Holdings. As of March 31, 2009, dividends on the Syncora Holdings Series A Preference Shares have not been paid in an aggregate amount equivalent to six quarterly periods.
On April 5, 2007, Syncora Holdings consummated the sale of $250.0 million of the Syncora Holdings Series A Preference Shares which were offered for sale pursuant to a private placement. Gross proceeds from the offering were $250.0 million, offering costs were $3.4 million, and net proceeds were $246.6 million. The Syncora Holdings Series A Preference Shares are perpetual securities with no fixed maturity date and, if declared by the Board of Syncora Holdings, will pay a fixed dividend, on a semi-annual basis during the first and third quarters of each fiscal year, at the annualized rate of 6.88% until September 30, 2017. After such date, the Syncora Holdings Series A
Preference Shares, if declared by the Board of Syncora Holdings, will pay dividends, on a quarterly basis, at a floating rate based on three-month LIBOR plus 2.715%. Dividends on the Syncora Holdings Series A Preference Shares are non-cumulative. The Syncora Holdings Series A Preference Shares have a liquidation preference of $1,000 per preference share. There are 250,000 Syncora Holdings Series A preference shares outstanding.
Effective August 4, 2006 the Board of Directors of the Company adopted the 2006 Long-Term Incentive and Share Award Plan (the “Plan”). The Plan provides for grants to eligible employees, consultants and directors of stock options, share appreciation rights, which the Company refers to as “SARs,” restricted shares, restricted share units, performance shares, performance units, dividend equivalents, and other share based and non-share based awards, which collectively the Company refers to as the “Awards.”
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised) “Share-Based Payments” (“SFAS 123R”). As there was no stock based compensation issued by the Company prior to the effective date of the IPO, the Company is utilizing the modified prospective transition method. Under the modified prospective transition method, compensation cost recognized relates to the estimated fair value at the grant date of stock-based compensation granted subsequent to January 1, 2006 in accordance with SFAS 123R.
At the effective date of the IPO, the Company awarded employees 447,963 shares under the Plan in the form of stock options and 500,428 shares under the Plan in the form of restricted stock. In addition, the Company awarded 200,000 shares under the plan in the form of stock options to
During the year ended December 31, 2007, the Company awarded 329,825 shares under the Plan in the form of stock options and 718,096 shares under the Plan in the form of restricted stock. In addition, the Company awarded 7,600 restricted stock units under the plan to directors. The stock options awarded under the Plan in 2007 had a weighted average grant-date fair value of $22.27. During the year ended December 31, 2007, the Company recognized approximately $1.3 million of compensation expense related to its stock option Awards.
During the year ended December 31, 2008, the Company did not make any awards under the Plan in the form of stock options and made awards of 100,000 shares under the Plan in the form of restricted stock. During the year ended December 31, 2008, the Company recognized approximately $1.2 million of compensation expense related to its stock option Awards.
There were approximately 5.3 million options available for grant as of December 31, 2008 irrespective of the form of the Award (e.g. SAR’s, restricted shares, restricted share units, performance shares, performance units, dividend equivalents, and other share-based awards).