Item 1. Business.
Financial Security Assurance Holdings Ltd., through its insurance company subsidiaries, is primarily engaged in providing financial guaranty insurance on public finance obligations in domestic and international markets. Historically, the Company also provided financial guaranty insurance on asset-backed obligations. In addition, the Company historically issued FSA-insured guaranteed investment contracts and other investment agreements ("GICs") as well as medium term notes to municipalities and other market participants through its Financial Products ("FP") segment. In August 2008, the Company announced that it would cease insuring asset-backed obligations and instead participate exclusively in the global public finance financial guaranty business. In November 2008, the Company ceased issuing GICs. While the Company has ceased new originations of asset-backed financial guaranty business and GICs, a substantial portfolio of such obligations remains outstanding.
The Company's principal insurance company subsidiary is Financial Security Assurance Inc. ("FSA"), a wholly owned New York insurance company. References to the "Company" are to Financial Security Assurance Holdings Ltd. together with its subsidiaries. References to "FSA Holdings" are to Financial Security Assurance Holdings Ltd. without its subsidiaries.
In November 2008, the Company's principal shareholder entered into a Purchase Agreement (the "Purchase Agreement") providing for the sale of the Company to Assured Guaranty Ltd. ("Assured"), subject to the consummation of specified closing conditions, including regulatory approvals, absence of rating impairment and segregation or separation of the Company's FP operations from the Company's financial guaranty operations. In February 2009, the Company's ultimate parent, Dexia S.A. ("Dexia"), through its bank affiliates, entered into agreements assuming credit and liquidity risks associated with the Company's GIC operations, resulting in the "deconsolidation" of FSA Asset Management LLC ("FSAM") from the Company under accounting principles generally accepted in the United States of America ("GAAP").
Obligations insured by the Company are generally awarded ratings on the basis of the financial strength ratings given to the Company's insurance company subsidiaries by the major securities rating agencies. On December 31, 2008, the Company was rated Triple-A (negative credit watch) by Standard & Poor's Ratings Services ("S&P") and Fitch Ratings ("Fitch") and Aa3 (developing outlook) by Moody's Investors Service, Inc. ("Moody's"). Prior to the third quarter of 2008, the Company's insurance company subsidiaries, as well as the obligations they insured, had been awarded Triple-A ratings by the three major rating agencies.
During 2007 and 2008, the global financial crisis that began in the U.S. subprime residential mortgage market transformed the financial guaranty industry. By the end of November 2008, all of the monoline guarantors that had been rated Triple-A at the beginning of the year had been downgraded in varying degrees by Moody's, and all but one had been either downgraded or placed on negative outlook or negative credit watch by S&P and Fitch. FSA and the Company's other insurance company subsidiaries were among the last companies to be affected, and were rated "Triple-A/stable" by all three rating agencies until July 2008. Rating agencies raised concerns about the stability of FSA's rating during the second half of 2008, and Moody's lowered FSA's Aaa rating to Aa3 (developing outlook) in November. These developments, combined with illiquidity in the capital markets, led to a marked reduction in FSA's production in the second half of 2008. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Executive Overview."
For the year ended December 31, 2008, the Company had gross premiums written of $690.4 million, of which approximately 88% related to insurance of public finance obligations and approximately 12% related to insurance of asset-backed and other non-public finance obligations. The Company also had realized gains on credit derivatives of $126.9 million in 2008. At December 31, 2008,
the Company had net par outstanding of $408.5 billion, of which approximately 75% represented insurance of public finance obligations and approximately 25% represented insurance of asset-backed and other non-public finance obligations. At December 31, 2008, the Company had $16.4 billion principal amount of outstanding FP segment debt.
FSA's exposure to mortgage-backed obligations with deteriorating credit performance has generated losses, as reflected in the Company's net loss reserves, which have increased from $198.1 million as of December 31, 2007 to $1,476.9 million at December 31, 2008, and a negative $7.2 billion change in fair value of the FP segment's investment portfolio over the same period, despite the fact that the Company has no material exposures to collateralized debt obligations ("CDOs") of asset-backed securities ("ABS") that include residential mortgage-backed securities ("RMBS"), which caused severe losses for a number of other financial guarantors. The full extent of credit losses in the mortgage sector, and the extent to which they may affect the Company, will not be known for several years. The Company is also closely monitoring the consumer and corporate sectors for signs of deepening economic stress. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Executive Overview-Summary Results of Operations and Financial Condition."
Transfer of Credit and Liquidity Risk of the GIC Business
The proceeds of GICs issued in connection with the Company's FP business were invested in securities owned by FSAM. Most of FSAM's assets consist of RMBS that have suffered significant market value declines and, in more limited cases, credit deterioration. The market value declines of FSAM's assets subject FSAM to significant liquidity risk insofar as the GICs are in most cases subject to redemption or collateralization upon the downgrade of FSA below certain thresholds, with a significant number of GICs subject to redemption or collateralization should FSA be downgraded below Aa3 by Moody's (FSA's current Moody's rating) or below AA- by S&P. Dexia had previously announced its intention to assume the credit and liquidity risk associated with the Company's FP business, and provided significant support to the FP business in the course of 2008.
In February 2009, Dexia entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia, which resulted in "deconsolidation" of FSAM from the Company (the "FSAM Risk Transfer Transaction") as of that date. These agreements provide for the (i) elimination of FSA's guaranty of repayment of FSAM's borrowings under the credit facilities provided by Dexia's bank subsidiaries; (ii) elimination of FSA's guaranty of certain of FSAM's investments; and (iii) increase in the credit facilities provided to FSAM by Dexia's bank subsidiaries from $5 billion to $8 billion. For further information regarding these agreements, see "-Expected Sale of the Company-Dexia's Retention of the FP Business" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation-Liquidity and Capital Resources-FP Segment Liquidity-Liquidity Resources."
Expected Sale of the Company
Purchase Agreement with Assured
In November 2008, Dexia and Assured entered into the Purchase Agreement providing for the purchase by Assured of all Company shares owned by Dexia (the "Acquisition"), subject to the satisfaction of specified closing conditions. Purchase Agreement closing conditions include (1) receipt of regulatory and Assured shareholder approvals; (2) confirmation from S&P, Moody's and Fitch that the acquisition of the Company would not result in a downgrade of the financial strength ratings of the insurance company subsidiaries of Assured or of the Company; and (3) segregation or separation of the Company's FP business such that the credit and liquidity risk of the FP business resides with Dexia, with FSA protected against any future Dexia credit impairment.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the "HSR Act") and the rules promulgated thereunder by the Federal Trade Commission (the "FTC"), the Acquisition may not be consummated until notifications have been given and certain information has been furnished to the FTC and the Department of Justice (the "DOJ") and specified waiting period requirements have been satisfied. The HSR Act waiting period expired on January 21, 2009. In addition, under the insurance holding company laws and regulations applicable to the insurance subsidiaries of the Company and Assured, before a person can acquire control of a U.S. insurance company, prior written approval must be obtained from the insurance commissioner of the state where the insurer is domiciled. Assured has informed the Company that Assured filed applications with the insurance departments of the States of New York and Oklahoma and the U.K. Financial Services Authority; that the applications to the New York Insurance Department and the U.K. Financial Services Authority have been approved; and that it has made pre-acquisition filings regarding the potential competitive impact of the acquisition, which are deemed to have been approved. Dexia has informed the Company that it has filed an application with the U.K. Financial Services Authority in connection with its acquisition of Assured common shares pursuant to the Purchase Agreement, which has been approved, and that it has filed disclaimers of control with the insurance departments of the states of Maryland, New York, and Oklahoma.
The Company cannot estimate whether or when the remaining closing conditions will be satisfied or relevant agreements negotiated, whether the Acquisition will be completed and, if completed, whether it will be structured as currently contemplated, or what the effects of the change in control or removal of the FP business will be on the Company and its results of operations. If the Acquisition is not completed, Dexia may explore other options with respect to the Company, including selling the Company or some of its operations to a third party or ceasing to write new business, which may have a material adverse effect on the Company.
Post-Closing Parameters
The Purchase Agreement imposes a number of limitations on FSA after the Purchase Agreement closing (each, a "Post-Closing Parameter"), intended to maintain the creditworthiness of FSA. The Post-Closing Parameters are subject to change, and currently include the following:
1.Unless FSA is rated below Single-A-, it may not write any business other than insurance on municipal and infrastructure bonds, whether written directly, assumed, reinsured or occurring through any merger transaction.
2.Unless Dexia otherwise consents, FSA must continue to be domiciled in New York and treated as a monoline bond insurer for regulatory purposes.
3.FSA will not take any of the following actions without prior rating agency confirmation that such action would not cause its rating to be immediately downgraded: merger, issuance of debt or other borrowing exceeding $250 million, issuance of equity or other capital instruments exceeding $250 million, entry into new reinsurance arrangements involving more than 10% of the portfolio, or any waiver, amendment or modification of any agreement relating to capital or liquidity support of FSA exceeding $250 million.
4.FSA shall not repurchase, redeem or pay any dividends in relation to any class of equity interests (including interest payments on its surplus notes), unless (i) FSA is rated at least AA- by S&P and Fitch and Aa3 by Moody's and the aggregate amount of such dividends in any year does not exceed $25 million or (ii) FSA receives prior rating agency confirmation that such action would not cause its rating to be immediately downgraded.
5.FSA shall not (i) enter into commutation or novation agreements with respect to its insured portfolio involving a payment exceeding $250 million or (ii) enter into any "cut-through" reinsurance, pledge of collateral security or similar arrangement whereby the benefits of
reinsurance purchased by FSA or of other assets of FSA would be available on a preferred or priority basis to a particular class or subset of FSA policyholders relative to the position of Dexia as policyholder upon the default or insolvency of FSA, other than with Dexia's consent.
6.FSA shall restrict its liquidity exposure such that no GICs or similar liabilities insured by FSA shall have terms that require acceleration, termination or prepayment based on a downgrade or withdrawal of any rating assigned to FSA's financial strength, a downgrade of the issuer or obligor under the agreement, or a downgrade of any third party.
7.FSA shall continue to be rated by each of Moody's, S&P and Fitch (if such rating agencies still rate financial guaranty insurers generally) unless and until the date on which (i) the rating agencies have assigned a credit rating to FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and FSA Capital Markets Services LLC (collectively, the "GIC Subsidiaries") (and/or the liabilities of the GIC Subsidiaries under the relevant GICs have been separately rated) which is independent of FSA's financial strength rating and (ii) the principal amount of GICs in relation to which a downgrade of FSA may result in a requirement to post collateral or terminate such GIC (notwithstanding the existence of a separate rating referred to in (i) of at least Double-A or higher) is below $1.0 billion (the "De-Linkage Date").
The first five Post-Closing Parameters will be in effect for three years following the closing of the Acquisition and Post-Closing Parameters six and seven will be in effect until the De-Linkage Date occurs, provided that all of the Post-Closing Parameters will terminate if at any time after the De-Linkage Date the aggregate principal amount or notional amount of exposure of Dexia and any of its affiliates (excluding the exposures relating to the FP business) to any transactions insured by FSA or any of its affiliates prior to the signing date is less than $1 billion (the "Exposure Limitation Date").
As a general matter, if FSA merges with, enters into a consolidation with or sells all or substantially all of its assets to another company, that company will be subject to the Post-Closing Parameters. However, if FSA and Assured merge, Post-Closing Parameters one and two will terminate one year after the Purchase Agreement closing and the other Post-Closing Parameters will expire three years after the closing date (subject in each case to any Exposure Limitation Date).
Dexia's Retention of the FP Business
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. The Purchase Agreement provides that Dexia will provide guarantees with respect to the FP business' assets and liabilities, including derivative contracts, and anticipates that some of its guarantees will benefit from guarantees provided by the French and Belgian states. Dexia Holdings Inc. ("Dexia Holdings"), FSA Holdings' parent, agreed that if such sovereign guarantees are provided, it will cause FSA Holdings to transfer the ownership interests of certain of the subsidiaries that conduct the FP business, or all the assets and liabilities of such subsidiaries, to Dexia Holdings or one of its affiliates in form reasonably acceptable to Assured.
Under the Purchase Agreement, Dexia Holdings is expected to retain the risks associated with the medium term notes business and certain portions of its leveraged lease business, FSA is expected to retain the risks associated with the leveraged lease debt business, and no new business will be written by the variable interest entities ("VIEs") FSA Global Funding Limited ("FSA Global") and Premier International Funding Co. ("Premier"). See "-Organization-Financial Products Segment."
Organization
The Company is a subsidiary of Dexia Holdings, which, in turn, is owned 90% by Dexia Crédit Local S.A. ("Dexia Crédit Local") and 10% by Dexia. Dexia is a Belgian corporation whose shares are
traded on the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. Dexia is primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia. In connection with the recent financial crisis, Dexia has received significant support from the governments of France and Belgium, who remain indirect major shareholders of Dexia.
The Company divides its operations into two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance through FSA and its other insurance company subsidiaries, but also includes the Company's refinancing vehicles and several other direct subsidiaries not in the FP segment. The FP segment is a run-off operation that was formerly in the business of borrowing funds through the issuance of GICs and medium term notes and reinvesting the proceeds in investments insured or qualifying for insurance by FSA.
Financial Guaranty Segment
FSA wholly owns FSA Insurance Company ("FSAIC"), which in turn wholly owns Financial Security Assurance (U.K.) Limited ("FSA UK") and FSA Mexico Holdings Inc. ("FSA Mexico Holdings"). FSA and FSAIC together own Financial Security Assurance International Ltd. ("FSA International"). FSAIC is an Oklahoma insurance company that primarily provides reinsurance to FSA. FSA UK is a United Kingdom insurance company that primarily provides financial guaranty insurance for transactions in the United Kingdom and other European markets. FSA International is a Bermuda insurance company that provides reinsurance to FSA and financial guaranty insurance for transactions outside the United States and European markets. FSA Mexico Holdings is the New York holding company that, together with FSAIC, owns FSA's Mexican subsidiary, FSA Seguros México, S.A. de C.V. ("FSA Mexico"). FSA Mexico is licensed to transact financial guaranty insurance in Mexico.
The Company refinances certain underperforming transactions by employing special purpose vehicles to raise funds to refinance such transactions. These refinancing vehicles are consolidated with the Company.
FSA Portfolio Management Inc. ("FSA Portfolio Management"), a wholly owned subsidiary of the Company, is engaged in the business of managing a portion of the investment portfolios of the Company and certain of its subsidiaries. FSA Portfolio Management also owns strategic and other investments funded from time to time by the FSA group of companies. Transaction Services Corporation ("TSC"), a wholly owned subsidiary of the Company, is engaged in the business of managing troubled transactions within the insured portfolios of FSA and its subsidiaries.
Financial Products Segment
The Company conducted its GIC business through the GIC Subsidiaries FSACM, FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC. FSACM conducted substantially all the Company's GIC business since April 2003, following its receipt of an exemption from the requirements of the Investment Company Act of 1940. When the GIC Subsidiaries sold GICs, they loaned the proceeds to FSAM, which invested the funds in fixed-income securities that satisfy the Company's investment criteria. The GIC Subsidiaries ceased issuing GICs in November 2008 in contemplation of the sale of the Company to Assured. FSAM wholly owns FSA Portfolio Asset Limited ("FSA-PAL"), a U.K. company that invests in non-U.S. securities.
The Company consolidates the results of FSA Global and Premier, which are VIEs. FSA Global issued FSA-insured medium term notes and generally invested the proceeds from the sale of its notes in FSA-insured GICs or other FSA-insured obligations with a view to realizing the yield difference
between the notes issued and the obligations purchased with the note proceeds. Premier is principally engaged in leveraged lease transactions.
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. In contemplation of this change, FSACM, FSA Capital Markets Services LLC and FSAM became direct subsidiaries of a newly formed subsidiary, FSA Financial Products Inc. ("FSA Financial Products"), in December 2008. Previously they had been direct subsidiaries of FSA Holdings.
Under the Purchase Agreement, Assured and Dexia Holdings agreed to cooperate in good faith to evaluate the feasibility of the actual or functional separation of FSA Global's leveraged lease and medium term notes businesses with a view to maximizing the tax, accounting and financial efficiency of the separation of the businesses for both parties. At March 17, 2009, an agreement had not been reached on the structure of the business separation. Regardless of the structure of such business separation, under the Purchase Agreement Dexia Holdings is expected to retain the risks associated with FSA Global's medium term notes business and certain portions of its leveraged lease business, FSA is expected to retain the risks associated with the leveraged lease debt business, and no new business will be written by FSA Global or Premier.
The Company's management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company's creditors, even in bankruptcy or other receivership.
History
When the Company commenced operations in 1985, it was the first insurance company organized to insure non-municipal obligations. At that time, it was owned by a number of large insurance companies and other institutional investors. In 1989, the Company was acquired by U S WEST Capital Corporation, which subsequently changed its name to MediaOne Capital Corporation ("MediaOne"). MediaOne was a subsidiary of MediaOne Group, Inc., with operations and investments in domestic cable and broadband communications and international broadband and wireless communication. In 1990, the Company established a strategic relationship with The Tokio Marine and Nichido Fire Insurance Co., Ltd. ("Tokio Marine"), which acquired a minority interest in the Company. Tokio Marine is a major Japanese property and casualty insurance company. Also in 1990 the Company expanded the focus of its business to include financial guaranty insurance of municipal obligations and has since become a major insurer of municipal and other public finance obligations.
In 1994, the Company completed an initial public offering of common shares, at which time White Mountains Insurance Group, Ltd. ("White Mountains") (formerly known as Fund American Enterprises Holdings, Inc.) made an investment in the Company, and the chairman of White Mountains became non-executive chairman of the Company. White Mountains is an insurance holding company.
In 1998, the Company and XL Capital Ltd ("XL"), a major Bermuda-based insurance holding company, entered into a joint venture, establishing two Bermuda-domiciled financial guaranty insurance companies-FSA International and XL Financial Assurance Ltd, now Syncora Guarantee Re Ltd. ("SGR"). In connection with the joint venture, XL acquired a minority interest in the Company and FSA International, and the Company acquired a minority interest in SGR. The Company sold its interest in SGR during the third quarter of 2008.
On July 5, 2000, the Company completed a merger in which the Company became a direct subsidiary of Dexia Holdings. At the merger date, each outstanding share of the Company's common stock was converted into the right to receive $76.00 in cash. At December 31, 2008, 99.9% of the Company's common stock was held by Dexia Holdings. The other holders are directors of the Company who own shares of the Company's common stock or economic interests therein as described
under "Item 11. Executive Compensation-Compensation of Directors-Director Share Purchase Program" and "Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters-Directors and Executive Officers."
In October 2005, FSA purchased the interest in FSA International owned by XL for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect, wholly owned subsidiary of the Company.
In November 2008, Dexia entered in the Purchase Agreement providing for the sale of the Company to Assured.
Although the Company's common stock is no longer listed on the New York Stock Exchange ("NYSE") as a consequence of the merger, the Company continues to file periodic reports under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), because the Company has debt securities listed on the NYSE.
The Company's Executive Management Committee manages the Company's business. The Chief Executive Officer, President, General Counsel, Chief Risk Management Officer and Chief Financial Officer are members of the Executive Management Committee.
The principal executive offices of the Company and FSA are located at 31 West 52nd Street, New York, New York, 10019. The Company maintains offices domestically in San Francisco and Dallas and abroad in London, Madrid, Mexico City, Paris, Sydney, Tokyo and Bermuda. The Company is in the process of closing its Mexico and Paris offices.
The Financial Guaranty Business
Financial guaranty insurance written by FSA typically guarantees scheduled payments on financial obligations. Upon a payment default on an insured obligation, FSA is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or may, at its option, pay such amounts on an accelerated basis. FSA's underwriting policy is to insure obligations that would otherwise be investment grade without the benefit of FSA's insurance.
Business Objectives
The Company's objective for its financial guaranty business is to remain a leading insurer of public finance obligations while generating premium volume at attractive returns and minimizing the occurrence and severity of credit losses in its insured portfolio. The Company believes that short-term trends for the Company are unfavorable due, among other things, to the following factors:
•reduced market acceptance of financial guaranty insurance arising in part from the severe rating downgrades of most of FSA's industry peers;
•uncertainty surrounding the timing and consummation of the Purchase Agreement closing;
•uncertainty regarding the stability of FSA's ratings; and
•the prospect for continued loss development in the Company 's insured portfolio as the current economic crisis widens.
The Company believes that the demand for FSA's financial guaranty insurance will recover over the long term as a result of the following factors, subject to a restoration of stable ratings for FSA:
•an increasing need for municipal issuers to access the capital markets for funding in the face of declining tax and other revenues;
•expansion of infrastructure projects throughout the world that would benefit from capital market funding; and
•wide credit spreads combined with market appetite for credit protection attributable to reduced risk tolerance by retail and institutional investors.
Over the long term, the Company expects to continue to originate a diversified insured portfolio with a broad geographic distribution and a variety of revenue sources and transaction structures. In addition to its domestic business, the Company pursues international opportunities in Western European and Asia Pacific markets and, selectively, in Eastern European and Latin American markets.
Financial Guaranty Business
FSA's insurance is employed in both the new-issue and secondary markets. In the case of new issues, the insured obligations are sold with FSA insurance at the time the obligations are issued. For public finance obligations, FSA participates in negotiated offerings, where the investment banker and often the insurer have been selected by the sponsor or issuer. In addition, FSA participates in competitive offerings, where underwriting syndicates bid for securities and submit bids that may include insurance.
In certain insured transactions, the issuer of insured securities is party to an interest rate, basis or currency swap that matches the issuer's funding sources to the interest rate or currency of the insured securities or otherwise hedges the issuer's exposure. In certain of these transactions, FSA will insure the issuer's obligations under both the insured securities and the regularly scheduled payment under the derivative contract and, occasionally, the termination obligation. FSA may have provided its insurance directly to a security or other obligation or by insuring a credit default swap ("CDS") referencing such security or other obligation.
In November 2008, FSA ceased writing financial guaranties on GICs issued in connection with the Company's FP business.
FSA insures obligations already carrying insurance from other monoline guarantors, with FSA generally obligated to pay claims on a "second-to-pay" basis, following a default by both the underlying obligor and the first-to-pay financial guarantor. In recent years, FSA has also reinsured a modest amount of business from other financial guaranty insurers, but FSA did not assume reinsurance on any transactions during 2008.
FSA has several programs that provide insurance for public finance obligations trading in the secondary markets, including its Custody Receipt Program, which provides insurance primarily for domestic municipal obligations trading in the secondary market, and its Triple-A Guaranteed Secondary Securities ("TAGSS"®) Program, which provides insurance primarily for public infrastructure obligations trading in the secondary market. Investors and dealers generally obtain secondary-market insurance to upgrade or stabilize the credit ratings of securities they already hold or plan to acquire or to increase the market liquidity of such securities.
Prior to September 2008, FSA issued surety bonds under its Sure-Bid program, which provided an alternative to traditional types of good faith deposits for competitive municipal bond transactions. The Company may resume its Sure-Bid program, subject to improved credit protections from participating underwriters.
The table below shows par outstanding and excludes intercompany insured transactions.
Par Outstanding by Type
At December 31, 2008, the weighted average life of the direct par insured was approximately 4.0 years for asset-backed and 13.7 years for public finance obligations.
The following table indicates the Company's percentages of par amount (net of reinsurance) outstanding with respect to each type of public finance and asset-backed program.
Net Par Outstanding by Program Type
Premiums
In setting its premium rates for transactions, FSA takes into account the risk it assumes and its projected return. Critical factors in assessing risk include the credit quality of the risk, type of issue, sources of repayment, transaction structure and term to maturity. The premium rate is also a function of market factors, capital charges assessed by securities rating agencies and the competitive environment. Market factors include the value added by the use of insurance, such as the interest rate savings obtained by the issuer of an insured obligation. S&P assigns a "capital charge" for most obligations insured by FSA. The capital charge for a transaction is an important factor in determining the "return on equity" from a specified transaction premium rate under the Company's proprietary model. Competition arises from other insurers and alternative executions that do not involve insurance.
For insurance on GIC and medium term note transactions, transactions involving "repackaging" of outstanding securities and other transactions, FSA's premium may have been arbitrage-based, based upon the difference between the effective borrowing cost at a Triple-A rate and the interest rate on the underlying securities.
Public Finance Obligations
FSA insures a range of public finance obligations, including:
•general obligation bonds supported by the issuers' taxing power;
•tax-supported bonds supported by a specific or discrete source of taxation, leases or "subject to appropriation" or "moral obligation" (that is, a commitment to consider an appropriation for payment, but not an obligation to appropriate);
•revenue bonds and other obligations of states, their political subdivisions and other municipal issuers that are supported by the issuer's or obligor's covenant to impose and collect fees and charges for public services or specific projects;
•housing bonds secured by portfolios of single-family mortgages or secured by mortgages for government-supported multi-family residences; and
•international public finance obligations, including obligations of sovereign and sub-sovereign issuers and project finance transactions.
Public finance obligations include municipal bonds, notes and other indebtedness issued by or on behalf of public and quasi-public entities, including states and their political subdivisions, utility districts, public housing and transportation authorities and universities and hospitals. Public finance obligations also include bonds, notes and other indebtedness issued by special purpose entities established to finance investments in infrastructure projects. Some public finance obligations, including most project finance obligations, include non-governmental credit risks (to swap counterparties, insurance companies, construction companies or other non-governmental credits) and operating risks (such as traffic volume or student enrollment).
In the case of general obligation bonds, an issuer's obligation to pay is supported by the issuer's taxing power. In the case of most revenue bonds and public-private infrastructure financings, an issuer's obligation to pay is supported by the issuer's or obligor's ability to impose and collect fees and charges for public services or specific projects or, in some cases, by federal subsidies or grants.
The Public Finance Market
According to industry sources, the total and insured volume since 2004 of long-term U.S. municipal new issues sold were as follows:
U.S. Municipal New Issues Sold(1)
(1)Source: The Bond Buyer, February 7, 2007 and January 8, 2008 for 2004 to 2007. Estimate for 2008 is based on Thomson Financial database as of January 6, 2009 . Volume is expressed in terms of principal issued and insured on a sale-date basis. Subject to revision as additional information becomes available. In 2008, estimated U.S. municipal market volume of $391.5 billion was 9% lower than in 2007. After a slow start due to illiquidity in the auction rate securities ("ARS") market, municipal issuance rose significantly in the second quarter as a high volume of ARS were refinanced. However, volume fell off over the course of the second half as the cost of borrowing increased in response to the global
credit contraction. In 2007, estimated U.S. municipal market volume of $429.0 billion was 10% higher than in 2006 and the highest market volume on record. Insurance penetration of the market for new U.S. municipal bonds sold in 2008 was approximately 17%, compared with 47% in 2007 and 49% in 2006. FSA's share of the insured par sold was approximately 54% in 2008, compared with 25% in 2007 and 24% in 2006. However, both insurance penetration and FSA's market share were significantly higher in the first half of 2008 than in the second. For a discussion of the Company's financial guaranty segment's results of operations in 2008, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Financial Guaranty Segment-Results of Operations."
Outside the United States, the global credit crisis produced severe illiquidity in the public infrastructure market during 2008, and demand for financial guarantees was low because of negative rating actions. International public finance transactions include public-private partnership financings, such as those authorized under the U.K. Private Finance Initiative, where host governments make payments to private developers or operators based either on the project's availability to meet its public purpose or on its cash revenues or observed usage, as well as other highly structured transactions. Because such transactions tend to have long development times and large par amounts, the timing of transactions may cause volatility in insured volume from year to year.
Since 2004, the annual totals of non-U.S. public finance par insured of financial guaranty insurance directly originated by monoline guarantors, according to industry sources, were as follows:
Par of Non-U.S. Public Finance Obligations Insured by Monoline
Insurance Companies(1)
(1)Source: Association of Financial Guaranty Insurers ("AFGI"). Data is subject to revision as additional information becomes available.
(2)Not available from the same source. Based on information in the statistical operating supplements of monoline guarantors that disclose the public finance component of their international business, those guarantors directly insured, in the aggregate, a principal amount of approximately $2.1 billion of non-U.S. public finance obligations in 2008.
FSA's Public Finance Obligations
FSA's insured portfolio of public finance obligations is divided into nine major categories. Where FSA insures obligations that already carry insurance from another monoline guarantor, FSA categorizes the obligation based on the type of bond or obligation underlying the insurance policy.
Domestic General Obligation Bonds. General obligation or full faith and credit bonds are issued by states, their political subdivisions and other municipal issuers, such as state bond banks, and are supported by the general obligation of the issuer or obligor to pay from available funds and by a pledge of the issuer or obligor to levy taxes in an amount sufficient to provide for the full payment of the bonds.
Domestic Tax-Supported (Non-General Obligation) Bonds. Tax-supported (non-general obligation) bonds include a variety of bonds that, though not full faith and credit general obligations, are generally supported by leases, a specific or discrete source of taxation or moral obligation. Lease revenue bonds or certificates of participation ("COPs") are usually general fund obligations that finance real property or equipment that, in the case of leases subject to annual appropriation, FSA deems to serve an essential public purpose (e.g., schools, public safety facilities, courts and, less frequently, correctional facilities). Tax-backed revenue bonds are secured by a lien on pledged tax revenues, including income, retail sales, property, excise and gasoline taxes, or from tax increments (or tax allocations) generated by growth in property values within a district. FSA also insures bonds secured by special assessments levied against property owners, which benefit from covenants by the issuer to levy, collect and enforce collections and to foreclose on delinquent properties.
Domestic Municipal Utility Revenue Bonds. Municipal utility revenue bonds include obligations of municipal utilities, including electric, gas, water and sewer and solid waste. Insurable utilities may be organized as municipal enterprise systems, authorities or joint-action agencies.
Domestic Transportation Revenue Bonds. Transportation revenue bonds include a wide variety of revenue-supported bonds, such as bonds for airports, ports, municipal parking facilities, toll roads and toll bridges and tunnels.
Domestic Health Care Revenue Bonds. Health care revenue bonds include bonds of state and local municipal authorities issued on a conduit basis on behalf of not-for-profit health care providers and health care provider systems, payable from amounts derived under loan agreements and notes of such health care providers with such authorities. This category also includes exposure to HMOs, mental health providers and other health-related credits.
Domestic Housing Revenue Bonds. Housing revenue bonds include both multi-family and single family housing bonds, with multi-tiered security structures based on the underlying mortgages, reserve funds, and various other features such as Federal Housing Administration or private mortgage insurance, bank letters of credit, first-loss guarantees and, in some cases, the general obligation of the issuing housing agency or a state's moral obligation to make up deficiencies. This category also includes multi-family housing bonds supported by capital fund grants appropriated by Congress.
Domestic Education/University Bonds. Education/University bonds include obligations of colleges and universities, primarily public or state-supported, and independent primary and secondary schools.
Other Domestic Public Finance Obligations. Other domestic public finance obligations insured by FSA include bonds secured by revenues and guarantees from the Federal government, financings supported by specific state or local government entity revenues, and stadium financings. This category also includes guarantees of the debt of Citizens Property Insurance, a Florida state-sponsored entity, which provides residential and commercial property and casualty insurance coverage. This category also includes leveraged lease transactions ("Leveraged Lease Transactions"). A Leveraged Lease Transaction transfers the tax benefits from a tax-exempt entity, such as a transit agency (lessee) to a tax-paying entity (lessor) by transferring ownership of a depreciable asset, such as subway cars, to the lessor. The municipality (lessee) remains the primary user of the asset. In 2004, Congress amended the Internal Revenue Code to expressly prohibit tax benefits derived from such Leveraged Lease Transactions. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-FSA's Liquidity-Leveraged Lease Transactions."
International Public Finance Obligations. International public finance obligations have non-U.S. obligors and include obligations of sovereign and sub-sovereign issuers, project finance transactions involving projects leased to or supported by payments from governmental or quasi-governmental
entities, toll road transactions supported by toll revenues, obligations arising under leases of equipment or facilities by municipal obligors, distribution and transmission utility and water utility financings, securitizations of government- supported receivables or sovereign or municipal debt, corporate debt guaranteed by government-owned financial institutions and other obligations having international aspects but otherwise within the public finance categories described above.
Asset-Backed Obligations
FSA ceased issuing financial guaranties on asset-backed obligations in August 2008. The asset-backed obligations in FSA's insured portfolio were generally issued in structured transactions backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. Asset-backed obligations insured by FSA also included payment obligations of counterparties and issuers under synthetic obligations such as CDS and credit-linked notes referencing asset-backed securities or pools of securities or other obligations.
Asset-backed obligations are typically issued in connection with structured financings or securitizations where the securities being issued are secured by or payable with funds from a specific pool of assets. The assets are typically held by a special purpose entity that also acts as the issuer of the insured obligations. Most asset-backed obligations are secured by or represent interests in diverse pools of assets, such as residential mortgage loans, auto loans, credit card receivables, other consumer receivables, corporate loans or bonds, government debt and small business loans. Asset-backed obligations may also be secured by less diverse payment sources, such as small business loans. FSA sought to structure the asset-backed obligations it insured to mitigate the correlation risk.
Structure of Asset-backed and Other Non-Public Finance Obligations
The asset-backed obligations in the Company's insured portfolio include funded and synthetic transactions:
Funded Asset-backed Obligations. Funded asset-backed obligations are typically payable from cash flow generated by a pool of assets and take the form of either "pass-through" obligations, which represent interests in the related assets, or "pay-through" obligations, which generally are debt obligations collateralized by the related assets. Both types of funded asset-backed obligations generally have the benefit of one or more forms of credit enhancement, such as overcollateralization or excess cash flow, to cover credit risks associated with the related assets. Historically, asset securitization often represented an efficient way for commercial banks to comply with capital requirements and for corporations to access the capital markets at more attractive rates. Banks responded to increased capital requirements by selling certain of their assets, such as credit card receivables and automobile loans, in securitized structures to the financial markets. Some corporations found securitization of their assets to be a less costly funding alternative to traditional forms of borrowing or otherwise important in diversifying funding sources. Many finance companies have funded consumer finance and home equity lending through securitization.
Synthetic Asset-backed Obligations. Synthetic asset-backed obligations generally take the form of CDS obligations or credit-linked notes that reference either an asset-backed security or pool of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. The Company has two basic types of insured CDS contracts. One type references a pool of underlying corporate obligations ("pooled corporate CDS") and the other type references existing structured finance securities, primarily CDOs and collateralized loan obligations ("CLOs"), or infrastructure finance transactions, including obligations insured by another financial guaranty insurer. In both cases, exposures insured by the Company generally had an attachment point (i.e., the minimum level of losses in a portfolio to which a tranche is exposed, usually expressed as a percentage of the
total notional size of the portfolio) at the outset which was determined by the Company and the rating agencies to be at or above a Triple-A credit rating, or may have had such rating due to credit enhancement provided by another financial guaranty insurer.
•Pooled Corporate CDS: The Company's pooled corporate CDS contracts typically cover a pool of reference obligations, such as bonds, bank loans or single name CDS subject to a material deductible. The majority of the risks insured benefit from protection provided to the senior tranches, and are rated Triple-A or higher ("Super Triple-A") credit quality without the benefit of FSA's insurance. The majority are static pools, i.e., pools that are not "managed" in that reference obligations cannot be added or substituted. The Company's portfolio of pooled corporate CDS contracts is segregated into investment and non-investment grade (or "high yield") groups. "Super Triple-A" indicates a level of first-loss protection generally exceeding 1.3 times the level required by a rating agency for a Triple-A rating. Typically a higher attachment point is required to achieve a Super Triple-A level of subordination for a pool of non-investment grade credits than is required for a pool of investment grade credits.
•CDS Referencing Funded CDOs and CLOs: The Company's insured CDS contracts referencing CDOs and CLOs provide credit protection on the senior tranches of funded collateralized structures. CDOs and CLOs are securities backed or collateralized by a diversified managed pool of corporate bonds or loans, respectively. The senior tranches are typically rated Triple-A and would only suffer a loss if the deterioration of the underlying assets exceeds the collateral protection provided by the subordinated debt tranches and equity.
Some CDS obligations expose FSA to elements of market value risk arising from obligations to pay the difference between par and market value upon the occurrence of a payment default or other defined "credit events" specified in the CDS. FSA generally addressed these risks by requiring large deductibles as a condition to payment under pooled corporate CDS insured by FSA.
The terms of the Company's guaranteed or "insured" CDS contracts generally are modified from standard CDS contract forms approved by the International Swaps and Derivatives Association, Inc. ("ISDA") in order to provide for payments on a scheduled basis and otherwise replicate the terms of a traditional financial guaranty insurance policy.
The Company considered its CDS to be a normal part of its financial guaranty insurance business but, for accounting purposes, FSA-insured CDS are accounted for as derivatives and therefore must be recorded at fair value, with periodic changes reflected through the statements of operation and other comprehensive income, causing volatility in the Company's reported net income. Despite the structural protections associated with the Company's pooled corporate CDS, the significant widening of credit spreads on pooled corporate CDS, as with other structured credit products, which started during the second half of 2007 and continued throughout 2008, resulted in significant mark-to-market losses. The ultimate amount of actual credit losses will depend on actual loss developments as opposed to market factors. For additional discussion of the impact of the mark-to-market accounting treatment, including valuation methods, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Financial Guaranty Segment-Results of Operations-Fair Value of Credit Derivatives" and Note 3 to the consolidated financial statements in Item 8.
Most of the Company's industry peers have suffered material market concerns over their exposure to the CDO of ABS sector, relating to securitizations of high grade and mezzanine asset-backed securities, including subprime RMBS. Some of these companies assumed their exposure to CDOs of ABS in synthetic form, including through guaranties of CDS. Unlike other industry participants, the Company does not have material exposure in its insured portfolio to CDOs of ABS, either in the funded or synthetic form.
Categorization of Asset-backed and Other Non-Public Finance Obligations
FSA's insured portfolio of asset-backed and other non-public finance obligations may be divided into five major categories, which are broadly based on the type of assets backing the insured obligations and include funded and synthetic obligations and may be in the form of insurance or insurance of CDS. Where FSA insures obligations that already carry insurance from another monoline guarantor, FSA categorizes the obligation based on the type of assets backing the obligations underlying the insurance policy. Until the fourth quarter of 2007, such obligations were categorized as "other domestic non-public finance obligations."
Domestic Residential Mortgage Loans. Obligations primarily backed by residential mortgage loans generally take the form of conventional pass-through certificates or pay-through debt securities, but also include other structured products. Residential mortgage loans backing these insured obligations include closed- and open-end first and second mortgage loans or home equity loans on one-to-four family residential properties, including condominiums and cooperative apartments and non-owner occupied residential housing. Approximately 17% of the asset-backed net par in FSA's insured portfolio is domestic residential mortgage products.
The Company has projected losses on some of the home equity line of credit ("HELOC"), Alt-A closed-end second-lien mortgage ("CES") securities, Option Adjustable Rate Mortgage ("Option ARM") transactions, Alt-A first-lien mortgages, subprime U.S. RMBS and net interest margin securitizations ("NIMs") in its insured portfolio and has established net case reserves of $1,234.3 million in relation to its domestic residential mortgage loans. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Financial Guaranty Segment-Insured Portfolio Summary-Asset-Backed Insured Portfolio." "Alt-A" refers to borrowers whose credit quality falls between prime and subprime.
Approximately 6.2% of the asset-backed net par outstanding in FSA's insured portfolio are HELOCs. The HELOCs are primarily backed by second liens and made to higher quality ("prime") borrowers. They have lower levels of structural protection than typical subprime transactions. The protection is typically provided by excess spread, which is used to pay current period losses and build reserves. Most of FSA's insured HELOCs were originated by mortgage finance companies.
Approximately 4.5% of the asset-backed net par outstanding in FSA's insured portfolio are in the "subprime" sector, characterized by lower quality borrowers and higher levels of structural credit protection through subordination and/or excess spread. Most subprime transactions are secured by fully-amortizing first-lien mortgage loans that pay a fixed rate of interest for two to five years, after which they pay a floating rate of interest. Typically all principal received on the underlying mortgages is paid through to the Triple-A noteholders for at least the first 36 months, causing credit protection to increase over time.
Approximately 2.6% of the asset-backed net par outstanding in FSA's insured portfolio are backed by Option ARMs. Option ARMs are generally backed by first lien mortgage loans made to prime borrowers (on average) with average original loan-to-value ratios of approximately 76%. The loans have three payment options-fully amortizing payment, interest only, and a minimum payment that results in negative amortization of the borrower's loan. The loans generally reset to full amortization on their fifth anniversaries, or possibly earlier if the loan's negative amortization results in loan to value ratios that exceed limits usually between 110% and 120% of the original loan balance (which can happen if interest rates rise and the borrower makes only the minimum payment). Upon reset, monthly payment amounts can increase significantly.
Approximately 1.6% of asset-backed net par outstanding in FSA's insured portfolio consist of securities backed by Alt-A first lien residential mortgage loans. First lien Alt-A transactions insured by FSA are collateralized by fixed and floating rate loans secured by a first lien on residential property.
All principal received on the underlying mortgages is paid through to the senior Triple-A note holders for at least the first 36 months, causing credit protection to increase over time.
Approximately 1.5% of the asset-backed net par outstanding in FSA's insured portfolio consist of closed-end second-lien mortgage transactions. Closed-end second-lien mortgage loan transactions are backed by fully amortizing loans secured by a second lien on residential property. All FSA closed-end second-lien transactions involve Alt-A borrowers. All principal received on the underlying mortgages is paid through to the senior note holders for at least the first 36 months, causing credit protection to increase over time.
Approximately 0.2% of asset-backed net par outstanding in FSA's insured portfolio consist of NIMs. NIMs are securities backed by the senior portion of residual cash flows from securitizations of domestic residential mortgage loans, generally the residual cash flows expected to be produced during the first 12-36 months of a subprime transaction.
FSA generally declined participation in securitizations of so-called "high-cost mortgage loans," characterized by very high interest rates or "points and fees" and subject to restrictive federal and state regulations.
Domestic Consumer Receivables. Obligations primarily backed by consumer receivables include conventional pass-through and pay-through securities as well as more highly structured transactions. Consumer receivables backing these insured obligations primarily include automobile loans, with some credit card receivables, manufactured housing loans and cash consumer loans. Consumer receivable transactions in FSA's insured portfolio tend to be concentrated in the subprime automobile loan sector.
Domestic Pooled Corporate Obligations. Obligations primarily backed by pooled corporate obligations include funded and synthetic obligations collateralized by corporate debt securities or corporate loans and obligations backed by cash flow or market value of non-consumer indebtedness, and include CDOs, such as collateralized bond obligations ("CBOs"), CLOs and comparable risks under CDS obligations. Corporate obligations include corporate bonds, bank loan participations, trade receivables, franchise loans and equity securities.
CDOs are securitizations of bonds, loans or other securities and may be insured on a funded or synthetic basis. CDOs have been used by financial institutions to manage their risk profiles, optimize capital utilization and improve returns on equity. CDOs have also been used by dealers or portfolio managers to provide leveraged investments in bond and loan portfolios tailored to conform to differing risk appetites of investors.
Other Domestic Non-Public Finance Obligations. Other domestic non-public finance obligations in FSA's insured portfolio include bonds or other securities backed by government securities, letters of credit or repurchase agreements collateralized by government securities, securities backed by a combination of assets that include elements of more than one of the categories set forth above and unsecured corporate obligations satisfying FSA's underwriting criteria. Other domestic non-public finance obligations insured by FSA also include first mortgage bond obligations of for-profit electric or water utilities providing retail, industrial and commercial service, sale-leaseback obligation bonds supported by such utilities and other obligations backed by investor-owned utilities. These bonds are generally either secured by a mortgage on property owned by or leased to an investor-owned utility or have the benefit of a "negative pledge" ensuring that no other material creditors have priority claims to the utility assets. Other domestic non-public finance obligations include securitization of life insurance risks (including so-called "triple-X transactions") and airplane leases, including transactions benefiting from third-party financial guaranty insurance.
International Asset-Backed Obligations. International asset-backed obligations in FSA's insured portfolio include (1) funded and synthetic CDOs, (2) securitizations of perpetual floating rate notes of
non-domestic banks, diversified payment rights, future flows, health care receivables and residential housing construction loans, (3) obligations of non-domestic investor-owned utilities and (4) other obligations having international aspects but otherwise within the asset-backed categories described above. FSA allocates individual funded and synthetic CDOs between domestic and international based on the transactions' holdings or potential holdings. Most of the international obligations comprise the international component of funded or unfunded CDOs.
Insured Portfolio
A summary of the Company's insured portfolio at December 31, 2008 is shown below. Exposure amounts are expressed net of reinsurance but do not distinguish between quota share, first-loss or excess-of-loss reinsurance.
Summary of Insured Portfolio by Obligation Type
Obligation Type
The table below sets forth the relative percentages of net par insured by obligation type during each of the last five years:
Annual New Business Insured by Obligation Type
Terms to Maturity
Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. The expected maturities for asset-backed obligations, in general, are considerably shorter than the contractual maturities for such obligations. For asset-backed obligations, the full par outstanding for each insured risk is shown in the maturity category that corresponds to the legal final maturity of such risk.
The table below sets forth the contractual terms to maturity of the Company's policies:
Contractual Terms to Maturity of Net Par Outstanding of Insured Obligations
Issue Size
The table below sets forth the net par outstanding broken out by original net par amount:
Net Par Outstanding
Geographic Concentration
The Company seeks to maintain a diversified portfolio of insured public finance obligations designed to spread its risk across a number of geographic areas. The table below sets forth those
jurisdictions in which municipalities issued an aggregate of 2% or more of the total net par amount outstanding of FSA-insured public finance securities:
Public Finance Insured Portfolio by Location of Exposure
In its asset-backed business, the Company considered geographic concentration as a factor in its underwriting decisions for insurance for securitizations of pools of assets, such as residential mortgage loans or consumer receivables. However, the geographic concentration of the underlying assets may change over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration may not have been a significant credit factor given other more relevant measures of diversification, such as issuer or industry diversification.
The Company earns premiums in its financial guaranty segment. The table below shows amounts attributed to foreign and domestic premiums during each of the last three fiscal years, based on the underlying risks:
Net Premiums Earned by Geographic Distribution
For a discussion of risks related to the Company's foreign operations, see "Item 1A.
Item 1A. Risk Factors.
In this Annual Report, the Company has included statements that may constitute "forward-looking statements" within the meaning of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Words such as "believes," "anticipates," "expects," "intends" and "plans" and future and conditional verbs such as "will," "should," "would," "could" and "may" and similar expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements. The Company cautions that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. Important factors that could cause its results to differ, possible materially, from those indicated in the forward-looking statements include, but are not limited to, those discussed under "Item 1. Business-Forward-Looking Statements" and the risks and uncertainties expressed below.
The Acquisition of the Company by Assured may fail to close.
In September 2008, Dexia announced the provision of capital support to Dexia by the governments of Belgium, France and Luxembourg, which was followed by changes in Dexia senior management. Following such developments, Dexia announced its intention to refocus on its basic business lines, and its decision to explore options to reduce its risk related to the Company. On November 14, 2008, Dexia announced that Dexia and Assured entered into the Purchase Agreement, under which Assured will acquire all of Dexia's shares of the Company, subject to the satisfaction of specified closing conditions, including receipt of regulatory and Assured shareholder approvals, confirmation from S&P, Moody's and Fitch that the Acquisition of the Company would not have a negative impact on the financial strength ratings of Assured's insurance company subsidiaries or the Company's insurance company subsidiaries, and segregation or separation of the FP business, such that the credit and liquidity risk of the FP business resides with Dexia. The Company cannot estimate whether or when such closing conditions will be satisfied, whether the Acquisition will be completed and, if completed, whether it will be structured as currently contemplated, or what the effects of such a change in control will be on the Company and its results of operations. If the Acquisition is not carried out, Dexia may explore other options with respect to the Company, including selling the Company or some of its operations to a third party or ceasing to write new business, which may have a material adverse effect on the Company.
Following the Acquisition, the Company's management and processes may change materially and the Company may cease to file separately with the SEC.
The Purchase Agreement provides a number of Post-Closing Parameters intended to maintain the creditworthiness of FSA for a period of time following Purchase Agreement closing. Following Purchase Agreement closing, the Company and FSA are expected to come under new management and be overseen by the Board of Directors of Assured. Subject to the constraints of the Purchase Agreement Post-Closing Parameters, Assured is expected to take actions to combine the operations of Assured and the Company and, in some cases, may combine legal entities or accomplish risk transfers through intercompany reinsurance arrangements. As a result of such actions, the Company and FSA are likely to increase credit and operational exposure to Assured. In addition, following Purchase Agreement closing, Assured may take action that would eliminate the separate SEC disclosure requirements applicable to the Company.
Downgrade of FSA's financial strength ratings could impair its ability to originate new business.
The Triple-A ratings of the Company's insurance company subsidiaries were placed on "review for downgrade" on July 21, 2008 by Moody's and on "negative credit watch" on October 8, 2008 by S&P, and on October 9, 2008 by Fitch. On November 21, 2008, Moody's downgraded the Company's insurance company subsidiaries to Aa3 (developing outlook). These recent ratings actions have had a
negative impact on the Company's market opportunities. FSA's ability to originate new insurance business and compete with other credit enhancers is based upon the perceived financial strength of FSA's insurance, which in turn is based in large part upon the financial strength ratings assigned to FSA by the major securities rating agencies. Credit ratings are an important component of a financial institutions' ability to compete in the financial guaranty market.
The rating agencies base their ratings upon a number of objective and subjective factors. Credit deterioration in FSA's insured portfolio or changes to rating agency capital adequacy requirements could impair FSA's ratings. The recent ratings actions regarding FSA were based in part upon rating agency concerns regarding the prospects for new business originations by financial guarantors, as well as uncertainty about future support for FSA under Dexia's new ownership and management. For a discussion of other factors that might impair FSA's ratings, see "Item 1. Business-Rating Agencies." To maintain its current ratings, the Company may be required to take measures to preserve or raise capital, including through, among other things, increased use of reinsurance, capital contributions or the issuance of debt securities. The Company cannot ensure that it will be able to take the measures necessary to maintain its ratings. Further downgrades of FSA's financial strength ratings could have a material adverse effect on its long-term prospects for future business opportunities as well as its results of operations and financial condition.
The Company's FP business relies upon Dexia for material liquidity and credit support.
As a result of recent capital market developments, the Company's FP business has faced unanticipated GIC withdrawals at a time when issuance of new GICs has been curtailed. The Company expects to fund a material portion of GIC withdrawals by employing liquidity provided by Dexia in order to avoid realizing market value losses from the sale of RMBS and other securities in the Company's FP Investment Portfolio. In addition, the Company's FP business is dependent upon Dexia for the provision of liquidity support in the event that collateral is required to be posted to avoid GIC terminations in the event of a ratings downgrade of FSA. Insofar as the Company is dependent on the significant liquidity and credit support that Dexia has committed to provide the Company's FP business, any decrease in the creditworthiness of Dexia or any action by Dexia to limit its support for the Company's FP business may be adverse to the Company.
The Company's FP business may be required to repay GICs or post incremental collateral in the event of an FSA downgrade.
If FSA were downgraded, the Company may be required to repay GICs or post collateral to its GIC counterparties, introducing additional liquidity risk. Most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below AA- by S&P or Aa3 by Moody's, unless the relevant GIC Subsidiary posts collateral or otherwise enhances its credit. Some FSA-insured GICs also allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below A3 by Moody's or A- by S&P, with no right of the GIC provider to avoid such withdrawal by posting collateral or otherwise enhancing its credit. The November 2008 downgrade to Aa3 by Moody's resulted in a trigger breach on $1.7 billion of unsecured GICs and $1.6 billion of secured GICs. In respect of unsecured GICs, the Company posted $1.0 billion of collateral, terminated $0.4 billion of GICs and modified the trigger to below Aa3 on $0.2 billion of GICs. The Company also posted $80 million of additional collateral to secured GICs. At December 31, 2008, a downgrade of FSA to below AA- by S&P or Aa3 by Moody's (A+ by S&P or A1 by Moody's) would result in withdrawal of $0.8 billion of GICs and the need to post collateral on GICs with a balance of $13.4 billion. Each GIC contract stipulates the types of securities eligible for posting and the collateralization percentage applicable to each security type. These collateralization percentages range from 100% of the GIC balance for cash collateral to, typically, 108% for asset-backed securities. Assuming an average margin of 105%, the market value of required collateral would be $14.1 billion. At December 31, 2008, a
downgrade of FSA to below A- by S&P or A3 by Moody's (i.e., BBB+ by S&P or Baa1 by Moody's) would result in mandatory or optional withdrawals of $5.1 billion of GICs and repayment or collateralization of the remainder of the $9.1 billion of GICs outstanding.
A downgrade could result in a significant increase in collateral required to be posted to avoid GIC terminations. In such event, the Company would be required to raise cash to fund such withdrawals by accessing lines of credit provided by Dexia, selling assets, in some cases realizing substantial market loss, or borrowing against the value of such assets. In addition, assets posted as collateral are subject to changes in market value and ratings. Such changes may reduce the value of the collateral or disqualify the assets as collateral. As a result, additional collateral, to which the Company may or may not have access, may be required to be posted to meet collateral requirements.
The Company's loss reserves may prove inadequate.
The Company's insurance policies guarantee financial performance of obligations over specified periods of time, in some cases over 30 years, and are generally non-cancellable. The Company projects expected deterioration and ultimate loss amounts based on historical experience in order to estimate probable loss. If an individual policy risk has a probable and reasonably estimable loss as of the balance sheet date, the Company establishes a case reserve. For the remaining policy risks in the portfolio, the Company establishes a non-specific reserve to account for inherent credit losses. The establishment of these reserves is a systematic process that considers quantitative and statistical information together with qualitative factors, resulting in management's best estimate of inherent losses associated with providing credit protection at a given date. However, the process is inherently uncertain, and the Company cannot assure that its reserves will prove adequate. In the course of 2008, the Company adjusted reserves upward from quarter to quarter as the economic downturn worsened. There can be no assurance that such trend will not continue. If losses in its insured portfolio materially exceed the Company's loss reserves, it could have a material adverse effect on the financial ratings, results of operations and financial condition of the Company. For additional discussion of the Company's reserve methodologies, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Financial Guaranty Segment-Results of Operations-Losses" and Note 2 and Note 9 to the consolidated financial statements in Item 8.
Loss of management or other key personnel may have an adverse effect on the Company's business.
The Company's senior management plays an active role in its underwriting and business decisions, as well as in performing its financial reporting and compliance obligations. The Company's Chief Executive Officer and Chief Operating Officer have disputes regarding the terms of their employment agreements with the Company. The Company has deferred payment of a portion of 2008 bonuses and, in the case of senior management, made such bonuses contingent upon closing of the Acquisition. The Company has not otherwise established a retention plan for key personnel pending closing of the Acquisition, nor has a retention plan been otherwise established to retain key personnel should the Acquisition fail to close. Failure by the Company to retain management or key personnel could have an adverse effect on the Company's business.
Resignation of independent directors may have an adverse effect on the Company's business.
The Company's independent directors play an important role in the corporate governance of the Company. In accordance with applicable SEC and NYSE requirements, the Audit Committee of the Company's Board of Directors is comprised exclusively of independent directors. Three of the four independent directors of the Company have disputes with Dexia regarding the valuation of Company shares acquired by them under the Company's Director Share Purchase Program. Resignation by one or more of the Company's independent directors may adversely impact the corporate governance of the Company, result in failure to comply with applicable SEC and NYSE Audit Committee requirements
and be viewed unfavorably by the rating agencies in evaluating the corporate governance of FSA and the Company, which is a factor in determining their ratings.
Ceasing to provide financial guaranty insurance on asset-backed transactions could reduce the Company's new business originations.
On August 6, 2008, the Company announced that FSA would cease providing financial guaranty insurance on asset-backed obligations and participate exclusively in the global public finance and infrastructure markets. The long-term effect of the change has not yet been realized. The Company believes that withdrawal from the asset-backed business will enhance its ratings stability, reduce its exposure to structured credit risk in its insured portfolio, and reduce its operating costs. At the same time, however, withdrawal from the asset-backed business may result in decreased business originations, revenues and net income relative to historical levels. A decline in new business originations or profitability may, in turn, be considered adverse factors by the rating agencies in assessing FSA's financial strength.
Fair valuing the Company's insured CDS portfolio may subject the Company's reported earnings to extreme volatility.
The Company is required to mark to market certain derivatives, including FSA-insured CDS that are considered derivatives under GAAP. As a result of such treatment, and given the large principal balance of FSA's insured CDS portfolio, small changes in the market pricing for insurance of CDS will generally result in recognition by the Company of material gains or losses, with material market price increases generally resulting in large reported losses under GAAP. Sharp swings in the estimated fair value of the CDS portfolio may occur from quarter to quarter due to the volatility of credit spreads that drive the fair-value estimates. Such changes in fair value can be caused by general market conditions and perceptions of credit risk, including FSA's own credit risk, causing the Company's GAAP earnings to be more volatile than would be suggested by the actual performance of FSA's business operations and insured CDS portfolio.
While management believes that reported mark to market gains or losses on insured CDS are not necessarily indicative of realized losses, certain constituents, including capital market participants, may rely upon reported GAAP results. As a result, the Company's access to capital markets might be impaired if its reported earnings were considered unusually volatile.
The Company may face claims in connection with early termination of Leveraged Lease Transactions in the event of failure of municipal lessees to pay stipulated loss amounts when due.
At December 31, 2008, FSA had insured up to $2.8 billion of stipulated loss payments that may become due from investment grade municipal lessees upon early termination of Leveraged Lease Transactions. In the event of failure by the municipal lessees to make any stipulated loss payment when and if due, FSA would be obligated to pay such amounts, and would be entitled to reimbursement from the municipal lessees for any claims paid. AIG International Group, Inc. ("AIG") and Premier, among others, act as equity payment undertakers in a number of transactions in which FSA acts as strip coverage provider, with AIG acting as equity payment undertaker in the large majority of such transactions. AIG was downgraded in the third quarter of 2008 and FSA was downgraded by Moody's in the fourth quarter of 2008. As a result, 53 Leveraged Lease Transactions in which FSA acted as strip coverage provider have breached either a ratings trigger related to AIG or a ratings trigger related to FSA. Under Leveraged Lease Transactions, if an early termination of the lease occurs and the lessee does not make the required early termination payment, FSA would be exposed to a possible liquidity claim on the 53 transactions with a current gross exposure of approximately $1.5 billion. If FSA is further downgraded to A+ or A1 and an early termination of the lease occurs and the lessee does not make the required early termination payment, FSA would be exposed to a possible liquidity claim on a
total of 77 transactions with a current gross exposure of approximately $2.6 billion. For a discussion of the Leveraged Lease Transactions, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-FSA's Liquidity-Leveraged Lease Transactions."
The Company is exposed to large risks.
The Company is exposed to the risk that issuers of debt that FSA has insured, issuers of debt that it holds in its investment portfolio, reinsurers and other contract counterparties may default in their financial obligations, whether as the result of insolvency, lack of liquidity, operational failure or other reasons. FSA seeks to manage exposure to large single risks, as well as concentrations of risks that may be correlated, through credit and legal underwriting, reinsurance and other risk mitigation measures. In addition, the securities rating agencies and insurance regulations establish limits applicable to FSA on the size of risks and concentrations of risks that it may insure.
Given FSA's capital base and the quality of risks that it insures, FSA may insure and has insured individual public finance and asset-backed risks well in excess of $1 billion. Should FSA's risk assessments prove inaccurate and should the limits applicable to FSA prove inadequate, FSA could be exposed to larger than anticipated losses, and could be required by the rating agencies to hold additional capital against insured exposures whether or not downgraded by the rating agencies. While FSA has to date experienced catastrophic events (such as the terrorist attacks of September 11, 2001 and the 2005 hurricane season) without material loss, unexpected catastrophic events may have a material adverse effect upon FSA's insured portfolio and/or its investment portfolios.
General economic conditions could adversely affect the Company's business results and prospects.
Recessions; increases in corporate, municipal and/or consumer bankruptcies; a continued downturn in the U.S. housing market; increases in mortgage delinquency rates; intervention by governments in financial markets, including the imposition of limits on the ability of mortgagees to foreclose on defaulted mortgage loans and/or to increase interest rates on mortgage loans in accordance with original contract terms; wars; and terrorist acts could adversely affect the performance of FSA's insured portfolio, by leading to increases in losses and loss reserves, and of the General, FP and VIE Investment Portfolios, by leading to decreases in the value of the portfolios and, therefore, the Company's financial strength. Any of the listed developments could lead to increased losses in the insured portfolio and corresponding increases in the Company's loss reserves.
Changes in rating scales applied to municipal bonds may reduce demand for financial guaranty insurance.
Fitch and Moody's have announced initiatives to establish "corporate equivalent ratings" for municipal issuers. Recently, they each announced that they are postponing their plans to shift to a global ratings scale, but may elect to do so in the future. Implementation of corporate equivalent ratings would be expected to result in ratings being raised for many municipal issuers which, in turn, might result in reduced demand for financial guaranty insurance.
Rating instability of the monoline financial guaranty insurers may call into question the value/durability of a monoline guaranty.
Monoline financial guaranty insurers have had their ratings downgraded by one or more securities rating agencies. The resulting market turmoil has called into question the durability of the monoline ratings and may lead to decreased demand for FSA's financial guarantees. In response to the market instability resulting from the recent rating actions surrounding the monoline financial guaranty insurers,
rating agencies and regulators may enhance the requirements for conducting, or restrict the types of business conducted by, monoline financial guaranty insurers.
Further downgrades of one or more of the Company's reinsurers could reduce the Company's capital adequacy and return on equity.
At December 31, 2008, the Company had reinsured approximately 23% of its principal amount of insurance outstanding. In evaluating the credits insured by the Company, securities rating agencies allow "credit" for reinsurance based on the reinsurers' ratings. In recent years, a number of the Company's reinsurers were downgraded by one or more rating agencies, resulting in decreases in the credit allowed for reinsurance and in the financial benefits of using reinsurance under existing rating agency capital adequacy models. Many of the Company's reinsurers have already been downgraded to Single-A or below by one or more rating agencies. The Company could be required to raise additional capital to replace the lost reinsurance credit in order to satisfy rating agency and regulatory capital adequacy and single risk requirements. The rating agencies' reduction in credit for reinsurance could also ultimately reduce the Company's return on equity to the extent that ceding commissions paid to the Company by the reinsurers were not adequately increased to compensate for the effect of any additional capital required. In addition, downgraded reinsurers may default in amounts due to the Company and such reinsurer obligations may not be adequately collateralized.
Increased competition could reduce the Company's new business originations.
The Company's insurance company subsidiaries face competition from uninsured executions in the capital markets, other monoline financial guaranty insurers, banks and other credit providers, including government-sponsored entities in the mortgage-backed and multi-family sectors. Increased competition, either in terms of price, alternative structures, or the emergence of new providers of credit enhancement, could have an adverse effect on the Company's insurance business. In recent years, FSA also faces competition from new entrants to the market, including BHAC, MIAC and NPFG. In addition, there are proposals for Congress to establish a federally chartered bond insurer, and for states and pension funds to establish bond insurers. Any such bond insurer may have a competitive advantage over FSA.
Commencing with the fourth quarter of 2007, monoline financial guaranty insurers have had their ratings downgraded, placed on credit watch or placed on negative outlook by one or more rating agency. Ratings downgrades of major financial guaranty insurers and declining reliability of rating agency capital models impair investor confidence and reduce demand for financial guaranty insurance.
Changes in prevailing interest rates and other market risks could result in a decline in the market value of the Company's General Investment Portfolio.
At December 31, 2008, the Company's General Investment Portfolio had a fair value of approximately $5.9 billion dollars, almost entirely invested in bonds, primarily municipal bonds. The Company's investment strategy is to invest in highly rated marketable instruments of intermediate average duration so as to generate stable investment earnings with moderate market value or credit risk. Nonetheless, any increase in prevailing interest rates would reduce the market value of securities in the Company's General Investment Portfolio, which would in turn reduce the Company's capital as measured under GAAP. The market value of the General Investment Portfolio also may be adversely affected by general developments in the capital markets, including decreased market liquidity for investment assets, market perception of increased credit risk with respect to the types of securities held in the General Investment Portfolio, downgrades of credit ratings of issuers of investment assets and/or foreign exchange movements which impact investment assets. In addition, the Company invests in securities insured by other financial guarantors, the market value of which may be affected by the rating instability of the relevant financial guarantor.
Changes in prevailing interest rate levels could adversely affect demand for financial guaranty insurance and the Company's financial condition.
Demand for financial guaranty insurance generally reflects prevailing credit spreads. When interest rates are lower or when the market is otherwise relatively less risk averse, the spread between insured and uninsured obligations typically narrows and, as a result, financial guaranty insurance typically provides lower cost savings to issuers than it would during periods of relatively wider spreads. These lower cost savings generally lead to a corresponding decrease in demand or premiums obtainable for financial guaranty insurance.
Conversely, in a deteriorating credit environment, credit spreads widen and pricing for financial guaranty insurance may improve. However, if the weakening environment is sudden, pronounced or prolonged, the stresses on the insured portfolio may result in claims payments in excess of normal or historical expectations. In addition, increases in prevailing interest rate levels can lead to a decreased volume of capital markets activity and, correspondingly, a decreased volume of insured transactions.
Change in industry and other accounting practices could impair the Company's reported financial results and impede its ability to do business.
The Financial Accounting Standards Board (the "FASB") issued a new GAAP accounting standard applicable to financial guaranty insurers that changes the accounting for claims liability recognition and premium revenue recognition. The Company and its industry peers will be required to implement changes to GAAP reporting requirements effective January 1, 2009. Such alterations, as well as any changes in the interpretation of current accounting guidance or the issuance of other new accounting standards, may have an adverse effect on the Company's reported financial results, including future revenues, and may influence the types and/or volume of business that management may choose to pursue.
Changes in or inability to comply with applicable law could impede the Company's ability to do business.
The Company's businesses are subject to direct and indirect regulation under, among other things, state insurance laws, federal securities law, the U.S. Bank Holding Company Act, tax law and legal precedents affecting public finance and asset-backed obligations, as well as applicable law in the other countries in which the Company operates. Recent adverse developments in the industry have led regulators to re-examine the regulatory framework for financial guaranty insurers. In September 2008, the New York Insurance Department issued a circular letter, effective January 1, 2009, that prescribed best practices for financial guaranty issuers that would significantly narrow the permitted scope of insurance of asset-backed securities, a business no longer pursued by the Company. Future legislative, regulatory or judicial changes in the U.S. or abroad could adversely affect the Company's business by, among other things, limiting the types of risks FSA may insure, placing limits on the Company's ability to carry out its non-insurance business, lowering applicable single or aggregate risk limits, increasing the level of supervision or regulation to which its operations may be subject or creating restrictions that make the Company's products less attractive to potential buyers or lead to a need for increased reserves.
In addition, if FSA fails to comply with applicable insurance laws and regulations it could be exposed to fines, the loss of insurance licenses, limitations on the right to originate new business and restrictions on its ability to dividend monies to the Company, all of which could have an adverse impact on the Company's business results and prospects. As a result of a number of factors, including incurred losses and risks reassumed from troubled reinsurers, FSA has from time to time exceeded regulatory risk limits. Failure to comply with these limits allows the New York Insurance Department to cause the Company to cease writing new business, although it has not done so in the past.
The Company is exposed to volatility in GAAP net income from incorporating its own credit risk in the valuation of liabilities carried at fair value.
Effective January 1, 2008, the Company adopted SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"). SFAS 159 provides an option to elect fair value as an alternative measurement for selected financial assets and financial liabilities not previously carried at fair value. The fair-value option may be applied to single eligible instruments, is irrevocable and is applied only to entire instruments and not to portions of instruments. The Company's fair value elections were intended to mitigate the volatility in earnings that had been created by not recording financial instruments and the related risk management instruments at fair value, to eliminate the operational complexities of applying hedge accounting or to conform to the fair value elections made by the Company in 2006 under its IFRS reporting to Dexia. However, under SFAS No. 157, "Fair Value Measurements," the Company must incorporate its own credit risk in the valuation of liabilities which are carried at fair value, which adds volatility to GAAP earnings. During 2008, the Company's credit spread widened, leading to material unrealized gains.
The Company has received Department of Justice and SEC subpoenas and been named in class action lawsuits related to the municipal GIC industry.
In November 2006, the Company received subpoenas from (1) the Antitrust Division of the U.S. Department of Justice (the "DOJ"), issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs, and (2) the SEC, issued in connection with an ongoing industry-wide civil investigation of brokers of municipal GICs. In February 2008, the Company received a "Wells Notice" from the SEC in connection with the foregoing investigation, indicating that the SEC staff was considering recommending action against the Company. The Company issues municipal GICs through the FP segment, but does not serve as a GIC broker. The subpoenas request that the Company furnish to the DOJ and SEC records and other information with respect to the Company's municipal GIC business. The Company is at risk that information provided pursuant to the subpoenas or otherwise provided to the government in the course of its investigation will lead to indictments of the Company and/or its employees, with the potential for convictions or settlements providing for the payment of fines, restitution, disgorgement, restrictions on future business activities and, in the case of individual employees, imprisonment. Such an adverse outcome would damage the reputation of the Company and might impair the ability of the Company to conduct its financial products business and its financial guaranty business. The Company has had ongoing discussions with the DOJ and the SEC, but cannot predict the amount of loss that may arise from these investigations.
During 2008, nine putative class action lawsuits naming the Company and/or FSA were filed in federal court alleging antitrust violations in the municipal derivatives industry. The Company and FSA also are named in five non-class actions originally filed in the California Superior Courts alleging violations of California law related to the municipal derivatives industry. The suits name as plaintiffs various named and unnamed states and municipalities and name as defendants a large number of major financial institutions, including the Company and FSA. The lawsuits refer to the ongoing investigations by the DOJ Antitrust Division and the SEC regarding such activities, with respect to which the Company and FSA received subpoenas in November 2006. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. It is not possible to predict whether additional suits will be filed, and it is also not possible to predict the outcome of such litigation. There could be unfavorable outcomes in these or other proceedings. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits but, under some circumstances, adverse results in legal proceedings could be material to the Company's results of operations, financial condition or cash flows.
The Company's ability to make debt service payments on its outstanding debt is subject to the financial strength of its insurance company operations.
Because it is a holding company, the registrant does not conduct operations or generate material income. Instead, FSA Holdings' financial condition and results of operations, and thus its long-term ability to service its debt, will largely depend on its receipt of dividends from, or share repurchases by, FSA. FSA's ability to declare and pay dividends to the Company depends, among other factors, upon FSA's financial condition, results of operations, cash requirements, and compliance with rating agency requirements for maintaining its ratings, and is also subject to restrictions contained in the applicable insurance laws and regulations. Based on FSA's statutory statements for 2008, the maximum amount available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2008 is approximately $62.0 million. The Company has $46.1 million in debt service payments due over the 12 months following December 31, 2008, unless it elects to defer payments on its junior subordinated debentures, which would reduce its annual debt service payments due by $19.2 million per year for up to 10 years.
The Company's international operations expose it to less predictable credit and legal risks.
The Company pursues opportunities in international markets and currently operates in various countries in Europe, the Asia Pacific region and Latin America. The underwriting of obligations of an issuer in a foreign country involves the same process as that for a domestic issuer, but additional risks must be addressed, such as the evaluation of foreign currency exchange rates, foreign business and legal issues, and the economic and political environment of the foreign country or countries in which an issuer does business. Changes in such factors could impede the Company's ability to insure, or increase the risk of loss from insuring, obligations in the countries in which it currently does business and limit its ability to pursue business opportunities in other countries.
Item 1B.
Item 1B. Unresolved Staff Comments.
Item 1B is not applicable to the Company, because the Company is not an accelerated filer or large accelerated filer, as defined in Rule 12b-2 of the Exchange Act, or a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933, as amended (the "Securities Act").
Item 2.
Item 2. Properties.
The principal executive offices of the Company and FSA are located at 31 West 52nd Street, New York, New York, 10019, and consist of approximately 110,000 square feet of office space.
FSA or its subsidiaries also maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid (Spain), Mexico City (Mexico), Paris (France), Sydney (Australia) and Tokyo (Japan). The Company and its subsidiaries do not own any material real property.
The Company's telephone number at its principal executive offices is (212) 826-0100.
Item 3.
Item 3. Legal Proceedings.
In the ordinary course of business, the Company and certain subsidiaries are parties to litigation. Material legal proceedings are discussed below. It is not possible to predict whether additional inquiries or requests for information will be received from regulatory or other governmental authorities, and it is also not possible to predict the outcome of any proceedings, inquiries or requests for information. There could be unfavorable outcomes from these and other proceedings that could be material to the Company's business, operations, financial condition, results of operations or cash flows.
The entitlements of the Chief Executive Officer and the President of the Company under their employment agreements with the Company are in dispute. See "Item 11. Executive Compensation-Summary Compensation Table-Discussion of 2008 Compensation for the Named Executive Officers." In addition, holders of shares under the Director Share Purchase Program are in discussions with Dexia regarding the proper valuation of such shares, which may lead to mediation or arbitration of the dispute. See "Item 11. Executive Compensation-Compensation of Directors-Director Share Purchase Program."
Proceedings Related to the Financial Products Business
In November 2006, (i) the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs and other municipal derivatives and (ii) FSA received a subpoena from the SEC related to an ongoing industry-wide investigation concerning the bidding of municipal GICs and other municipal derivatives. Pursuant to the subpoenas the Company has furnished to the DOJ and SEC records and other information with respect to the Company's municipal GIC business. On February 4, 2008, the Company received a "Wells Notice" from the staff of the Philadelphia Regional Office of the SEC relating to the foregoing matter. The Wells Notice indicates that the SEC staff is considering recommending that the SEC authorize the staff to bring a civil injunctive action and/or institute administrative proceedings against the Company, alleging violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and Section 17(a) of the Securities Act. The Company has had ongoing discussions with the DOJ and the SEC. The ultimate loss that may arise from these investigations remains uncertain.
During 2008 nine putative class action lawsuits were filed in federal court alleging federal antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. These cases have been coordinated and consolidated for pretrial proceedings in the U.S. District Court for the Southern District of New York as MDL 1950, In re Municipal Derivatives Antitrust Litigation, Case No. 1:08-cv-2516 ("MDL 1950").
Five of these cases name both the Company and FSA: (a) Hinds County, Mississippi v. Wachovia Bank, N.A. (filed on or about March 13, 2008); (b) Fairfax County, Virginia v. Wachovia Bank, N.A. (filed on or about March 12, 2008); (c) Central Bucks School District, Pennsylvania v. Wachovia Bank N.A. (filed on or about June 4, 2008); (d) Mayor & City Counsel of Baltimore, Maryland v. Wachovia Bank N.A. (filed on or about July 3, 2008); and (e) Washington County, Tennessee v. Wachovia Bank N.A. (filed on or about July 14, 2008). Four of the cases name only the Company and also allege that the defendants violated state antitrust law and common law by engaging in illegal bid-rigging and market allocation, thereby depriving the cities of competition in the awarding of GICs and ultimately resulting in the cities paying higher fees for these products: (a) City of Oakland, California, v. AIG Financial Products Corp. (filed on or about April 23, 2008); (b) County of Alameda, California v. AIG Financial Products Corp. (filed on or about July 8, 2008); (c) City of Fresno, California v. AIG Financial Products Corp. (filed on or about July 17, 2008); and (d) Fresno County Financing Authority v. AIG Financial Products Corp. (filed on or about December 24, 2008).
Interim lead counsel for the MDL 1950 plaintiffs filed a Consolidated Class Action Complaint ("Consolidated Complaint") in August 2008 alleging violations of the federal antitrust laws. Defendants filed motions to dismiss the Consolidated Complaint. The MDL 1950 court has determined that it will handle federal claims alleged in the Consolidated Complaint before addressing state claims. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
The Company and FSA also are named in five non-class actions originally filed in the California Superior Courts alleging violations of California law related to the municipal derivatives industry:
(a)City of Los Angeles v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of Los Angeles, Case No. BC 394944, removed to the U.S. District Court for the Central District of California ("C.D. Cal.") as Case No. 2:08-cv-5574, transferred to S.D.N.Y. as Case No. 1:08-cv-10351);
(b)City of Stockton v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-477851, removed to the N.D. Cal. as Case No. 3:08-cv-4060, transferred to S.D.N.Y. as Case No. 1:08-cv-10350);
(c)County of San Diego v. Bank of America, N.A. (filed on or about August 28, 2008 in the Superior Court of the State of California in and for the County of Los Angeles, Case No. SC 99566, removed to C.D. Cal. as Case No. 2:08-cv-6283, transferred to S.D.N.Y. as Case No. 1:09-cv-1195);
(d)County of San Mateo v. Bank of America, N.A. (filed on or about October 7, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-480664, removed to N.D. Cal. as Case No. 3:08-cv-4751, transferred to S.D.N.Y. as Case No. 1:09-cv-1196); and
(e)County of Contra Costa v. Bank of America, N.A. (filed on or about October 8, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-480733, removed to N.D. Cal. as Case No. 4:08-cv-4752, transferred to S.D.N.Y. as Case No. 1:09-cv-1197).
These cases have been transferred to the S.D.N.Y. and consolidated with MDL 1950 for pretrial proceedings. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
Proceedings Relating to Financial Guaranty Business
The Company has received various regulatory inquiries and requests for information regarding a variety of subjects. These include subpoenas duces tecum and interrogatories from the State of Connecticut Attorney General and the Attorney General of the State of California related to antitrust concerns associated with the methodologies used by rating agencies for determining the credit rating of municipal debt, including a proposal by Moody's to assign corporate equivalent ratings to municipal obligations, and the Company's communications with rating agencies. The Company is in the process of satisfying such requests. The Company may receive additional inquiries from these or other regulators and expects to provide additional information to such regulators regarding their inquiries in the future.
In December 2008 and January 2009, FSA and various other financial guarantors were named in three complaints filed in the Superior Court, San Francisco County: (a) City of Los Angeles Department of Water and Power v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CG-08-483689; Sacramento Municipal Utility District v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CGC-08-483691; and (c) City of Sacramento v. Ambac Financial Group Inc. et. al (filed on or about January 6, 2009), Case No. CGC-09-483862. These complaints alleged participation in a conspiracy in violation of California's antitrust laws to maintain a dual credit rating scale that misstated the credit default risk of municipal bond issuers and created market demand for municipal bond insurance and participation in risky financial transactions in other lines of business that damaged each bond insurer's financial condition (thereby undermining the value of each of their guaranties), and a failure to adequately disclose the impact of those transactions on their financial
condition. These latter allegations form the predicate for five separate causes of action against each of the Insurers: breach of contract, breach of the covenant of good faith and fair dealing, fraud, negligence, and negligent misrepresentation. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
In August 2008 a number of financial institutions and other parties, including FSA, were named as defendants in a civil action brought in the circuit court of Jefferson County, Alabama relating to the County's problems meeting its debt obligations on its $3.2 billion sewer debt: Charles E. Wilson vs. JPMorgan Chase & Co et al (filed on or about August 8, 2008 in the Circuit Court of Jefferson County, Alabama), Case No. 01-CV-2008-901907.00, a putative class action. The action was brought on behalf of rate payers, tax payers and citizens residing in Jefferson County, and alleges conspiracy and fraud in connection with the issuance of the County's debt. The complaint in this lawsuit seeks unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from this lawsuit. FSA was also named as a defendant in a second civil action regarding Jefferson County, Alabama, but was dismissed from such action in January 2009.
There are no other material legal proceedings pending to which the Company is subject.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
On July 5, 2000, the Company completed a merger in which the Company became an indirect subsidiary of Dexia, a Belgian corporation whose shares are traded in the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. See "Item 1. Business-Organization." As a consequence of the merger, there is no longer an established public trading market for the Company's common stock, and bid quotations are not reported or otherwise available.
As of March 1, 2009, the only holders of the Company's common stock were Dexia Holdings and directors of the Company who own shares of the Company's common stock or economic interests therein as described in "Item 11. Executive Compensation-Compensation of Directors-Director Share Purchase Program."
After a period of suspension of dividends, the Company began payment of regular quarterly dividends in May 2004, paying $22.9 million in aggregate for 2004 and $71.1 million in aggregate for 2005. In 2006, the Company paid regular quarterly dividends of $130.0 million in aggregate, an extraordinary dividend of $300.0 million in November 2006 and an extraordinary dividend of $100.0 million in December 2006. In 2007, the Company paid regular quarterly dividends of $122.0 million in aggregate, and no extraordinary dividends. During the first quarter of 2008, the Company paid regular dividends of $33.6 million in aggregate, and no extraordinary dividends. In May 2008, the Board of Directors amended the Company's dividend policy to provide for a regular annual dividend rather than a regular quarterly dividend, with the first regular annual dividend expected to be considered by the Board of Directors at its May 2009 meeting. Information concerning restrictions on the payment of dividends is set forth in "Item 1. Business-Insurance Regulatory Matters-Dividend Restrictions."
Information about securities authorized for issuance under the Company's equity compensation plans is set forth in "Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters-Securities Available Under Equity Compensation Plans."
The Company does not have equity securities registered pursuant to Section 12 of the Exchange Act.
Item 6.
Item 6. Selected Financial Data.
The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and accompanying notes included elsewhere herein.
(a)Prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP").
(b)Amounts are statutory data for FSA and therefore differ from comparable GAAP amounts.
(c)Total claims-paying resources is used by Moody's to evaluate adequacy of capital resources and credit ratings. Moody's uses its judgment in making adjustments to some of the measures. This term represents the sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and money market committed preferred trust securities.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements
This Annual Report includes statements that may constitute "forward-looking statements" within the meaning of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Words such as "believes," "anticipates," "expects," "intends" and "plans" and future and conditional verbs such as "will," "should," "would," "could" and "may" and similar expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements. The Company cautions that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. Important factors that could cause its results to differ, possibly materially, from those indicated in the forward-looking statements include, but are not limited to, those discussed under "Item 1. Business-Forward-Looking Statements" and "Item 1A. Risk Factors."
Executive Overview
Financial Security Assurance Holdings Ltd. ("FSA Holdings" or, together with its subsidiaries, the "Company") is a holding company incorporated in the State of New York. The Company, through its insurance company subsidiaries, engages in providing financial guaranty insurance on public finance obligations in domestic and international markets. Historically, the Company also provided financial guaranty insurance on asset-backed obligations. In addition, the Company historically issued FSA-insured guaranteed investment contracts and other investment agreements ("GICs"), as well as medium term notes to municipalities and other market participants through its Financial Products ("FP") segment.
After a careful strategic analysis, the Company decided, in August 2008, to cease issuing financial guaranty insurance contracts of asset-backed obligations in order to devote its resources to expanding its position in the global public finance and infrastructure markets. This decision was based on weighing the risks and volatility embedded in the asset-backed security business, in particular residential mortgage-backed securities ("RMBS"), versus the opportunities available in lower-risk sectors of the public finance markets. The change in strategic focus resulted in a staff reduction of 29 positions in 2008. The continuation of the lack of market opportunities led to a further reduction of 32 positions in the first quarter of 2009. The amortizing asset-backed portfolio is expected to generate in excess of $583.7 million of earned revenue over the remaining life of the policies. In November 2008, the Company ceased issuing GICs. While the Company has ceased new originations in its asset-backed financial guaranty business and of GICs, a substantial portfolio of such obligations remains outstanding.
Although the economy is faced with an unprecedented crisis, the Company believes that the current U.S. municipal operating environment remains favorable for highly rated bond insurers. While the insured penetration of bond insurance in the U.S. municipal market decreased to approximately 17% in 2008 compared with 47% in 2007, the Company believes that it will normalize to a higher level as financial markets stabilize, provided that there are highly rated financially stable bond insurers available to service market demand.
The Company's principal insurance company subsidiary is Financial Security Assurance Inc. ("FSA"), a wholly owned New York insurance company. The Company is a subsidiary of Dexia Holdings Inc. ("Dexia Holdings"), which, in turn, is owned 90% by Dexia Crédit Local S.A. ("Dexia Crédit Local") and 10% by Dexia S.A. ("Dexia"). Dexia is a Belgian corporation primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia.
The Company conducted its GIC business through its non-insurance subsidiaries FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the "GIC Subsidiaries"). FSACM conducted substantially all the Company's GIC business since April 2003, following its receipt of an exemption from the requirements of the Investment Company Act of 1940. When the GIC Subsidiaries sold GICs, they loaned the proceeds to FSA Asset Management LLC ("FSAM"), which invests the funds in fixed-income obligations that satisfy the Company's investment criteria. The Company's affiliates ceased issuing GICs in November 2008 in contemplation of the sale of the Company to Assured Guaranty Ltd. ("Assured"). FSAM wholly owns FSA Portfolio Asset Limited ("FSA-PAL"), a U.K. company that invests in non-U.S. securities.
For the year ended December 31, 2008, the Company had gross premiums written of $690.4 million, of which approximately 88% related to insurance of public finance obligations and approximately 12% related to insurance of asset-backed and other non-public finance obligations. The Company also had realized gains on credit derivatives of $126.9 million in 2008. At December 31, 2008, the Company had net par outstanding of $408.5 billion, of which approximately 75% represented insurance of public finance obligations and approximately 25% represented insurance of asset-backed and other non-public finance obligations. At December 31, 2008, the Company had $16.4 billion principal amount of FP segment debt.
In 2008, the Company reported a net loss of $8,443.2 million, compared with a net loss of $65.7 million in 2007 and net income of $424.2 million in 2006, primarily due to $8,397.9 million of other than temporary impairment ("OTTI") charges in the FP investment portfolio supporting FSA-insured GICs (the "FP Investment Portfolio"). Of the FP investment portfolio OTTI, $797.5 million was considered economic credit impairment at December 31, 2008. In prior years, unrealized gains and losses in the FP Investment Portfolio and the portfolio of investments supporting the variable interest entity ("VIE") liabilities (the "VIE Investment Portfolio") were generally recorded in other comprehensive income, based in part on the Company's ability and intent to hold the FP Segment Investment Portfolio to maturity and the Company's conclusion that the unrealized losses were temporary. The FP Investment Portfolio and VIE Investment Portfolio together make up the "FP Segment Investment Portfolio." See "-Expected Sale of the Company-Dexia's Retention of the FP Business."
Under the Purchase Agreement described below, Dexia agreed to segregate or separate the Company's FP operations from the financial guaranty operations and retain the FP segment. Consequently, the Company no longer has the intent to hold these assets to maturity and was required to record an OTTI for all securities in a loss position at December 31, 2008. The magnitude of the amount of the OTTI was a result of declines in fair value of RMBS securities in the portfolio. During 2008, the Company has relied on liquidity resources available under agreements with Dexia to meet the GIC withdrawal and collateralization requirements. Further deterioration in the market value of the FP Investment Portfolio or ratings downgrades could result in the FP business having inadequate market value of securities eligible to be pledged as collateral in the event of an FSA downgrade. For more information regarding the liquidity risks inherent to the FP business and the liquidity resources available to it, see "-Liquidity and Capital Resources-FP Segment Liquidity."
FSA's exposure to mortgage-backed obligations with deteriorating credit performance was the primary driver of loss expense in the Company's financial guaranty segment which have increased from $31.6 million as of December 31, 2007 to $1,877.7 million as of December 31, 2008, despite the fact that the Company has no material exposures to collateralized debt obligations ("CDOs") of asset-backed securities ("ABS") that include RMBS, which caused severe losses for a number of other financial guarantors. The full extent of credit losses in the mortgage sector, and the extent to which they may affect the Company, will not be known for several years. The Company is also closely
monitoring the consumer and corporate sectors for signs of deepening economic stress. See Note 3 to the consolidated financial statements in Item 8.
The Company is affected by conditions in the financial markets and general economic conditions, primarily domestic, but also international.
Expected Sale of the Company
Purchase Agreement with Assured Guaranty Ltd.
In November 2008, Dexia and Assured entered into a purchase agreement (the "Purchase Agreement") providing for the purchase by Assured of all Company shares owned by Dexia (the "Acquisition"), subject to the satisfaction of specified closing conditions. Purchase Agreement closing conditions include (1) receipt of regulatory and Assured shareholder approvals; (2) confirmation from Standard & Poor's Ratings Services ("S&P"), Moody's Investors Service, Inc. ("Moody's") and Fitch Ratings ("Fitch") that the acquisition of the Company would not result in a downgrade of the financial strength ratings of the insurance company subsidiaries of Assured or of the Company; and (3) segregation or separation of the Company's FP business such that the credit and liquidity risk of the FP business resides with Dexia, with FSA protected against any future Dexia credit impairment. In February 2009, the Company's ultimate parent, Dexia, entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia, which resulted in the "deconsolidation" of FSAM from the Company (the "FSAM Risk Transfer Transaction").
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the "HSR Act") and the rules promulgated thereunder by the Federal Trade Commission (the "FTC"), the Acquisition may not be consummated until notifications have been given and certain information has been furnished to the FTC and the Department of Justice (the "DOJ") and specified waiting period requirements have been satisfied. The HSR Act waiting period expired on January 21, 2009. In addition, under the insurance holding company laws and regulations applicable to the insurance subsidiaries of the Company and Assured, before a person can acquire control of a U.S. insurance company, prior written approval must be obtained from the insurance commissioner of the state where the insurer is domiciled. Assured has informed the Company that Assured filed applications with the insurance departments of the States of New York and Oklahoma and the U.K. Financial Services Authority; that the applications to the New York Insurance Department and the U.K. Financial Services Authority have been approved; and that it has made pre-acquisition filings regarding the potential competitive impact of the acquisition, which are deemed to have been approved. Dexia has informed the Company that it has filed an application with the U.K. Financial Services Authority in connection with its acquisition of Assured common shares pursuant to the Purchase Agreement, which has been approved, and that it has filed disclaimers of control with the insurance departments of the states of Maryland, New York, and Oklahoma.
Satisfying all three rating agencies that the necessary steps have or will be taken to transfer the FP segment credit and liquidity risk to Dexia is one of the last conditions to the Purchase Agreement closing. Rating agency confirmation that the Acquisition will not have a negative impact on the financial strength ratings of Assured's insurance company subsidiaries or the Company's insurance company subsidiaries is a condition for closing, and is beyond the Company's control.
The Company cannot estimate whether or when the remaining closing conditions will be satisfied or relevant agreements negotiated, whether the Acquisition will be completed and, if completed, whether it will be structured as currently contemplated, or what the effects of the change in control or removal of the FP business will be on the Company and its results of operations. If the Acquisition is not carried out, Dexia may explore other options with respect to the Company, including selling the Company or some of its operations to a third party or ceasing to write new business, which may have a material adverse effect on the Company.
Dexia's Retention of the FP Business
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. The Purchase Agreement provides that Dexia will provide guarantees with respect to the FP business' assets and liabilities, including derivative contracts, and anticipates that some of its guarantees will benefit from guarantees provided by the French and Belgian states. Dexia Holdings, the Company's parent, agreed that if such sovereign guarantees are provided, it will cause FSA Holdings to transfer the ownership interests of certain of the subsidiaries that conduct the FP business, or all the assets and liabilities of such subsidiaries, to Dexia Holdings or one of its affiliates in form reasonably acceptable to Assured.
Transfer of Credit and Liquidity Risk of the GIC Business
When the GIC Subsidiaries sold a GIC, they loaned the proceeds to FSAM. The terms governing FSAM's repayment of those proceeds to the GIC Subsidiaries match the payment terms under the related GIC. FSAM invests the proceeds in securities and enters into derivative transactions to convert any fixed-rate assets and liabilities into London Interbank Offered Rate ("LIBOR")-based floating rate assets and liabilities. Most of FSAM's assets consist of residential mortgage-backed securities ("RMBS") that have suffered significant market value declines and, in more limited cases, credit deterioration resulting in a shareholders' deficit for FSAM at December 31, 2008. The market value declines of FSAM's assets subject FSAM to significant liquidity risk insofar as the GICs are in most cases subject to redemption or collateralization upon the downgrade of FSA below certain thresholds, with a significant number of GICs subject to redemption or collateralization should FSA be downgraded below Aa3 by Moody's (FSA's current Moody's rating) or below AA- by S&P. Dexia had previously announced its intention to assume the credit and liquidity risk associated with the Company's FP business, and provided significant support to the FP business in the course of 2008.
In February 2009, Dexia entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia, (the "FSAM Risk Transfer Transaction"). Each of the agreements executed under the FSAM Risk Transfer Transaction directly affect (1) FSAM and (2) the entities that absorb the risks created by FSAM. These agreements provide for the (i) elimination of FSA's guaranty of repayment of FSAM's borrowings under the credit facilities provided by Dexia's bank subsidiaries; (ii) elimination of FSA's guaranty of certain of FSAM's investments; and (iii) increase in the credit facilities provided to FSAM by Dexia's bank subsidiaries from $5 billion to $8 billion.
As a result of the significant decline in asset value and the November 2008 cessation of issuing GICs, the GIC business changed from a business model managed by the Company focused on attaining positive net interest margin, to a run-off business managed by Dexia seeking to minimize liquidity risk and optimize asset recovery values. As a result, the FSAM Risk Transfer Transaction was deemed a reconsideration event for FSAM under FASB Interpretation 46 (R), "Consolidation of Variable Interest Entities" ("FIN 46"). There was no reconsideration event for any of the GIC Subsidiaries.
Upon the reconsideration event, management determined that Dexia is now absorbing the majority of the variability of expected losses of FSAM, which resulted in deconsolidation of FSAM as of February 24, 2009, the effective date of the FSAM Risk Transfer Transaction.
The GIC subsidiaries, unlike FSAM, remain part of the Company's consolidated financial statements notwithstanding the FSAM Risk Transfer Transaction, which means that the GICs issued to third parties and the note receivable from FSAM will represent the primary liabilities and assets of the FP business in the Company's consolidated financial statements. Since some of the GICs were designated as fair value option, they will continue to be marked to market; however, derivatives are maintained within FSAM, so contracts meant to hedge the interest rate risk of those GICs will no longer be included in the Company's consolidated financial statements, increasing the volatility of the Company's net income (loss).
The following table shows the effect of deconsolidation of FSAM had the FSAM Risk Transfer Transaction been executed at December 31, 2008.
(1)Represents the deconsolidation of FSAM resulting from the February 2009 FSAM Risk Transfer Transaction.
(2)Represents the reversal of eliminations related to intercompany note between FSAM and the GIC Subsidiaries. In the table above, the carrying value of the note receivable from FSAM represents net realizable value, in accordance with accounting principles generally accepted in the United States of America ("GAAP") in effect at December 31, 2008. Statement of Financial Accounting Standards ("SFAS") No. 160, "Noncontrolling Interests in Consolidated Financial Statements" ("SFAS 160"), became effective January 1, 2009 and may be applicable to the deconsolidation of FSAM. The Company is currently evaluating the impact of SFAS 160 on the Company's financial statements in 2009 as SFAS 160 may materially affect the method of valuing the carrying amount of the GIC entities' notes receivable from FSAM at the February 2009 deconsolidation date.
Business Environment and Market Trends
Continuing Stress on the Financial Guaranty Industry
Obligations insured by the Company are generally awarded ratings on the basis of the financial strength ratings given to the Company's insurance company subsidiaries by the major securities rating agencies. During 2007 and 2008, the global financial crisis that began in the U.S. subprime residential mortgage market transformed the financial guaranty industry. By the end of November 2008, all of the monoline guarantors that had been rated Triple-A at the beginning of the year had been downgraded in varying degrees by Moody's, and all but two had been either downgraded or placed on negative outlook or negative credit watch by S&P and Fitch, reducing the number of active providers of financial guaranty insurance while calling into question the durability of financial guaranties in general. On December 31, 2008, the Company was rated Triple-A (negative credit watch) by S&P and Fitch and
Aa3 (developing outlook) by Moody's. Prior to November 2008, the Company's insurance company subsidiaries, as well as the obligations they insured, had been awarded Triple-A ratings by the three major rating agencies. Rating agencies raised concerns about the stability of FSA's rating during the second half of 2008. The rating agencies stated that their actions regarding FSA were based in part upon concerns regarding the prospects for new business originations by financial guarantors, as well as uncertainty about future support for FSA. As a result of the recent ratings actions, FSA's market opportunities were severely limited beginning in the second half of 2008 and its long-term opportunities remain unclear. These developments, combined with illiquidity in the capital markets, led to a marked reduction in FSA's production in the second half of 2008.
Given the rapidly deteriorating state of the U.S. economy, it is difficult to project the future for the Company. Unemployment rates are likely to continue to rise, fueling more residential mortgage delinquencies and putting further pressure on home prices. Loss reserves would grow if these trends continue beyond current assumptions. Consumer and corporate credits are also under pressure, although the Company's consumer and corporate portfolios are holding up relatively well. Commercial mortgage securitizations may be a future source of pain in the economy, however the Company is not exposed to this category of risk. The current environment represents a stress-case worse than any of the models had projected. In the public finance sector, the combination of falling property values and reduced commercial activity, which drive local tax revenues, are putting increasing pressure on municipal budgets at a time when the population is putting increasing pressure on municipal services. The closing of the proposed business combination with Assured is an important component of the Company's survival and, ultimately, return to success.
The following table shows the current ratings of the Company and its four main competitors at March 13, 2009, by each of the rating agencies:
Current Competitors' Ratings
In addition to FSA, a number of the Company's competitors in the financial guaranty industry have incurred unprecedented increases in projected losses on insured RMBS transactions in 2008 and subsequently were downgraded or placed on credit watch, negative outlook or review for further downgrade by the major securities rating agencies. Several guarantors had significant exposure to CDOs of ABS, which include CDOs of CDOs (also referred to as "CDO squared").
FSA was the U.S. municipal market leader in 2008, achieving a 54% share of market. However, most of its business was originated in the first half of 2008, after which the rating agency actions decreased demand for FSA guarantees. In international public finance markets, where liquidity was constrained all year, FSA's 2008 production decreased significantly in comparison to full year 2007.
Concerns regarding the capital adequacy of Triple-A guarantors have drawn attention not only from rating agencies but also state regulators, the federal government and financial institutions concerned about their own exposure to monolines. In September 2008, the New York Insurance Department issued a circular letter, effective January 1, 2009, that prescribes best practices for financial guaranty issuers that would significantly narrow the permitted scope of insurance of asset-backed securities, a business no longer pursued by the Company. There also have been proposals for a federal
office to oversee bond insurers. The cost of buying protection in the credit default swap ("CDS") market on monoline names rose significantly during 2008.
In the fourth quarter of 2007, Berkshire Hathaway Assurance Company ("BHAC") commenced operations as a financial guaranty insurer. Given BHAC's affiliation with Triple-A rated Berkshire Hathaway Company, BHAC has the potential to be a significant competitor to the Company in the public finance sector but has to date insured transactions only on an opportunistic basis. Another new monoline competitor, Municipal and Infrastructure Assurance Corporation ("MIAC"), commenced operations in October 2008, intending to focus on municipal and infrastructure finance. National Public Finance Guaranty Corp. ("NPFG"), an affiliate of MBIA Insurance Corporation, commenced operations in February 2009, intending to focus on municipal finance. In addition, Ambac Assurance Corporation has announced an intention to establish an affiliate, Everspan Financial Guaranty Corp, that will engage in municipal financial guaranty insurance. There are proposals for Congress to establish a federally chartered bond insurer, and for states and pension funds to establish bond insurers, in each case to address the public sector demand for bond insurance. Any such Federal, state or pension fund sponsored bond insurer would likely prove to be a significant competitor to the Company.
The Company has direct exposure to other financial guaranty insurers through secondary guaranties of previously insured securities, reinsurance and investments. Downgrades of other monolines could cause incurred loss in the insured and investment portfolios. Additionally, such downgrades could reduce the credit for reinsurance and for previously wrapped insured transactions that rating agencies assign in their capital adequacy models, increasing the capital charges in those models. At this stage, management cannot predict how the situation will be resolved for the Company or its competitors, or what competitive, regulatory and rating agency environments may emerge.
In 2008, the market turmoil resulted in disruptions in the domestic public finance market, evidenced by auction failures for auction rate municipal bonds, higher rates on variable rate demand notes and historic high yields for tax-exempt municipal bonds compared with U.S. government treasury securities. If these conditions persist for an extended period of time, the Company's own insured obligations could experience increased losses because, in extreme cases, higher borrowing costs could put financial stress on municipal issuers, leading to defaults of FSA-insured securities.
Credit Deterioration in Certain RMBS Sectors Accelerated
The credit crisis that began in 2007 followed several years of seemingly benign credit conditions, during which delinquency and default rates were comparatively low across the residential mortgage, consumer finance and corporate finance credit markets. Beginning in 2005, credit spreads were tight, indicating that investors were relatively undiscriminating about risk, and structures of some asset-backed securities were based on loss assumptions that have proven to be too optimistic. This was particularly true in the RMBS sector and with CDOs of ABS that contain a high percentage of RMBS. During these years, FSA maintained its underwriting and pricing standards, even though this meant declining to insure certain transactions.
The Company generally avoided insurance of CDOs of ABS. In all, FSA insured two CDOs of ABS with a total net par outstanding of $339 million: (1) a Double-A rated obligation insured in 2000 with $47 million net par outstanding and less than 3% invested in U.S. subprime and "Alt-A" RMBS collateral, and (2) a Triple-B rated CDS excess-of-loss reinsurance transaction insured in 2005 at four times the original Triple-A attachment point with $292 million net par outstanding at December 31, 2008. "Alt-A" refers to borrowers whose credit quality falls between prime and subprime. In contrast, most of the Company's peers have suffered from projected losses and market concerns related to their exposure to CDOs of ABS that contain a high percentage of mezzanine tranches of subprime RMBS, with most credit concerns focused on 2006 and 2007 originations.
In 2007 and 2008, mortgage performance deteriorated rapidly, exceeding the most conservative historical loss expectations. For the first time since the Great Depression, year-over-year home prices declined across the entire United States, not just regionally. As projected losses on subprime and other RMBS increased, some mortgage lenders failed, and rating agencies downgraded many mortgage-related securities. This included a large amount of CDOs of ABS. In the home equity line of credit ("HELOC") market, which generally involves prime borrowers, projected losses rose to unprecedented levels. In the first quarter of 2008, these borrowers began to default at much higher rates, a trend which continued through the year.
In 2008, the Company established 38 new case reserves, primarily for first and second lien RMBS insured transactions. Loss provisions, primarily those related to the insured RMBS portfolio, reflect the assumption that economic stress in the U.S. economy will continue for the foreseeable future. Loss expense for the year ended December 31, 2008 was $1,877.7 million, related primarily to increases in loss estimates on RMBS transactions.
Additionally, in 2008 the Company recorded pre-tax OTTI charges in the FP Investment Portfolio of $8,397.9 million, of which $797.5 million was considered economic credit impairment. In the fourth quarter of 2008, $236.2 million was recorded in OTTI in the VIE Investment Portfolio, none of which was deemed to be economic. The fourth quarter OTTI charge reflects the Company's lack of intent to hold the securities as a result of the Purchase Agreement, which requires immediate recognition in income of all unrealized losses that had been previously recorded in other comprehensive income because the Company no longer intends to hold these assets to maturity or recovery of the losses. At December 31, 2008, approximately 56.6% of the available-for-sale FP Investment Portfolio based on amortized cost was invested in non-agency RMBS, of which 38.8% were rated Triple-A, with 17.2% rated Double-A, 7.0% rated Single-A, 10.0% rated Triple-B and 27.0% below investment grade.
The Company has evaluated all its U.S. RMBS of 2005 vintage or later, in both the insured portfolio and the FP Investment Portfolio, using the same modeling assumptions and the same approach to setting transaction default assumptions, driven by the actual performance of each transaction. The Company is also closely monitoring the consumer and corporate sectors for signs of deepening economic stress.
Adverse loss developments surrounding subprime RMBS may lead to earlier than anticipated withdrawals on GICs issued in connection with CDOs of ABS. At December 31, 2008, $983.6 million of CDO of ABS GICs had been terminated due to an event of default in the underlying collateral of the CDOs of ABS and a subsequent liquidation of the CDO portfolio. Between January 1, 2009 and March 2, 2009, no additional CDO of ABS GICs were terminated. Also in 2008, $852.0 million of pooled corporate CDO GICs were terminated due to an event of default caused by the bankruptcy of Lehman Brothers Holdings Inc. ("Lehman Brothers"), which was the guarantor of the CDS protection buyer in those transactions. The Company expects further GIC withdrawals and is regularly evaluating general market conditions, as well as specific transactions.
The full extent of credit losses in the mortgage sector, and the extent to which they may affect the Company, will not be known for several years.
Illiquidity Continued to Limit Public Finance Issuance Volume
Credit problems expanded beyond the mortgage market to constrain liquidity across the capital markets in 2008. This had a negative impact on new-issue volume in the public finance and structured finance markets. Credit spreads trended wider throughout 2008. Wider spreads generally necessitate unrealized negative fair-value (mark-to-market) adjustments for credit derivatives in the insured portfolio and for certain FP investments. On the other hand, wider spreads generally mean that a financial guarantor has more opportunities to sell insurance at higher premium rates. This was true for the first half of 2008 in the primary U.S. municipal business, where FSA's business production was
strong. The Company's originations since mid-2008 have been limited, primarily due to market conditions and concerns regarding rating agency actions.
Summary Results of Operations and Financial Condition
Net Income (Loss)
In 2008, the Company reported a net loss of $8,443.2 million, compared with a net loss of $65.7 million in 2007 and net income of $424.2 million in 2006. Net income is volatile primarily because it includes (a) where applicable, OTTI charges that are not indicative of estimated economic loss, (b) fair-value adjustments for credit derivatives in the insured portfolio in excess of estimated economic loss, (c) beginning January 1, 2008, fair-value adjustments related to the Company's own credit risk, and (d) fair-value adjustments for instruments with economically hedged risks that are not in designated hedging relationships under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), and adjustments related to non-economic changes in fair value related to the trading portfolio.
Net income decreased in both the financial guaranty and FP segments. In the financial guaranty segment, higher losses related to insured RMBS transactions and negative fair-value adjustments for credit derivatives were primarily responsible for producing negative segment results. In the FP segment, the loss was largely due to OTTI charges. The Company no longer has the intent to hold such securities to maturity, due to Dexia's Purchase Agreement covenant to retain the FP operations and segregate or separate the FP operations from the Company's financial guaranty operations. As a result, the Company was required to record an OTTI charge for all assets in the Portfolio in an unrealized loss position at December 31, 2008.
In order to understand the results of operations reported in accordance with GAAP, the discussion that follows explains certain fair-value adjustments that cause volatility in reported earnings. While there is also volatility in reported earnings due to reserves and other economic gains and losses, management typically views fair-value adjustments that are not indicative of expected loss separate from its core operating results in making its decisions. For discussion of the Company's fair value methodology, see Note 3 to the consolidated financial statements in Item 8.
The fair-value adjustments that have an impact on net income (loss) are shown in the table below:
Noteworthy Fair-Value Adjustments
(1)Includes the unhedged component of the fair-value adjustment, such as credit risk.
Fair-value adjustments attributable to impairment charges: OTTI securities must be written down to fair value through the income statement, regardless of management's estimate of economic loss. Economic loss is determined by the Company using cash flow models that project the present value of future expected shortfalls in principal and interest. Management views the economic component of impairment charges separate from the full negative fair-value adjustments. For 2008, on a pre-tax basis, the Company recorded $8,397.9 million in OTTI charges in the FP Investment Portfolio, of which $797.5 million represented estimated economic loss. In addition, the Company recorded $236.2 million in non-economic OTTI charges in the VIE Investments Portfolio. The 2008 FP and VIE Investment Portfolio OTTI charges were recognized to reflect Dexia's Purchase Agreement covenant to segregate or separate the Company's FP operations from the Company's financial guaranty operations and retain the FP segment, resulting in the Company's inability to hold the securities to maturity. At December 31, 2008, 72.2% of the FP Segment Investment Portfolio was categorized as Level 3 in the SFAS 157 fair value hierarchy, indicating the significance of unobservable inputs in determining fair value.
Fair-value adjustments for credit derivatives in the insured portfolio: Fair-value adjustments for credit derivatives in the insured portfolio include credit impairments representing estimated economic losses as well as non-economic fair-value adjustments expected to reverse to zero over time. In 2008, the Company estimated credit impairments of $152.4 million pre-tax. At December 31, 2008, the non-economic portion of fair-value adjustments for credit derivatives in the insured portfolio of $592.6 million had no effect on insurance company statutory equity or claims-paying resources, and rating agencies generally do not take these unrealized gains or losses into account for evaluating FSA's capital adequacy. At December 31, 2008, all of the credit derivatives in the insured portfolio were categorized as Level 3 in the SFAS 157 fair value hierarchy.
Fair-value adjustments attributable to the Company's own credit risk: Fair value measurement rules under SFAS No. 157, "Fair Value Measurements" ("SFAS 157") require the consideration of the Company's own credit risk. The effect of fair-value adjustments attributable to the Company's own credit risk is included in net income. In 2008, the Company's credit spread widened, leading to material unrealized gains on the FP segment debt and on the Company's committed preferred trust securities ("CPS"). At December 31, 2008, all FP segment debt at fair value and the CPS were categorized as Level 3 in the SFAS 157 fair value hierarchy.
Fair-value adjustments for instruments with economically hedged risks: The majority of the Company's economic hedges relate to FP segment interest rate derivatives used to convert the fixed interest rates of certain assets to dollar-denominated floating rates based on the London Interbank Offered Rate ("LIBOR"). Without hedge accounting or a fair-value option, SFAS 133 requires the marking to fair value of each such derivative in income without the offsetting mark to fair value on the risk it is intended to hedge. The one-sided valuations for economically hedged risks that do not qualify for hedge accounting and unhedged credit risk valuations for securities in the trading portfolio cause volatility in the consolidated statements of operations and comprehensive income. Management views fair-value adjustments on economically hedged risks together with the fair-value adjustments on the hedging items in order to analyze and manage hedge inefficiency, regardless of the prescribed accounting treatment. For assets within the trading portfolio, net income reflects both the economic effect of hedged economic risks related to interest and foreign exchange rates, and non-economic changes in fair value related to credit spreads. At December 31, 2008, the majority of derivative instruments were categorized as Level 3 in the SFAS 157 fair value hierarchy.
Prior to January 1, 2008, the Company elected to comply with the SFAS 133 documentation and testing requirements for certain liability hedging relationships and for none of the asset hedging relationships. Effective January 1, 2008, the Company elected the fair value option under SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"), for
certain of its FP segment liabilities, which allowed for fair value accounting through current income without the onerous SFAS 133 requirements. On January 1, 2008, the Company elected to designate fair-value hedging for certain assets and derivatives qualifying for hedge accounting under SFAS 133.
The Company established a tax valuation allowance of $2.5 billion in 2008 against deferred tax assets attributable to FP segment net unrealized losses.
Book Value
Shareholders' equity under GAAP ("book value") was negative $5.2 billion at December 31, 2008, compared with positive $1.6 billion at December 31, 2007. The decline in 2008 was primarily the result of mark-to-market losses in the FP segment, losses incurred in the financial guaranty segment and negative fair-value adjustments for credit derivatives.
New Business Production
The Company employs the non-GAAP measure present value originations ("PV originations") to describe the economic value of the Company's new business originations in a given period. PV originations are the sum of the non-GAAP measures PV financial guaranty originations and PV net interest margin ("NIM") originated in the FP segment and represents the Company's measure of business production in a given period. PV financial guaranty originations, PV NIM originated and PV originations are based on estimates of, among other things, prepayment speeds of asset-backed securities. PV financial guaranty originations is a measure of gross origination activity and does not reflect premiums ceded to reinsurers or the cost of CDS or other credit protection, which may be considerable, employed by the Company to manage its credit exposures.
Present Value Financial Guaranty Originations
The GAAP measure "gross premiums written" captures financial guaranty premiums collected or accrued in a given period, whether collected for business originated in the period or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a portion of the Company's premiums are collected in installments. Therefore, management calculates the non-GAAP measure PV financial guaranty originations as a measure of current-period premium production. To do so, management combines the following for business closed in the reporting period: (1) gross present value of premium and credit derivative fee installments and (2) premiums received upfront.
The Company's insurance policies, including credit derivatives, are generally non-cancelable and remain outstanding for years from date of inception, in some cases 30 years or longer. Accordingly, PV financial guaranty originations, as distinct from earned premium or realized gains (losses) on credit derivatives, represents amounts to be realized in the future.
Viewed at a policy level, installment premiums and credit derivative fees are generally calculated as a fixed premium rate multiplied by the estimated or expected insured debt outstanding as of dates established by the terms of the policy. Because the actual installment premiums and credit derivative fees received could vary from the amount estimated at the time of origination based on variances in the actual versus estimated outstanding debt balances and foreign exchange rate fluctuations, the realization of PV financial guaranty originations could be greater or less than the amount reported.
Installment premiums and credit derivative fees are not recorded in the financial statements until due, which is a function of the terms of each insurance policy. Future installment premiums and credit derivative fees are not captured in current-period premiums earned or premiums written, the most comparable GAAP measures. Management therefore uses PV premiums and credit derivative fees originated to measure current business production.
PV financial guaranty originations reflects estimated future installment premiums and credit derivative fees discounted to their present value, as well as upfront premiums, with respect to business originated during the period. To calculate PV financial guaranty originations, management discounts an estimate of all future installment premium receipts. The Company calculates the discount rate for PV financial guaranty originations as the average pre-tax yield on its insurance investment portfolio for the previous three years. The estimated installment premium receipts are determined based on each installment policy's projected par balance outstanding multiplied by its premium rate. The Company's Transaction Oversight Groups estimate the relevant schedule of future par balances outstanding for each insurance policy with installment premiums. At the time of origination, projected debt schedules are generally based on good faith estimates developed and used by the parties negotiating the transaction.
Year-to-year comparisons of PV financial guaranty originations are affected by the application of a different discount rate each year. The discount rates employed by the Company for this purpose were 4.92%, 4.86%, and 5.07% for 2008, 2007 and 2006 originations, respectively.
For a reconciliation of gross premiums written to the non-GAAP measure PV Financial Guaranty Originations, see "-Financial Guaranty Segment-PV Financial Guaranty Originations."
Present Value of Financial Products Net Interest Margin Originated
The FP segment produces NIM, which is a non-GAAP measure, rather than insurance premiums. Like installment premiums, PV NIM originated in a given period is expected to be earned and collected in future periods.
FP segment debt is issued at or converted into LIBOR-based floating rate obligations, with proceeds invested in or converted into LIBOR-based floating rate investments intended to result in profits from a higher investment rate than borrowing rate. FP NIM represents the difference between the current period investment revenue and borrowing cost, net of the economic effect of derivatives used to hedge interest rate and currency risk.
PV NIM originated represents the difference between the present value of estimated interest to be received on investments and the present value of estimated interest to be paid on liabilities issued by the FP segment, net of transaction expenses and the expected results of derivatives used to hedge interest rate risk. The Company's future positive interest rate spread estimate generally relates to contracts or security instruments that extend for multiple years.
Net interest income and net interest expense are reflected in the consolidated statements of operations and comprehensive income but are limited to current period earnings. As the GICs and the assets they fund extend beyond the current period, management considers the PV NIM originated to be a useful indicator of future FP NIM to be earned.
Originations
Total Originations
In 2008, the disruption of credit markets and the bond insurance industry reduced FSA's opportunities in the global asset-backed and public infrastructure sectors and, in the second half, the U.S. public finance market, resulting in declines from 2007 to 2008 of 57.2% in gross par originated
and 47.8% in PV originations. FSA withdrew from the asset-backed business after the first half of 2008. Additionally, FSA's domestic public finance production fell significantly in the second half due to the negative impact of rating agency actions. PV NIM was negative in 2008 primarily due to the Company curtailing FP asset acquisitions throughout the year to build liquidity. The Company also curtailed the issuance of new GICs in the asset-backed market in August 2008, and ceased issuing GICs in November 2008, in contemplation of the sale of the Company to Assured.
In 2007, PV originations rose to a record level of $1,271.0 million, an increase of 39.6% over that of the previous year, primarily due to increased FSA production in the international public infrastructure sector, a preference for FSA insurance over guarantees from other monolines in the fourth quarter of 2007 and wider credit spreads across FSA's financial guaranty markets, partially offset by a decline in FP originations due to the Company's decision to build liquidity in the fourth quarter.
For discussion of the changes in the components of PV originations, see "-Financial Guaranty Segment-PV Financial Guaranty Originations" and "-Financial Products Segment-PV NIM Originated."
Financial Guaranty Segment
Results of Operations
Financial Guaranty Segment
(1)The primary components of the GAAP income to segment operating earnings adjustments were non-economic fair-value adjustments on credit derivatives in the insured portfolio and fair-value adjustments on the CPS.
The financial guaranty segment includes the results of operations of the insurance company subsidiaries as well as the results of operations related to holding company activities. The primary components of financial guaranty segment earnings are premiums, credit derivative fees, net investment income from the Company's portfolio of investments held by FSA, FSA Holdings and certain other subsidiaries (the "General Investment Portfolio") and income on assets acquired in refinancing transactions, offset by loss and loss adjustment expenses ("LAE"), interest expense on corporate debt and other operating expenses. In prior years, all credit derivative fees were recorded in premiums earned but have been reclassified to realized gains (losses) and other settlements to conform to the 2008 presentation. Management analyzes segment results on a pre-tax operating earnings basis.
2008 vs. 2007: In the financial guaranty segment, negative operating earnings for the year ended December 31, 2008 were due to increased loss expense driven by increased net RMBS loss estimates, as well as higher public finance losses, credit impairments on the Company's insured CDS and insured net interest margin securitizations ("NIMs") portfolio and realized losses related to its investment in Syncora Guarantee Re Ltd. ("SGR") (formerly XL Financial Assurance Ltd.) and investments in Lehman Brothers. Higher upfront premiums in the first half of 2008 and $804.3 million of 2008 capital contributions to the financial guaranty segment increased the General Investment Portfolio's invested asset balance, which increased net investment income. Premiums earned and realized gains (losses) of credit derivative fees, collectively, also increased.
2007 vs. 2006: In the financial guaranty segment, higher invested assets in the General Investment Portfolio, resulting partially from record premiums received in 2007, produced higher net investment income. New business originations also contributed to earned premiums. Refundings (net of amortization) were up 14%. Non-recurring realized foreign exchange gains accounted for a $10.6 million pre-tax increase year over year. These increases were offset, in part, by increased interest expense, loss expense and other operating expenses. Interest expense increased due to the issuance of $300 million in hybrid debt in the fourth quarter of 2006. Loss expense rose primarily due to an increase in the experience factor used in calculating the non-specific reserve and higher originations in the international public finance sector, which attract higher charges in the non-specific reserving methodology. Higher operating expenses were caused by higher compensation expenses, which vary with production and growth in the non-GAAP adjusted book value ("ABV"), and lower deferral rates.
Premiums Earned
Premiums Earned
Net premiums earned are broken down into two major categories: premiums earned on refundings and accelerations and premiums earned on new and recurring insured obligations. Refundings may vary significantly from year to year as they are affected by the interest rate environment. In periods of declining interest rates, issuers generally seek to refinance their obligations. In cases where an issuer defeases or calls an outstanding obligation insured by the Company, all unearned premiums are accelerated and recognized in current earnings. Accelerations also include premiums earned on ceded contracts that have been commuted or terminated.
The Company ceased issuing financial guaranties on asset-backed securities in August 2008. For several years prior to then, the Company had limited its originations of asset-backed securities, primarily because tightening credit spreads and the competitive market environment had resulted in unattractive premium rates or credit quality that did not comply with the Company's underwriting guidelines. As transactions originated in earlier years matured, they were not replaced with the same volume of new originations, resulting in a decline in asset-backed earnings. At December 31, 2008, the asset-backed transactions in FSA's insured portfolio had an average life of approximately 4.0 years. As the Company has ceased insuring such transactions, premium earnings from insured asset-backed transactions will continue for several years, but will decline as the insured par runs off.
At the same time, public finance originations and premiums earned had steadily increased over the past several years. In the second half of 2008, however, the Company's new originations in the public finance sector were restricted due to the ratings changes in the second half of 2008, including Moody's downgrade of FSA's rating to Aa3, as well as a decline in market acceptance of financial guaranties.
The Company employs reinsurance to manage single-risk limits and maintain capacity to write new business. Due to the 2008 downgrades of certain reinsurers, the Company has and may continue to re-assume ceded exposure. In 2008, net premiums earned included $28.5 million resulting from commutations or cancellations of reinsurance contracts. This primarily resulted in a ratio of ceded premiums written to gross premiums written of 5% in 2008, compared to 38% in 2007 and 2006.
Geographic diversification has always been a risk management strategy for the financial guaranty segment, particularly in the public finance sector. Through 2007, the Company's growth area had been in international business, particularly public-private partnership transactions in the infrastructure sector and financings of water and other utility companies. These types of transactions serve to support the Company's future earnings for extended periods of time due to their long-dated maturities. The table below shows the amount of U.S. and international premiums earned based on geography of underlying risks.
Net Premiums Earned by Geographic Distribution
Net Investment Income and Realized Gains (Losses) from General Investment Portfolio
Premium collections are invested in the General Investment Portfolio, which consists primarily of municipal tax-exempt bonds. The Company's invested balances have increased since prior year-end as a result of higher upfront premium originations (which occurred primarily in the first half of 2008), and capital contributions from Dexia Holdings in 2008, which increased net investment income. These increases were partially offset by claim payments during the year and a decrease in book yield as the Company accumulated short-term liquidity throughout the year. The Company's year-to-date effective tax rate on investment income (excluding the effects of realized gains and losses) was 12.7%, 12.4%, and 12.2% for 2008, 2007 and 2006, respectively.
In 2008, the Company had net realized losses of $6.7 million, which included a $36.1 million loss on the sale of its investment in SGR preferred stock and an OTTI charge of $6.0 million for several municipal bonds, offset in part by realized gains on sales of assets. Realized losses from the General Investment Portfolio were $1.9 million in 2007 and $8.3 million in 2006.
The following table sets forth certain information concerning the securities in the Company's General Investment Portfolio based on amortized cost and fair value.
General Investment Portfolio
(1)Yields are based on amortized cost and stated on a pre-tax basis.
Fair Value of Credit Derivatives
Prior to ceasing to insure asset-backed securities in August 2008, the Company sold credit protection by insuring CDS contracts under which special purpose entities or other parties provided credit protection to various financial institutions. In certain cases the Company acquired back-to-back credit protection on all or a portion of the risk written, primarily by reinsuring its CDS guaranties. Management viewed these CDS contracts as part of its financial guarantee business, under which the Company generally intends to hold its written and purchased positions for the entire term of the related contracts. These CDS contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under SFAS 133.
In consultation with the Securities and Exchange Commission (the "SEC"), members of the financial guaranty industry have collaborated to develop a presentation of credit derivatives issued by financial guaranty insurers that is more consistent with that of non-insurers. The tables below illustrate the current required presentation with prior period balances reclassified to conform to the current presentation. The reclassifications do not affect net income or equity, although they do affect various revenue, asset and liability line items. Changes in fair value are recorded in "net change in fair value of credit derivatives" in the consolidated statements of operations and comprehensive income. The "realized gains (losses) and other settlements" component of this income statement line includes premiums received and receivable on written CDS contracts and premiums paid and payable on
purchased contracts. If a credit event occurred that required a payment under the contract terms, this line item would also include losses paid and payable to CDS contract counterparties due to the credit event and losses recovered and recoverable on purchased contracts.
The Company's insured portfolio includes other contracts accounted for as derivatives, including (a) insured interest rate swaps entered into by the issuer in connection with the issuance of certain public finance obligations ("IR swaps") and (b) insured NIM securitizations and other financial guaranty contracts that guarantee risks other than credit risk, such as interest rate basis risk, issued after January 1, 2007 ("FG contracts with embedded derivatives").
The components of the net change in the fair value of credit derivatives are shown in the table below:
Summary of the Net Change in the Fair Value of Credit Derivatives
(1)Includes amounts which in prior periods were classified as premiums earned. Considerable judgment is necessary to interpret the data to develop the estimates of fair value. Under the SFAS 157 fair value hierarchy, all credit derivative valuations are categorized as Level 3. (For a description of the SFAS 157 fair value hierarchy, see Note 3 to the consolidated financial statements in Item 8.) Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair-value amounts.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is the case with most of the Company's CDS contracts because these contracts are not traded, then the determination of fair value is based on internally developed estimates. The Company's methodology for estimating the fair value of a CDS contract incorporates all the remaining future premiums to be received over the life of the CDS contract, discounted to present value using the current LIBOR swap rate, which conforms to market practice, and multiplied by the ratio of the current exit value premium to the contractual premium. The estimation of the current exit value premium is derived using a unique
credit-spread algorithm for each defined CDS category that utilizes various publicly available credit indices, depending on the types of assets referenced by the CDS contract and the length of the contract. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, if available, performance of underlying assets, changes in internal credit assessments or rating agency-based shadow ratings, and the level at which the deductible has been set. Estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions. For more information regarding the Company's valuation process, see "Credit Derivatives in the Insured Portfolio" in Note 3 to the consolidated financial statements in Item 8.
As the fair value of a CDS contract incorporates all the remaining future payments to be received over the life of the CDS contract, the fair value of that contract will change, in part, solely from the passage of time as fees are received. Absent any claims under the contract, any "losses" recorded in marking the contract to fair value will be reversed by an equivalent "gain" at or prior to the expiration of the contract, and any "gain" recorded will be reversed by an equivalent "loss" over the remaining life of the transaction, with the cumulative changes in the fair value of the CDS summing to zero by the time of each contract's maturity. Unrealized fair-value adjustments for credit derivatives, except for estimates of economic losses, have no effect on operations, liquidity or capital resources.
Unrealized Gains (Losses) of Credit Derivatives Portfolio(1)
(1)Upon the adoption of SFAS 157, $40.9 million pre-tax, or $26.6 million after-tax, was recorded as an adjustment to beginning retained earnings related to credit derivatives.
(2)Two insured CDS and five NIM securitizations had credit impairment totaling $152.4 million at December 31, 2008. The negative fair-value adjustments over the past two years were a result of widening credit spreads in the underlying CDS portfolio and, in 2008, were offset in part by the positive income effects of the Company's own credit spread widening as reflected in the non-collateral posting factor. Despite the structural protections associated with the Company's CDS, the widening of credit spreads on pooled corporate CDS and funded CDOs and collateralized loan obligations ("CLOs"), as with other structured credit products, resulted in a decline in the fair value of these contracts compared with December 31, 2007.
The Company's typical CDS contract is different from CDS contracts entered into by parties that are not financial guarantors because:
•CDS contracts are neither held for trading purposes (i.e., a short-term duration contract written for the purpose of generating trading gains) nor used as hedging instruments. Instead, they are
written with the intent to provide protection for the stated duration of the contract, similar to the Company's intent with regard to a financial guaranty contract.
•FSA is not entitled to terminate CDS and realize a profit on a position that is "in the money." A counterparty to a CDS contract written by FSA generally is not able to force FSA to terminate a CDS that is "out of the money."
•The liquidity risk present in most CDS contracts sold outside the financial guaranty industry (i.e., the risk that the CDS writer would be required to make cash payments) is not present in a CDS contract sold by a financial guarantor. Terms of the CDS contracts are designed to replicate the payment provisions of financial guaranty contracts in that (a) losses, if any, are generally paid over time subject to market value termination payments generally due in the event of insurer insolvency, and (b) the financial guarantor is not required to post collateral to secure its obligation under the CDS contract.
Credit derivatives in the asset-backed portfolio represent 71.2% of total asset-backed par outstanding. The Company has grouped CDS contracts by major category of underlying instrument for purposes of internal risk management and external reporting. The tables below summarize the credit rating, net par outstanding and remaining weighted-average life ("WAL") for the primary components of the Company's CDS portfolio.
Selected Information for CDS Portfolio
(1)Triple-A*, also referred to as "Super Triple-A," indicates a level of first-loss protection generally exceeding 1.3 times the level required by a rating agency for a Triple-A rating.
(2)Various investment grades below Double-A minus.
(3)Amount includes two CDS contracts with Triple-C underlying ratings. These two risks incurred economic losses at December 31, 2008.
(4)Net par outstanding represents the net maximum potential amount of future payments which the Company could be required to make.
(5)Amounts include transactions previously wrapped by other monolines.
(6)Primarily infrastructure obligations and European mortgage-backed securities. Also includes $375.2 million and $421.4 million at December 31, 2008 and 2007, respectively, in U.S. RMBS net par outstanding. All U.S. RMBS exposures were rated Triple-B or higher. Includes certain pooled corporate obligations. For the sensitivity of CDS contracts that would result from an increase of one basis point in market credit spreads, see "Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company is exposed to various types of risk including market risk which represents the potential for loss due to adverse changes in the fair value of financial instruments caused by:
•changes in credit spread
•changes in interest rates
•changes in foreign exchange rates, and
•liquidity risk.
The Company has exposure to market risk in:
•the General Investment Portfolio
•the FP Segment Investment Portfolio
•the FP segment debt
•the FP segment derivative instruments
•the portfolio of assets acquired in FSA-insured refinancing transactions, and
•the portfolio of insured obligations.
Qualitative Disclosures about Market Risk
Credit Risk
Credit risk is risk due to uncertainty in a counterparty's ability to meet its financial obligations. The Company is exposed to credit risk in its investment portfolios and its insured portfolios. Beginning in 2007, market perception of these risks, together with certain market dislocations, began having an adverse effect on the fair value of securities held in the investment portfolios, particularly the FP Investment Portfolio, of which more than half is invested in non-agency RMBS. The Company also has exposure to RMBS in its insured portfolio. Continued deterioration in 2008 of the housing markets and other consumer receivable markets has further eroded the credit protection embedded in the FP Investment Portfolio and ABS insured portfolio.
Financial Guaranty Segment: The Company's insured portfolio exposure to RMBS was concentrated in highly rated categories at origination. There has been wide spread credit deterioration in most if not all RMBS sectors. In the HELOC sector, the Company estimates, as of December 31, 2008, an expected ultimate loss of $1.2 billion, net of reinsurance and recoveries, across ten transactions. The Company's Risk Management Group reviewed all other mortgage exposures, as well as its exposure to automobile and credit card receivable insured obligations, as of December 31, 2008 and does not expect an ultimate loss on such transactions.
Financial Products Segment: The Company monitors the FP Investment Portfolio utilizing both proprietary and third-party models to facilitate analysis, focusing on the cash flows generated by the collateral to determine if a security's performance is consistent with its ability to pay principal and interest as contractually required.
The Company regularly reviews the FP Segment Investment Portfolio to determine if there is expected economic loss. The Company has made assumptions based on current market conditions and expected borrower behavior that could change, adversely affecting the performance of its securities, and, as a result, future reviews could result in additional economic losses for security positions management currently expects to perform fully.
Interest Rate Risk
Interest rate risk is the risk that financial instruments' value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. As interest rates rise for an available-for-sale portfolio, the fair value of fixed-income securities decreases.
Financial Guaranty Segment: The Company is subject to interest rate risk in all of its investment portfolios. However, the Company's policy is generally to hold assets in the General Investment Portfolio to maturity. Therefore, barring credit deterioration, interest rate movements do not result in realized gains or losses unless assets are sold prior to maturity.
When interest rates are lower or when the market is otherwise relatively less risk averse, the spread between insured and uninsured obligations typically narrows and, as a result, financial guaranty insurance typically provides lower cost savings to issuers than it would during periods of relatively wider spreads. These lower cost savings generally lead to a corresponding decrease in demand and premiums obtainable for financial guaranty insurance.
Conversely, in a deteriorating credit environment, credit spreads widen and pricing for financial guaranty insurance typically improves. However, if the weakening environment is sudden, pronounced or prolonged, the stresses on the insured portfolio may result in claims payments in excess of normal or historical expectations. In addition, increases in prevailing interest rate levels can lead to a decreased volume of capital markets activity and, correspondingly, a decreased volume of insured transactions.
Financial Products Segment: The Company's objective for its FP segment is to generate net interest margin by borrowing funds in the municipal GIC and other markets and investing the proceeds in fixed income investments satisfying the Company's investment criteria. Accordingly, the Company's GICs are issued at or are converted into LIBOR-based floating rate obligations, with proceeds invested in or converted into LIBOR-based floating rate investments intended to result in profits from a higher investment rate than the borrowing rate. This investment and funding strategy minimizes the Company's exposure to interest rate changes as long as the portfolio of assets and liabilities matures according to the expected schedule.
Foreign Exchange Risk
Foreign exchange risk is the risk that a financial instrument's value will change due to a change in the foreign currency exchange rates. To minimize foreign exchange risk in the FP segment, the Company enters into cross-currency swaps to convert all foreign-denominated cash flows into U.S.-dollar cash flows. The General Investment Portfolio is invested in foreign denominated investments with exposure to changes in value relative to the U.S. dollar. Less than 6% of this portfolio was exposed to such risk at December 31, 2008.
Liquidity Risk
Liquidity risk relates to the possible inability to satisfy contractual obligations when due and includes the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value.
For information regarding the liquidity risks inherent to the FP business and the liquidity resources available to it, see "Item 7. Liquidity and Capital Resources-FP Segment Liquidity."
Operational Risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, controls, people and systems, or from external events. The definition includes legal risk, which is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. It also includes the exposure to litigation from all aspects of an institution's activities. The Company mitigates operational risk by maintaining and testing critical systems (and their system backup) and performing ongoing control procedures to monitor transactions and positions, maintain documentation, confirm transactions and ensure compliance with Company policy and regulations.
General Investment Portfolio
Over 99% of the Company's General Investment Portfolio was invested in fixed-income securities at December 31, 2008. All investments in the General Investment Portfolio are designated as available-for-sale, with changes in fair value recorded in other comprehensive income unless such positions are deemed OTTI.
Management's primary objective in managing the Company's General Investment Portfolio is to generate an optimal level of after-tax investment income while preserving capital, maintaining adequate liquidity and meeting rating agency capital adequacy criteria that apply discount factors to investments based on their ratings. The Company bases its investment strategies on many factors, including the Company's tax position, anticipated changes in interest rates, regulatory and rating agency criteria and other market factors. One internal investment manager and two external investment managers buy investments on behalf of the Company, primarily in the fixed-income market. Management, with the approval of the Board of Directors, establishes guidelines for investment decisions.
The sensitivity of the General Investment Portfolio to interest rate movements can be estimated by projecting a hypothetical increase in interest rates of 1.0%. Based on market values and interest rates at year-end 2008 and 2007, this hypothetical increase in interest rates of 1.0% across the entire yield curve, also known as a "parallel shift" of the yield curve, would result in an estimated after-tax decrease of $291.7 million and $150.9 million, respectively, in the fair value of the Company's fixed-income portfolio, which would be recorded in other comprehensive income unless such positions are deemed OTTI.
In calculating the sensitivity to interest rates for the taxable securities, U.S. Treasury rates are instantaneously increased at year-end by 1.0%. Tax-exempt securities are subjected to a parallel shift in the municipal Triple-A obligation curve that would be equivalent to a 1.0% taxable interest rate change based on the average taxable/tax-exempt ratios for the prior 12 months. The tax-exempt simulation utilizes duration, which takes into account the applicable call date if the bond is priced at a premium or the maturity date if the bond is priced at a discount.
The sensitivity of the General Investment Portfolio to foreign exchange rate movements can be estimated by projecting a hypothetical decrease of 1.0% in the foreign exchange rates of each foreign currency (i.e., relative dollar strengthening) represented in the portfolio. Foreign currencies currently represented in the General Investment Portfolio are the British pound, euro, Australian dollar, Japanese yen and Mexican peso. A large majority of the foreign currency securities were denominated in British pounds during 2008 and 2007. Based on the market values of foreign-denominated securities at year-end 2008 and 2007, a hypothetical decrease in foreign exchange rates of 1.0% would result in an estimated after-tax decrease of $1.8 million and $2.1 million, respectively, in the fair value of the Company's fixed-income portfolio, which would be recorded in other comprehensive income unless deemed OTTI.
Financial Products Segment
FP Investment Portfolio
The primary objective managing the FP Investment Portfolio was to generate a stable net interest margin, to maintain liquidity and to optimize risk-adjusted returns. Fixed rate assets and liabilities supporting the GIC business are hedged to LIBOR floating rates using interest rate swaps or futures. Certain categories of assets and liabilities are naturally floating rate without the use of derivatives. The after-tax effect of a hypothetical increase in interest rates of 1% as of year-end is shown in the table below. The tables and discussions below assume the ability to recognize the full tax benefit with no further valuation allowance. As a result of the FSAM Risk Transfer Transaction effective in February 2009, the Company will deconsolidate FSAM and therefore would not be subject to or record in its financial statements the effects of the movements in fair value of the assets or derivatives in the table below.
Effect of a Hypothetical Increase in Interest Rates of 1%
(1)Recorded in other comprehensive income unless deemed OTTI.
(2)Recorded in net income.
(3)Changes in the fair value of the liability portfolio are not recorded in the financial statements unless they are designated as hedges for accounting purposes in accordance with SFAS 133 or are designated as fair value option. At December 31, 2008, there were no liabilities in a designated SFAS 133 hedging relationship and certain fixed rate liabilities were at FVO. At December 31, 2007, certain fixed rate liabilities were in a designated SFAS 133 hedging relationship.
At December 31, 2008, certain assets were in a designated SFAS 133 hedging relationship. At December 31, 2007, there were no assets in designated SFAS 133 hedging relationships. See Notes 3 and 4 to the Consolidated Financial Statements in Item 8.
Item 8. Financial Statements and Supplementary Data.
Financial Security Assurance Holdings Ltd. and Subsidiaries
Index to Consolidated Financial Statements and Schedule
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2008 and 2007
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2008, 2007 and
Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2008, 2007 and
Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006
Notes to Consolidated Financial Statements
Schedule:
I. Condensed Financial Statements of Financial Security Assurance Holdings Ltd. as of December 31, 2008 and 2007 and for the Years Ended December 31, 2008, 2007 and 2006
Report of Independent Registered Public Accounting Firm
To Board of Directors and Shareholders
of Financial Security Assurance Holdings Ltd.:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries (the "Company") at December 31, 2008 and December 31, 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, in November 2008, Dexia S.A. ("Dexia"), the Company's ultimate parent, entered into an agreement to sell the Company. In February 2009, Dexia assumed significant credit and liquidity risk arising from the Company's Financial Products operations. As discussed in Notes 3 and 4 to the consolidated financial statements, the Company has adopted SFAS No. 157, "Fair Value Measurements" and SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" in 2008.
/s/ PricewaterhouseCoopers LLP
New York, New York
March 18, 2009
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(in thousands)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(in thousands, except share data)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(in thousands)
The Company received tax benefits of $4.7 million in 2008, $1.3 million in 2007 and no tax benefits in 2006 from its parent company. See Note 14 for disclosure of non-cash transactions relating to restricted treasury stock transactions.
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006
1. ORGANIZATION AND OWNERSHIP
Financial Security Assurance Holdings Ltd. ("FSA Holdings") is a holding company incorporated in the State of New York. The Company, through its insurance company subsidiaries, engages in providing financial guaranty insurance on public finance obligations in domestic and international markets. The Company's principal insurance company subsidiary is Financial Security Assurance Inc. ("FSA"), a wholly owned New York insurance company. Historically, the Company also provided financial guaranty insurance on asset-backed obligations. In August 2008, the Company announced that it would cease insuring asset-backed obligations and instead participate exclusively in the global public finance financial guaranty business. References to the "Company" are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.
In addition to its financial guaranty business, the Company historically offered FSA-insured guaranteed investment contracts and other investment agreements ("GICs") as well as medium-term notes to municipalities and other market participants through consolidated entities in its financial products ("FP") segment. In November 2008, the Company ceased issuing GICs in contemplation of the sale of the Company to Assured Guaranty Ltd. ("Assured"). While the Company has ceased new originations of asset-backed financial guaranty business and GICs, a substantial portfolio of such obligations remains outstanding.
At December 31, 2008, Dexia Holdings Inc. ("Dexia Holdings") owned over 99% of outstanding FSA Holdings shares; the only other holders of FSA Holdings common stock were directors of FSA Holdings who owned shares of FSA Holdings common stock or economic interests therein under the Company's Director Share Purchase Program.
The Company is a subsidiary of Dexia Holdings which, in turn, is owned 90% by Dexia Crédit Local S.A. ("Dexia Crédit Local") and 10% by Dexia S.A. ("Dexia"). Dexia is a Belgian corporation primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia.
The Company conducted its GIC business through its non-insurance subsidiaries FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the "GIC Subsidiaries"). FSACM conducted substantially all the Company's GIC business since April 2003, following its receipt of an exemption from the requirements of the Investment Company Act of 1940. When the GIC Subsidiaries sold GICs, they loaned the proceeds to FSA Asset Management LLC ("FSAM"), which invests the funds in fixed-income obligations that satisfy the Company's investment criteria. FSAM wholly owns FSA Portfolio Asset Limited ("FSA-PAL"), a U.K. company that invests in non-U.S. securities.
Expected Sale of the Company
Purchase Agreement with Assured Guaranty Ltd.
In November 2008, Dexia Holdings entered into a purchase agreement (the "Purchase Agreement") providing for the sale of all Company shares owned by Dexia to Assured (the "Acquisition"), subject to the consummation of specified closing conditions, including regulatory approvals, absence of rating impairment and segregation or separation of the Company's FP operations from the Company's financial guaranty operations.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the "HSR Act") and the rules promulgated thereunder by the Federal Trade Commission (the "FTC"), the Acquisition may not be consummated until notifications have been given and certain information has been furnished to the FTC and the Department of Justice (the "DOJ") and specified waiting period requirements have been satisfied. The HSR Act waiting period expired on January 21, 2009. In addition, under the insurance holding company laws and regulations applicable to the insurance subsidiaries of the Company and Assured, before a person can acquire control of a U.S. insurance company, prior written approval must be obtained from the insurance commissioner of the state where the insurer is domiciled. Assured has informed the Company that Assured filed applications with the insurance departments of the States of New York and Oklahoma and the U.K. Financial Services Authority; that the applications to the New York Insurance Department and the U.K. Financial Services Authority have been approved; and that it has made pre-acquisition filings regarding the potential competitive impact of the acquisition, which are deemed to have been approved. Dexia has informed the Company that it has filed an application with the U.K. Financial Services Authority in connection with its acquisition of Assured common shares pursuant to the Purchase Agreement, which has been approved, and that it has filed disclaimers of control with the insurance departments of the states of Maryland, New York, and Oklahoma.
Satisfying all three rating agencies that the necessary steps have or will be taken to transfer the FP segment credit and liquidity risk to Dexia is one of the last conditions to the Purchase Agreement closing. Rating agency confirmation that the Acquisition will not have a negative impact on the financial strength ratings of Assured's insurance company subsidiaries or the Company's insurance company subsidiaries is a condition for closing, and is beyond the Company's control.
The Company cannot estimate whether or when the remaining closing conditions will be satisfied or relevant agreements negotiated, whether the Acquisition will be completed and, if completed, whether it will be structured as currently contemplated, or what the effects of the change in control or removal of the FP business will be on the Company and its results of operations. If the Acquisition is not carried out, Dexia may explore other options with respect to the Company, including selling the Company or some of its operations to a third party or ceasing to write new business, which may have a material adverse effect on the Company.
Dexia's Retention of the FP Business
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. The Purchase Agreement provides that Dexia will provide guarantees with respect to the FP business' assets and liabilities, including derivative contracts and anticipates that some of its guarantees will benefit from guarantees provided by the French and Belgian states. Dexia Holdings, the Company's parent, agreed that if such sovereign guarantees are provided, it will cause FSA Holdings to transfer the ownership interests of certain of the subsidiaries that conduct the FP business, or all the assets and liabilities of such subsidiaries, to Dexia Holdings or one of its affiliates in form reasonably acceptable to Assured.
Transfer of Credit and Liquidity Risk of the GIC Business
When the GIC Subsidiaries sold a GIC, they loaned the proceeds to FSAM. The terms governing FSAM's repayment of those proceeds to the GIC Subsidiaries match the payment terms under the related GIC. FSAM invests the proceeds in securities and enters into derivative transactions to convert any fixed-rate assets and liabilities into London Interbank Offered Rate ("LIBOR")-based floating rate assets and liabilities. Most of FSAM's assets consist of residential mortgage-backed securities ("RMBS") that have suffered significant market value declines and, in more limited cases, credit deterioration resulting in a shareholders' deficit for FSAM at December 31, 2008. The market value declines of FSAM's assets subject FSAM to significant liquidity risk insofar as the GICs are in most cases subject to redemption or collateralization upon the downgrade of FSA below certain thresholds,
with a significant number of GICs subject to redemption or collateralization should FSA be downgraded below Aa3 by Moody's Investors Service, Inc. ("Moody's") (FSA's current Moody's rating) or below AA- by Standard & Poor's Ratings Service ("S&P"). Dexia had previously announced its intention to assume the credit and liquidity risk associated with the Company's FP business, and provided significant support to the FP business in the course of 2008.
As a result of the significant decline in asset value and the November 2008 cessation of issuing GICs, the GIC business changed from a business model managed by the Company focused on attaining positive net interest margin, to a run-off business managed by Dexia seeking to minimize liquidity risk and optimize asset recovery values.
Subsequent Event
In February 2009, Dexia entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia (the "FSAM Risk Transfer Transaction"). Each of the agreements executed under the FSAM Risk Transfer Transaction directly affect (1) FSAM and (2) the entities that absorb the risks created by FSAM. These agreements provide for the (i) elimination of FSA's guaranty of repayment of FSAM's borrowings under the credit facilities provided by Dexia's bank subsidiaries; (ii) elimination of FSA's guaranty of certain of FSAM's investments; and (iii) increase in the credit facilities provided to FSAM by Dexia's bank subsidiaries from $5 billion to $8 billion.
As a result, the FSAM Risk Transfer Transaction was deemed a reconsideration event for FSAM under FASB Interpretation 46 (R), "Consolidation of Variable Interest Entities" ("FIN 46"). There was no reconsideration event for any of the GIC Subsidiaries. Upon the reconsideration event, management determined that Dexia is now absorbing the majority of the variability of expected losses of FSAM, which resulted in deconsolidation of FSAM as of February 24, 2009, the effective date of the FSAM Risk Transfer Transaction.
The GIC subsidiaries, unlike FSAM, remain part of the Company's consolidated financial statements, notwithstanding the FSAM Risk Transfer Transaction, which means that the GICs issued to third parties and the note receivable from FSAM will represent the primary liabilities and assets of the FP business in the Company's consolidated financial statements. Since some of the GICs were designated as fair value option, they will continue to be marked to market; however, derivatives are maintained within FSAM, so contracts meant to hedge the interest rate risk of those GICs will no longer be included in the Company's consolidated financial statements, increasing the volatility of the Company's net income (loss).
See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-FP Segment Liquidity-Sources of Liquidity" for more information on the FSAM Risk Transfer Transaction.
Financial Guaranty
Financial guaranty insurance generally provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Upon a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or, at its option, to pay such amounts on an accelerated basis.
Obligations insured by the Company are generally awarded ratings on the basis of the financial strength ratings given to the Company's insurance company subsidiaries by the major securities rating agencies. On December 31, 2008, the Company was rated Triple-A (negative credit watch) by S&P and Fitch Ratings ("Fitch") and Aa3 (developing outlook) by Moody's. Prior to the third quarter of 2008,
the Company's insurance company subsidiaries, as well as the obligations they insured, had been awarded Triple-A ratings by the three major rating agencies.
During 2007 and 2008, the global financial crisis that began in the U.S. subprime residential mortgage market transformed the financial guaranty industry. By the end of November 2008, all of the monoline guarantors that had been rated Triple-A at the beginning of the year had been downgraded in varying degrees by Moody's, and all but one had been either downgraded or placed on negative outlook or negative credit watch by S&P and Fitch. FSA and the Company's other insurance company subsidiaries were among the last companies to be affected, and were rated "Triple-A/stable" by all three rating agencies until July 2008. Rating agencies raised concerns about the stability of FSA's rating during the second half of 2008, and Moody's lowered FSA's Aaa rating to Aa3 (developing outlook) in November. These developments, combined with illiquidity in the capital markets, led to a marked reduction in FSA's production in the second half of 2008.
Public finance obligations insured by the Company consist primarily of general obligation bonds supported by the issuers' taxing powers, tax-supported bonds and revenue bonds and other obligations of states, their political subdivisions and other municipal issuers supported by the issuers' or obligors' covenant to impose and collect fees and charges for public services or specific projects. Public finance obligations include obligations backed by the cash flow from leases or other revenues from projects serving substantial public purposes, including government office buildings, toll roads, health care facilities and utilities.
Asset-backed obligations insured by the Company were generally issued in structured transactions and are backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. The Company insured synthetic asset-backed obligations that generally took the form of credit default swap ("CDS") obligations or credit-linked notes that reference asset-backed securities ("ABS") or pools of securities or other obligations, with a defined deductible to cover credit risks associated with the referenced securities or loans.
The Company has refinanced certain poorly performing transactions by employing refinancing vehicles to raise funds, prepay the claim obligations and take control of the assets. These refinancing vehicles are consolidated with the Company and considered part of the financial guaranty segment.
Financial Products
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. In contemplation of this change, FSACM, FSA Capital Markets Services, LLC and FSAM became direct subsidiaries of a newly formed subsidiary, FSA Financial Products Inc. ("FSA Financial Products"), in December 2008. Previously they had been direct subsidiaries of FSA Holdings. FSA Financial Products is owned by FSA Holdings.
In the third quarter of 2008, to address FP segment liquidity requirements, Dexia entered into an agreement to provide a $5 billion committed, unsecured, standby line of credit (the "First Dexia Line of Credit") to FSAM. At December 31, 2008, FSAM had $1.3 billion in draws outstanding under the First Dexia Line of Credit. In addition, on November 13, 2008, the Company entered into two new agreements with Dexia and its affiliates in support of its FP business, which provide additional protection through a $3.5 billion collateral swap facility and a $500 million capital facility to cover economic losses beyond the $316.5 million of pre-tax loss estimated at the end of June 2008. In February 2009, Dexia increased the credit facilities provided to FSAM from $5 billion to $8 billion. At March 2, 2009, the outstanding amount drawn by the Company had increased to $2.7 billion.
The Company consolidates the results of certain variable interest entities ("VIEs"), which include FSA Global Funding Limited ("FSA Global") and Premier International Funding Co. ("Premier"). FSA
Global is a special purpose funding vehicle partially owned by a subsidiary of FSA Holdings. FSA Global issues FSA-insured medium term notes and generally invests the proceeds from the sale of its notes in FSA-insured GICs or other FSA-insured obligations with a view to realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. Premier is principally engaged in leveraged lease transactions. The GIC Subsidiaries, FSAM, FSA-PAL, FSA Global and Premier are collectively referred to as the "FP segment."
The Company's management believes that the assets held by FSA Global and Premier, including those that are eliminated in consolidation, are beyond the reach of the Company's creditors, even in bankruptcy or other receivership. Substantially all of the assets of FSA Global are pledged to secure the repayment, on a pro rata basis, of FSA Global's notes and its other obligations.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 25). The preparation of financial statements in conformity with GAAP requires management to make extensive estimates and assumptions that affect the reported amounts of assets and liabilities in the Company's consolidated balance sheets at December 31, 2008 and 2007, the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2008, 2007 and 2006 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments, the determination of other-than-temporary impairment ("OTTI"), the deferral and amortization of policy acquisition costs and taxes. Actual results may differ from those estimates.
Basis of Presentation
The consolidated financial statements include the accounts of FSA Holdings and its direct and indirect subsidiaries, (collectively, the "Subsidiaries"), principally including:
•FSA
•FSA Insurance Company
•Financial Security Assurance International Ltd. ("FSA International")
•Financial Security Assurance (U.K.) Limited
•FSA Financial Products
•the GIC Subsidiaries
•FSAM
•FSA-PAL
•FSA Portfolio Management Inc.
•Transaction Services Corporation
•FSA Services (Australia) Pty Limited
•FSA Seguros México, S.A. de C.V.
•FSA Services (Japan) Inc.
The consolidated financial statements also include the accounts of certain VIEs and refinancing vehicles. Intercompany accounts and transactions have been eliminated. Certain prior year balances have been reclassified to conform to the current year's presentation.
Significant accounting policies under GAAP are described below. To the extent the accounting policy calls for fair value measurement, see Note 3 for a discussion of how fair value is measured for each financial instrument.
Investments
The Company segregates its investments into the following portfolios:
•the "FP Segment Investment Portfolio," which is made up of:
•the "FP Investment Portfolio," consisting of the investments supporting the GIC liabilities, which are primarily designated as available-for-sale, but in some cases are classified as trading; and
•the "VIE Investment Portfolio," consisting of the investments supporting the VIE liabilities, which are designated as available-for-sale;
•the assets acquired in refinancing transactions, which are designated as available-for-sale, fair-value option or lower of cost or market; and
•the "General Investment Portfolio," consisting of the investments held by FSA, FSA Holdings and other subsidiaries not included in the other portfolios and which are designated as available-for-sale.
Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged with derivatives or are economically hedged but do not qualify for hedge accounting is reflected as a separate component of shareholders' equity, net of tax, unless deemed to be OTTI. OTTI is reflected in earnings as a realized loss. The unrealized gain or loss attributable to the hedged risk on investments that qualify as fair-value hedges is recorded in the consolidated statements of operations and comprehensive income in "net interest income on financial products segment."
Investments in debt and equity securities designated as trading are carried at fair value. The unrealized gain or loss on trading investments is recognized in the consolidated statements of operations and comprehensive income in "net unrealized gains (losses) on financial instruments at fair value."
Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. The cost of securities sold is based on specific identification of each security.
Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at fair value. Amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less are included in short-term investments.
Variable rate demand notes ("VRDNs") are included in bonds in the General Investment Portfolio.
VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. Auction Rate Securities are long-term securities with interest rate reset features and are traded in the marketplace through a bidding process. The cash flows related to these securities are presented on a gross basis in the consolidated statements of cash flows.
Mortgage loans are carried at the lower of cost or market on an aggregate basis.
Premium Revenue Recognition
Gross and ceded premiums received at inception of an insurance contract (i.e., upfront premiums) are earned in proportion to the expiration of the related risk. For upfront payouts, premium earnings are greater in the earlier periods, when there is a higher amount of exposure outstanding. The amount of risk outstanding is equal to the sum of the par amount of debt insured over the expected period of coverage. Deferred premium revenue and prepaid reinsurance premiums represent the portions of gross and ceded premium, respectively, that are applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized. For premiums received on an installment basis, the Company earns the premium over the installment period, typically less than one year, throughout the period of coverage. When the Company, through its ongoing credit review process, identifies transactions where premiums are paid on an installment basis and certain default triggers have been breached, the Company ceases to earn premiums on such transactions.
Effective January 1, 2009, the Company's recognition of premium revenue will change due to the adoption of Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standard ("SFAS") No. 163, "Accounting for Financial Guarantee Insurance Contracts" ("SFAS 163"), as described in "-Recently Issued Accounting Standards that are Not Yet Effective."
Losses and Loss Adjustment Expenses
The financial guaranty industry has emerged over the past 35 years. Management believes that accounting literature in effect for 2008, including insurance accounting under SFAS No. 60, "Accounting and Reporting by Insurance Enterprises" ("SFAS 60"), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing literature, including sections of SFAS 60, SFAS No. 5, "Accounting for Contingencies" ("SFAS 5") and Emerging Issues Task Force Issue 85-20, "Recognition of fees for guaranteeing a loan" ("EITF 85-20").
The Company establishes loss and loss adjustment expense ("LAE") liabilities based on its estimate of specific and non-specific losses. LAE consists of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process.
Case Reserves
The Company calculates a case reserve for the portion of the loss and LAE liability based upon identified risks inherent in its insured portfolio. If an individual policy risk has a reasonably estimable and probable loss as of the balance sheet date, a case reserve is established. For the remaining policy risks in the portfolio, a non-specific reserve is established to account for the inherent credit losses that can be statistically estimated.
Case reserves for financial guaranty insurance companies differ from those of traditional property and casualty insurance companies. The primary difference is that traditional property and casualty case reserves include only claims that have been incurred and reported to the insurance company. In a traditional property and casualty company, claims are incurred when defined events occur such as an automobile accident, home fire or storm. Unlike traditional property and casualty claims, financial guaranty losses arise from the extension of credit protection and occur as the result of the credit deterioration of the issuer or underlying assets of the insured obligations over the lives of those insured obligations. Such deterioration and ultimate loss amounts can be projected based on historical experience in order to estimate probable loss, if any. Accordingly, specific loss events that require case reserves include (1) policies under which claim payments have been made and additional claim payments are expected and (2) policies under which claim payments are probable and reasonably estimable, but have not yet been made.
The Company establishes a case reserve for the present value of the estimated loss, net of subrogation recoveries, when, in management's opinion, the likelihood of a future loss on a particular insured obligation is probable and reasonably estimable at the balance sheet date. When an insured obligation has met the criteria for establishing a case reserve and that transaction pays a premium in installments, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue. Typically, a case reserve is determined using cash flow or similar models that represent the Company's estimate of the net present value of the anticipated shortfall between (1) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (2) anticipated cash flow from and proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. The estimated loss, net of recovery, on a transaction is discounted using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established and is not subsequently adjusted. In certain situations where cash flow models are not practical, a case reserve represents management's best estimate of expected loss.
The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. The non-specific and case reserves together represent the Company's estimate of total reserves. The establishment of a non-specific reserve for credits that have not yet defaulted is a common practice in the financial guaranty industry, although there are differences in the specific methodologies applied by other financial guarantors in establishing and measuring these reserves.
Non-Specific Reserve
The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be statistically estimated using data such as that published by rating agencies. The establishment of the reserve is a systematic process that considers this quantitative, statistical information obtained primarily from Moody's and S&P, together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount with the incurred losses as represented by case reserve activity to develop an experience factor that is updated and applied to current-year originations. Management's best estimate of inherent losses associated with providing credit protection at each balance sheet date is evaluated by applying the Moody's expected loss algorithm as an estimate of the reserve required for non-investment grade risks not requiring a core reserve. If such amount is greater than 10% of the statistical product then an additional contribution to the non-specific reserve is made.
The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by
loss frequency and severity factors, with the resulting amounts discounted at the risk-free rates using the treasury yield curve (the "statistical calculation"). The discount rate does not change and is used to accrete the loss for the life of each policy. The loss factors used for the calculation are the product of default frequency rates obtained from Moody's and severity factors obtained from S&P. Moody's is chosen for default frequency rates due to its credibility, large population, statistical format and reliability of future update. The Moody's default information is applied to all credit sectors or asset classes as described below. In its publication of default rates for bonds issued from 1970-2007, Moody's tracks bonds over a 20-year horizon by credit rating at time of issuance. For the purpose of establishing appropriate severity factors, the Company's methodology segregates the portfolio into asset classes, including health care transactions, all other public finance transactions, pooled corporate transactions, commercial real estate, and all other asset-backed transactions. The severity factors are derived from capital charge assessments provided by S&P. S&P capital charges project loss levels by asset class and are incorporated into their capital adequacy stress scenario analysis.
The product of the current-year statistical calculation multiplied by the current-year experience factor represents the present value of loss amounts calculated for current-year originations. The present value of loss amounts calculated for the current-year originations is established at inception of each policy, and there is no subsequent change unless significant adverse or favorable loss experience is observed. The experience factor is based on the Company's cumulative-to-date historical losses starting from 1993, when the Company established the non-specific reserve methodology. The experience factor is calculated by dividing cumulative-to-date actual losses incurred by the Company by the cumulative-to-date losses determined by the statistical calculation. The experience factor is reviewed and, where appropriate, updated periodically, but no less than annually.
The present value of loss amounts calculated for the current-year originations plus an amount representing the accretion of discount pertaining to prior-year originations are charged to loss expense and increase the non-specific loss reserve after adjustments that may be made to reflect observed favorable or adverse experience. The entire non-specific reserve is available to absorb probable losses inherent in the portfolio.
Since the non-specific reserve contains the inherent losses of the portfolio, when a case reserve adjustment is deemed appropriate, whether the result of adverse or positive credit developments, accretion or the addition of a new case reserve, a full transfer is made between the non-specific reserve and the case reserve balances with no effect to income. The adequacy of the non-specific reserve balance is reviewed periodically and at least annually. Such analyses are performed to quantify appropriate adjustments that may be either charges or benefits on the consolidated statements of operations and comprehensive income.
In order to determine any adjustment to the non-specific reserve, management uses a methodology that references a calculation of expected loss for risks that are below-investment-grade according to the Company's ratings. The calculation of expected loss relies on the following assumptions and parameters:
•FSA credit rating of the risk
•FSA sector assigned (default rate and severity are defined by sector)
•Average life
•Moody's severity assumptions
•Moody's default assumptions
In 2008, management recorded additional non-specific reserves as a result of such analysis.
Reserving Methodology and Industry Practice
Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms such as, but not limited to, "unallocated losses," "active credit reserves" and "portfolio reserves," or may use different statistical techniques from those the Company uses to determine loss at a given point in time.
Management believes that accounting literature in effect for 2008 does not address the unique attributes of financial guaranty insurance. As an insurance enterprise, the Company initially refers to the accounting and financial reporting guidance in SFAS 60. In establishing loss liabilities, the Company relies principally on SFAS 60, which prescribes differing treatment depending on whether a contract is a short-duration contract or a long-duration contract. Financial guaranty insurance does not fall clearly within the definition of either short-duration or long-duration contracts. Therefore, the Company does not believe that SFAS 60 alone provides sufficient guidance for financial guaranty claim liability recognition.
As a result, the Company also analogizes to SFAS 5, which requires the establishment of liabilities when a loss is both probable and reasonably estimable. The Company also relies by analogy on EITF 85-20, which provides general guidance on the recognition of losses related to guaranteeing a loan. In the absence of a comprehensive accounting model provided by SFAS 60, industry participants, including the Company, have looked to such other guidance referred to above to develop their accounting policies for the establishment and measurement of loss liabilities. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that a portfolio of credit-based insurance, comprising irrevocable contracts that cannot be unilaterally changed by the insurer and that match the maturity terms of the underlying insured obligations, contains probable and reasonably estimable losses.
Effective January 1, 2009, the Company's measurement and recognition of claims liabilities will change due to the adoption of SFAS 163, as described in "-Recently Issued Accounting Standards."
Deferred Costs
Financial Guaranty
Deferred acquisition costs comprise expenses primarily related to the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission received on premiums ceded to reinsurers. Deferred acquisition costs are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. A premium deficiency would be recognized if the present value of anticipated losses and loss adjustment expenses exceeded the sum of deferred premium revenue and estimated installment premiums.
Derivatives
The Company enters into derivative contracts to manage interest rate and foreign currency risks associated with the Company's FP Segment Investment Portfolio and FP segment debt. The derivatives are recorded at fair value and generally include interest rate futures and interest rate and currency swap agreements, which are primarily utilized to convert the Company's fixed rate securities in the FP Segment Investment Portfolio and FP segment debt into U.S.-dollar floating rate assets and liabilities.
Cash collateral received from derivative counterparties is netted with derivative receivables from the same counterparties when the right of offset exists under master netting agreements.
The gains and losses relating to derivatives not designated as fair-value hedges are included in "net realized and unrealized gains (losses) on derivative instruments" in the consolidated statements of operations and comprehensive income. The gains and losses related to derivatives designated as fair-value hedges are included in either "net interest income from financial products segment" or "net interest expense from financial products segment," as appropriate, along with the offsetting change in the fair value of the risk being hedged. Hedge accounting is applied to fair value hedges provided certain criteria are met. See Note 16 for more information. All cash flows from derivative instruments are classified as "financial products segment net derivative receipts (payments)" on the statement of cash flows, regardless of their designation as fair-value hedges.
The Company also has a portfolio of insured derivatives (primarily CDS). It considers these agreements to be a normal part of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. It ceased issuing asset-backed guarantees in August 2008. These agreements are recorded at fair value. Changes in fair value are recorded in "net change in fair value of credit derivatives."
In consultation with the Securities and Exchange Commission (the "SEC"), members of the financial guaranty industry have collaborated to develop a presentation of credit derivatives issued by financial guaranty insurers that is more consistent with that of non-insurers. Prior-period balances have been reclassified to conform to the current presentation. The reclassifications do not affect net income or equity, although they do affect various revenue, asset and liability line items. Changes in fair value are recorded in "net change in fair value of credit derivatives" in the consolidated statements of operations and comprehensive income. The "realized gains (losses) and other settlements" component of this income statement line includes premiums received and receivable on written CDS contracts and premiums paid and payable on purchased contracts. If a credit event occurred that required a payment under the contract terms, this line item would also include losses paid and payable to CDS contract counterparties due to the credit event and losses recovered and recoverable on purchased contracts.
Securities Purchased under Agreements to Resell and Securities Sold under Agreements to Repurchase
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized transactions and recorded at contract value plus accrued interest. It is the Company's policy to take possession of securities borrowed under agreements to resell.
Financial Products Segment Debt
FP segment debt is recorded at amortized cost or fair value, if the fair value option was elected. Certain VIE liabilities include embedded derivatives. Prior to the adoption of SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159") on January 1, 2008, changes in fair value of embedded derivatives in VIE debt were recorded in "net realized and unrealized gains (losses) on derivative instruments." In 2008, the fair value option was elected for all VIE liabilities containing embedded derivatives and the change in fair value of the entire debt instrument is recorded in "net unrealized gains (losses) on financial instruments at fair value."
Foreign Currency Translation
Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are recorded at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities resulting from translating investments
denominated in foreign currencies are recorded in accumulated other comprehensive income unless the security is deemed OTTI. Gains and losses from transactions in foreign currencies are recorded in "other income."
Federal Income Taxes
The provision for income taxes consists of an amount for taxes currently payable and an amount for deferred taxes arising from temporary differences between the tax bases of assets and liabilities and the amounts reported in the financial statements. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets are evaluated for recoverability and a valuation allowance is established if a deferred tax asset is determined to be non-recoverable.
Non-interest-bearing tax and loss bonds are purchased to prepay the tax benefit that results from deducting contingency reserves as provided under Internal Revenue Code Section 832(e). The Company records the purchase of tax and loss bonds in other assets.
The Company recognizes tax benefits only if a tax position is "more likely than not" to prevail.
Special Purpose Entities
Asset-backed and, to a lesser extent, public finance transactions insured by the Company may employ special purpose entities ("SPEs") for a variety of purposes. A typical asset-backed transaction, for example, employs an SPE as the purchaser of the securitized assets and as the issuer of the insured obligations. SPEs are typically owned by transaction sponsors or charitable trusts, although the Company may have an ownership interest in some cases. The Company generally maintains certain contractual rights and exercises varying degrees of influence over SPE issuers of FSA-insured obligations.
The Company also bears some of the "risks and rewards" associated with the performance of those SPE's assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given SPE's obligations, the Company bears the risk of asset performance (typically, but not always, after a significant depletion of overcollateralization, excess spread, a deductible or other credit protection).
The Company's underwriting guidelines for public finance obligations generally require that a transaction be rated investment grade when FSA's insurance is applied. The Company's underwriting guidelines for asset-backed obligations, which it followed prior to its August 2008 decision to cease insuring such obligations, varied by obligation type in order to reflect different structures and types of credit support. The Company sought to insure asset-backed obligations that generally provided for one or more forms of overcollateralization or third-party protection. In addition, the SPE typically pays a periodic premium to the Company in consideration of the issuance by the Company of its insurance policy, with the SPE's assets typically serving as the source of payment of such premium, thereby providing some of the "rewards" of the SPE's assets to the Company. SPEs are also employed by the Company in connection with secondary market transactions and with refinancing underperforming, non-investment-grade transactions insured by FSA. See Note 7 for more information.
The degree of influence exercised by FSA over these SPEs varies from transaction to transaction, as does the degree to which "risks and rewards" associated with asset performance are assumed by FSA. In analyzing special purpose entities described above, the Company considers reinsurance to be an implicit variable interest. Where the Company determines it is required to consolidate the special purpose entity, the outstanding exposure is excluded from outstanding exposure amounts reported.
The Company is required to consolidate SPEs that are considered VIEs where the Company is considered the primary beneficiary.
In determining whether the Company is the Primary Beneficiary of a particular VIE, a number of factors are considered. The significant factors considered are: the design of the entity and the risks it was created to pass-along to variable interest holders; the extent of credit risk absorbed by the Company through its insurance contract and the extent to which credit protection provided by other variable interest holders reduces this exposure; the exposure that the Company cedes to third party reinsurers, to reduce the extent of expected loss which the Company absorbs; and the portion of the VIE's total notional exposure covered by the Company's insurance policy. The Company's accounting policy is to first conduct a qualitative analysis based on the design of the VIE in order to identify whether it is the primary beneficiary. Should the qualitative analysis not provide a basis for conclusion, the Company will perform a quantitative analysis in order to determine if it is the primary beneficiary of the VIE under review.
In considering the significance of its interest in a particular VIE, the Company considers the extent to which both the variability it absorbs from the VIE and the Company's exposure to that VIE are material to the Company's own financial statements. The Company believes that its surveillance categories are an appropriate measure to use for identification of VIEs in which the Company absorbs other than insignificant variability. VIEs selected for this purpose are related to risks classified as surveillance Category IV, defined as "demonstrating sufficient deterioration to indicate that material credit losses are possible even though not yet probable" or risks classified as surveillance Category V, defined as "transactions where losses are probable." The Company believes that VIE-related risks classified as surveillance Categories IV and V are VIEs in which the Company absorbs a significant portion of the variability created by the particular VIE. For a more detailed description of the surveillance categories used by the Company, see Note 9.
VIEs in which the Company holds a significant variable interest, but which are not consolidated, have been aggregated according to principle line of business for the purpose of disclosing the nature and extent of the Company's exposure to such VIEs. The Company aggregates such VIEs according to principle line of business to appropriately reflect the VIE risk and reward characteristics in an aggregated manner. The table below displays the Company's exposure to these VIEs at December 31, 2008.
Non-Consolidated VIEs
(1)Represents the net par outstanding that corresponds to insured bonds issued by VIEs. FSA's interest in these non-consolidated VIEs is included in "losses and loss adjustment expenses" and "credit derivatives" in the Company's balance sheet.
The Company has consolidated certain VIEs for which it has determined that it is the primary beneficiary. The table below shows the carrying value and classification of the consolidated VIE assets and liabilities in the Company's financial statements:
Consolidated VIEs
FSA has provided financial guarantee insurance contracts on the assets held and the notes issued by FSA Global Funding and, as such, FSA is exposed to the risk of non-payment of the assets held by FSA Global Funding. In addition, aside from the financial guarantee insurance contracts provided by FSA, there are no arrangements, either explicit or implicit, which could require the Company to provide financial support to the VIEs.
Employee Compensation Plans
The Company records a liability in other liabilities related to the vested portion of employees' outstanding "performance shares" under the Company's 2004 Equity Participation Plan and 1993 Equity Participation Plan (the "Equity Plans"). The expense is recognized ratably over specified performance cycles. The Company also records prepaid assets for Dexia restricted share awards made under the Company's Equity Plans and amortize these amounts over the employees' vesting periods. For more information regarding the Equity Plans, see Note 14.
Under SFAS No. 123, "Share-Based Payment" (revised 2004), the Company recorded $1.2 million and $1.0 million in additional after-tax expense related to the Dexia Employee Share Plans in 2007 and 2006, respectively. There was no expense recorded in 2008.
Recently Issued Accounting Standards
In October 2008, the FASB issued FSP No. FAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active" ("FSP 157"). FSP 157 clarifies the application of SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), in an inactive market, without changing its existing principles. The FSP was effective immediately upon issuance. The adoption of FSP No. FAS 157-3 did not have an effect on the Company's financial position or results of operations or cash flows.
Recently Issued Accounting Standards that are Not Yet Effective
In May 2008, the FASB issued SFAS 163. This statement addresses accounting standards applicable to existing and future financial guaranty insurance and reinsurance contracts issued by insurance companies, including accounting for claims liability measurement and recognition and premium recognition and related disclosures. SFAS 163 requires the Company to recognize a claim liability when there is an expectation that a claim loss will exceed the unearned premium revenue (liability) on a policy basis based on the present value of expected net cash flows. The premium earnings methodology under SFAS 163 will be based on a constant rate methodology. SFAS 163 does not apply to financial guarantee insurance contracts accounted for as derivatives within the scope of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 163 also requires the Company to provide expanded disclosures relating to factors affecting the recognition and measurement of financial guaranty contracts. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, except for the presentation and disclosure requirements related to claim liabilities which were effective for financial statements prepared as of September 30, 2008. The cumulative effect of initially applying SFAS 163 is required to be recognized as an adjustment to the opening balance of retained earnings. The Company is currently assessing the impact of SFAS 163 on the Company's consolidated financial position and results of operations.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities, an amendment of SFAS 133" ("SFAS 161"). This statement amends and expands the disclosure requirements for derivative instruments and hedging activities by requiring companies to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. This statement is effective for fiscal years and interim periods beginning after November 15, 2008. Since SFAS 161 only requires additional disclosures concerning derivatives and hedging activities, adoption of SFAS 161 will not affect the Company's consolidated financial position and results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements" ("SFAS 160"). SFAS 160 will change the accounting for minority interests, which will be recharacterized as noncontrolling interests and classified by the parent company as a component of equity. SFAS 160 also addresses the accounting for deconsolidations of certain subsidiaries. This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. Upon adoption, SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests and prospective adoption for all other requirements. The Company is currently assessing the impact of SFAS 160 on the Company's consolidated financial position, results of operations and cash flows.
3. FAIR VALUE MEASUREMENT
The Company adopted SFAS 157, effective January 1, 2008. SFAS 157 addresses how companies should measure fair value when required to use fair value measures under GAAP. SFAS 157:
•defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework for measuring fair value;
•establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date;
•nullifies the guidance in Emerging Issues Task Force Issue No. 02-03, "Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities" ("EITF 02-03"), which required the deferral of profit at inception of a transaction involving a derivative financial instrument in the absence of observable data supporting the valuation technique;
•requires consideration of a company's creditworthiness when valuing liabilities; and
•expands disclosure requirements about instruments measured at fair value.
In February 2007 the FASB issued SFAS 159. SFAS 159 provides an option to elect fair value as an alternative measurement for selected financial assets and financial liabilities not previously recorded at fair value. The Company adopted SFAS 159 on January 1, 2008 and elected fair value accounting for certain FP segment debt and certain assets acquired in refinancing FSA-insured transactions not previously carried at fair value. For more information regarding the fair value option, see Note 4.
The Company applied its valuation methodologies for its assets and liabilities measured at fair value to all of the assets and liabilities carried at fair value effective January 1, 2008, whether those instruments are carried at fair value as a result of the adoption of SFAS 159 or in compliance with other authoritative accounting guidance. The Company has fair value committees to review and approve valuations and assumptions used in its models. These committees meet quarterly prior to the Company issuing its financial statements.
Fair value is based upon pricing received from dealer quotes or alternative pricing sources with reasonable levels of price transparency, internally developed estimates that employ credit-spread algorithms or models that use market-based or independently sourced market data inputs, including yield curves, interest rates, volatilities, debt prices, foreign exchange rates and credit curves. In addition to market information, models also incorporate instrument-specific data, such as maturity date.
Considerable judgment is necessary to interpret the data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company would realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair-value amounts.
The transition adjustment in connection with the adoption of SFAS 157 was an increase of $26.6 million after-tax to beginning retained earnings, which relates to day one gains that had been deferred under EITF 02-03.
The following table summarizes the components of the fair-value adjustments included in the consolidated statements of operations and comprehensive income:
(1)There was no hedge accounting in 2007 or 2006.
(2)Represents derivatives not in designated fair-value hedging relationships.
(3)Represents fair-value adjustments on the assets that economically defease the Company's liability for deferred compensation plans ("DCP") and supplemental executive retirement plans ("SERP").
(4)There is no hedge accounting in 2008.
Valuation Hierarchy
SFAS 157 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
•Level 1-inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
•Level 2-inputs to the valuation methodology include quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
•Level 3-inputs to the valuation methodology are unobservable and significant drivers of the fair value measurement.
A financial instrument's categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
Inputs to Valuation Techniques
Inputs refer broadly to the assumptions that market participants use in pricing assets or liabilities, including assumptions about risk. Inputs may be observable or unobservable.
•Observable inputs are inputs that reflect assumptions market participants would use in pricing the asset or liability, developed based on market data obtained from independent sources.
•Unobservable inputs are inputs that reflect the assumptions management makes about the assumptions market participants would use in pricing the asset or liability, developed based on the best information available in the circumstances.
Valuation Techniques
Valuation techniques used for assets and liabilities accounted for at fair value are generally categorized into three types:
•The market approach uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities. Valuation techniques consistent with the market approach often use market multiples derived from a set of comparables or matrix pricing. Market multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering both quantitative and qualitative factors specific to the measurement. Matrix pricing is a mathematical technique used principally to value certain securities without relying exclusively on quoted prices for the specific securities but comparing the securities to benchmark or comparable securities.
•The income approach converts future amounts, such as cash flows or earnings, to a single present amount, or a discounted amount. Income approach techniques rely on current market expectations of future amounts. Examples of income approach valuation techniques include present value techniques, option-pricing models that incorporate present value techniques, and the multi-period excess earnings method.
•The cost approach is based upon the amount that currently would be required to replace the service capacity of an asset, or the current replacement cost. That is, from the perspective of a market participant (seller), the price that would be received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility.
The Company uses valuation techniques that it concludes are appropriate in the specific circumstances and for which sufficient data are available. In selecting the valuation technique to apply, management considers the definition of an exit price and considers the nature of the asset or liability being valued.
The following is a description of the valuation methodologies the Company uses for financial instruments including the general classification of such instruments within the valuation hierarchy.
General Investment Portfolio
The fair value of bonds in the General Investment Portfolio is generally based on quoted market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. If quoted market prices are not available, the valuation is based on pricing models that use dealer price quotations, price activity for traded securities with similar attributes and other relevant market factors as inputs, including security type, rating, vintage, tenor and its position in the capital structure of the issuer. Assets in this category are primarily categorized as Level 2.
At December 31, 2008, the Company's equity securities were comprised of common stock of Dexia. The fair value of the common stock is based upon quoted prices and is categorized as Level 1. At December 31, 2007, the fair value of the Company's equity investment in Syncora Guarantee Re Ltd. ("SGR") was based on redemption value and other inputs.
For short-term investments in the General Investment Portfolio, which are those investments with a maturity of less than one year at time of purchase, the carrying amount approximates fair value. These short-term investments include money-market funds and other highly liquid short-term investments, which are categorized as Level 1 on the valuation hierarchy, and foreign government and agency securities, which are categorized as Level 2.
FP Segment Investment Portfolio
The FP Segment Investment Portfolio is comprised of investments made with the proceeds of FSA-insured GICs. Together with the VIE Investment Portfolio, it forms the FP Segment Investment Portfolio. The available-for-sale FP Investment Portfolio is broadly comprised of short-term investments, non-agency RMBS, securities issued or guaranteed by U.S. government sponsored agencies, taxable municipal bonds, securities issued by utilities, infrastructure-related securities, collateralized debt obligations ("CDOs"), and other asset backed securities. In addition to its available-for-sale portfolio, the FP Investment Portfolio includes foreign currency denominated securities classified as "trading."
The fair value of bonds in the FP Segment Investment Portfolio is generally based on quoted market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. If quoted market prices are not available, the valuation is based on pricing models that use dealer price quotations, price activity for traded securities with similar attributes and other relevant market factors as inputs, including security type, rating, vintage, tenor and its position in the capital structure of the issuer. For assets not valued by quoted market prices received from dealer quotes or alternative pricing sources, fair value is based on either internally developed models using market based inputs or based on broker quotes for identical or similar assets. Valuation results, particularly those derived from valuation models and quotes on certain mortgage and asset-backed securities, could differ materially from amounts that would actually be realized in the market. Non-agency mortgage-backed and other asset-backed investments are generally categorized as Level 3 due to the reduced liquidity that exists for such assets, which increases use of unobservable inputs.
For short-term investments in the FP Segment Investment Portfolio, which are those investments with a maturity of less than one year at time of purchase, the carrying amount is fair value. These short-term investments include overnight federal funds and money market funds, which are categorized as Level 1 on the valuation hierarchy.
The trading portfolio is comprised of U.K. pound sterling-denominated inflation-linked bonds for which fair value is based on broker quotes that are derived from their internally-developed models that use observable market inputs to the extent possible. The investments are classified as Level 3.
Cash
For cash, the carrying amount equals fair value.
Assets Acquired in Refinancing Transactions
For certain assets acquired in refinancing transactions, fair value is either the present value of expected cash flows or a quoted market price as of the reporting date. This portfolio is comprised primarily of bonds, securitized loans, common stock, mortgage loans, real estate and short term investments, of which bonds, common stocks and certain securitized loans are carried at fair value. Mortgage loans are accounted for at fair value when lower than cost. The majority of the assets in this portfolio are categorized as Level 3 in the valuation hierarchy, except for the short-term investments, which are categorized as Level 2.
Credit Derivatives in the Insured Portfolio
The Company's insured portfolio includes contracts accounted for as derivatives, namely,
•CDS contracts in which the Company sells protection to various financial credit institutions, and in certain cases, purchases back-to-back credit protection on all or a portion of the risk written, primarily from reinsurance companies,
•insured interest rate ("IR") swaps entered into by the issuer in connection with the issuance of certain public finance obligations, which guaranty the municipality's performance under the IR swap to the IR swap counterparty,
•insured net interest margin ("NIM") securitizations and other financial guaranty contracts that guarantee risks other than credit risk, such as interest rate basis risk ("FG contracts with embedded derivatives") issued after January 1, 2007.
The Company considers all such agreements to be a normal part of its financial guaranty insurance business but, for accounting purposes, these contracts are deemed to be derivative instruments and therefore must be recorded at fair value, with changes in fair value recorded in the consolidated statements of operations and comprehensive income in "net change in fair value of credit derivatives."
Credit Default Swap Contracts
In the case of CDS contracts, a trust that is consolidated by the Company writes a derivative contract that provides for payments to be made if certain credit events occur related to certain specified reference obligations, in exchange for a fee. The need to interpose a trust is a regulatory requirement imposed by the New York State Insurance Department as an exception to its general rule, in order to allow the financial guarantors to sell credit protection by entering into credit derivative contracts (albeit indirectly by guaranteeing the trust), while other types of insurance enterprises may neither directly enter into such credit derivative contracts, nor provide such guarantees to a trust. The trust's obligation on the CDS contracts it writes are guaranteed by a financial guaranty contract written by FSA that provides payments to the insured if the trust defaults on its payments under the derivative
contract. In these transactions, FSA is considered the counterparty to a financial guaranty contract that is defined as a derivative. The credit event is typically based upon failure to pay or the insolvency of a referenced obligation. In such cases, the claim represents payment for the shortfall amount.
The Company's accounting policy regarding CDS contract valuations requires management to make numerous complex and subjective judgments relating to amounts that are inherently uncertain. CDS contracts are valued using proprietary models because such instruments are unique, complex and are typically highly customized transactions. Valuation models and the related assumptions are continuously reevaluated by management and enhanced, as appropriate, based on market developments and improvements in modeling techniques and the availability of market observable data. Due to the significance of unobservable inputs required to value CDS contracts, they are considered to be Level 3 under the SFAS 157 fair value hierarchy.
Significant assumptions that, if changed, could result in materially different fair values include:
•the assumed credit quality of the underlying referenced obligations,
•the assumed credit spread attributable to credit risk of the underlying referenced obligations exclusive of funding costs,
•the reference credit index used, which includes a market correlation factor for pooled corporate CDS contracts, and
•the price source and credit spread attributable to the Company's own credit risk.
Market perceptions of credit deterioration of the underlying referenced obligation would result in an increase in the expected exit value (the amount required to be paid to exit the transaction due to wider credit spreads).
Fair Value of CDS Contracts in which the Company Sells Protection
Determination of Current Exit Value Premium: The estimation of the current exit value premium is derived using a unique credit-spread algorithm for each defined CDS category that utilizes various publicly available credit indices, depending on the types of assets referenced by the CDS contract and the duration of the contract. The "exit price" derived is technically an "entry price" and not an "exit price" (i.e., the price that would be received to sell an asset or paid to transfer a liability that is required under SFAS 157). This is because a monoline insurer cannot observe "exit prices" for the CDS contract that it writes in a principal market since these contracts are not transferable. While SFAS 157 provides that the transaction (entry) price and the exit price may not be equal if the transaction price includes transaction costs, the Company believes those transaction costs would be the same in an "entry" market and a hypothetical "exit" market and thus it would be inappropriate to record a day one gain when using the estimated "entry price" to determine the exit value premium.
Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, if available, performance of underlying assets, changes in internal credit assessments or rating agency-based shadow ratings, and the level at which the deductible has been set. Estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions.
In a financial guaranty insurance policy, a deductible is the portion of a loss under that policy that is not covered by the policy, or in other words, the amount of the loss for which the insurer is not responsible. In a CDS contract, the deductible is quoted as a percentage of the contract's notional amount, and is also referred to as the contract's attachment point. For example, for a CDS with a $1 billion notional amount and a 15% deductible, the Company would only be obligated to make a claim payment after the insured incurred more than $150 million (15% of $1 billion) of losses (net of
recoveries). The attachment points for each of the Company's CDS contracts vary, as the deductibles are negotiated on a contract-by-contract basis.
In the ordinary course, the Company does not post collateral to the counterparty as security for the Company's obligation under CDS contracts. As a result, the Company receives a smaller fee than it would for a CDS contract that required the posting of collateral. In order to calculate the exit value premium for CDS that do not require collateral to be posted, the Company applies a factor (the "non-collateral posting factor") to the indicated market premium for CDS contracts that require collateral to be posted. The non-collateral posting factor was 70% for the year ended December 31, 2008.
The Company calculates the non-collateral posting factor quarterly based in part on observable market inputs. In the market where transactions are executed, the Company has observed since the beginning of 2008 that when a collateral posting counterparty executes a CDS contract purchasing protection from a non-collateral posting counterparty, it will hold back a minimum of 20% of the CDS premium it charged to provide the CDS protection. The Company believes that the non-collateral posting factor has the effect of adjusting the fair value of these contracts for the Company's credit quality in addition to adjusting the contract to a collateral posting basis. Accordingly, the Company adds to the 20% minimum an additional amount to reflect the market price of CDS protection on FSA. The Company estimated the additional amount as of December 31, 2008 to be 50% using an algorithm that uses as an input FSA's current annual five-year CDS credit spread, which was approximately 1,421 basis points as of December 31, 2008. The Company uses the current five-year CDS credit spread based on its observation that the five-year instrument is the standard term for CDS contracts used to hedge counterparty credit risk. Quoted prices for shorter or longer terms are typically not available and, when available, are less reliable.
The underlying securities of the Company's CDS contracts are predominantly corporate obligations, specifically investment grade pooled corporate CDS, high yield pooled corporate CDS and collateralized loan obligations ("CLOs"). The Company's exposure to underlying securities such as those backed by domestic RMBS and CDOs of ABS was less than one percent of the total CDS par outstanding as of December 31, 2008.
Below is an explanation of how the Company determines the current exit value for each of the following types of CDS contracts:
•Pooled Corporate CDS Contracts:
•investment grade pooled corporate CDS;
•high yield pooled corporate CDS; and
•CDS of funded CDOs and CLOs.
For each of these types of CDS contracts, the price the Company charges when entering into such contract sometimes differs from the fair value determined by the Company's fair value model at the time when the Company enters into the CDS contract. The Company refers to this difference as the "initial model adjustment," and is not an indicator of a day one gain. The initial model adjustment is needed because of differences between the CDS contract being valued and the reference index. The initial model adjustment is calculated at the inception of a CDS contract in order to calibrate the indicated model fair value of the CDS contract to the contractual premium rate on the trade date.
Pooled Corporate CDS Contracts: A pooled corporate CDS contract insures the default risk of a pool of referenced corporate entities. As there is no observable exchange trading of bespoke pooled corporate CDS, the Company values these contracts using an internal pricing model that uses the mid-point of the bid and ask prices (the "mid-market price") of dealer quotes on specific indexes as inputs to its pricing model, principally the Dow Jones CDX for domestic corporate CDS ("DJ CDX")
and iTraxx for European corporate CDS ("iTraxx"). The mid-market price is a practical expedient for the fair-value measurement within a bid-ask spread. For those pooled corporate CDS contracts that include both domestic and foreign reference entities, the Company applies the iTraxx price in proportion to the pool of applicable foreign reference entities comprising the pool by calculating a weighted average of the DJ CDX and iTraxx quoted prices.
The Company's valuation process for pooled corporate CDS involves stratifying the pools into either investment grade credits or high-yield credits and then by remaining term to maturity, consistent with the reference indexes. Within maturity bands, further distinction is made for contracts that have higher attachment points. Both the DJ CDX and iTraxx indices provide quoted prices for standard attachment and detachment points (or "tranches") for contracts with maturities of three, five, seven and ten years.
Prices quoted for these tranches do not represent perfect pricing references, but are the only relevant market-based information available for this type of non-traded contract. The recent market volatility in the index tranches has had a significant impact on the estimated fair value of the Company's portfolio of pooled corporate CDS.
Investment-Grade Pooled Corporate CDS Contracts: The Company applies quoted prices to its investment-grade pooled corporate CDS contracts ("IG CDS") by stratifying its IG CDS contracts into four maturity bands: less than 3.5 years; 3.5 to 5.5 years; 5.5 to 7.5 years; and 7.5 to 10 years. Within the maturity bands, further distinction is made for contracts that have a significantly higher starting attachment point (usually 30% or higher).
The CDX North America IG Index ("CDX IG Index") is comprised of prices sourced from 125 North American investment grade CDS quoted (each, an "Index CDS") and is supported by at least 10 of the largest CDS dealers. In addition to the full capital structure, the CDX IG Index also provides price quotes for various tranches delineated by attachment and detachment points: 0 to 3%; 3 to 7%; 7 to10%; 10 to 15%; 15 to 30% and 30 to 100%. Approximately every six months, a new "series" of the CDX IG Index is published ("on-the-run") based on a new grouping of 125 Index CDS, which changes the composition of the 125 Index CDS of older ("off-the-run") series. Each quarter, the Company compares the composition of the 125 Index CDS in both the on-the-run and off-the run series of the CDX IG Index to the CDS pool referenced by the Company's IG CDS contracts (the "reference CDS pool") and uses the average of the series of the CDX IG Index and the comparable iTraxx Index that most closely relates to the credit characteristics of the Company's IG CDS contracts, mainly the Weighted-Average Rating Factor ("WARF"), of the Company's IG CDS contracts. The Company also remodels each of its contracts to determine if the credit quality remains Super Triple-A and compares the WARF of the index to the WARF of each of the Company's IG CDS contracts. A "Super Triple-A" credit rating indicates a level of first-loss protection generally exceeding 1.3 times the level required by a rating agency for a Triple-A rating. WARF is a 10,000 point scale developed by Moody's that is used as an indicator of collateral pool risk. A higher WARF indicates a lower average collateral rating.
The Company calibrates the quoted index price to the approximate attachment points for its IG CDS contracts by calculating the weighted average of the given quoted tranche prices for IG CDS of a given maturity using the CDX IG Index and iTraxx quoted tranche widths. The relevant widths of the quoted tranches used by the two indices differ. DJ CDX uses tranches of 10 to 15%, 15 to 30%, and 30 to 100%, resulting in tranche widths of five, 15 and 70 percentage points, whereas iTraxx uses tranches of 9 to 12%, 12 to 22% and 22 to 100%, resulting in tranche widths of three, 10 and 78 percentage points.
The Company's IG CDS contracts typically attach at 10% or higher. The following table indicates FSA's typical attachment points and total tranche widths:
To calculate the weighted average price for the entire tranche width of the Company's IG CDS (the "total tranche width"), a price is obtained for each quoted tranche comprising the total tranche width, and the sum of the weighted average prices is divided by the total tranche width. The price for each quoted tranche is the mid-market of the quoted price for that tranche, weighted by the width of that tranche. The following table illustrates the calculation of the weighted-average price of the Company's IG CDS contracts with a maturity of up to 3.5 years, given quoted CDX IG tranche prices of 332 basis points, 83.5 basis points and 68.4 basis points for the 10 to 15%, 15 to 30%, and 30 to 100% tranches, respectively.
The Company applies a factor to the quoted prices (the "IG calibration factor"). The calibration factor is intended to calibrate the index price to each of the Company's pooled corporate investment grade CDS contracts, which reference pools of entities that are typically of lower average credit quality than those reflected in the CDX IG Index. The IG calibration factor is determined for each IG CDS contract by calibrating the WARF of the index so that it approximately equals the WARF of each IG CDS contract. To do so, the Company recalculates the index price after removing from the index the reference obligations that have the highest ratings. This recalculated index price is then divided by the unadjusted index to arrive at the IG calibration factor. As of December 31, 2008, the IG calibration factor applied to the Company's IG CDS contracts ranged from 112% to 530% of the WARF of the index.
The Company's Transaction Oversight Department reviews the pooled corporate CDS portfolio regularly and no less than quarterly and factors in any rating changes. Any new reported credit events under a given CDS contract are factored into the contract's deductible level. As such credit events occur, the contract's attachment point is recalculated based on the revised deductible amount to determine if the attachment point for each contract in the portfolio continues to be at a "Super Triple-A" credit rating.
To arrive at the exit value premium applied to each of the Company's IG CDS contracts, the Company:
(a)determines the weighted average of the mid-market prices for the applicable tranches by (1) multiplying the mid-market price for each tranche by the tranche width and (2) dividing the total amount derived by the total tranche width, using CDX IG and iTraxx quoted prices; and then
(b)applies the IG calibration factor and non-collateral posting factor to the weighted-average market price determined for each maturity band.
Below is an example of the pricing algorithm that is applied to the Company's domestic IG CDS contracts with durations of 3.5 to 5.5 years, assuming an average IG calibration factor of 296%, to determine the exit premium value as of December 31, 2008:
Index Duration
Unadjusted
Quoted Price
After IG
Calibration Factor
Adjusted to Non-Collateral
Posting Contract Value
5 yrs
85.1 bps
251.9 bps
75.6 bps
High-Yield Pooled Corporate CDS Contracts: In order to estimate the market price for high-yield pooled corporate CDS contracts ("HY CDS"), the Company uses the average of the dealer mid-market prices obtained for the most senior quoted of the respective three-year, five-year and seven-year tranches of the CDX North America High Yield Index ("CDX HY Index"). The CDX HY Index is comprised of prices sourced from 100 of the most liquid North American high yield CDS quoted (each, an "Index CDS") and is supported by more than 10 of the largest CDS dealers. In addition to the full capital structure, the CDX HY Index also provides price quotes for various tranches delineated by attachment and detachment points: 0 to 10%; 10 to 15%; 15 to 25%; 25 to 35%; and 35 to 100%. The Company uses an average of the dealer mid-market quotes of the index because the Company believes that dealer price quotes have historically been indicative of where trades have been executed in the high-yield market.
The Company applies a factor to the quoted prices (the "HY calibration factor"). The HY calibration factor is intended to calibrate the index price to each of the Company's pooled corporate high-yield CDS contracts, which reference pools of entities that are typically of higher average credit quality than those reflected in the CDX HY Index. The HY calibration factor is determined for each HY CDS contract by calibrating the WARF of the index so that it approximately equals the WARF of each HY CDS contract. To do so, the Company recalculates the index price after removing from the index the reference obligations that have the lowest ratings. This recalculated index price is then divided by the unadjusted index to arrive at the HY calibration factor. At December 31, 2008, the HY calibration factor applied to the Company's HY CDS contracts ranged from 28% to 100% of the WARF of the index.
Approximately every six months, a new "series" of the CDX HY Index is published ("on-the-run") based on a new grouping of 100 single name CDS, which changes the composition of the Index of older ("off-the-run") series. The Company compares the composition of the Index in both the on-the-run and off-the run series of the HY index to each CDS pool (i.e., "reference entities" or companies included in each contract) referenced by the Company's contracts (the "reference CDS pool"). Based on that comparison, the Company determines which of the actively quoted series most
closely relates to the credit characteristics, mainly with reference to the WARF, of the Company's HY CDS contracts, and then uses the average of dealer quotes of that series. The Company also remodels each of its contracts to determine if the credit quality remains Super Triple-A and compares the WARF of the index to the WARF of each of the Company's HY CDS contracts.
To arrive at the exit value premium that is applied to each of the Company's CDS contracts in a given maturity band, the non-collateral posting factor is applied to the weighted-average market price determined for that maturity band.
•For purposes of this calculation, the Company's HY CDS contracts are stratified into three maturity bands: less than 3.5 years; 3.5 to 5.5 years; and 5.5 to 7.5 years.
•Each quarter, the average of the series of the CDX HY or iTraxx that most closely relates to the credit characteristics of the CDS contracts in the Company's portfolio is used. In some cases it may be the most recently published series of those indices, but in other cases, it may be the previously published series to the extent that it is still being published.
•The appropriate HY calibration factor and a 70% non-collateral posting factor adjustment are applied to the average of the quotes received at December 31, 2008.
Below is an example of the pricing algorithm that is applied to the Company's domestic HY CDS contracts with durations of 3.5 to 5.5 years, assuming an average HY calibration factor of 100% to determine the exit premium value as of December 31, 2008:
Index Duration
Unadjusted
Quoted Price
After HY
Calibration Factor
Adjusted to Non-Collateral
Posting Contract Value
5 yrs
266.3 bps
266.3 bps
79.9 bps
CDS of Funded CDOs and CLOs: Prior to August 2008, the Company sold protection to financial institutions in a principal-to-principal market in which transactions are highly customized and negotiated independently. The Company therefore cannot observe "exit" prices for the CDS contracts it writes in this market since these contracts are not transferable. In the absence of a principal exit market, the Company determines the fair value of a CDS contract it writes by using an internally-developed estimate of an "exit price" that a hypothetical market participant (i.e., a similarly rated monoline financial guarantee insurer, or "monoline insurer") would accept to assume the risk from the CDS writer on the measurement date, on terms identical to the contract written by the CDS writer. The Company believes this approach is reasonable because the hypothetical exit market has been defined as other monoline insurers. In essence, the exit market participants are the same as the monoline participants competing in the entry market.
As with pooled corporate CDS, there is no observable exchange trading of CDS of funded CDOs and CLOs. The price of protection charged by a CDS writer is based on the "credit spread component" of the "all-in credit spread" of funded CLOs, as quoted by underwriter participants. As the all-in credit spread for a given CLO may not always be observable in the market, the CDS writer often utilizes an index, published by an underwriter participant, such as the "all-in" London Interbank Offered Rate ("LIBOR") spread for Triple-A rated cash-funded CLOs (the "Triple-A CLO Funded Rate") as published by J.P. Morgan Chase & Co. The Triple-A CLO Rate is an all-in credit spread that includes both a funding and credit spread component.
The CDS protection of a CLO provided by the Company is priced to capture only the credit spread component, as the CDS writer is not providing funding for the CLO, only credit protection. The contracts on which the Company has provided credit protection are regularly evaluated to ascertain whether or not the original Triple-A credit rating is still considered appropriate. The Company determines the exit value premium for all these CDS of CLO contracts in its portfolio that are rated Triple-A with reference to the Triple-A CLO Funded Rate, which is currently the only regularly and frequently quoted rate observable in the market. The Triple-A CLO Funded Rate was 500 bps as of
December 31, 2008. The Company applies a credit component factor to the Triple-A CLO Funded Rate as a means of estimating the fair value of its Triple-A rated contract, which only refers to the credit component. The credit and funding components were 50% each as of December 31, 2008. The components are determined judgmentally and can vary based on estimates provided to the Company by external market participants, specifically purchasers of CDS protection on Triple-A CLO risk and investors in Triple-A CLO bonds.
To arrive at the exit value premium that is applied to each of the Company' CDO and CLO CDS contracts, the non-collateral posting factor is applied to the weighted-average market price determined for each maturity band.
The determination of the exit value premium is summarized as follows:
Other Structured Obligations Valuation: For CDS for which observable market value information is not available, management applies its best judgment to estimate the appropriate current exit value premium, and takes into consideration the Company's estimation of the price at which the Company would currently charge to provide similar protection, and other factors such as the nature of the underlying reference credit, the Company's attachment point, and the tenor of the CDS contract.
Fair Value of CDS Contracts in which the Company Purchases Protection
The Company generally utilizes reinsurance to purchase protection for CDS contracts it writes in the same way that it employs reinsurance in respect of other financial guaranty insurance policies. The Company's uses of reinsurance to mitigate risk exposures for CDS contracts and financial guaranty insurance policies are nearly identical as they involve the same reinsurers, the same underwriting process evaluating the reinsurers and the same credit risk management and surveillance processes supporting the reinsurance function. The Company enters into reinsurance agreements on CDS contracts primarily on a quota share basis. Under a quota share reinsurance agreement with a reinsurer, the Company cedes to the assuming reinsurer a proportionate share of the risk and premium.
The determination of the hypothetical exit market is a key factor in determining the fair value of protection purchased (the "ceded" or "reinsurance" contract) with respect to a CDS contract written by a financial guarantor (the "direct contract"). SFAS 157 requires that the valuation premise, used to measure the fair value of an asset, must consider the asset's "highest and best use" from the perspective of market participants. Generally, the valuation premise used for a financial asset is "in-exchange" since this type of asset provides maximum value to market participants on a stand-alone basis. The maximum value of a ceded contract to the CDS writer's exit market participants is in combination with the CDS writer's direct contract. Therefore the appropriate valuation premise to use for a ceded contract is the "in-use" premise.
The Company determines the fair value of a CDS contract in which it purchases protection from a reinsurer (the "ceded CDS contract") as the proportionate percentage of the fair value of the related written CDS contracts, adjusted for any ceding commission and consideration of counterparty risk. In quota share reinsurance agreements, the assuming reinsurer typically pays a ceding commission periodically over the life of the CDS contract to the ceding company that is intended to defray the ceding company's costs for the services it provides to the reinsurer, such as risk selection, underwriting activities and ongoing servicing and reporting. As an element of the fair value of the ceded CDS contract, the ceding commission paid to the ceding company represents the ceding company's profit on the ceded CDS contract after considering counterparty credit risk, (i.e., the difference between (a) the price of the protection the ceding company purchased from the reinsurer, which is net of the ceding commission, and (b) the price that the ceding company would receive to exit the ceded CDS contract
in its principal market, which is comprised of other ceding insurers of comparable credit standing). The Company applies a credit valuation adjustment to the fair value of a ceded CDS contract due from a reinsurer if the reinsurer's credit quality (as determined by CDS price if available, or if not, its credit rating) is less than that of the Company's based upon the premise that the exit market for these contracts would be another monoline financial guarantee insurer that has similar credit rating or spread as the Company.
Insured Interest Rate Swaps and Financial Guarantee Contracts Deemed to be Derivatives
The Company insures IR swaps entered into in connection with the issuance of certain public finance obligations. Because the financial guaranty contract insures a derivative, the financial guaranty contract is deemed to be a derivative. Therefore, the contract is required to be carried at fair value, with the change in fair value being recorded in the determination of net income (loss). As there is no observable market for these policies, the fair value of these contracts is determined by using an internally-developed model and, therefore, they are classified as Level 3 in the valuation hierarchy.
Insured NIM securitizations issued in connection with certain mortgage-backed security financings and financial guaranty contracts with embedded derivatives are deemed to be hybrid instruments that contain an embedded derivative if they were issued after January 1, 2007. The Company elected to record these financial instruments at fair value under SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments." Changes in the fair value of these contracts are recorded in the consolidated statements of operations and comprehensive income. As there is no observable market for these policies, the fair value of these contracts is based on internally-derived estimates and they are, therefore, classified as Level 3 in the valuation hierarchy.
FP Segment Derivatives
Derivatives in the FP segment, except for those used to hedge the VIE debt, are valued using a pricing model that uses observable market inputs, such as interest rate curves, foreign exchange rates and inflation indices. These derivatives are therefore classified as Level 2 in the valuation hierarchy, except for exchange traded futures contracts, which are classified as Level 1, or Level 3 if any of the significant model inputs were not observable in the market. On the date of adoption, all derivatives used to hedge VIE debt were valued by obtaining prices from brokers or counterparties, and accordingly were classified as Level 3 in the valuation hierarchy. At December 31, 2008, the majority of these derivatives were valued using a pricing model that uses observable market inputs such as interest rate curves, foreign exchange rates and inflation indices. Therefore, these derivatives are classified as Level 2 in the valuation hierarchy at December 31, 2008. If a significant model input had been used that was not observable in the market, the derivative would have been classified as a Level 3 in the valuation hierarchy.
Other Assets and Other Liabilities and Minority Interest
Other assets primarily include receivables for securities sold, deferred compensation plans ("DCP"), supplemental executive retirement plans ("SERP"), and committed preferred trust securities ("CPS"). As there is no observable market for the Company's CPS, fair value of the CPS is based on internally-derived estimates and, therefore, is categorized as Level 3 in the fair value hierarchy.
The Company determined the fair value of the CPS by estimating the fair value of a floating rate security with an estimated market yield reflective of the underlying committed preferred security structure and the relevant coupon based on the capped auction rate.
Other liabilities and minority interest include payables for securities purchased and derivative obligations. For receivable for securities sold and payable for securities purchased, the carrying amount is cost, which approximates fair value because of the short maturity.
FP Segment Debt
The fair value of the FP segment debt is determined based on a discounted cash flow model. Fair value calculated by these models includes assumptions for interest rate curves based on selected
benchmark securities and weighted average expected lives. In addition, the valuation of the fair-valued liabilities includes an adjustment to reflect the credit quality of FSA that represents the impact of changes in market credit spreads on these liabilities. The fair-valued liabilities are categorized as Level 3 in the valuation hierarchy. See Note 4 for a description of the FP segment debt for which the Company elected fair value option.
Net Financial Guarantee Contracts Written
The fair value of net financial guarantees written is based on the estimated cost to the Company of transferring the outstanding insured portfolio to another financial guarantor of comparable credit standing, under current market conditions. The fair value of net financial guarantees written incorporates (i) deferred premium revenue, (ii) amounts recoverable from reinsurers on unpaid losses, (iii) estimated future installment premiums receivable, and (iv) losses and loss adjustment expenses. These fair values are based on inputs observable in the market, where available, as well as inputs which are not readily observable in the market. SFAS 157 requires the risk of nonperformance to be included in the estimation of fair value of financial liabilities. The Company's credit risk, as measured by the credit spread on its CDS, has been factored into the fair value of the financial guarantees written in order to account for the risk of nonperformance.
Notes Payable
For notes payable, the carrying amount represents the principal amount due at maturity. The fair value is based on the quoted market price or other third party sources.
The following table presents the financial instruments carried at fair value at December 31, 2008, by caption on the consolidated balance sheet and SFAS 157 valuation hierarchy.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
(1)As permitted by FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39," the Company has elected to net derivative receivables and payables and the related cash collateral received under a master netting agreement.
(2)At December 31, 2008, approximately 97% or $278.1 million of the credit derivative asset in the "assets: credit derivatives" line item above represents the fair value of derivative contracts where the Company purchases protection on its CDS exposure. The remaining 3% or approximately $9.3 million relates to the fair value of certain of the Company's primary contracts (i.e., sold protection), where the fair value is in an asset position because the cash flows necessary to exit such a contract, including the effect of the Company's creditworthiness as determined by CDS referencing the Company's principal insurance subsidiary, would be less than the contractual cash flows to be received. Reinsurance and direct derivative contracts, which call for contractual fees below (reinsurance) or in excess of (direct contracts) the current market price, represent a benefit to the Company and, accordingly, are accounted for as credit derivative assets. Non-Recurring Fair Value Measurements
Mortgage loans in the portfolio of assets acquired in refinancing transactions are carried at the lower of cost or market on an aggregate basis. At December 31, 2008, such investments were carried at their market value of $13.8 million. The mortgage loans are classified as Level 3 of the fair value hierarchy as there are significant unobservable inputs used in the valuation of such loans. An indicative dealer quote is used to price the non-performing portion of these mortgage loans. The performing loans are valued using management's determination of future cash flows arising from these loans, discounted at the rate of return that would be required by a market participant. This rate of return is based on indicative dealer quotes.
Changes in Level 3 Recurring Fair Value Measurements
The table below includes a rollforward of the balance sheet amounts for financial instruments classified by the Company within Level 3 of the valuation hierarchy for the year ended December 31, 2008. When a determination is made to classify a financial instrument within Level 3, the determination is based upon the significance of the unobservable data to the overall fair value measurement. However, Level 3 financial instruments may include, in addition to the unobservable or Level 3 components, observable components. Accordingly, the gains and losses in the table below include changes in fair value due in part to observable factors that are part of the valuation methodology.
Level 3 assets were 38.9% of total assets at December 31, 2008. Level 3 liabilities were 37.7% of total liabilities at December 31, 2008.
Level 3 Rollforward
(1)Realized and unrealized gains/(losses) from changes in values of Level 3 financial instruments represent gains/(losses) from changes in values of those financial instruments only for the periods in which the instruments were classified as Level 3.
(2)Transfers are assumed to be made at the beginning of the period.
(3)Included in net realized gains (losses) from general investment portfolio.
(4)Reported in net interest income from financial products segment if designated in a qualifying fair-value hedging relationship, or net realized gains (losses) from financial products segment if determined to be OTTI.
(5)Reported in net unrealized gains (losses) on financial instruments at fair value.
(6)Reported in net unrealized gains (losses) on financial instruments at fair value.
(7)Unrealized gains are reported in net unrealized gains (losses) on financial instruments at fair value and interest expense is recorded in net interest expense from financial products segment.
(8)Represents net position of derivatives. The consolidated balance sheet presents gross assets and liabilities based on net counterparty exposure.
(9)Reported in net interest income from financial products segment if designated in a qualifying fair-value hedging relationship, or net realized and unrealized gains (losses) on derivative instruments if not so designated.
(10)Reported in net change in fair value of credit derivatives.
The table below shows the carrying amount and fair value of the Company's other financial instruments:
Other Financial Instruments(2)
(1)Represents the portion of FP segment debt not carried at fair value.
(2)Excludes $1.3 billion of draws on the First Dexia Line of Credit outstanding at December 31, 2008. 4. FAIR VALUE OPTION
The Company adopted SFAS 159 effective January 1, 2008. SFAS 159 provides an option to elect fair value as an alternative measurement for selected financial assets and financial liabilities not previously carried at fair value. The fair-value option may be applied to single eligible instruments, is irrevocable and is applied only to entire instruments and not to portions of instruments. For a discussion of the Company's valuation methodologies, see Note 3.
The Company's fair value elections were intended to mitigate the volatility in earnings that had been created by recording financial instruments and the related risk management instruments on a different basis of accounting, to eliminate the operational complexities of applying hedge accounting or to conform to the fair value elections made by the Company in 2006 under its International Financial Reporting Standards reporting to Dexia. The requirement, under SFAS 157, to incorporate a reporting entity's own credit risk in the valuation of liabilities which are carried at fair value, has created additional volatility in earnings as credit risk is not hedged. The following table provides detail regarding the Company's elections by consolidated balance sheet line at January 1, 2008.
(1)Includes the reversal of $0.7 million of valuation allowances.
Elections
On January 1, 2008, the Company elected to record the following at fair value:
•Certain FP segment debt instruments including fixed-rate GICs and VIE liabilities for which interest rate risk is hedged using interest rate derivatives in accordance with the Company's risk management strategies. The fair value election enabled the Company to record GICs hedged with IR swaps and/or foreign exchange rate swaps at fair value without having to designate them in a fair value hedge relationship under SFAS 133, as it had previously.
•Certain fixed-rate assets in the portfolio of assets acquired in refinancing transactions. The fair value election enabled the Company to record those assets that are economically hedged with derivatives at fair value without having to designate them in a fair value hedge relationship under SFAS 133.
Changes in Fair Value under the Fair Value Option Election
The following table presents the pre-tax changes in fair value included in the consolidated statements of operations and comprehensive income for the year ended December 31, 2008, for items for which the SFAS 159 fair value election was made.
Net Unrealized Gains (Losses) on Financial Instruments at Fair Value
The table above includes gains of approximately $1.4 billion for the year ended December 31, 2008, that are attributable to changes in the Company's own credit spread.
Aggregate Fair Value and Aggregate Remaining Contractual Principal Balance Outstanding
The following table reflects the aggregate fair value and the aggregate remaining contractual principal balance outstanding at December 31, 2008, for certain assets acquired in refinancing transactions and FP segment debt for which the SFAS 159 fair value option has been elected.
(1)Includes $33.8 million of loans that are 90 days or more past due.
(2)The fair-value adjustment for FP segment debt considers interest rate, foreign exchange rates and the Company's own credit risk.
5. GENERAL INVESTMENT PORTFOLIO
The following table summarizes the components of the net investment income generated by the General Investment Portfolio:
The credit quality of fixed-income securities in the General Investment Portfolio based on amortized cost was as follows:
General Investment Portfolio Fixed-Income Securities by Rating
(1)Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2008.
(2)Includes U.S. Treasury obligations which comprised 7.4% of the portfolio as of December 31, 2008.
The General Investment Portfolio includes bonds insured by FSA ("FSA-Insured Investments") that were acquired in the ordinary course of business. Of the bonds included in the General Investment Portfolio at December 31, 2008, 6.6% were insured by FSA and 28.6% were insured by other monolines. All of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA guaranty, was in the Single-A range. These assets are included in the Company's surveillance process and, at December 31, 2008, no loss reserves were anticipated on any of these assets. See Note 26 for more information.
The amortized cost and fair value of the securities in the General Investment Portfolio were as follows:
General Investment Portfolio by Security Type
(1)The majority of foreign securities are government issues and corporate securities that are denominated primarily in U.K. pounds sterling.
(2)Includes $24.2 million of short-term investments that are restricted.
The following table shows the gross unrealized losses and fair value of bonds in the General Investment Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
Aging of Unrealized Losses of Bonds in General Investment Portfolio
(1)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $4.1 million, or 18.5% of its amortized cost.
(2)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $4.0 million, or 17.9% of its amortized cost.
(3)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $3.8 million, or 37.6% of its amortized cost.
(1)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $0.2 million, or 7.7% of its amortized cost.
(2)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $0.5 million, or 6.9% of its amortized cost.
(3)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $0.3 million, or 4.5% of its amortized cost. In 2008, the Company had realized gains for sales of bonds, offset in part by an OTTI charge of $6.0 million for several municipal bonds. There were no OTTI charges in the General Investment Portfolio in 2007 and 2006.
Management has determined that the remaining unrealized losses in fixed-income securities at December 31, 2008 are primarily attributable to the current interest rate environment and has concluded that these unrealized losses are temporary in nature based upon (a) the lack of principal or interest payment defaults on these securities, (b) the creditworthiness of the issuers, and (c) the Company's ability and current intent to hold these securities until a recovery in fair value or maturity. As of December 31, 2008 and 2007, 100% of the securities that were in a gross unrealized loss position were rated investment grade. Management has based its conclusions on current facts and circumstances. Events could occur in the future that could change management conclusions about its ability and intent to hold such securities.
The amortized cost and fair value of fixed-income securities in the General Investment Portfolio at December 31, 2008 and 2007, by contractual maturity, are shown below. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
Distribution of Fixed-Income Securities in General Investment Portfolio
by Contractual Maturity
(1)Stated maturities for mortgage-backed securities of three to 30 years at December 31, 2008 and of four to 30 years at December 31, 2007.
(2)Stated maturities for asset-backed securities of one to 15 years at December 31, 2008 and of one to 15 years at December 31, 2007. Proceeds from sales of long-term bonds from the General Investment Portfolio during 2008, 2007 and 2006 were $4,011.4 million, $3,568.2 million and $1,637.3 million, respectively. Proceeds from maturities of bonds for the General Investment Portfolio during 2008, 2007 and 2006 were $519.2 million, $189.2 million and $163.3 million, respectively. Gross gains of $51.8 million, $5.6 million and $0.9 million and gross losses of $52.2 million, $7.5 million and $5.8 million were realized on sales in 2008, 2007 and 2006, respectively.
Bonds and short-term investments at an amortized cost of $10.0 million and cash of $1.8 million at December 31, 2008 and bonds and short-term investments at an amortized cost of $10.1 million and cash of $1.8 million at December 31, 2007, were on deposit with regulatory authorities as required by insurance regulations.
Equity Investments
In 2008, the Company sold its investment in SGR Redeemable Preferred Shares. Amounts recorded by the Company in connection with SGR are as follows:
6. FP SEGMENT INVESTMENT PORTFOLIO
Within the FP Investment Portfolio, the Company classifies all securities as available-for-sale, except for securities owned by FSA-PAL which are classified as trading securities. The assets in the trading portfolio are bonds denominated in foreign currencies. The VIE Investment Portfolio is classified as available-for-sale at December 31, 2008.
FP Investment Portfolio
The following table sets forth the FP Investment Portfolio fixed income securities based on ratings:
FP Investment Portfolio Fixed Income Securities by Rating
(1)Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2008. Rating agencies continue to monitor the ratings on the residential mortgage-backed securities closely, and future adverse rating actions on these securities may occur.
The FP Investment Portfolio includes FSA-Insured Investments bought in the ordinary course of business. Of the bonds included in the available-for-sale FP Investment Portfolio at December 31, 2008, 4.5% were insured by FSA. At that date, 98.1% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA guaranty, was in the Triple-B range. Of the bonds included in the FP Investment Portfolio at December 31, 2008, 15.7% were insured by other monoline guarantors. These assets are included in the Company's surveillance process and, at December 31, 2008, no loss reserves were anticipated on any or these assets. See Note 26.
Trading Securities
During 2008, the Company recorded unrealized losses of $202.6 million in income related to the assets in the trading portfolio, compared with unrealized gains of $14.0 million in 2007 and $3.6 million in 2006.
Available-for-Sale Securities
The following tables present the amortized cost and fair value of available-for-sale bonds and short-term investments held in the FP Investment Portfolio:
Available-for-Sale Securities in the FP Investment Portfolio by Security Type
(1)Amortized cost includes fair value adjustments recorded as OTTI and hedge accounting adjustments.
(2)All securities in an unrealized loss position at December 31, 2008 were recorded in the statement of operations and comprehensive income as OTTI in net realized gains (losses) from financial products segment. See "-Review of FP Investment Portfolio for Other-than-Temporary Impairments."
(3)Includes primarily asset-backed, U.S. agency debentures and treasury securities. The following table shows the gross unrealized losses recorded in accumulated other comprehensive income and fair values of the available-for-sale bonds in the FP Investment Portfolio as of December 31, 2007, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position. There were no unrealized losses recorded in 2008. All securities in an unrealized loss position as of December 31, 2008, were recorded in OTTI.
Aging of Unrealized Losses of Available-for-Sale Bonds in the FP Investment Portfolio
(1)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $32.2 million, or 30.1% of its amortized cost.
(2)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $21.3 million, or 32.1% of its amortized cost.
(3)The largest unrealized loss on an individual investment, in terms of absolute dollars, was $6.3 million, or 18.0% of its amortized cost. For the year ended December 31, 2008, the OTTI charge in the FP Investment Portfolio was $8,397.9 million and was recorded in net realized gains (losses) from financial products segment. The amount of the OTTI charge recorded in the statement of operations and comprehensive income is not necessarily indicative of management's estimate of economic loss, but instead represents the write-down to current fair-value. Historically, the Company had the ability and intent to hold the FP Segment Investment Portfolio to maturity. However, the Company no longer has the intent to hold such securities to maturity, due to Dexia's agreement under the Purchase Agreement to retain the FP
operations and segregate or separate the FP operations from the Company's financial guaranty operations. As a result, the Company is required to record an OTTI charge for all assets in the Portfolio in an unrealized loss position at December 31, 2008.
The table below provides the composition of the OTTI charge by asset class.
Other-than-Temporary Impairment Charge
The amortized cost and fair value of the available-for-sale securities in the FP Investment Portfolio are shown below by contractual maturity. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. At December 31, 2008, the estimated weighted average expected life of the FP Investment Portfolio was 7.0 years.
Distribution of Available-for-Sale Securities
in the FP Investment Portfolio by Contractual Maturity
(1)Amortized cost includes fair-value adjustments recorded as OTTI and hedge accounting adjustments.
(2)Stated maturities for mortgage-backed securities of one to 39 years as of December 31, 2008 and of two to 39 years as of December 31, 2007.
(3)Stated maturities for asset-backed and other securities of three to 44 years as of December 31, 2008 and of four to 44 years as of December 31, 2007.
Proceeds from sales of available-for-sale bonds held in the FP Investment Portfolio during 2007 and 2006 were $2,971.7 million and $4,512.5 million, respectively. Sales were de minimus in 2008. Proceeds from maturities of bonds for the FP Investment Portfolio during 2008, 2007 and 2006 were $1,777.9 million, $3,299.0 million and $4,485.1 million, respectively. Gross losses were realized on sales during 2008 of $0.7 million. Gross gains were realized on sales during 2007 and 2006 of $13.0 million and $0.1 million, respectively.
VIE Investment Portfolio
All the investments supporting VIE liabilities are insured by FSA. The credit quality of the available-for-sale securities in the VIE Investment Portfolio, without the benefit of FSA's insurance, was as follows:
Available-for-Sale Securities in the VIE Investment Portfolio by Rating
(1)Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2008.
The amortized cost and fair value of available-for-sale bonds and short-term investments in the VIE Investment Portfolio were as follows:
Available-for-Sale Securities in the VIE Investment Portfolio by Security Type
Historically, the Company had the ability and intent to hold the FP Segment Investment Portfolio to maturity. However, the Company no longer has the intent to hold such securities to maturity, due to Dexia's agreement under the Purchase Agreement to retain the FP operations and segregate or separate the Company's FP operations from the Company's financial guaranty operations. As a result, the Company was required to record an OTTI charge for all assets in the portfolio in an unrealized loss position at December 31, 2008.
OTTI of $236.2 million was recorded in "net realized gains (losses) from financial products segment" on the VIE Investment Portfolio in 2008. At December 31, 2007, there were no securities in an unrealized loss position.
The amortized cost and fair value of available-for-sale bonds and short-term investments in the VIE Investment Portfolio by contractual maturity are shown below. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
Distribution of Available-for-Sale Securities
in the VIE Investment Portfolio by Contractual Maturity
(1)Stated maturities for asset-backed securities of one to 23 years at December 31, 2008 and of two to 24 years at December 31, 2007.
Proceeds from maturities of bonds for the VIE Investment Portfolio during 2007 and 2006 were $165.9 million and $24.7 million, respectively. There were no maturities for the VIE Investment Portfolio in 2008.
The Company pledges and receives collateral related to certain business lines or transactions. The following is a description of those arrangements by transaction type.
Securities Pledged to Note Holders
In the normal course of business, the Company may hold securities purchased under agreements to resell. A portion of these securities may be pledged to the Company's investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). However, such securities generally may not be rehypothecated by the investment agreement counterparty. The Company also pledges investments held in the FP Investment Portfolio to investment agreement counterparties. At December 31, 2008, $6,120.5 million of the assets held in the FP Investment Portfolio, together with related accrued interest, were pledged as collateral to investment agreement counterparties.
With respect to transactions governed by ISDA master agreements, FP Risk Management monitors net counterparty credit exposure and, when the exposure exceeds an agreed to limit, demands collateral from the counterparty in accordance with the relevant master agreement.
Securities Pledged to Derivative Counterparties
Securities purchased under agreements to resell are eligible to be pledged to certain interest rate swap counterparties. In general, under the terms of each of these counterparty-specific derivative agreements, the Company and its counterparty may be required to pledge collateral or transfer assets as a result of changes in the fair value of those derivative agreements. The timing and amount are generally dependent on which entity is exposed, as well as the credit rating of the party in the payable position. The Company and the counterparty typically have identical rights and obligations to pledge and rehypothecate collateral according to the terms included within each of the counterparty-specific derivative agreements. At December 31, 2008, $18.2 million of the assets held in the FP Investment Portfolio and related accrued interest were pledged as collateral to margin accounts. FSA Global, under the terms of its derivative agreements, is not required to pledge collateral. Its counterparties, however, may be required to pledge collateral or transfer assets to FSA Global.
At December 31, 2008, the Company had received $1,057.9 million of collateral from counterparties to reduce its net derivative exposure to such parties.
7. ASSETS ACQUIRED IN REFINANCING TRANSACTIONS
The Company has rights under certain of its financial guaranty insurance policies and indentures that allow it to accelerate the insured notes and pay claims under its insurance policies upon the occurrence of predefined events of default. To mitigate financial guaranty insurance losses, the Company may elect to purchase the outstanding insured obligation or its underlying collateral. Generally, refinancing vehicles reimburse FSA in whole for its claims payments in exchange for assignments of certain of FSA's rights against the trusts. The refinancing vehicles obtain their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Subsidiaries. The refinancing vehicles are consolidated into the Company's financial statements.
The following table presents the balance sheet components of the assets acquired in refinancing transactions:
Summary of Assets Acquired in Refinanced Transactions
The accretable yield on the securitized loans at December 31, 2008, 2007 and 2006 was $7.5 million, $148.8 million and $157.3 million, respectively.
The bonds within the refinanced asset portfolio all have contractual maturities of less than five years. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
8. DEFERRED ACQUISITION COSTS
Acquisition costs deferred and the related amortization charged to expense are as follows:
Rollforward of Deferred Acquisition Costs
9. LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the liability for losses and loss adjustment expenses, which consist of the case and non-specific reserves, is summarized below. Adjustments to reserves represent management's estimate of the amount required to cover the present value of the net cost of claims based on statistical provisions for new originations.
Reconciliation of Net Losses and Loss Adjustment Expenses
The following table shows the gross and net par outstanding on transactions with case reserves, the gross and net case reserves recorded and the number of transactions comprising case reserves.
Case Reserve Summary
(1)The amount of the discount at December 31, 2007 for the gross and net case reserves was $14.5 million and $3.3 million, respectively. The table below presents certain assumptions inherent in the calculations of the case and non-specific reserves:
Assumptions for Case and Non-Specific Reserves
During 2008, loss and loss adjustment expenses was $1,877.7 million. The increase for the year was driven primarily by deteriorating credit performance in home equity lines of credit ("HELOCs"), Alt-A closed end second lien mortgage securities ("CES"), Option adjustable rate mortgage loan ("Option ARMs"), Alt-A first lien and public finance transactions. "Alt-A" refers to borrowers whose credit falls between prime and subprime. In addition, the net non-specific reserves increased by $54.5 million for the year. Management's current reserve estimates assume loss levels for transactions backed by second-lien mortgage products will remain at their peaks until mid-2009 and slowly recover to more normal rates by mid-2010. For first-lien mortgage transactions, where losses take longer to develop than in second-lien mortgage transactions, peak conditional default rates are assumed to continue until mid-2010 and then decline linearly over 12 months to 25% of the peak, remain there for three years and then taper down to 5% of peak rates over several years.
The increase in losses paid is driven by payments on HELOC transactions. Generally, once the overcollateralization is exhausted on an insured HELOC transaction, the Company pays a claim if losses in a period exceed spread for the period, and, to the extent spread exceeds losses, the Company is reimbursed for any losses paid to date. In 2008, the Company paid net HELOC claims of $577.7 million. This brought the inception to date net claim payments on HELOC transactions to $625.3 million. There were no claims paid on most other classes of insured transactions through December 31, 2008. Most claim payments on Alt-A CES are not payable until 2037 or later. Option ARM claim payments are expected to occur between 2010 and 2012.
During 2007, the Company charged $31.6 million to loss expense, consisting of $25.8 million for originations of new business and $5.8 million related to accretion on the reserve for in-force business. Net case reserves increased $45.1 million in 2007 due primarily to the establishment of new case reserves for HELOC and public finance transactions, offset in part by the settlement of several pooled corporate collateralized bond obligations ("CBOs"), which were accrued for in prior years. As of December 31, 2007, an estimated ultimate loss (discounted to present value) of $65.0 million on HELOC transactions had been transferred from the non-specific reserve to case reserves, which increased the experience factor. Such estimate of loss is net of reinsurance and anticipated recoveries and is reevaluated on a quarterly basis. In the second half of 2007, the Company paid a total of $47.6 million in HELOC claims, of which $39.5 million represented what the Company deemed to be recoverable and was recorded as salvage and subrogation ("S&S") recoverable as of December 31, 2007.
During 2006, the Company charged $23.3 million to loss expense, consisting of $17.8 million for originations of new business and $5.5 million related to accretion on the reserve for in-force business. Net case reserves decreased $0.7 million due primarily to loss payments and some improvement in CBO transactions, offset in part by the establishment of a new case reserve for a municipal health care transaction.
The Company assigns each insured credit to one of five designated surveillance categories to facilitate the appropriate allocation of resources to monitoring, loss mitigation efforts and rating the credit condition of each risk exposure. Such categorization is determined in part by the risk of loss and in part by the level of routine involvement required. The surveillance categories are organized as follows:
•Categories I and II represent fundamentally sound transactions requiring routine monitoring, with Category II indicating that routine monitoring is more frequent, due, for example, to the sector or a need to monitor triggers.
•Category III represents transactions with some deterioration in asset performance, financial health of the issuer or other factors, but for which losses are deemed unlikely. Active monitoring and intervention is employed for Category III transactions.
•Category IV reflects transactions demonstrating sufficient deterioration to indicate that material credit losses are possible even though not yet probable.
•Category V reflects transactions where losses are probable. This category includes (1) risks where claim payments have been made and where ultimate losses, net of recoveries, are expected, and (2) risks where claim payments are probable but none have yet been made and ultimate losses, net of recoveries, are expected. Category IV and Category V transactions are subject to intense monitoring and intervention.
The tables below present the gross and net par and interest outstanding and deferred premium revenue in the insured portfolio for risks classified as described above:
Par and Interest Outstanding
Excluding Credit Derivatives
Case Reserves
Management periodically evaluates its estimates for losses and LAE and establishes reserves that management believes are adequate to cover the present value of the ultimate net cost of claims. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company's actual loss experience, its mix of business and economic conditions. However, because of the uncertainty involved in developing these estimates, the ultimate liability may differ materially from current estimates.
10. FINANCIAL PRODUCTS SEGMENT DEBT
FP segment debt consists of GIC and VIE debt. The obligations under GICs issued by the GIC Subsidiaries may be called at various times prior to maturity based on certain agreed-upon events. As of December 31, 2008, interest rates were between 1.18% and 8.71% per annum on outstanding GICs and between 1.98% and 6.22% per annum on VIE debt. Payments due under GICs are based on expected withdrawal dates, which are subject to change, and include accretion of $825.7 million. VIE debt includes $692.2 million of future interest accretion on zero-coupon obligations. The following table presents the combined principal amounts due under FP segment debt for 2009 and each of the next four years ending December 31, and thereafter:
Expected Maturity Schedule of FP Segment Debt(1)
(1)Excludes $1.3 billion of draws on the First Dexia Line of Credit outstanding as of December 31, 2008.
11. LONG-TERM DEBT
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption or, if greater, the make-whole redemption price. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, FSA Holdings entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of FSA Holdings long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by FSA Holdings or any of its subsidiaries on or before the date that is 20 years prior to the final repayment date, except to the extent that FSA Holdings has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings. The Junior Subordinated Debentures were issued at a discount of $1.2 million.
On July 31, 2003, the Company issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
On November 26, 2002, the Company issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt.
On December 19, 2001, the Company issued $100.0 million of 67/8% notes due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
12. OUTSTANDING EXPOSURE
The Company's insurance policies typically guarantee the scheduled payments of principal and interest on public finance and asset-backed (including credit derivatives in the insured portfolio) obligations. The gross amount of financial guaranties in force (principal and interest) was $813.9 billion at December 31, 2008 and $833.2 billion at December 31, 2007. The net amount of financial guaranties in force was $611.4 billion at December 31, 2008 and $598.3 billion at December 31, 2007.
The Company seeks to limit its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on asset-backed obligations, as well as through reinsurance.
Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. The expected maturities for asset-backed obligations are, in general, considerably shorter than the contractual maturities for such obligations. For asset-backed obligations, the full par outstanding for each insured risk is shown in the maturity category that corresponds to the final legal maturity of such risk:
Contractual Terms to Maturity of Net Par Outstanding of Insured Obligations
Contractual Terms to Maturity of Ceded Par Outstanding of Insured Obligations
The par outstanding of insured obligations in the public finance insured portfolio includes the following amounts by type of issue:
Summary of Public Finance Insured Portfolio
The par outstanding of insured obligations in the asset-backed insured portfolio includes the following amounts by type of collateral:
Summary of Asset-Backed Insured Portfolio
In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitizations, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not deemed by the Company to be significant, given other more relevant measures of diversification, such as issuer or industry diversification.
The Company seeks to maintain a diversified portfolio of insured public finance obligations designed to spread its risk across a number of geographic areas. The following table sets forth those states in which municipalities located therein issued an aggregate of 2% or more of the Company's net par amount outstanding of insured public finance securities:
Public Finance Insured Portfolio by Location of Exposure
13. FEDERAL INCOME TAXES
Dexia Holdings, FSA Holdings and its Subsidiaries, except FSA International, file a consolidated U.S. federal income tax return. Under the terms of a tax-sharing agreement, each company pays taxes on a separate return basis.
In addition, the Company and its subsidiaries or branches file separate tax returns in various states and local and foreign jurisdictions, including the United Kingdom, Japan, Mexico and Australia. With limited exceptions, the Company and its subsidiaries are no longer subject to income tax examinations for its 2004 and prior tax years for U.S. federal, state and local, or non-U.S. jurisdictions.
In connection with Dexia's acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. ("WMH"). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains Insurance Group, Ltd. ("White Mountains") for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains. While the Company had no legal liability in connection with the indemnity payment, the payment was treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a tax benefit of $16.5 million. In
addition, the Company shared 50% of the tax benefit with White Mountains when the required circumstances were satisfied in the third quarter of 2008.
The cumulative balance sheet effects of deferred federal tax consequences are as follows:
Components of Deferred Tax Assets and Liabilities
At December 31, 2008 and 2007, the Company had a net deferred tax asset before valuation allowance of $3.3 billion and $0.4 billion, respectively. A valuation allowance is required when it is more likely than not that a portion or all of a deferred tax asset will not be realized. All evidence, both positive and negative, needs to be identified and considered in making the determination. Future realization of the existing deferred tax asset will depend on the Company's ability to generate sufficient taxable income of appropriate character (i.e., ordinary income versus capital gains) within the carryback and carryforward periods available under the tax law.
The economic conditions adversely affecting the Company did not fully materialize and the Purchase Agreement was not entered into until 2008 and, thus, the Company did not provide any valuation allowance on its net deferred tax assets at December 31, 2007.
The net deferred tax asset of $3.3 billion at December 31, 2008 consists primarily of unrealized capital losses and foreign exchange losses of $3.0 billion, $368 million related to loss reserves, and $453 million related to mark to market on CDS, offset by other net liabilities. The unrealized losses were primarily generated from OTTI losses recognized in the FP investment portfolio. The Company's
management has concluded that a valuation allowance of $2.5 billion is required based on the following factors:
1.The Company's unrealized capital and foreign exchange losses in the FP Investment Portfolio, if realized, would trigger capital losses which, for tax benefit purposes, could only be offset against capital gains. Capital losses could be carried back up to three years to offset capital gains realized in the prior three years and then carried forward for up to five years. Compelling negative evidence exists since there is no assurance that the Company could generate sufficient capital gains to offset these capital losses. Positive evidence exists if the Company were able to hold the FP Investment Portfolio to maturity, thus realizing only the losses due to impairment. The Company no longer definitively asserts that it has the ability and intent to hold the FP Investment Portfolio to maturity and has accordingly established a valuation allowance of $2.5 billion. A full valuation allowance of $3.0 billion was not established primarily because a portion of the loss is ordinary due to FSA's insurance of certain troubled FP assets and its ability to offset capital losses with gains on fair valued liabilities at FSA Global.
2.The $368 million tax benefit from loss reserves and $453 million from CDS would be realizable against future ordinary income. Negative evidence includes the uncertainty of selling financial guaranty policies in the future as well as the stability of the Company's credit rating by the three principal rating agencies. However, the Company has substantial streams of future premium earnings from its in force insured portfolio, with the total aggregating to approximately $3.5 billion at December 31, 2008. Even with the uncertainty of future business and the stability of the Company's credit rating, future premium revenues, coupled with investment income less expenses, are expected to be more than sufficient to offset current incurred losses, including credit derivatives losses. The Company's loss reserves represent the discounted value of future claims. Therefore, the accretion of losses to the undiscounted future value has also been taken into consideration, and the Company does not anticipate any significant additional loss trends. The Company expects future accretion on loss reserves of about $410.2 million. In addition, except for true credit losses, mark-to-market losses from CDS contracts will reverse over time. As the mark-to-market losses reverse, the deferred tax asset will also reverse. To the extent that true credit losses increase, the related mark-to-market losses will not fully reverse and the Company may not be able to offset such future losses against future ordinary income.
The Company treats its CDS contracts as insurance contracts for U.S. tax purposes. The current federal tax treatment of CDS contracts is an unsettled area of tax law. Market participants are generally treating CDS contracts for tax purposes as either: (1) notional principal contract ("NPC") derivative instruments, (2) guarantees, (3) insurance contracts, or (4) capital assets. The Company believes that it is more likely than not that its CDS contracts are either NPC or insurance contracts. Both receipts and payments arising from NPC and insurance contracts are characterized as ordinary income (although a termination of a CDS contract as an NPC may be treated as a capital transaction). Although the Company believes it is properly treating potential losses on its CDS contracts as ordinary, there are no assurances that the Internal Revenue Service ("IRS") will agree with the Company. Should the IRS disagree with the Company and characterize such losses, if any, as capital losses, the Company's ability to realize a related tax asset would be more limited, possibly leading to a reduction or elimination of the related deferred tax asset.
In 2008 and 2007, the Company recognized a tax benefit of $5.6 million and $4.2 million respectively, which include the benefit of $1.4 million and $0.7 million of interest, respectively, from the expiration of the statute of limitations for the 2004 and 2003 tax years.
A reconciliation of the effective tax rate (before minority interest and equity in earnings of unconsolidated affiliates) with the federal statutory rate follows:
Effective Tax Rate Reconciliation
The 2008 effective tax rate reflects a lower than expected benefit of 35% due to the establishment of valuation allowance of $2.5 billion, offset by benefits from tax-exempt interest income and the tax-exempt fair value adjustments related to the Company's committed preferred securities. The 2007 and 2006 rates differ from the statutory rate of 35% due primarily to tax-exempt interest. The 2007 rate reflects an unusually high benefit due to the disproportionately low amount of pre-tax income to tax-exempt interest.
The total amount of unrecognized tax benefits at December 31, 2008 and December 31, 2007 was $15.1 million and $19.2 million, respectively. If recognized, the entire amount would favorably affect the effective tax rate. The Company recognizes interest and penalties related to unrecognized tax benefits as part of income taxes. For the year ended December 31, 2008 and 2007, the Company recognized a benefit of $0.9 million and an expense of approximately $0.4 million, respectively, related to interest and penalties. Cumulative interest and penalties of approximately $1.4 million and $2.3 million have been accrued on the Company's balance sheet at December 31, 2008 and December 31, 2007, respectively. A reconciliation of the beginning to ending unrecognized tax benefits follows:
Reconciliation of Unrecognized Tax Benefit
The Company believes that within the next 12 months, it is reasonably possible that unrecognized tax benefits for positions taken on previously filed tax returns will become recognized as a result of the expiration of statute of limitations for the 2005 tax year, which absent any extension, will close in September 2009.
14. EMPLOYEE BENEFIT PLANS
Defined Contribution Plans
The Company maintains both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of
employee compensation. Pension expense, which is funded annually, amounted to $6.8 million, $7.7 million and $7.5 million for the years ended December 31, 2008, 2007 and 2006, respectively.
The Company has an employee retirement savings plan for the benefit of eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by Internal Revenue Code Section 401(k). Contributions by the Company are discretionary, and none have been made.
Equity Participation Plans
Through 2004, performance shares were awarded under the 1993 Equity Participation Plan (the "1993 Equity Plan"). The 1993 Equity Plan authorized the discretionary grant of performance shares by the Human Resources Committee to key employees. The amount earned for each performance share depends on the attainment of certain growth rates of adjusted book value as defined by the 1993 Equity Plan, and book value per outstanding share over specified three-year performance cycles.
Performance shares issued prior to January 1, 2005 permitted the participant to elect, at the time of award, growth rates including or excluding realized and unrealized gains and losses on the investment portfolios. Performance shares issued after January 1, 2005 do not offer the option to include the impact of unrealized gains and losses on the investment portfolios. No payout occurs if the compound annual growth rate of adjusted book value and book value per outstanding share over specified three-year performance cycles is less than 7%, and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%.
In 2004, the Company adopted the 2004 Equity Participation Plan (the "2004 Equity Plan"), which continues the incentive compensation program formerly provided under the Company's 1993 Equity Participation Plan. The 2004 Equity Plan provides for performance share units comprised 90% of performance shares (which provide for payment based upon the Company's performance over two specified three-year performance cycles) and 10% of shares of Dexia restricted stock. Performance shares have generally been awarded on the basis of two sequential three-year performance cycle, with one-third of each award allocated to the first cycle, which commences on the date of grant, and two-thirds of each award allocated to the second cycle, which commences one year after the date of grant. The Company recognizes expense ratably over the course of each three-year performance cycle. The total number of performance shares authorized under this plan was 3.3 million. At December 31, 2008, 2.3 million performance shares remained available for distribution.
The Dexia restricted stock component is a fixed plan, where the Company purchases Dexia shares and establishes a prepaid expense for the amount paid, which is amortized over 2.5-year and 3.5-year vesting periods. In 2008 and 2007, FSA purchased shares that economically defeased its liability for $3.8 million and $4.7 million, respectively. These amounts are being amortized to expense over the employees' vesting periods. For the years ended December 31, 2008, 2007 and 2006, the after-tax amounts amortized into income were $3.1 million, $2.7 million and $1.9 million, respectively.
Performance shares granted under the 1993 Equity Plan and 2004 Equity Plan are as follows:
Performance Shares
At December 31, 2008, 276,842 outstanding performance shares were fully vested, with a value of $0. At December 31, 2008, the total compensation cost related to non-vested performance shares (not yet recognized) was $0.
At December 31, 2007, 349,533 outstanding performance shares were fully vested, with a value of $46.6 million. These amounts were paid in the first quarter of 2008. At December 31, 2007, the total compensation cost related to non-vested performance shares not yet recognized was $130.2 million.
The estimated final cost of these performance shares is accrued over the performance period. The after-tax benefit of $42.6 million for the year ended December 31, 2008 and expense of $40.0 million and $37.3 million for the years ended December 31, 2007 and 2006, respectively, was recorded for the performance shares. In 2008, the accrual for performance shares was completely written off to reflect the Company's performance, resulting in a benefit to income.
Awards of Dexia restricted stock remain restricted for an additional six months after the end of each vesting period. Shares of Dexia restricted stock purchased under the 2004 Equity Plan are as follows:
Dexia Restricted Stock Shares
Director Share Purchase Program
In the fourth quarter of 2000, the Company purchased 304,757 shares of its common stock from Dexia Holdings for $24.0 million. Additional purchases are intended to fund obligations relating to the Company's Director Share Purchase Program ("DSPP"), which enables its participants to make deemed investments in the Company's common stock under the Deferred Compensation Plan and Supplemental Executive Retirement Plan. Under the DSPP, the deemed investments in the Company's stock are irrevocable, settlement of the deemed investments must be in stock and, after receipt, the participants must generally hold the stock for at least six months. Restricted treasury stock is distributed to a director as a DSPP payout at the end of applicable restriction periods.
The Company purchased and distributed shares of its common stock under the DSPP in the following amounts:
Director Share Purchase Program Shares
15. CREDIT DERIVATIVES IN THE INSURED PORTFOLIO
The components of the net change in the fair value of credit derivatives are shown in the table below:
Summary of the Net Change in the Fair Value of Credit Derivatives
(1)Includes amounts that in prior periods were classified as premiums earned. The fair value of credit derivatives is reported in the balance sheet as "other assets" or "other liabilities and minority interest" based on the net gain or loss position with each counterparty. The unrealized component includes the market appreciation or depreciation of the derivative contracts, as discussed in Note 3.
Unrealized Gains (Losses) of the Credit Derivative Portfolio(1)
(1)Upon the adoption of SFAS 157, $40.9 million pre-tax, or $26.6 million after tax, was recorded as an adjustment to beginning retained earnings related to credit derivatives.
(2)Two insured CDS and five NIM securitizations had credit impairment totaling $152.4 million in 2008.
Prior to the adoption of SFAS 157 on January 1, 2008 (the "Adoption Date"), the Company followed EITF 02-03. Under EITF 02-03, the Company was prohibited from recognizing a profit at the inception of its CDS contracts (referred to as "day one" gains) because the fair value of those derivatives is based on a valuation technique that incorporated unobservable inputs. Accordingly, the Company deferred approximately $40.9 million pre-tax of day one gains related to the fair value of CDS contracts purchased that were not permitted to be recognized under EITF 02-03. As SFAS 157 nullified the guidance in EITF 02-03, the Company recognized a transition adjustment totaling $40.9 million of previously deferred day one gains (pre-tax) in beginning retained earnings on the Adoption Date. See Note 3 for further discussion of the Company's adoption of SFAS 157.
The negative fair-value adjustments for the year ended December 31, 2008 were a result of continued widening of credit spreads in the insured CDS portfolio, offset in part by the positive income effects of the Company's own credit spread widening. Despite the structural protections associated with CDS contracts written by FSA, the significant widening of credit spreads on pooled corporate CDS and funded CDOs and CLOs, as with other structured credit products, resulted in a decline in the fair value of these contracts compared with December 31, 2007.
As the fair value of a CDS contract incorporates all the remaining future payments to be received over the life of the CDS contract, the fair value of that contract will change, in part, solely from the passage of time as fees are received.
The Company's typical CDS contract is different from CDS contracts entered into by parties that are not financial guarantors because:
•CDS contracts written by FSA are neither held for trading purposes (i.e., a short-term duration contract written for the purpose of generating trading gains) nor used as hedging instruments. Instead, they are written with the intent to provide protection for the stated duration of the contract, similar to the Company's intent with regard to a financial guaranty contract.
•FSA is not entitled to terminate its CDS contracts and realize a profit on a position that is "in the money." A counterparty to a CDS contract written by FSA generally is not able to force FSA to terminate a CDS contract that is "out of the money."
•The liquidity risk present in most CDS contracts sold outside the financial guaranty industry (i.e., the risk that the CDS writer would be required to make cash payments) is not present in a CDS contract sold by a financial guarantor. Terms of the CDS contracts are designed to replicate the payment provisions of financial guaranty contracts in that (a) losses, if any, are generally paid over time subject to market value termination payments generally due in the event of insurer insolvency, and (b) the financial guarantor is not required to post collateral to secure its obligation under the CDS contract.
CDS contracts in the asset-backed portfolio represent 71.2% of total asset-backed par outstanding. The Company has grouped CDS contracts by major category of underlying instrument for purposes of internal risk management and external reporting. The tables below summarize the credit rating, net par outstanding and remaining weighted average lives for the primary components of the Company's CDS portfolio. Net par outstanding in the table below is also included in the tables in Note 12.
Selected Information for CDS Portfolio
(1)Triple-A*, also referred to as "Super Triple-A," indicates a level of first-loss protection generally exceeding 1.3 times the level required by a rating agency for a Triple-A rating.
(2)Various investment grades below Double-A minus.
(3)Amount includes two CDS contracts with Triple-C underlying ratings. These two risks incurred economic losses at December 31, 2008.
(4)Net par outstanding represents the net maximum potential amount of future payments which the Company could be required to make.
(5)Amounts include transactions previously wrapped by other monolines.
(6)Primarily infrastructure obligations and European mortgage-backed securities. Also includes $375.2 million and $421.4 million at December 31, 2008 and 2007, respectively, in U.S. RMBS net par outstanding. All U.S. RMBS exposures were rated Triple-B or higher. Includes certain pooled corporate obligations. 16. FINANCIAL PRODUCTS SEGMENT DERIVATIVE INSTRUMENTS AND HEDGE ACCOUNTING
The Company enters into derivative contracts to manage interest rate and foreign currency exposure in its FP Segment Investment Portfolio and FP segment debt.
As a result of market interest rate fluctuations, fixed-rate assets and liabilities appreciate or depreciate in market value. Gains or losses on the derivative instruments that are linked to the fixed-rate assets and liabilities being hedged are expected to substantially offset this unrealized appreciation or depreciation relating to the risk being hedged.
The Company uses foreign currency contracts to manage the foreign exchange risk associated with certain foreign currency-denominated assets and liabilities. Gains or losses on the derivative instruments that are linked to the foreign currency denominated assets or liabilities being hedged are expected to substantially offset this variability.
In order for a derivative to qualify for hedge accounting, it must be highly effective at reducing the risk associated with the exposure being hedged. In order for a derivative to be designated as a hedge, there must be documentation of the risk management objective and strategy, including identification of the hedging instrument, the hedged item and the risk exposure, and how effectiveness is to be assessed prospectively and retrospectively. To assess effectiveness, the Company uses analysis of the sensitivity of fair values to changes in the risk being hedged, as well as dollar value comparisons of the change in the fair value of the derivative to the change in the fair value of the hedged item that is attributable to the risk being hedged. The extent to which a hedging instrument has been and is expected to continue to be effective at achieving offsetting changes in fair value must be assessed and documented at least quarterly. Any ineffectiveness must be reported in current-period earnings. If it is determined that a derivative is not highly effective at hedging the designated exposure, hedge accounting is discontinued.
An effective fair-value hedge is defined as one whose periodic change in fair value is 80% to 125% correlated with the change in fair value of the hedged item. The difference between a perfect hedge (i.e., the change in fair value of the hedge and hedged item offset one another so that there is zero effect on the consolidated statements of operations and comprehensive income, referred to as being "100% correlated") and the actual correlation within the 80% to 125% effectiveness range is the ineffective portion of the hedge. A failed hedge is one whose correlation falls outside of the 80% to 125% effectiveness range.
The net gain related to the ineffective portion of the Company's fair-value hedges including changes in fair value of hedging instruments related to the passage of time, which was excluded from the assessment of hedge ineffectiveness, was $2.8 million in 2007 and $9.3 million in 2006. For 2008, this measure is not meaningful as substantially all assets in fair value hedging relationships have been recorded in the statement of operations and comprehensive income as OTTI.
The inception-to-date net unrealized gain on derivatives (excluding accrued interest and collateral) in the FP segment of $1,278.4 million and $560.4 million at December 31, 2008 and 2007, respectively, is recorded in "other assets" or "other liabilities and minority interest," as applicable.
Changes in Hedge Accounting Designations
In 2007, the Company designated certain IR swaps, which economically hedged FP segment GIC liabilities, as being in fair value hedging relationships. All derivative income, expense and fair value adjustments were reflected in the caption "Net interest expense from financial products segment" in order to offset interest expense and fair value adjustments on the hedged interest rate risk of the GICs, which were also recorded in that caption. With the adoption of SFAS 159 on January 1, 2008, the Company elected to discontinue hedge accounting for these GICs and elected the fair value option for certain liabilities in the FP segment debt portfolio, as described in Note 4. The fair value option allows the fair value adjustment on these liabilities to be recorded in earnings without hedge documentation and effectiveness testing requirements prescribed under SFAS 133. However, when the fair value option is elected, the fair value adjustment of liabilities must incorporate all components of fair value, including valuation adjustments related to the reporting entity's own credit risk. Under hedge accounting, only the component of fair value attributable to the hedged risk (i.e., market interest rate risk) was recorded in earnings.
As of January 1, 2008, fixed-rate assets in the available-for-sale FP Segment Investment Portfolio that were economically hedged with interest rate swaps were designated in fair value hedging relationships. Prior to January 1, 2008, changes in the fair value of these economically hedged assets
were recorded in "accumulated other comprehensive income," whereas the corresponding changes in fair value of the related hedging instrument were recorded in earnings. Under fair value hedge accounting, the fair value adjustments related to the hedged risk are recorded in earnings and adjust the amortized cost basis of the related assets. The interest and fair value adjustments on the derivatives and the interest income and fair value adjustment on the assets attributable to the hedged interest rate risk are recorded in "net interest income from financial products segment" in the consolidated statements of operations and comprehensive income, thereby offsetting each other and reflecting economic inefficiency on the hedging relationship in earnings. The Company does not seek to apply hedge accounting to all of its economic hedges.
Other Derivatives
The Company enters into various other derivative contracts that do not qualify for hedge accounting treatment. These derivatives may include swaptions, caps and other derivatives, which are used principally as protection against large interest rate movements. Gains and losses on these derivatives are reflected in "net realized and unrealized gains (losses) on other derivative instruments" in the consolidated statements of operations and comprehensive income.
17. MINORITY INTEREST IN FSA GLOBAL
On April 28, 2006, the Company increased its ownership of the ordinary shares of FSA Global from 29% to 49% through an acquisition of shares from an unaffiliated third party. Immediately thereafter, FSA Global's charter documents were amended to create a new class of nonvoting preference shares, which was issued to the Company. Holders of such preference shares have exclusive rights to any future dividends and, upon any winding up of FSA Global, all net assets available for distribution to shareholders (after a distribution of $250,000 to the ordinary shareholder). As a result of the issuance of such preference shares, (a) a substantive sale and purchase of an interest took place between the ordinary shareholders of FSA Global and the Company, resulting in an assessment and recording of the fair value of the assets and liabilities sold and purchased at the time of such transaction, and (b) the Company's minority interest liability associated with FSA Global was eliminated. In the second quarter of 2006, the Company realized a pre-tax gain of $1.8 million as a result of this transaction. Prior to this transaction, the Company recorded minority interest for the 71% of FSA Global common equity not owned by the Company.
18. REINSURANCE
The Company obtains reinsurance to increase its policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Company reinsures portions of its risks with affiliated (see Note 24 for more information) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis.
Reinsurance does not relieve the Company of its obligations to policyholders. In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company may be unable to recover amounts due. A number of FSA's reinsurers are required to pledge collateral to secure their reinsurance obligations to FSA in an amount equal to their statutory unearned premium, loss and contingency reserves associated with the ceded business. FSA requires collateral from reinsurers primarily to (a) receive statutory credit for the reinsurance, (b) provide liquidity to FSA in the event of claims on the reinsured exposures, and (c) enhance rating agency credit for the reinsurance.
Amounts of ceded and assumed business were as follows:
Summary of Reinsurance
The Company cedes approximately 23% of its gross par insured to a diversified group of reinsurers, including other monolines. Based on ceded par outstanding at December 31, 2008, 56.1% of FSA's reinsurers were rated Double-A- or higher at March 13, 2009. Some are still under review by rating agencies. The Company's reinsurance contracts generally allow the Company to recapture ceded business after certain triggering events, such as reinsurer downgrades. Included in the table below is $12,099 million in ceded par outstanding related to insured CDS.
Reinsurance Recoverable and Ceded Par Outstanding by Reinsurer and Ratings
(1)The Company has structural collateral agreements satisfying the Triple-A credit requirement of S&P and/or Moody's.
(2)Includes a credit-linked note issuer that is fair valued as part of the Company's credit derivative portfolio. In 2008, $28.5 million of net premiums earned resulted from commutations or cancellations of reinsurance contracts. The largest such transactions were with SGR and Bluepoint Re. Limited ("Bluepoint").
In July 2008, FSA agreed to re-assume all reinsurance ceded to SGR, which consisted of $8.4 billion in outstanding par, in exchange for the June 30, 2008 statutory basis ceded unearned premium, net of its applicable ceding commission, any case basis reserves established at that date and a $35.0 million commutation premium. FSA agreed to cede a portion of this business, approximately $6.4 billion of outstanding par with no outstanding case basis reserves, to Syncora Guarantee Inc. ("SGI") (formerly XL Capital Assurance), an affiliate of SGR, as of the re-assumption date. Ceded net unearned premiums and future ceded case reserves are secured by collateral then held in a trust. Since SGI was an affiliate of SGR, FSA did not consider the portion of the business bought back from SGR and subsequently ceded to SGI as commuted and as a result did not record any commutation gain on that portion of the business. FSA recorded a commutation gain of $10.0 million on the business it retained, which was recorded in "other income" in the statement of operations and comprehensive income. In 2008, $14.8 million of earned premium related to this commutation.
In September 2008, FSA agreed to re-assume a portion of the business it ceded to SGI in July for the statutory basis ceded unearned premium, net of its applicable ceding commissions. This resulted in a commutation gain of $10.0 million, which was recorded in "other income" in the statement of operations and comprehensive income. In 2008, $1.5 million of earned premium related to this commutation.
Due to a liquidation order against Bluepoint, FSA is treating all reinsurance ceded to Bluepoint as cancelled as of the August 29, 2008 date of the liquidation order. Subsequent to September 30, 2008, in accordance with guidance obtained from the New York Insurance Department, FSA drew down from collateral maintained in trust by Bluepoint an amount equal to the net statutory basis unearned premium and case basis reserves and, as a result, FSA was able to take credit for such balances. In 2008, $9.4 million of earned premium related to this commutation.
19. OTHER ASSETS AND OTHER LIABILITIES AND MINORITY INTEREST
The detailed balances that comprise "other assets" and "other liabilities and minority interest" at December 31, 2008 and 2007 are as follows:
Other Assets
Other Liabilities and Minority Interest
20. COMMITMENTS AND CONTINGENCIES
Leases
Effective June 2004, the Company entered into a 21-year sublease agreement with Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York, to be used as the Company's headquarters. The Company moved to this space in June 2005. The lease contains scheduled rent increases every five years after a 19-month rent-free period, as well as lease incentives for initial construction costs of up to $6.0 million, as defined in the sublease. The lease contains provisions for rent increases related to increases in the building's operating expenses. The lease also contains a renewal option for an additional ten-year period and an option to rent additional office space at various points in the future, in each case at then-current market rents. In addition, the Company and its Subsidiaries lease additional office space under non-cancelable operating leases, which expire at various dates through 2013.
Future Minimum Rental Payments
Rent expense was $10.6 million in 2008, $10.2 million in 2007 and $10.7 million in 2006.
Insured Portfolio
In connection with its financial guaranty business, the Company had outstanding commitments to provide guarantees of $4,639.4 million as of December 31, 2008. These commitments are typically short term and principally relate to primary and secondary public finance debt issuances. Commitments are contingent on the satisfaction of all conditions set forth in the contract. These commitments may expire unused or be cancelled at the counterparty's request. Therefore, the total commitment amount does not necessarily reflect actual future guaranteed amounts.
Legal Proceedings
The entitlements of the Chief Executive Officer and the President of the Company under their employment agreements with the Company are in dispute. In addition, holders of shares under the
Director Share Purchase Program are in discussions with Dexia regarding the proper valuation of such shares, which may lead to mediation or arbitration of the dispute.
In November 2006, (i) the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs and other municipal derivatives and (ii) FSA received a subpoena from the SEC related to an ongoing industry-wide investigation concerning the bidding of municipal GICs and other municipal derivatives. Pursuant to the subpoenas the Company has furnished to the DOJ and SEC records and other information with respect to the Company's municipal GIC business. On February 4, 2008, the Company received a "Wells Notice" from the staff of the Philadelphia Regional Office of the SEC relating to the foregoing matter. The Wells Notice indicates that the SEC staff is considering recommending that the SEC authorize the staff to bring a civil injunctive action and/or institute administrative proceedings against the Company, alleging violations of Section 10(b) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") and Rule 10b-5 thereunder and Section 17(a) of the Securities Act of 1933, as amended. The Company has had ongoing discussions with the DOJ and the SEC. The ultimate loss that may arise from these investigations remains uncertain.
During 2008 nine putative class action lawsuits were filed in federal court alleging federal antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. These cases have been coordinated and consolidated for pretrial proceedings in the U.S. District Court for the Southern District of New York as MDL 1950, In re Municipal Derivatives Antitrust Litigation, Case No. 1:08-cv-2516 ("MDL 1950").
Five of these cases name both the Company and FSA: (a) Hinds County, Mississippi v. Wachovia Bank, N.A. (filed on or about March 13, 2008); (b) Fairfax County, Virginia v. Wachovia Bank, N.A. (filed on or about March 12, 2008); (c) Central Bucks School District, Pennsylvania v. Wachovia Bank N.A. (filed on or about June 4, 2008); (d) Mayor & City Counsel of Baltimore, Maryland v. Wachovia Bank N.A. (filed on or about July 3, 2008); and (e) Washington County, Tennessee v. Wachovia Bank N.A. (filed on or about July 14, 2008). Four of the cases name only the Company and also allege that the defendants violated state antitrust law and common law by engaging in illegal bid-rigging and market allocation, thereby depriving the cities of competition in the awarding of GICs and ultimately resulting in the cities paying higher fees for these products: (a) City of Oakland, California v. AIG Financial Products Corp. (filed on or about April 23, 2008); (b) County of Alameda, California v. AIG Financial Products Corp. (filed on or about July 8, 2008); (c) City of Fresno, California v. AIG Financial Products Corp. (filed on or about July 17, 2008); and (d) Fresno County Financing Authority v. AIG Financial Products Corp. (filed on or about December 24, 2008).
Interim lead counsel for the MDL 1950 plaintiffs filed a Consolidated Class Action Complaint ("Consolidated Complaint") in August 2008 alleging violations of the federal antitrust laws. Defendants filed motions to dismiss the Consolidated Complaint. The MDL 1950 court has determined that it will handle federal claims alleged in the Consolidated Complaint before addressing state claims. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
The Company and FSA also are named in five non-class actions originally filed in the California Superior Courts alleging violations of California law related to the municipal derivatives industry:
(a)City of Los Angeles v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of Los Angeles, Case No. BC 394944, removed to the U.S. District Court for the Central District of California ("C.D. Cal.") as Case No. 2:08-cv-5574, transferred to S.D.N.Y. as Case No. 1:08-cv-10351);
(b)City of Stockton v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-477851, removed to the N.D. Cal. as Case No. 3:08-cv-4060, transferred to S.D.N.Y. as Case No. 1:08-cv-10350);
(c)County of San Diego v. Bank of America, N.A. (filed on or about August 28, 2008 in the Superior Court of the State of California in and for the County of Los Angeles, Case No. SC 99566, removed to C.D. Cal. as Case No. 2:08-cv-6283, transferred to S.D.N.Y. as Case No. 1:09-cv-1195);
(d)County of San Mateo v. Bank of America, N.A. (filed on or about October 7, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-480664, removed to N.D. Cal. as Case No. 3:08-cv-4751, transferred to S.D.N.Y. as Case No. 1:09-cv-1196); and
(e)County of Contra Costa v. Bank of America, N.A. (filed on or about October 8, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-480733, removed to N.D. Cal. as Case No. 4:08-cv-4752, transferred to S.D.N.Y. as Case No. 1:09-cv-1197).
These cases have been transferred to the S.D.N.Y. and consolidated with MDL 1950 for pretrial proceedings. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
The Company has received various regulatory inquiries and requests for information regarding a variety of subjects. These include subpoenas duces tecum and interrogatories from the State of Connecticut Attorney General and the Attorney General of the State of California related to antitrust concerns associated with the methodologies used by rating agencies for determining the credit rating of municipal debt, including a proposal by Moody's to assign corporate equivalent ratings to municipal obligations, and the Company's communications with rating agencies. The Company is in the process of satisfying such requests. The Company may receive additional inquiries from these or other regulators and expects to provide additional information to such regulators regarding their inquiries in the future.
In December 2008 and January 2009, FSA and various other financial guarantors were named in three complaints filed in the Superior Court, San Francisco County: (a) City of Los Angeles Department of Water and Power v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CG-08-483689; Sacramento Municipal Utility District v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CGC-08-483691; and (c) City of Sacramento v. Ambac Financial Group Inc. et. al (filed on or about January 6, 2009), Case No. CGC-09-483862. These complaints alleged participation in a conspiracy in violation of California's antitrust laws to maintain a dual credit rating scale that misstated the credit default risk of municipal bond issuers and created market demand for municipal bond insurance and participation in risky financial transactions in other lines of business that damaged each bond insurer's financial condition (thereby undermining the value of each of their guaranties), and a failure to adequately disclose the impact of those transactions on their financial condition. These latter allegations form the predicate for five separate causes of action against each of the Insurers: breach of contract, breach of the covenant of good faith and fair dealing, fraud, negligence, and negligent misrepresentation. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
In August 2008 a number of financial institutions and other parties, including FSA, were named as defendants in a civil action brought in the circuit court of Jefferson County, Alabama relating to the County's problems meeting its debt obligations on its $3.2 billion sewer debt: Charles E. Wilson vs. JPMorgan Chase & Co et al (filed on or about August 8, 2008 in the Circuit Court of Jefferson County, Alabama), Case No. 01-CV-2008-901907.00, a putative class action. The action was brought on
behalf of rate payers, tax payers and citizens residing in Jefferson County, and alleges conspiracy and fraud in connection with the issuance of the County's debt. The complaint in this lawsuit seeks unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from this lawsuit. FSA was also named as a defendant in a second civil action regarding Jefferson County, Alabama, but was dismissed from such action in January 2009.
There are no other material legal proceedings pending to which the Company is subject.
21. DIVIDENDS AND CAPITAL REQUIREMENTS
Because the majority of the Company's operations are conducted through FSA, the long-term ability of FSA Holdings to service its debt will largely depend on its ability to extract cash from FSA in the form of FSA's repurchase of its stock or receipt of dividends from FSA.
FSA's ability to pay dividends or repurchase shares depends on FSA's financial condition, results of operations, cash requirements, rating agency capital adequacy and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders' surplus as of its last statement filed with the Superintendent of Insurance of the State of New York (the "New York Superintendent") or (b) adjusted net investment income during this period. FSA paid dividends of $30.0 million in 2008, no dividends in 2007 and $140.0 million in 2006. Based upon FSA's statutory statements for December 31, 2008, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $62.0 million, subject to certain limitations.
In lieu of dividends, FSA may repurchase shares of its common stock from shareholders, subject to the New York Superintendent's approval. The New York Superintendent has approved the repurchase by the Company of up to $500.0 million of its shares from FSA Holdings through December 31, 2008. FSA repurchased $70.0 million of its common stock during the first six months of 2008, and retired the shares. As the amounts paid for repurchases may not exceed cumulative statutory earnings from January 1, 2006 through the end of the quarter prior to the repurchase, FSA was unable to make repurchases during the third and fourth quarter of 2008. In 2007 and 2006, FSA repurchased $180.0 million and $100.0 million of shares of its common stock, respectively, from FSA Holdings and retired such shares.
FSA Holdings paid dividends of $33.6 million in 2008, $122.0 million in 2007 and $530.0 million in 2006.
At December 31, 2007, FSA repaid its entire surplus note obligation of $108.9 million to FSA Holdings. In addition, FSA Holdings forgave all interest expense for 2007, which totaled $5.0 million, including $3.6 million already paid by FSA and $1.4 million of accrued interest. FSA Holdings recontributed to FSA the proceeds from the repayment of the surplus note plus the amount of interest expense already paid. All surplus note transactions were approved by the New York Superintendent. FSA paid surplus note interest of $5.4 million in 2006.
In 2008, Dexia Holdings contributed $1,012.1 million of capital to FSA Holdings, which included $4.3 million contributed by a liquidation of program shares and phantom program shares held by directors. In the first quarter of 2008, FSA Holdings contributed capital to FSA of $500 million. In the third quarter of 2008, FSA issued a non-interest bearing surplus note with no term to FSA Holdings in exchange for $300 million. In the fourth quarter of 2008, FSA Holdings contributed $207.8 million to FSAM, part of the FP segment.
22. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES
FSA has a credit arrangement aggregating $150.0 million provided by commercial banks and intended for general application to insured transactions. If FSA is downgraded below Aa3 by Moody's and AA- by S&P, the lenders may terminate the commitment, and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 by Moody's and BBB- by S&P, any outstanding loans become due and payable. At December 31, 2008, there were no borrowings under this arrangement, which expires on April 21, 2011.
FSA has a standby line of credit in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5%, which amounted to $1,612.0 million at December 31, 2008. The obligation to repay loans under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a ten-year term expiring on April 30, 2015. The ratings downgrade of FSA by Moody's to Aa3 in November 2008 resulted in an increase to the commitment fee. No amounts have been utilized under this commitment at December 31, 2008.
In June 2003, $200.0 million of CPS, money market committed preferred trust securities, were issued by trusts created for the primary purpose of issuing the CPS, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the "Preferred Stock") of FSA. There are four trusts, each with an initial aggregate face amount of $50 million. These trusts hold auctions every 28 days at which time investors submit bid orders to purchase CPS. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts, which represents the difference between the commercial paper yield and the winning auction rate (plus all fees and expenses of the trust). If an auction does not attract sufficient clearing bids, however, the auction rate will be subject to a maximum rate of 200 basis points above LIBOR for the next succeeding distribution period. Beginning in August 2007, the CPS required the maximum rate for each of the relevant trusts. FSA continues to have the ability to exercise its put option and cause the related trusts to purchase FSA Preferred Stock. The cost of the facility was $4.9 million, $1.8 million and $1.0 million for 2008, 2007 and 2006, respectively, and was recorded within other operating expenses. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts because it does not retain the majority of the residual benefits or expected losses.
Certain notes held by FSA Global contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its own debt issuances that relate to such notes, it entered into several liquidity facilities with Dexia for $419.4 million. Certain notes held by FSA Global benefit from a liquidity facility with XL Insurance Ltd. for $341.5 million.
In the third quarter of 2008, to address FP segment liquidity requirements, Dexia entered into an agreement to provide FSAM the First Dexia Line of Credit, a $5 billion committed, unsecured, standby line of credit. At December 31, 2008, there were $1.3 billion in draws outstanding under the First Dexia Line of Credit. In February 2009, Dexia and FSAM entered into an agreement for a second committed, unsecured, standby line of credit of $3 billion (the "Second Dexia Line of Credit"). At March 2, 2009, the amount outstanding on the First Dexia Line of Credit had increased to $2.7 billion.
In addition, on November 13, 2008, the Company entered into two agreements with Dexia and its affiliates in support of its FP business, which provide a $3.5 billion collateral swap facility and a $500 million capital facility to cover economic losses beyond the $316.5 million of pre-tax loss estimated at the end of June 2008.
23. SEGMENT REPORTING
The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on public finance and asset-backed obligations. The FP segment includes the VIEs and the GIC operations of the Company, which historically issued medium term notes through a reverse inquiry process to institutional investors and GICs to municipalities and other market participants. Since the November 2008 execution of the Purchase Agreement, no new GICs have been issued. See Note 1 for a description of each segment's business. The following tables summarize the financial information by segment as of and for the years ended December 31, 2008, 2007 and 2006:
Financial Information Summary by Segment
(1)Comprised primarily of non-economic impairment charges.
Reconciliations of the Segments' Pre-Tax Operating Earnings (Losses) to Net Income (Loss)
The intersegment assets consist primarily of intercompany notes issued by FSA and held within the FP Investment Portfolio. The intersegment revenues and expenses relate to interest income and interest expense on intercompany notes and premiums paid by FSA Global on FSA-insured notes.
GAAP income to operating earnings adjustments are primarily comprised of fair-value adjustments deemed to be non-economic. Such adjustments relate to (1) non-economic fair-value adjustments for credit derivatives in the insured portfolio, (2) non-economic impairment charges on investments, (3) fair-value adjustments for instruments with economically hedged risks and (4) fair-value adjustments attributable to the Company's own credit risk. Management believes that by making such adjustments the measure more closely reflects the underlying economic performance of segment operations.
The GIC Subsidiaries and VIEs in the FP segment pay premiums to FSA, which is in the financial guaranty segment. In addition, management of FSA provides management, oversight and administrative support services ("indirect FP expenses") to the entities in the FP segment. The Company's management evaluates the FP segment based on the separate results of operation of the GIC Subsidiaries and FSAM, excluding the premium paid to FSA and including the indirect FP expenses. For the VIEs, the premium paid approximates the indirect expenses incurred by FSA.
Net Premiums Earned by Geographic Distribution
24. RELATED PARTY TRANSACTIONS
The Company enters into various related party transactions, primarily with Dexia and, until mid-2008, SGR. The primary related party transactions during 2008 between the Company and Dexia are as follows:
•The Company enters into transactions with various affiliates of Dexia, in which Dexia acts as the counterparty in swap contracts, primarily in the FP segment. The interest income and expense as well as the fair-value adjustments for those derivative contracts are recorded in the statement of operations and comprehensive income.
•Dexia acts as intermediary in certain CDS transactions. The premiums earned and fair-value adjustments related to those contracts are recorded in the consolidated statements of operations and comprehensive income.
•The Company invests short-term or cash assets in Dexia accounts and earns interest income on those accounts, which is recorded in the consolidated statements of operations and comprehensive income.
•The Company has debt issued to Dexia and records related interest expense in the consolidated statements of operations and comprehensive income and accrued interest expense on the balance sheet.
•The Company has loans receivable from Dexia recorded in other assets.
•The Company leases premises from Dexia outside the United States.
•The Company maintains certain lines of credit with Dexia affiliates.
•The Company reimbursed Dexia Crédit Local for the portion of former director Bruno Deletré's Dexia Crédit Local compensation that related to his work as liaison with the Company on behalf of Dexia until July 2008.
•The Company files consolidated tax returns with DHI.
•The Company charges DHI for administrative and shared service expenses.
•FSA Global maintains liquidity facilities with Dexia aggregating $419.4 million.
•First and Second Dexia Lines of Credit to FSAM.
•A $3.5 billion collateral swap facility with Dexia in support of the FP business.
SGR had an equity interest in FSA International until 2005, at which time the Company repurchased shares in FSA International held by SGR. The Company had a preferred stock investment in SGR until third quarter of 2008. The primary related party transactions with SGR are as follows.
•Business is ceded to SGR under various reinsurance contracts.
•The Company received dividends on its preferred stock investment in SGR until mid-2008, which was recorded in the consolidated statements of operations and comprehensive income and held two positions on the board of directors of SGR.
The table below summarizes amounts included in the financial statement captions resulting from various types of transactions executed with related parties, as well as outstanding exposures with related parties:
Amounts Reported for Related Party Transactions
in the Consolidated Balance Sheets
Amounts Reported for Related Party Transactions
in the Consolidated Statements of Operations and Comprehensive Income
(1)Represents business with Dexia and its affiliates.
(2)The Company ceded business to XL Insurance (Bermuda) Ltd. Prior to 2008, SGR was considered a related party. 25. STATUTORY ACCOUNTING PRACTICES
GAAP differs in certain significant respects from statutory accounting practices, applicable to insurance companies, that are prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices:
•upfront premiums are earned when related principal and interest have expired rather than earned over the expected period of coverage;
•acquisition costs are charged to operations as incurred rather than over the period that related premiums are earned;
•a contingency reserve (rather than a non-specific reserve) is computed based on the following statutory requirements:
1)for all policies written prior to July 1, 1989, an amount equal to 50% of cumulative earned premiums less permitted reductions, plus
2)for all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either 1/60th or 1/80th of the total required for each category, less permitted reductions;
•certain assets designated as "non-admitted assets" are charged directly to statutory surplus but are reflected as assets under GAAP;
•deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carryback or if greater, the amount of deferred tax asset expected to be realized within one year of the balance sheet date;
•insured CDS are accounted for as insurance contracts rather than as derivative contracts recorded at fair value;
•bonds are generally carried at amortized cost rather than fair value;
•VIEs and refinancing vehicles are not consolidated;
•surplus notes are recognized as surplus rather than as a liability unless approved for repayment; and
•non-insurance company subsidiaries do not prepare accounts applying statutory accounting standards.
Consolidated statutory net loss was $1,376.7 million for 2008 and net income of $312.9 million for 2007 and $339.6 million for 2006. Statutory surplus totaled $710.7 million for 2008 and $1,608.8 million for 2007. Statutory contingency reserves totaled $1,281.6 million for 2008 and $1,094.3 million for 2007.
26. EXPOSURE TO MONOLINES
The tables below summarize the exposure to each financial guaranty monoline insurer by exposure category and the underlying ratings of the Company's insured risks.
Summary of Exposure to Monolines
(1)Represents transactions with second-to-pay FSA-insurance that were previously insured by other monolines. Based on net par outstanding. Includes credit derivatives in the insured portfolio.
(2)Represents amortized cost of investments insured by other monolines. Amortized cost includes write-downs of securities that were deemed to be OTTI.
Exposures to Monolines
and Ratings of Underlying Risks
(1)Ratings are based on internal ratings.
(2)Represents transactions with second-to-pay FSA insurance that were previously insured by other monolines.
(3)Ratings are based on the lower of S&P or Moody's.
(4)Represents par balances for the insured portfolios and amortized cost for the investment portfolios.
27. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
Quarterly Financial Information
(1)Amount revised from the one reported in the Company's quarterly report on Form 10-Q for March 31, 2008 to reflect a reclassification of ceding commission income from "other income."
(2)Amount revised from the one reported in the Company's quarterly report on Form 10-Q for March 31, 2008 to reflect a reclassification of foreign exchange loss from "net unrealized gains (losses) on financial instruments at fair value" to "foreign exchange (gains) losses from financial products segment." Fourth quarter 2008 results include OTTI charges on FP Segment Investment Portfolio of $8.6 billion (See Note 6) and loss expense of $1.9 billion (see Note 9).
28. OTHER INCOME
The following table shows the components of "other income." In 2008, other income includes $20.1 million related to commutation gains. See Note 26 for more information.
(1)DCP and SERP assets are held to defease the Company's plan obligations and the changes in fair value may vary significantly from period to period. Increases or decreases in the fair value of the assets are primarily offset by like changes in the related liability, which are recorded in other operating expenses.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
There have been no changes in accountants, or any disagreements with accountants on accounting and financial disclosure within the two years in the period ended December 31, 2008.
Item 9AT. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, completed an evaluation of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act of 1934, as amended) as of December 31, 2008. Based on that evaluation, the Company's management, including the Chief Executive Officer and the Chief Financial Officer, have concluded that as of such date the Company's disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the rules and forms of the SEC and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, in a manner that allows timely decisions regarding required disclosure.
Management's Report on Internal Control Over Financial Reporting
The Company's management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company's internal control over financial reporting is a process designed under the supervision of the chief executive officer and chief financial officer and effected by the Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company's financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. The Company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company's assets that could have a material effect on the financial statements.
As of December 31, 2008, management conducted an assessment of the effectiveness of the Company's internal control over financial reporting based on the framework established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on its evaluation in relation to the criteria established in Internal Control-Integrated Framework, management concluded that the Company's internal control over financial reporting was effective as of December 31, 2008.
This annual report does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's report in this annual report.
Changes in Internal Control over Financial Reporting
There has been no change in the Company's internal control over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f) under the Exchange Act) during the year ended December 31, 2008 that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting.
There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. The Company will continue to improve the design and effectiveness of its disclosure controls and procedures and internal control over financial reporting to the extent necessary in the future to provide management with timely access to such material information and to correct any deficiencies that may be discovered in the future.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
Directors
On May 21, 2008, the Company's shareholders appointed twelve directors to serve until the later of the Company's next annual meeting of shareholders or until their successors have been duly elected and qualified. Upon resignation of some of the existing board members, new members were elected in special meetings of the Board of Directors of the Company on August 6, 2008 (Messrs Delouis and Piret), November 7, 2008 (Mr. Joly) and December 22, 2008 (Messrs Buysschaert and Poupelle), increasing the total number of directors to thirteen. Information about the directors as of December 31, 2008 is set forth below and in "Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters-Directors and Executive Officers."
Executive Officers of the Company
In addition to Messrs. Cochran and McCarthy (who are described above under the caption "Directors"), the Company's other executive officers are described below. The Company's executive officers consist of the members of the Executive Management Committee.
The present principal occupation and five-year employment history of each of the above-named executive officers of the Company, as well as other directorships of corporations currently held by each such person, are set forth below.
Mr. Stern has been a Managing Director, the Secretary and the General Counsel of the Company since April 1993. Since April 1993, he has been the Secretary of FSA, and since March 1989, he has been a Managing Director of FSA. He has been a director of FSA since August 1990. Prior to joining FSA as General Counsel in 1987, Mr. Stern was an attorney with Cravath, Swaine & Moore.
Mr. Simon has been a Managing Director and the Chief Financial Officer of the Company and FSA since September 2002, having joined the Company in such capacity in April 2002. Prior to joining the Company, Mr. Simon was Chief Financial Officer of Intralinks, a technology company serving the financial markets. From 1993 to 1999, he was a senior financial officer, last serving as the Chief Financial Officer, of Cantor Fitzgerald. From 1986 to 1993 he was a senior member of Morgan Stanley's controller department. Mr. Simon, a certified public accountant, began his professional career at Price Waterhouse in 1983.
Mr. Brewer has been a Managing Director of FSA since March 1989 and the Chief Risk Management Officer of FSA since September 2003. Mr. Brewer was the Chief Underwriting Officer of FSA from September 1990 until September 2003. He has been a Managing Director of the Company since May 1999 and a director of FSA since September 1993. From March 1989 to August 1990, Mr. Brewer was Managing Director, Asset Finance Group, of FSA. Prior to joining FSA in 1986, Mr. Brewer was an Associate Director of Moody's Investors Service, Inc.
Audit Committee
The Company has a separately designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. During 2008, the Audit Committee consisted of Mr. Ozanne (Chairman), Mr. Everets and Mr. Taylor.
All members of the Audit Committee are independent within the meaning of Rule 10A-3(b)(1) of the Exchange Act. Because the Company has only debt securities listed on the NYSE, it is not subject to the additional independence standards for directors imposed by the NYSE.
The Board of Directors of the Company has determined that Audit Committee members James H. Ozanne and John W. Everets are audit committee financial experts as defined by item 407(d)(5) of Regulation S-K of the Exchange Act.
Code of Ethics
The Company has adopted a code of ethics for directors, officers (including the Company's principal executive officer, principal financial officer, and principal accounting officer and controller) and employees, known as the Code of Conduct. The Company has posted its Code of Conduct on its Internet website, www.fsa.com. The Company intends to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding amendments to, or waivers from, provisions of its code of ethics that applies to its principal executive officer, principal financial officer and principal accounting officer and controller, or persons performing similar functions, and that relates to any element of the code of ethics definition enumerated in paragraph (b) of Item 406 of Regulation S-K of the Exchange Act, by posting such information on its website, www.fsa.com.
Nomination of Directors
Holders of the Company's registered debt securities are not entitled to recommend nominees to the Company's Board of Directors.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16 of the Exchange Act requires periodic reporting by beneficial owners of more than 10% of any equity security registered under Section 12 of the Exchange Act and directors and executive officers of issuers of such equity securities. Upon its merger with a subsidiary of Dexia in July 2000, the Company's common stock ceased to be registered under Section 12 of the Exchange Act or listed on the NYSE. Consequently, the reporting obligations of Section 16 of the Exchange Act do not apply.
Item 11.
Item 11. Executive Compensation.
Compensation Discussion and Analysis
The Company's compensation program was historically designed to attract, motivate and retain employees while, at the same time, aligning the interests of the Company's employees with those of the Company's shareholders. The Company's compensation program was established in substantially its current form in 1994, in connection with the initial public offering by the Company. When the Company was acquired by Dexia in 2000, the acquisition documents expressly provided for continuation of the Company's existing compensation program through 2004, with specified changes to the compensation program to reflect the fact that the Company's shares were no longer publicly traded. In 2004, the Human Resources Committee (the "HR Committee") of the Board of Directors of the Company reviewed the Company's compensation program with the advice of the HR Committee's independent compensation consultants, Hewitt Associates, and on the basis of that advice determined to continue the Company's compensation program with only minor changes, concluding that the existing program was successful in achieving its intended purposes. The proposed sale of the Company and the significant losses incurred by the Company in 2008 have had a material impact on the Company compensation program. Since the Company employed considerable performance based compensation for its senior management, 2008 compensation payouts were materially reduced, as was the value of outstanding vested and unvested equity based compensation awards.
Historical Compensation Philosophy
The objectives underlying the Company's compensation program historically included the following:
•The Company sought to attract and retain quality employees at all levels of the organization. To this end, the HR Committee maintained a general target of compensating the Company's employees within the 75th percentile of overall compensation provided by the Company's industry peers.
•The Company sought to align the interests of employees with those of the Company's parent and, specifically, to motivate employees to grow the value and earnings of the Company. To this end, the Company employed measures of value and earnings generation in determining annual and longer term compensation.
•The Company sought to have its employees take a long term view of the Company's business and the risks that the Company underwrites. To this end, higher ranking employees of the Company received a high percentage of their overall compensation in the form of incentive compensation that pays out based upon the Company's performance over three to four year periods.
Non-GAAP Measures of Value Creation Underlying the Company's Compensation Program
The Company measures its overall success on the basis of a number of factors, including growth in adjusted book value ("ABV") per share, growth in book value per share (adjusted as described below), present value ("PV") financial guaranty originations, PV net interest margin ("PV NIM") and "operating earnings." ABV, PV financial guaranty originations, PV NIM and operating earnings are non-GAAP measures. Although measures identified as non-GAAP should not be considered substitutes for GAAP measures, management considers them key performance indicators and employs them in determining compensation. Non-GAAP measures therefore provide investors with important information about the way management analyzes its business and rewards performance.
ABV and book value growth are measures of value creation. ABV growth emphasizes new business production, since it captures the present value of insurance premiums and financial products net interest margin originated during a specified period. Book value growth, which emphasizes operating
earnings, can be considerably more volatile than ABV growth, and will, for example, be more influenced by negative events such as increases in loss reserves. In applying these measures for compensation purposes, certain aspects of GAAP are eliminated that, in the view of management and the Board of Directors, distort the Company's economic results, most notably the impact of (i) marking to market investment grade FSA-insured credit default swaps under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), (ii) not applying hedge accounting treatment for economic hedges under SFAS 133 and (iii) unrealized gains and losses on investments and liabilities. Growth in ABV and book value are applied on a per share basis. In order to incentivize management to return capital to the Company's shareholders to the extent such capital is not being deployed, the calculation of the rate of growth per share is adjusted to offset the effects of dividends and capital contributions, which do not affect the number of shares outstanding.
For a discussion of the non-GAAP measures PV financial guaranty originations and PV NIM originated for the FP segment, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Executive Overview-New Business Production."
Adjusted Book Value
To calculate ABV, the following adjustments, on an after-tax basis, are made to book value:
1.addition of unearned financial guaranty revenues, net of amounts ceded;
2.addition of PV premiums and credit derivative fees outstanding, net of amounts ceded and estimated premium taxes;
3.addition of PV NIM outstanding;
4.subtraction of the deferred costs of acquiring policies;
5.elimination of fair-value adjustments for credit derivatives in the insured portfolio, other than credit impairment losses representing the present value of estimated losses;
6.elimination of the fair-value adjustments for instruments with economically hedged risks, with any residual ineffectiveness remaining in ABV, and adjustments related to non-economic changes in fair value related to the trading portfolio, such as the effect of changes in credit spreads;
7.elimination of unrealized gains or losses on investments, other than credit impairment losses representing the present value of estimated losses;
8.elimination of fair-value adjustments attributable to the Company's own credit risk, such as debt valuation adjustments on FP segment debt for which the fair-value option was elected and fair-value adjustments on the Company's committed preferred trust put options; and
9.IFRS adjustments.
ABV is reconciled to book value in the table that follows.
Reconciliation of Book Value to Non-GAAP Adjusted Book Value
(1)PV outstanding includes the present value of future earnings from premiums, credit derivative fees, FP net interest margin and ceding commissions. The discount rate varies according to the year of origination. For each year's originations, the Company calculates the discount rate as the average pre-tax yield on its investment portfolio for the previous three years. The rate was 4.92% for 2008 and 4.86% for 2007. Management considers ABV an operating measure of the Company's intrinsic value. Book value includes an estimate of loss for all insured risks made at the time of contract origination. ABV adds back certain GAAP liabilities and deducts certain GAAP assets (adjustments 1, 4, 5, 6, 7 and 8 in the calculation above), and also captures the estimated value of future contractual cash flows related to transactions in force as of the balance sheet date (adjustments 2 and 3 in the calculation above) because installment payment contracts, whether in the form of future premiums or future NIM, are generally non-cancelable and represent a claim to future cash flows. ABV also reflects certain IFRS adjustments in order to better align the interests of employees with the interests of Dexia, the Company's principal shareholder, whose accounts are maintained under IFRS. An investor attempting to evaluate the Company using GAAP measures alone would not have the benefit of this information. In addition, investors may consider the growth of ABV to be a performance measure indicating the degree to which management has succeeded in building a reliable source of future earnings. The Company's compensation formulas are based, in part, on the ABV growth rate.
The ABV metric has certain limitations. It reflects the accelerated realization of certain assets and liabilities through equity, and relies on an estimate of the amount and timing of receipt of installment premiums and credit derivative fees and future NIM. Actual installment premium and credit derivative receipts could vary from the estimate due to differences between actual and estimated insured debt balances outstanding and foreign exchange rate fluctuations. Actual NIM results could vary from the amount estimated based on changes in expected lives of assets and variances in the actual timing and amount of repayment associated with flexible-draw GICs that the Company issues. ABV excludes the
fair-value adjustments deemed non-economic because they are expected to sum to zero over the lives of the related contracts.
Adjustments 1, 2 and 3 above represent the sum of cumulative years' reported PV financial guaranty originations and PV NIM originated, as described below, less what has been earned or adjusted due to changes in estimates as described above. Installment payment contracts, whether in the form of premiums, credit derivatives or NIM, are generally non-cancelable by the Company and represent a claim to future cash flows. Therefore, management includes these amounts in its estimate of ABV. PV NIM outstanding is adjusted for management's estimate of transaction and hedging related costs. Adjustments 1 and 2 in the calculation of ABV represent unearned financial guaranty revenues that have been collected and the Company's best estimate of the present value of its future installments (comprising current- and prior-period originations that have not yet been earned). Debt schedules related to installment transactions can change from time to time. Critical assumptions underlying adjustment 2 are discussed below under "Present Value Financial Guaranty Originations."
The Company calculates PV NIM originated because net interest income and net interest expense reflected in the consolidated statements of operations and comprehensive income are limited to current-period earnings. The Company's future positive interest rate spread from outstanding FP segment business (adjustment 3) can be estimated and generally relates to contracts or security instruments that are expected to be held for multiple years. Management therefore includes the present value of the expected economic effect in ABV as another element of intrinsic value not found in GAAP book value.
Adjustment 4 reflects the realization of costs deferred and associated with premium originated.
Adjustments 5 through 8 reflect the effect of certain items excluded from operating earnings, as described below, and ABV because, absent credit impairment that would cause a payment under the contract, these fair value adjustments will sum to zero over time. Any credit impairments, defined as the present value of estimated economic losses, would be included in operating earnings and ABV. ABV and operating earnings drive management compensation payouts. As the Company's objective is to optimize long-term stable growth in economic value, management generally seeks to minimize turnover and therefore any unrealized gain or loss, unless economic, is subtracted from book value to exclude it from the ABV metric. In the event that an investment is liquidated prior to its maturity, any related gain or loss is reflected in both earnings and ABV without further adjustment.
Adjustment 9 reflects IFRS adjustments, which are differences that relate primarily to foreign exchange gains or losses related to foreign-denominated investments and to contingencies and certain fair-value adjustments.
Operating Earnings
The Company defines operating earnings as net income excluding the effects of fair-value adjustments considered to be non-economic and, beginning in 2008, IFRS adjustments. IFRS is the basis of accounting used by Dexia and is the basis on which all of FSA's compensation plans are referenced in 2008 and forward. The fair-value adjustments excluded from operating earnings are itemized below.
•Fair-value adjustments for instruments with economically hedged risks. These include adjustments related to hedges that are economically effective but do not meet the criteria necessary to receive hedge accounting treatment under SFAS 133 (any residual hedge ineffectiveness remains in operating earnings). These also include adjustments related to non-economic changes in fair value related to the trading portfolio, such as the effect of changes in credit spreads.
•Fair-value adjustments for credit derivatives in the insured portfolio, which are certain contracts for which fair-value adjustments are recorded through the consolidated statements of operations and comprehensive income because they qualify as derivatives under SFAS 133 or SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments." These contracts include CDS, insured swaps in certain public finance obligations and insured NIM securitizations. In the event of credit impairment, operating earnings would include the present value of estimated economic losses.
•Impairment charges on investments, other than the present value of estimated economic losses.
•Fair-value adjustments attributable to the Company's own credit risk, such as debt valuation adjustments on FP segment debt for which the fair-value option was elected and fair-value adjustments on the Company's committed preferred trust capital facility.
Operating earnings (losses) are reconciled to net income (loss) as follows:
Reconciliation of Net Income (Loss) to Non-GAAP Operating Earnings (Losses)
(1)Hedge ineffectiveness remains in operating earnings. See following table for a more detailed presentation of fair-value adjustments for instruments with economically hedged risks.
(2)Comprised of the fair value adjustment attributable to the Company's own credit risk recorded on FP segment debt at fair value and committed preferred trust put options. Pre-tax Fair-Value Adjustments for Instruments with Economically Hedged Risks
Components of Compensation Provided by the Company
The Company's compensation program in 2008 included the following basic elements (described in more detail below): (i) salary; (ii) cash bonus; (iii) equity compensation in the form of performance share units under the Company's 2004 Equity Compensation Plan (the "2004 Equity Plan"); (iv) health and other customary benefit plans; and (v) optional participation in Employee Share Plans sponsored by Dexia. In addition, the Company has employment agreements with its two most senior executive officers. For the more highly compensated employees within the Company, equity compensation historically represented the largest component of compensation, followed by cash bonus and salary.
Salaries
Employee salaries are generally established on the basis of competitive market standards, and are thereafter generally changed to reflect cost of living adjustments and changes in responsibility.
Cash Bonuses
Cash bonuses are paid on an annual basis out of a bonus pool (the "Bonus Pool") determined pursuant to a guideline formula intended to provide employees with a percentage of the growth in value in the Company during the preceding calendar year. In 2008, the Company experienced significant losses and did not experience a growth in value. Therefore, the guideline Bonus Pool for bonuses in respect of 2008 was $0. However, in establishing the Bonus Pool guideline, the HR Committee recognized that non-distributed Bonus Pool amounts from prior years may to a limited extent be accumulated and memorialized in future years as a "Rainy Day Fund" that would be available in subsequent years to fund bonus payments to employees in excess of the guideline Bonus Pool. The Committee also recognized that adjustments to the Bonus Pool guideline may be recommended by management, subject to approval of the HR Committee, to reflect changes in circumstances. Notwithstanding the Bonus Pool guideline, bonuses remain within the discretion of the HR Committee, except insofar as otherwise provided in the Company's employment agreements. Specifically, aggregate bonuses in any year may be more or less than the guideline Bonus Pool for that year, and individual employee bonuses are not directly tied to the guideline Bonus Pool, except insofar as provided in the Company's employment agreements. The HR Committee did not award a 2008 bonus to Mr. Cochran or Mr. McCarthy. The HR Committee determined that it was appropriate to award bonuses to the other members of the Executive Management Committee contingent on the closing of the sale to Assured in reduced amounts as compared to their 2007 bonuses.
The current Bonus Pool guideline operates as follows. The guideline provides for an annual Bonus Pool equal to a predetermined percentage (the "Specified Percentage") of the increase in ABV of the Company during the applicable year (as derived from the Company's IFRS financial statements), excluding unrealized gains and losses on investments, net of tax, and excluding the mark-to-market, net of tax, of investment grade credit derivatives, but including a transaction return on equity ("Transaction ROE") modifier described below. ABV growth is considered by management and the HR Committee as a proxy for value creation. For the 2004 Bonus Pool, the HR Committee set the Specified Percentage at 11.25%. The increase in ABV during the applicable year is equal to (a) the percentage growth in ABV per share during such year, with credit given for dividends paid, multiplied by (b) ABV as of the beginning of such year.
The HR Committee retained the right to evaluate the Bonus Pool formula annually; however, the intent was to maintain the Bonus Pool formula as long as practicable to promote stability. Since 2004, the Specified Percentage remained unchanged until February 2008, when the HR Committee reduced the Specified Percentage to 9.5%, since the Company's larger than anticipated ABV growth in recent years had been disproportionate with the growth in the number of employees and their compensation
requirements. The revised Specified Percentage would have generated a 2007 guideline bonus pool approximately equal to the guideline Bonus Pool actually distributed in 2008 in respect of 2007.
The Transaction ROE modifier adjusts downward the percentage growth in ABV per share if the Transaction ROE achieved in the aggregate for all transactions insured during the applicable year (the "Actual Average Transaction ROE") is less than the "Target Transaction ROE," with a maximum adjustment of 2%. The Actual Average Transaction ROE is a measure of the return on equity expected from transactions insured and GICs written by the Company during a specified period, based upon the Company's internal proprietary capital model. The "Target Transaction ROE" equals the after-tax book yield on the Company's investment portfolio (excluding the investment portfolios for financial products, variable interest entities and refinanced transactions) (determined as of the December 31 immediately preceding the compensation year) plus 9%, with a maximum Target Transaction ROE of 15%. In the event that the Actual Average Transaction ROE is less than the Target Transaction ROE for any year, then percentage growth in ABV per share for such year is reduced by an amount equal to one half the excess of the Target Transaction ROE (expressed as a percentage) over the Actual Average Transaction ROE (expressed as a percentage), subject to a maximum reduction of 2%. The Transaction ROE modifier was intended to motivate management to use the Company's capital prudently in building ABV per share. At the time of establishing the 9% figure, the HR Committee concluded that 9% over the Company's insurance company investment portfolio yield represented a reasonable target for aggregate transaction returns under the Company's internal capital model based upon the historical performance of the Company and its industry peers.
Amounts of the Bonus Pool in respect of any year, determined as provided above, that are not distributed to employees for that year are credited, but not accrued for accounting purposes, to a "Rainy Day Fund" that will be available in subsequent years to fund bonus payments to employees in excess of the Bonus Pool determined as provided above, provided that the Rainy Day Fund may not exceed an amount equal to $25.0 million, adjusted to reflect increases in the Consumer Price Index from and after January 1, 2005. The Rainy Day Fund concept was employed to allow management to "save" Bonus Pool allocations for future years when the formula dictates a reduced Bonus Pool although staff retention and other considerations might support larger bonuses than the formula would dictate. At December 31, 2008, the Rainy Day Fund balance was $28 million. Neither the Rainy Day Fund nor the guideline Bonus Pool, however, provides any entitlement to employees, since the HR Committee retains full discretion to award or decline to award bonuses, subject, in the case of the Chief Executive Officer and the President, to provisions of their employment agreements with the Company. Prior to payment of 2008 bonuses discussed below, the Rainy Day Fund had not been used to supplement the guideline Bonus Pool for any year.
In January 2006, the HR Committee decided that determinations under the Bonus Pool Guideline would be made in accordance with IFRS rather than GAAP, subject to the HR Committee's obligation to make adjustments to reflect a change in, or a change in the interpretation or application by the Company of, such accounting principles to preserve the value of the Bonus Pool consistent with the intent that such value should reflect true economic financial performance of the Company, with any such adjustment determined by the HR Committee (or, if any director objects to any such adjustment, by the Board of Directors of the Company). IFRS was chosen in order to better align the interests of employees with the interests of Dexia, the Company's principal shareholder, whose accounts are maintained under IFRS.
Section 404 of the Sarbanes-Oxley Act of 2002 ("SOX Section 404") provides that if the Company must prepare an accounting restatement due to the Company's material noncompliance, as a result of misconduct, with any financial reporting requirement under the securities laws, the principal executive and financial officers must reimburse the Company for any bonus or other incentive-based or equity-based compensation received from the Company during the 12-month period following the first public issuance or filing with the SEC of the financial document embodying the financial reporting
requirement, and any profits realized from the sale of securities of the Company during that 12-month period. The Company does not have any other express policy regarding the adjustment or recovery of bonuses if the relevant Company performance measures upon which the guideline Bonus Pool is based are restated or otherwise adjusted following the bonus payment date in a manner that would reduce the size of the guideline Bonus Pool.
Performance Share Units
The 2004 Equity Plan provides for awards of performance share units, which represent awards of both performance shares and shares of Dexia restricted stock. The Company has employed performance shares as its principal form of equity compensation since implementation by the Company of its 1993 Equity Participation Plan (the "1993 Equity Plan") in connection with its 1994 initial public offering. In 2004, the Company adopted the 2004 Equity Plan to replace the 1993 Equity Plan and ceased making further awards under the 1993 Equity Plan. The 2004 Equity Plan added Dexia restricted stock as a component of equity awards in order to further align the interests of the Company's employees with its parent, and to give Company employees a greater sense of membership in the Dexia group. The 2004 Equity Plan also provides that book value measurements employed in valuing performance shares are determined in accordance with IFRS, whereas valuations under the 1993 Equity Plan were in accordance with GAAP. Again, IFRS was chosen in order to better align the interests of employees with the interests of the Company's parent, whose accounts are maintained under IFRS.
Performance share units awarded under the 2004 Equity Plan are comprised 90% of performance shares and 10% of Dexia restricted stock. Specifically, in order to determine the number of shares of Dexia restricted stock allocable to an award of performance share units, the recipient receives the number of Dexia shares that can be purchased with the proceeds of 10% of the units. For these purposes, the Dexia shares are valued at a purchase price per share historically equal to the average cost in dollars paid by the Company to acquire such shares, and each unit is given the value of one outstanding share of the Company's common stock valued as of the preceding year-end, as described below with respect to performance shares. Historically, performance share units have been awarded to Company employees in the first calendar quarter of each year and no more frequently than once per calendar year. The HR Committee has not awarded performance share units or performance shares in 2009 to date. Performance share units that were awarded in 2008 are described in the Company's 2007 Annual Report on Form 10-K.
Performance Shares. Performance shares are designed to provide recipients with an interest in the growth in value of the Company's shares during specified performance cycles. Performance shares have generally been awarded on the basis of two sequential three-year performance cycles, with 1/3 of each award allocated to the first cycle and 2/3 of each award allocated to the second cycle. For example, an award of 300 performance shares made in 2008 represents 100 performance shares allocated to the 2008/2009/2010 performance cycle and 200 performance shares allocated to the 2009/2010/2011 performance cycle. The length of the cycles are intended to provide employees with a "longer term" view of the Company's financial performance and to provide the Company with retentive value insofar as employees generally forfeit performance share awards should they voluntarily terminate employment with the Company prior to the completion of the related performance cycle.
Each performance share represents a right to receive up to two shares of the Company's common stock (or the cash value thereof), with the actual number of common shares receivable determined on the basis of the change in ABV and book value per share over a specified performance cycle. The performance shares were designed to provide less compensation to participants than stock options if the Company performs poorly and more compensation to participants if the Company performs well. In particular, the performance shares were designed to have no value if the Company fails to generate growth in "value" per share in excess of 7%, which at the time of initial program implementation was a proxy for the risk-free yield on treasury securities. The actual dollar value received by a holder of performance shares, in general, varies in accordance with the annualized rate of ABV growth and book value growth per share (the "Internal Rate of Return" or "IRR") of the Company's common stock during an applicable "performance cycle" and the estimated value of the common stock at the time of payout of such performance shares.
For purposes of the foregoing, ABV per share and book value per share are adjusted to exclude the after-tax change in "accumulated other comprehensive income" and any mark-to-market adjustments on investment grade CDS and economic interest rate hedges. Accumulated other comprehensive income includes, for example, unrealized gains and losses in the Company's investment portfolio. Specifically,
•if the IRR is 7% or less per annum for any performance cycle, no shares of common stock will be earned for the performance cycle;
•if the IRR is 13% per annum for any performance cycle, a number of shares of common stock equal to the number of performance shares will be earned for the performance cycle; and
•if the IRR is 19% per annum or higher for any performance cycle, a number of shares of common stock equal to two times the number of performance shares will be earned for the performance cycle.
If the IRR is between 7% and 19%, the payout percentage is interpolated. The median IRR allowing for a 100% payout was set at 13%, which was considered reasonably acceptable Company performance.
So long as the Company's common stock is not publicly traded, the Company expects to pay amounts due under performance share awards (if any) in cash rather than stock, with shares having a value (the "Share Value") equal to the greater of:
(1)the average of (a) 1.15 times ABV per share and (b) 14 times "operating earnings" per share (each such term as defined in the respective Equity Plans) and
(2)0.85 times ABV per share.
The 1.15 times ABV and 14 times operating earnings multiples were based upon the multiples of ABV and operating earnings prevailing in the marketplace for the Company's industry peers when Dexia acquired the Company in 2000, representing a discount to the multiples (1.4676 times ABV and 17 times operating earnings) paid by Dexia when it acquired the Company in 2000. The 0.85 ABV floor in share value was intended to reflect a minimum value for shares in the face of an adverse earnings environment.
Except as otherwise provided in the employment agreements described below, performance shares (i) are generally forfeited in the event of a voluntary termination of employment prior to completion of the performance cycle; (ii) vest pro-rata in the event of termination without cause or retirement (generally at age 55 plus five years of service); (iii) vest fully in the event of death or disability; and (iv) vest fully in the event of termination without cause or constructive termination of employment following a "change in control."
Since the inception of the 2004 Equity Plan, up to 3,300,000 shares of common stock have been available for distribution in respect of performance shares. Such shares may be newly issued shares, treasury shares or shares purchased in the open market. If performance shares awarded under the 2004 Equity Plan are forfeited, the shares allocated to such awards are again available for distribution in connection with future awards under the Plan.
Except as provided by SOX Section 404, the Company does not have any express policy regarding the adjustment or recovery of performance share payouts if the relevant Company performance measures upon which they are based are restated or otherwise adjusted following the payment date in a manner that would reduce the amount of a performance share payout.
Dexia Restricted Stock. Shares of Dexia restricted stock awarded under the 2004 Equity Plan represent ordinary shares of Dexia, including the right to receive dividends thereon. Dexia restricted stock associated with a performance share unit award is allocated (i) 1/3 to a 2.5-year vesting period and 3-year restricted period and (ii) 2/3 to a 3.5-year vesting period and 4-year restricted period. Except as otherwise provided in the employment agreements described below, unvested Dexia restricted stock (i) is generally forfeited in the event of a voluntary termination of employment prior to completion of the performance cycle; (ii) vests pro-rata in the event of termination without cause or eligibility for retirement (generally at age 55 plus five years of service); and (iii) vests in the event of death or disability. The restricted period (during which Dexia restricted stock may not be traded) lapses six months after vesting. Short sales of Dexia stock by any Company employee are prohibited as a matter of corporate policy, absent prior approval of the Company's Executive Management Committee.
Benefit Plans and Programs
Benefit plans and programs generally available at the Company for all full time U.S. resident employees are, for the most part, customary in nature, and include:
•medical, prescription drug and dental plans;
•a qualified defined contribution "money purchase pension plan" (the "Pension Plan") with an annual contribution by the Company equal to 9% of prior year salary and bonus, subject to a salary/bonus cap provided under the Internal Revenue Code;
•a cash or deferred ("401(k)") plan, which does not include Company contributions, allowing pre-tax employee contributions up to limits provided under the Internal Revenue Code;
•a flexible spending plan (the "Flex Plan") allowing employees to pay certain medical, dependent care, mass transit and parking expenses with pre-tax dollars;
•a severance plan;
•life insurance coverage (the "Life Insurance Program") in the amount of two times annual salary up to a limit of $500,000;
•a program (the "Travel Incentive Program") under which employees share a portion of the savings from flying a lower class or less expensive flight pattern than allowed under the Company's travel policy or for using non-refundable tickets;
•an optional retiree medical program under which Company retirees are entitled to participate in the Company's medical plan following retirement provided that they pay the full cost plus a 5% administrative fee to the Company;
•$65 per month of "transit cheks" for commutation expenses (the "Transit Chek Program");
•reimbursement of up to $400 per annum for health club expenses (the "Health Club Program");
•a matching gift program for gifts to qualifying charities of up to $20,000 per annum in the aggregate (the "Matching Gift Program"); and
•customary vacation, leave of absence, bereavement and similar policies.
The Company also maintains "top hat" plans, which are unfunded and unsecured non-qualified plans restricted under the tax laws to a limited number of highly compensated employees, and consist of
•supplemental executive retirement plans (each, a "SERP") under which the Company makes an annual contribution equal to 9% of prior year salary and bonus in excess of the money purchase plan salary/bonus cap (but disregarding salary/bonus in excess of $1.0 million) payable upon termination of employment unless deferred by the employee, with such contributed amounts generally credited with returns on mutual funds or securities selected by the participants and "match funded" by the Company and
•deferred compensation plans (each, a "DCP") under which participants are entitled to defer receipt (generally for a minimum deferral period of three years) of bonus and performance share compensation otherwise payable to them by the Company, with such deferred amounts generally credited with returns on mutual funds or securities selected by the participants and "match funded" by the Company.
The Company maintains two SERPs and two DCPs due to tax law changes adopted in 2004 under Section 409A of the Internal Revenue Code with respect to "deferred compensation arrangements." The Company adopted a new SERP and new DCP in 2004 that conform with the 2004 tax law requirements to receive all new contributions, while the pre-existing SERP and DCP were "grandfathered" under the pre-existing tax law but were closed to further contributions. The pre-existing DCP was subsequently amended to conform to the new tax law. As described in more detail below, the Company maintains a separate severance plan for members of its Executive Management Committee and has employment agreements providing severance arrangements for its two most senior executive officers.
Different benefit plans and programs may apply to Company employees who are not United States residents.
Dexia Employee Share Plans
Company employees were historically entitled to participate in Employee Share Plans sponsored and funded by Dexia. Dexia did not offer an Employee Share Plan in 2008, but investments remain outstanding under Dexia Share Plans offered in prior years.
Under the Dexia Employee Share Plans, Company employees are generally entitled to invest up to 25% of their prior year compensation (comprised primarily of salary, bonus and performance share payout for such year) in Dexia shares subject to a 5-year minimum investment period (with specified rights to withdraw funds in the event of termination of employment or special circumstances). The investment alternatives include:
i)a "classic option" under which U.S. resident employees may purchase Dexia shares at a 15% discount (up to a limit prescribed annually under Section 423 of the Internal Revenue Code, which was $24.04 for 2007); and
ii)leveraged options, under which employees may purchase Dexia shares at a 20% discount employing 90% leverage pursuant to which
a)the discount, dividends and a portion of any profits from the investment are allocated to the lender, and
b)the employee receives (i) a guaranteed return of the dollars invested and (ii) either (depending on which option the employee has elected):
•a multiple (9.8 times for shares purchased in 2007) of the Dexia share appreciation over the initial non-discounted purchase price in euros over the five-year term (the "Standard Leveraged Option");
•a multiple (11.35 times for shares purchased in 2007) of the average monthly increase in Dexia share price over the initial non-discounted purchase price in euros over 52 months of the five-year term (the "Average Leveraged Option"); or
•a multiple (5.15 times for shares purchased in 2007) of the sum of the annual gains in Dexia share price during each year of the 5-year term (the "Click Leveraged Option").
Employment Agreements and Arrangements
Each of Messrs. Cochran and McCarthy entered into four-year employment agreements with the Company effective with the July 2000 acquisition of the Company by Dexia. Upon expiration of these initial agreements, each of Messrs. Cochran and McCarthy entered into similar employment agreements with the Company effective July 5, 2004, which agreements were amended January 1, 2005 and February 14, 2008 to address provisions of Section 409A of the Internal Revenue Code applicable to severance and other deferred compensation arrangements. Each of the employment agreements generally guaranteed continuation of compensation and benefits through December 31, 2007, and provides for extensions of their initial term for two-year terms, subject to notice of termination from either party at least six months prior to the end of the expiring term. These agreements were automatically extended in accordance with their terms during 2007 and will expire on December 31, 2009 if notice of termination is provided on or prior to June 30, 2009 or will extend until December 31, 2011 if such notice is not provided. At any point after the initial term has expired, Mr. Cochran may elect to become Non-Executive Chairman of the Company for the remainder of the term and any extensions.
Under the agreements, compensation consists of:
•base salary at the annual rate in effect immediately prior to the agreement, subject to increase at the Board's discretion;
•annual bonus equal to a minimum percentage of the "Bonus Pool" determined pursuant to formulae from time to time determined by the HR Committee; and
•annual awards of performance shares under the 2004 Equity Plan having an estimated economic value at least equal to the employee's 2004 performance share award.
Their employment agreements provide that Messrs. Cochran and McCarthy are entitled to receive an annual cash bonus equal to at least 5.0% and 4.0%, respectively, of the Company's annual Bonus Pool. The employment agreements provide that an additional 2.0% of the annual Bonus Pool will be allocated among those two executive officers as determined by the HR Committee.
For a discussion of the terms of the employment agreements relating to payments to Messrs. Cochran and McCarthy at, following or in connection with any termination of employment with the Company, retirement or change in control of the Company, see "-Potential Payments Upon Termination of Employment, Retirement or Change-in-Control."
Tax and Accounting Considerations Bearing on the Company's Compensation Program
The Company designed performance shares so that the cost to the Company is fully expensed, based upon the principal that fully expensed compensation properly reflects the financial performance of the Company, while noting that such treatment puts the Company at a disadvantage in comparing its financial results to those of its industry peers that employ stock options or other equity compensation that is not fully expensed. The Company designed Dexia restricted stock awarded under the 2004 Equity Plan to qualify as equity (as opposed to liability) awards under Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123-R"). The Company is not subject to Section 162(m) of the Internal Revenue Code, which limits the deductibility of non-performance based compensation paid to executives of corporations having common equity securities required to be registered under Section 12 of the Exchange Act. The Company's various benefit programs described above are intended to comply with applicable tax requirements, including Section 409A of the Internal Revenue Code governing deferred compensation arrangements.
Purchase Agreement Provisions Bearing on the 2008 Compensation Process
The Purchase Agreement providing for the sale of the Company to Assured provides a number of provisions bearing on the Company's 2008 compensation process. The Purchase Agreement imposes restrictions on the Company doing any of the following without Assured's consent:
•Cash Compensation: making any material change in cash compensation of employees other than (i) arrangements that do not involve payments by the Company after closing or (ii) changes pursuant to normal compensation practices or pursuant to existing contractual commitments and consistent with past practices.
•Bonuses/Incentive Compensation: paying any bonuses or incentive compensation, including equity-based compensation, in amounts on an annualized basis in excess of amounts accrued as of September 30, 2008 (provided that this shall not limit the amount of any bonus or incentive compensation payable to any particular individual).
•General Benefits: instituting any material increase in any benefit provided under any profit-sharing, bonus, incentive, deferred compensation, insurance, pension, retirement, medical, hospital, disability, welfare or other benefits available to employees other than (i) in the ordinary course of business or (ii) arrangements that do not involve payments by the Company after closing.
•Employment/Severance Agreements: entering into any employment or severance agreements other than for new employees in the ordinary course of business.
•Severance/Termination Plan Benefits: increasing benefits payable in the aggregate under severance or termination pay plans or policies other than as required by law or any existing plan.
•New Plans/Plan Amendments: adopting any new or amending any existing bonus, profit sharing, compensation, stock option, pension, retirement, deferred compensation, employment or other employee benefit plan or policy for the benefit of any director, officer or employee other than (i) for new employees in the ordinary course or (ii) amendments to such plans or policies applicable to all or a portion of the Company and that do not in the aggregate materially increase amounts otherwise payable thereunder, other than required amendments to the definition of "constructive termination" under the Company's severance policies intended to eliminate constructive termination by reason of reduced cash bonus payments.
•Director/Executive Officer Compensation: increasing the compensation or benefits of any director or executive officer other than in the ordinary course or as required by the applicable benefit plan.
• Non-Competition/Solicitation: waiving or amending any non-competition or non-solicitation agreement with any employee.
•Issuance of Equity: issuing or selling any equity interests or rights to acquire such interests other than (i) shares of Company issued pursuant to the Share Purchase Program Agreement and the DCP or SERP, as applicable, in respect of deemed investments by certain directors under the DCP and SERP, which shall not exceed 172,002 shares, (ii) performance shares under the Equity Participation Plan or (iii) shares issued to Dexia Holdings, FSA Holdings or a FSA Holdings subsidiary.
Purchase Agreement Provisions Bearing on the Post-Closing Compensation Matters
The Purchase Agreement includes provisions bearing on compensation of Company employees post-closing, including the following:
•Salaries and Benefit Plans. Each active employee on the closing date shall receive (i) a salary no less than in effect immediately prior to closing for a period of one year and (ii) employee benefit plans, programs, policies and arrangements (other than salary) comparable to other New York City-based employees of Assured's subsidiaries; provided that Assured, FSA Holdings and FSA Holdings' subsidiaries will retain the right to terminate any employee.
•Recognition of Service. The Assured employee benefit plans, programs and policies will recognize each Company employee's service for purposes of eligibility, vesting and benefit accrual (other than accrual under defined benefit pension plans), to the same extent such service was credited under the comparable FSA benefit plan applicable to the employee.
•Continuation of Severance Policies. In connection with the Purchase Agreement, Assured has agreed that benefit provisions of the Company's severance policies (as opposed to those of Assured's severance policies) will apply to Company employees whose employment is terminated within one year of the Purchase Agreement closing.
The Company's 2008 Compensation Process
The HR Committee determines the compensation of the Chief Executive Officer and the Chief Operating Officer and reviews and approves management's compensation recommendations for other employees of the Company. In December 2008, four additional directors designated by Dexia were appointed to the HR Committee. Following the appointment of the new HR Committee members, the HR Committee was comprised of Messrs. Downey (Chairman), Cochran, Taylor, Joly, Buysschaert, Piret and Poupelle. Mr. Cochran recuses himself from HR Committee deliberations concerning his own compensation.
Historically, the HR Committee engaged compensation consultants to review market compensation levels. Johnson Associates, Inc. ("Johnson Associates") prepared a report for the HR Committee in connection with compensation decisions made in February 2008, as described in the Company's Annual Report on Form 10-K for 2007. Johnson Associates did not provide a similar report in connection with the HR Committee's compensation decisions made in January and February 2009 with respect to 2008 bonuses and 2009 salaries and performance share unit awards, since these decisions were made under unique circumstances for the Company, and were subject to the constraints and requirements applicable to the Company's compensation provided by the Purchase Agreement.
The Company's Executive Management Committee (comprised of Messrs. Cochran, McCarthy, Brewer, Stern and Simon) provides input to the Human Resources Committee on compensation matters. Generally, managers within the Company prepared compensation recommendations of year-end bonuses, new year salaries and new year performance share unit awards for employees under their supervision, in what management characterized as a "bottom-up" compensation process, with
initial compensation recommendations originating from lower levels of management. This process was not followed in arriving at 2008 bonuses, 2009 salaries and 2009 performance share unit awards. For 2008 bonus determinations, the Company's Executive Management Committee prepared recommendations taking into account the requirements of the Purchase Agreement. Specifically, the Purchase Agreement allowed for customary salary increases and a 2008 bonus pool of up to $28 million, which was based upon the "Rainy Day Fund" established under the Company's bonus guideline. Given the performance-based parameters of the Company's bonus guideline, adverse 2008 financial performance eliminated the guideline Bonus Pool but allowed for a "Rainy Day Fund" bonus pool comprised, as described above, of non-distributed amounts from prior year guideline bonus pools. The Rainy Day Fund bonus pool allowed at best for significantly reduced cash bonuses compared to prior years. The Executive Management Committee recommended a distribution of substantially the entire Rainy Day Fund bonus pool to employees of the Company (excluding the Executive Management Committee), and thereafter obtained an understanding, agreed by Assured, that up to an additional $3 million was available for bonuses to Executive Management Committee members to the extent that the HR Committee approved such bonuses. The HR Committee approved 2008 bonuses at its January 2009 meeting. 2008 bonus payouts for the named executive officers are described under "-Summary Compensation Table-Discussion of 2008 Compensation for the Named Executive Officers-2008 Cash Bonuses."
At its January 2009 meeting, the HR Committee was provided with (i) the 2008 bonus and 2009 salary recommendations for Company employees (other than members of the Executive Management Committee); (ii) the Chief Executive Officer's recommendation of compensation for the Company's General Counsel and Chief Financial Officer and advice with respect to compensation of the Company's Chief Risk Management Officer and Chief Operating Officer; and (iii) the provisions of the Company's employment agreements with the Chief Executive Officer and Chief Operating Officer with respect to their entitlements for salary, bonus and performance share awards. On the basis of the foregoing, the HR Committee approved 2008 bonuses and 2009 salaries for employees of the Company, and declined to award performance share units or performance shares, as discussed in further detail below.
Compensation Committee Report
The HR Committee has reviewed and discussed with management the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K. Based on such review and discussions, the HR Committee recommended to the Board of Directors of the Company that the Compensation Discussion and Analysis be included in the Company's Annual Report on Form 10-K for the year ended December 31, 2008.
Robert N. Downey (Chairman)
Michel Buysschaert
Robert P. Cochran
Alexandre Joly
Claude Piret
Pascal Poupelle
Roger K. Taylor
Summary Compensation Table
The table below sets forth a summary of all compensation paid to the chief executive officer, the principal financial officer and the three most highly compensated other executive officers of the Company, in each case for services rendered in all capacities to the Company for the three years ended December 31, 2008, 2007 and 2006.
2008 Summary Compensation Table(1)
(1)Annual compensation for each year includes amounts deferred under the DCPs or paid into the Company's 401(k) plan or Flex Plan.
(2)The bonus set forth for 2008 is contingent upon, and payable promptly following, the closing of the sale of the Company to Assured.
(3)The amount under this column for 2008 is a negative number representing a reversal of prior year accruals with respect to stock awards having a multi-year valuation period. The amount under this column reflects the expense reported by the Company in the specified year under SFAS 123-R with respect to performance shares and Dexia restricted stock awarded under the Equity Plans in 2008, 2007, 2006 and 2005, except that (a) estimates of forfeiture related to service-based vesting provisions have not been taken into account in calculating such dollar amounts and (b) for purposes of determining the amount of compensation reflected for pre-2006 awards, the "modified prospective transition method" under SFAS 123-R was employed. No awards of restricted stock of the Company or options were made to any of the executives named in the table during the period
covered by the table. Amounts included under this column are attributable to performance shares and Dexia restricted stock as set forth below:
(4)The amount under this column reflects the excess, if any, of (a) dividends and realized and unrealized gains on Company common stock acquired under the Director Share Purchase Program described below and credited by the Company to participants under the DCPs and SERPs over (b) a market rate of interest identified by the Internal Revenue Service as a proxy for the rate the Company would be paying to a lender if the Company had paid out the deferred compensation up front and did not have the use of funds, equal to 120% of the federal rate with compounding prescribed under Section 1274(d) of the Internal Revenue Code (5.68% for 2007 and 5.35% for 2008) (the "Proxy Market Rate"). This column does not include earnings on publicly traded securities and mutual funds credited by the Company to participants under the DCPs and SERPs. The Company currently match funds all phantom investments made by participants in the DCPs and SERPs. Investment alternatives under the DCPs include mutual funds, shares of individual companies and, in the case of director participants, shares under the Director Share Purchase Program described below. Since the Company match funds all phantom investments under the DCPs and SERPs, the principal costs associated with these plans (in addition to the amounts actually contributed by the Company under the SERPs) come from (i) the delay in recognition by the Company of compensation expense for the deferred amounts and (ii) the recognition of gains on matched investments if and when realized by the Company prior to the time that the Company recognizes a deduction for compensation expense to the employee (at the time payments are made by the plans to the participants). Reference is made to "-Nonqualified Deferred Compensation," below, for a list of the mutual funds and stock benchmarks under the DCPs and SERPs and their respective 2008 rates of return. The dollar amounts under this column do not include earnings under the SERPs, which qualify as "excess benefit plans" under Rule 16(b)-3(b)(2) of the Exchange Act, except insofar as SERP investments are in Company common stock under the Director Share Purchase Program. The dollar amounts under this column are not included in determining amounts under the "total" compensation column.
(5)All Other Compensation includes the contributions by the Company to the Pension Plan and SERPs set forth below:
Pension Plan and SERP amounts shown were accrued during 2007 and 2008 and paid in February of 2008 and 2009, respectively. The Pension Plan provides for a Company funded contribution equal to 9% of cash compensation (salary and bonus) up to the compensation limit specified by the Internal Revenue Service. The SERPs provide for an unfunded Company contribution equal to 9% of cash compensation over and above the Pension Plan compensation limit but limited to $1.0 million of compensation. The Pension Plan and SERPs provide for vesting of contributions over a six-year employment period, after which all subsequent contributions are 100% vested. Given the tenure with the Company of the named executive officers, all contributions to the Pension Plan and SERPs on behalf of the named executive officers are fully vested when made.
All other compensation includes dividends on unvested shares of Dexia restricted stock paid (without adjustment for withholding taxes) by Dexia during 2006, 2007 and 2008 in the amounts set forth below:
All other compensation does not include the dollar value of the Company's Travel Incentive Program, Transit Chek Program, Health Club Program or group life, health, hospitalization and medical reimbursement plans that do not discriminate in scope, terms or operation in favor of the named executive officers and that are available generally to all salaried employees. All other compensation also does not include payments contributed under the Company's Matching Gift Program. Neither Mr. Cochran nor Mr. McCarthy receive additional compensation for their services as directors of the Company, although such service entitles them to participate in the Director Share Purchase Program described below.
(6)All other compensation for Mr. Cochran includes the excess of (a) dividends and realized and unrealized gains on common stock of the Company, purchased through the Director Share Purchase Program (and not owned under the DCPs or SERPs), over (b) the Proxy Market Rate of 5.68% in 2007 and 5.35% in 2008, which was $417,325 for 2007 and $0 for 2008. For a discussion of the Director Share Purchase Program, see "-Compensation of Directors-Director Share Purchase Program," below.
Performance shares generally vest upon completion of the related 3-year performance cycle. The dollar value of performance share awards reported in the Summary Compensation Table for 2006, 2007 and 2008 vest as follows, absent termination of employment, death or retirement:
(1)The amounts for 2008 are negative numbers representing reversals of prior year accruals with respect to stock awards having a multi-year valuation period. Generally, one third of a Dexia restricted stock award vests after 2.5 years and two thirds vests after 3.5 years, with transfer restrictions lapsing six months after the vesting date. The 2004 Equity Plan provides that, when a participant becomes eligible for retirement at age 55, shares of Dexia restricted stock vest thereafter to the extent the shares would have vested had the employee actually retired. Commencing in 2007, however, an exception to this general provision was adopted providing for delayed vesting for any employee over the age of 55 who is not entitled to retire pursuant to the terms of an employment agreement with the Company, as is the case with Mr. Cochran. Prior to adoption of this exception, shares of Dexia restricted stock held by Mr. Cochran vested in 2006 as set forth in the table below. The dollar value of Dexia restricted stock reported in the Summary Compensation Table
for 2006, 2007 and 2008 for Messrs. Cochran, McCarthy, Brewer, Stern and Simon have vested or will vest as follows, absent termination of employment, death or retirement:
Discussion of 2008 Compensation for the Named Executive Officers
Set forth below is a discussion of the 2008 bonuses and 2009 salaries for the named executive officers. For the Chief Executive Officer and the President, these amounts were determined with reference to their agreements with the Company, about which there is a dispute. The compensation of the General Counsel, Chief Risk Management Officer and Chief Financial Officer was determined on the premise that the services of these senior officers are required to effectuate a closing of the sale of the Company under the Purchase Agreement. The HR Committee of the Board of Directors accepted management's recommendations regarding compensation for employees (other than members of the Executive Management Committee) and the high end of the range of the Chief Executive Officer's recommendation regarding compensation of the General Counsel and Chief Financial Officer, but made payment of the 2008 bonuses for the General Counsel, the Chief Financial Officer and the Chief Risk Management Officer contingent upon a closing of the sale of the Company to Assured.
2009 Salaries
The named executive officers received salary increases for 2009 of 1.5%, representing 50% of the 3% salary increase provided to other Company employees, primarily representing cost of living adjustments.
Chief Executive Officer. The 2009 salary for the Company's Chief Executive Officer was set at $507,500, compared to a 2008 salary of $500,000, representing a 1.5% salary increase as awarded to other Executive Management Committee members as a cost of living increase. Under his employment agreement with the Company, Mr. Cochran is entitled to a base salary at the annual rate in effect immediately prior to the effective date of the agreement ($490,000), subject to increase at the Board's discretion.
Chief Operating Officer. The 2009 salary for the Company's Chief Operating Officer was set at $355,250 compared to a 2008 salary of $350,000, representing a 1.5% salary increase as awarded to other Executive Management Committee members as a cost of living increase. Under his employment agreement with the Company, Mr. McCarthy is entitled to a base salary at the annual rate in effect immediately prior to the effective date of the agreement ($300,000), subject to increase at the Board's discretion.
Chief Risk Management Officer, General Counsel and Chief Financial Officer. The 2009 salaries for the Company's Chief Risk Management Officer, General Counsel and Chief Financial Officer were set at $284,200 compared to 2008 salaries of $280,000, representing a 1.5% salary increase as awarded to other Executive Management Committee members as a cost of living increase.
2008 Cash Bonuses
Based on the Company's 2008 financial performance, under Company's Bonus Pool guideline the Bonus Pool for 2008 was $0. However, the "Rainy Day Fund," which totaled $28 million, was available to fund 2008 bonuses. The Purchase Agreement contemplated distribution of a 2008 bonus pool of up to $28 million absent approval from Assured. Assured consented to the distribution of up to an additional $3 million to fund 2008 bonuses to members of the Company's Executive Management Committee. The $28 million Rainy Day Fund bonus pool was significantly less than the 2007 guideline Bonus Pool of $79.5 million, of which $65.3 million was distributed, and the 2006 guideline Bonus Pool of $61.4 million, of which $57.3 million was distributed.
Chief Executive Officer and Chief Operating Officer. Neither Mr. Cochran nor Mr. McCarthy was awarded a bonus for 2008.
General Counsel, Chief Financial Officer and Chief Risk Management Officer. The 2008 bonus for each of Messrs. Stern and Simon was set at $500,000, a decrease from their 2007 bonuses of $1,000,000 each. The bonuses awarded to Messrs. Stern and Simon are contingent upon the closing of the sale of the Company to Assured, and were considered necessary by the HR Committee for retentive purposes. The 2008 bonus for Mr. Brewer was set at $300,000, a decrease from his 2007 bonus of $1,200,000, and is also contingent upon closing of the sale of the Company to Assured and was considered necessary for retentive purposes.
Performance Share Unit Awards
The HR Committee has not awarded performance share units or performance shares in 2009 to date. Performance share unit awards made in February 2008 are described in the Company's 2007 Annual Report on Form 10-K, including the Grants of Plan-Based Awards table. Because there have been no further awards since the previously reported awards granted in 2008, a Grants of Plan-Based Awards table is not included in this Annual Report.
Outstanding Equity Awards
The following table sets forth a summary of the outstanding unvested equity awards to each of the named executive officers as of December 31, 2008 (excluding awards vesting on such date and payable in February 2009).
Outstanding Equity Awards at 2008 Fiscal Year-End
(1)Performance shares generally vest upon completion of the related 3-year performance cycle. The performance shares reported vest as follows:
(2)Based upon management's expectation of whether performance objectives for outstanding performance shares will be achieved, such shares have no value. If the performance objectives were achieved, resulting in a 100% payout for performance shares using the December 31, 2008 share value under the 2004 Equity Plan, then the amounts in this column would be as follows: Mr. Cochran, $7,725,884; Mr. McCarthy, $6,477,857; Mr. Stern, $2,139,476; Mr. Simon, $2,139,476; and Mr. Brewer, $2,228,620.
(3)Generally, one third of a Dexia restricted stock award vests after 2.5 years and two thirds vests after 3.5 years, with transfer restrictions lapsing six months after the vesting date. The Dexia restricted stock reported vests as follows:
(4)Market value is based upon the December 31, 2008 closing price of Dexia ordinary shares converted into dollars at Euro 1.00 = $1.3971, the December 31, 2008 exchange rate as reported on the Bloomberg data screen.
2006/2007/2008 Performance Share Payout
Performance Shares awarded under the 2004 Equity Plan with respect to the 2006/2007/2008 performance cycle ("2006/2007/2008 performance shares") vested in accordance with their award agreements on December 31, 2008 but there was no payout as they had no value due to the poor financial performance of the Company. The 2006/2007/2008 performance shares held by the named executive officers were awarded in February 2005 and February 2006, and disclosed in the Company's
Annual Reports on Form 10-K for the years ended December 31, 2004 and December 31, 2005, respectively.
Dexia Restricted Stock Vested During 2008
The following table sets forth a summary of Dexia Restricted Stock awarded to each of the named executive officers that vested during the year ended December 31, 2008:
Dexia Restricted Stock Vested During 2008
(1)The value realized on vesting is based upon the closing market price of Dexia ordinary shares as of the last day of each calendar quarter converted into U.S. dollars as reported on the books of the Company.
(2)Dexia restricted stock awards initially provided for pro-rata vesting upon eligibility for retirement at age 55. This provision was amended in February 2007 to delay vesting for employees like Mr. Cochran, who are not eligible to retire until a later date. Prior to such amendment, some shares of Dexia restricted stock owned by Mr. Cochran had vested.
Nonqualified Deferred Compensation
The following table sets forth a summary of information with respect to the Company's Deferred Compensation Plans (DCPs) and Supplemental Executive Retirement Plans (SERPs) as of and for the year ended December 31, 2008:
2008 Nonqualified Deferred Compensation
(1)This column reflects compensation otherwise payable in 2008 voluntarily deferred by the named executive officer under the DCPs.
(2)This column reflects contributions by the Company to the SERPs on behalf of the named executive officers accrued in 2007 and contributed in 2008. These amounts were included in the Summary Compensation Table in the Company's 2007 Form 10-K. All amounts were 100% vested at December 31, 2008.
The SERPs and DCPs are "top hat" plans, which are unfunded and unsecured non-qualified plans restricted under applicable law to a limited number of highly compensated employees. Under the SERPs, the Company makes an annual contribution equal to 9% of prior year salary and bonus in excess of the money purchase plan salary/bonus cap (but disregarding salary/bonus in excess of $1.0 million), with such contributed amounts generally credited with returns on mutual funds or securities selected by the participants and "match funded" by the Company. The mutual funds and securities employed as investment benchmarks under the DCPs and SERPs in 2008 and their respective 2008 rates of return were as follows:
Amounts contributed by the Company under the SERPs and the earnings thereon are payable upon or after termination of employment in accordance with a schedule elected by the employee. Under the DCPs, participants are entitled to irrevocably defer receipt (generally for a minimum deferral period equal to the earlier of three years or until termination of employment) of bonus and performance share compensation otherwise payable to them by the Company, with such deferred amounts generally credited with returns on mutual funds or securities selected by the participants and "match funded" by the Company. While the SERPs and DCPs are unfunded plans, the plans contemplate that the Company will make available to plan participants "deemed" investment alternatives comprised of mutual funds or securities. Plan participants are generally entitled to select one or more such "deemed" investments for their plan balances (and to change such selections on a quarterly basis) and their plan balances are credited or debited with the performance of such selected investments. Plan participants are entitled to elect to receive SERP and DCP payouts in lump sums at the payout date or in installments (over a period of years elected in advance by the participant) commencing with the payout date. The SERPs and DCPs generally do not permit early withdrawals of funds absent extreme financial hardship, but allow for extensions of deferrals to the extent permitted by the Internal Revenue Code. In connection with amendments made in 2007 and 2008 to the DCPs, participants were entitled, in accordance with applicable Internal Revenue Code requirements, to change deferral elections previously made under those plans.
Potential Payments Upon Termination of Employment, Retirement or Change-in-Control
Set forth below is a description of amounts payable to the named executive officers upon termination of employment with the Company, retirement from the Company or change in control of the Company. Amounts set forth below do not include amounts payable under the Company's Pension Plan, 401(k) plan, DCPs or SERPs described above.
Payments Upon Termination of Employment
Chief Executive Officer and Chief Operating Officer
The employment agreements provide for continued participation by Messrs. Cochran and McCarthy in the Company's benefit plans and severance benefits in lieu of the Company's existing severance policy. Specifically, if the Company terminates Mr. Cochran or Mr. McCarthy without "cause" or either of such executive officers terminates his employment for "good reason," the terminated employee will be entitled to:
•his pro-rata annual base salary and annual bonus through the date of termination;
•twice his annual base salary at the rate then in effect and twice his average annual bonus for the two immediately prior years;
•vesting of his outstanding performance shares and all performance shares he was entitled to be awarded during the remaining term of the employment agreement, with uncompleted years in any performance cycle valued as if the performance objective had been 100% satisfied; and
•a gross-up payment to hold the employee harmless from any excise tax imposed by Section 4999 of the Internal Revenue Code of 1986, as amended ("Golden Parachute Tax").
For purposes of each employment agreement, (a) "cause" means conviction of, or a plea of nolo contendere to, a criminal misdemeanor or felony materially injurious to the Company, willful and continued failure to perform duties after a specific demand to do so or willful misconduct in carrying out duties directly and materially harmful to the Company's business or reputation; and (b) "good reason" means a diminution in the employee's significant duties or responsibilities, breach by the Company of its obligations under the employment agreement, relocation of the executive more than 25 miles from New York City, a material adverse change in total compensation, or, in the case of Mr. McCarthy, not being named Mr. Cochran's successor as Chief Executive Officer of the Company.
If his employment with the Company had been terminated without cause by the Company on December 31, 2008, then pursuant to his employment agreement Mr. Cochran would have been entitled to receive a minimum of up to $15,364,902, comprised of:
(a)$1,000,380 representing (i) $1,000,000, equal to two times the annual base salary at the 2008 rate, plus (ii) interest at the year-end three-month Treasury rate for the six month period prior to payment;
(b)up to $6,902,622, representing (i) $6,900,000, equal to two times the average annual bonus payable for the two years immediately prior to the termination, plus (ii) interest at the year-end three-month Treasury rate for the six month period prior to payment;
(c)up to $2,085,737, representing (i) the vesting of all previously granted outstanding performance shares valued at $99.05 per share under the 2004 Equity Plan, with the payouts for each completed year based on actual results and the payout for uncompleted years valued at 100% achievement of the performance objectives, plus (ii) interest at 8% per annum, compounded semi-annually, for the two year restricted period described below;
(d)up to $5,133,807, representing the award and vesting of performance shares the employee is entitled to be awarded in 2009 valued at $99.05 per share under the 2004 Equity Plan, with the payout valued at 100% achievement of the performance objectives, plus (ii) interest at 8% per annum, compounded semi-annually, for the two year restricted period described below; and
(e)up to $242,356, representing (i) the vesting of the 46,346 outstanding shares of Dexia restricted stock previously granted under the 2004 Equity Plan, valued as of December 31, 2008 at $4.47 per share, plus (ii) interest at 8% per annum, compounded semi-annually, for a two year restricted period.
The amounts provided above represent the Company's understanding of the amount payable under the interpretation of the severance provisions of Mr. Cochran's employment agreement most favorable to the employee.
If his employment with the Company had been terminated without cause by the Company on December 31, 2008, then pursuant to his employment agreement Mr. McCarthy would have been entitled to receive a minimum of $13,033,202, comprised of:
(a)$700,266, representing (i) $700,000, equal to two times the annual base salary at the 2008 rate, plus (ii) interest at the year-end three-month Treasury rate for the six month period prior to payment;
(b)up to $6,302,394, representing (i) 6,300,000, equal to two times the average annual bonus payable for the two years immediately prior to the termination, plus (ii) interest at the year-end three-month Treasury rate for the six month period prior to payment;
(c)up to $2,085,737, representing (i) the vesting of all previously granted outstanding performance shares valued at $99.05 per share under the 2004 Equity Plan, with the payouts for each completed year based on actual results and the payout for uncompleted years valued at 100% achievement of the performance objectives, plus (ii) interest at 8% per annum, compounded semi-annually, for the two year restricted period described below;
(d)up to $3,722,010, representing the award and vesting of performance shares the employee is entitled to be awarded in 2009 valued at $99.05 per share under the 2004 Equity Plan, with the payout valued at 100% achievement of the performance objectives, plus (ii) interest at 8% per annum, compounded semi-annually, for the two year restricted period described below; and
(e)up to $222,795, representing (i) the vesting of the 42,605 outstanding shares of Dexia restricted stock previously granted under the 2004 Equity Plan, valued as of December 31, 2008 at $4.47per share, plus (ii) interest at 8% per annum, compounded semi-annually, for a two year restricted period.
The amounts provided above represent the Company's understanding of the amount payable under the interpretation of the severance provisions of Mr. McCarthy's employment agreement most favorable to the employee.
In the fourth quarter of 2008, Mr. McCarthy provided notice of constructive termination of employment under his employment agreement alleging a diminution of his significant duties and responsibilities. The Company has entered into a "tolling agreement" with Mr. McCarthy with respect to the termination notice period under the employment agreement, pending further discussions.
Both employment agreements provide that payments in respect of salary and bonus are, to the extent otherwise subject to penalty under Section 409A of the Internal Revenue Code, payable six months after termination of employment and are credited with interest at the three-month Treasury bill rate until so paid. Payments in respect of performance shares (a) are subject to forfeiture in the event of a breach by the employee of the covenant not to compete or covenant not to solicit Company clients or employees during a two year restricted period following termination of employment, and (b) are payable in a lump sum following expiration of the restricted period, together with interest accrued at 8% per annum, compounded semi-annually, during the restricted period.
Both employment agreements provide that, if the employee is terminated for cause or terminates his employment without "good reason" during the term, he will be entitled only to be paid his pro rata annual base salary through the date of termination and all unvested performance shares and Dexia restricted stock will be forfeited. If such termination occurs after the term of the agreement, he will also be entitled to his pro-rata annual bonus through the date of termination and his performance shares will vest pro rata in proportion to the percentage of the applicable performance cycle during
which he was employed by the Company. Each employment agreement contains a non-compete provision extending through the greater of two years and the term of the agreement.
If Mr. Cochran becomes Non-Executive Chairman of the Company, he will be entitled to his then-current salary and an annual performance share unit award with an estimated economic value at least equal to 50% of normal prior awards, but will not be entitled to a mandatory annual cash bonus. If Mr. McCarthy becomes the Chief Executive Officer of the Company, he will be entitled to compensation equal to 90% or more of Mr. Cochran's latest compensation, including salary, bonus and performance share units.
General Counsel, Chief Risk Management Officer and Chief Financial Officer
Pursuant to the Severance Policy for Senior Management, upon termination of employment (including constructive termination) by the Company other than for cause, each of Messrs. Brewer, Stern and Simon will become entitled to twelve months of pay, as well as a gross-up payment to hold the employee harmless from any excise Golden Parachute Tax. For purposes of the foregoing:
•"for cause" means termination for unethical practices, illegal conduct or gross insubordination, but specifically excludes termination as a result of substandard performance;
•"constructive termination" of employment occurs if an eligible employee's base salary or incentive compensation opportunities are materially reduced out of line with Company results, or if there is a material reduction in responsibilities, such that the employee's termination of employment is an involuntary termination under Section 409A of the Internal Revenue Code; and
•"months of pay" (a) shall be determined on the basis of the eligible employee's monthly salary on his separation date and (b) shall include the eligible employee's most recent bonus (or three year average, if higher), with one-twelfth (1/12th) of such bonus amount being allocated to each month of pay.
An eligible employee's base salary and bonus shall include amounts deferred under the DCPs and the 401(k), and amounts allocated to the Flex Plan. In addition, severance benefits (applicable to all employees of the Company during their severance period) include:
•continuation of employee hospital, medical, dental, prescription drug and vision coverages for the severance period;
•continuation of life and disability insurance coverage at the employee's expense for the severance period to the extent allowed by the insurer (such coverage is not currently allowed by the insurer);
•reimbursement of life insurance premiums to the extent that such life insurance is continued during the severance period; and
•payment for unused vacation days.
Payments of severance under the Severance Policy for Senior Management is subject to execution by the employee of a waiver and release agreement, and any unpaid severance amounts are subject to up to a 50% reduction when offset by any employment or consulting income of the employee during the severance period. If any of Mr. Brewer, Mr. Stern or Mr. Simon is terminated for cause or terminates his employment absent "constructive termination", he will be entitled only to be paid his pro rata annual base salary through the date of termination and all unvested performance shares and Dexia restricted stock will be forfeited.
If his employment with the Company had been terminated without cause by the Company on December 31, 2008, then pursuant to the Severance Policy for Senior Management, Mr. Stern would have been entitled to receive $1,397,672, comprised of:
(a)one year salary at the 2008 rate of $280,000;
(b)one year bonus at the 2007 rate of $1,000,000;
(c)$34,987, the estimated value of outstanding performance shares and performance share units vested pro-rata, representing (i) 8,100 performance shares valued at $0, based upon management's expectation of whether performance objectives for outstanding performance shares will be achieved. If the performance objectives were achieved, resulting in a 100% payout for performance shares using the December 31, 2008 share value of $99.05 under the 2004 Equity Plan, then the amount would be $802,303; and (ii) $34,987 in respect of 7,827 shares of Dexia restricted stock valued at $4.47 per share;
(d)$29,352, representing the estimated cost of continuation of hospital, medical, dental, prescription drug and vision coverages for the severance period; and
(e)$53,333, representing payment for unused vacation days.
If his employment with the Company had been terminated without cause by the Company on December 31, 2008, then pursuant to the Severance Policy for Senior Management, Mr. Simon would have been entitled to receive $1,395,872, comprised of:
(a)one year salary at the 2008 rate of $280,000;
(b)one year bonus at the 2007 rate of $1,000,000;
(c)$34,987, the estimated value of outstanding performance shares and performance share units vested pro-rata, representing (i) 8,100 performance shares valued at $0, based upon management's expectation of whether performance objectives for outstanding performance shares will be achieved. If the performance objectives were achieved, resulting in a 100% payout for performance shares using the December 31, 2008 share value of $99.05 under the 2004 Equity Plan, then the amount would be $802,303; and (ii) $34,987 in respect of 7,827 shares of Dexia restricted stock valued at $4.47 per share;
d)$27,552, representing the estimated cost of continuation of hospital, medical, dental, prescription drug and vision coverages for the severance period; and
(e)$53,333, representing payment for unused vacation days.
If his employment with the Company had been terminated without cause by the Company on December 31, 2008, then pursuant to the Severance Policy for Senior Management, Mr. Brewer would have been entitled to receive $1,606,968, comprised of:
(a)one year salary at the 2008 rate of $280,000;
(b)one year bonus at the 2007 rate of $1,200,000;
(c)$35,949, the estimated value of outstanding performance shares and performance share units vested pro-rata, representing (i) 8,200 performance shares valued at $0, based upon management's expectation of whether performance objectives for outstanding performance shares will be achieved. If the performance objectives were achieved, resulting in a 100% payout for performance shares using the December 31, 2008 share value of $99.05 under the 2004 Equity Plan, then the amount would be $812,208; and (ii) $35,949 in respect of 8,042 shares of Dexia restricted stock valued at $4.47 per share;
(d)$29,352, representing the estimated cost of continuation of hospital, medical, dental, prescription drug and vision coverages for the severance period; and
(e)$61,667, representing payment for unused vacation days.
Payments Upon Retirement
Their employment agreements provide that Messrs. Cochran and McCarthy may elect to retire at the end of any employment agreement term after age 60, but that retirement is mandatory at age 65. Upon any such retirement, each of Mr. Cochran and Mr. McCarthy will be entitled to his pro-rata annual base salary and annual bonus through the date of retirement and the vesting of his outstanding performance shares over time as if he remained employed. Messrs. Cochran and McCarthy are not entitled to any other on-going retirement compensation except as provided by the Pension Plan and SERPs. Each of Mr. Cochran and Mr. McCarthy is below the minimum retirement age of 60 provided in their employment agreements. Each of Mr. Brewer, Mr. Stern and Mr. Simon is below the minimum retirement age of 55 otherwise applicable to employees of the Company. Accordingly, none of the named executive officers would be entitled to any payments by reason of retirement at December 31, 2008. In addition, under the Company's Optional Retiree Medical Program applicable to all U. S. Company employees, Messrs. Cochran, McCarthy, Brewer, Stern and Simon are entitled to participate in the Company's medical plan following retirement provided that they pay the full cost of coverage plus a 5% administrative fee to the Company. The Company retains the right to terminate the Optional Retiree Medical Program at any time.
Payments Upon Change in Control
The 2004 Equity Plan provides that the plan shall automatically continue if a change in control occurs. Following a "plan continuation," performance shares and Dexia restricted stock are not accelerated, but vest and are payable as if no change in control had occurred, except that performance shares and Dexia restricted stock vest in the case of any employee who is terminated without cause or leaves for "good reason" following the change in control, with the payouts for each completed year prior to termination of employment based on actual results and the payout for each uncompleted year following termination of employment based upon 100% achievement of the performance objectives.
Compensation of Directors
The table below sets forth a summary of all compensation paid to the directors of the Company, in each case for services rendered to the Company for the year ended December 31, 2008. Employees of the Company and Dexia received no additional compensation for their services as directors of the Company.
2008 Director Compensation Table
Each director of the Company who is not an officer of the Company or Dexia received a fee of $50,000 per annum for service as a director and an additional annual fee of $20,000 if Chairman of the Underwriting Committee or Audit Committee of the Board of Directors or $5,000 if Chairman of another Committee of the Board of Directors. Each director also received $2,000 for each Board meeting and regular Committee meeting attended and reimbursement for expenses for each such
meeting attended. Each director is entitled to defer fees under the Company's DCP and to participate in the Director Share Purchase Program.
Director Share Purchase Program
In the fourth quarter of 2000, the Company entered into an agreement with Dexia Holdings and Dexia Public Finance Bank, now Dexia Crédit Local, to establish the Director Share Purchase Program (the "Director Share Purchase Program"), pursuant to which Company directors could invest in shares of the Company's common stock. Dexia and the Company established the Director Share Purchase Program to encourage directors to have a financial interest in the Company to better align their financial interests with those of the Company's shareholders.
The Director Share Purchase Program entitles each director of the Company to purchase from Dexia (or an affiliate thereof) up to 126,958 restricted shares of the Company's common stock (which represented a $10.0 million investment at the purchase price at inception of the program) at a price determined in accordance with the provisions of the Director Share Purchase Program Agreement:
•restricted shares must be held for the lesser of four years or the participant's tenure as a director of the Company;
•restricted shares may be put to Dexia Crédit Local at any time or from time to time following the required holding period for cash; and
•purchases of shares after inception of the program are at a price equal to the purchase price for shares put to Dexia Crédit Local.
Directors may purchase such shares either directly or through deemed investments under the DCPs or, in the case of Company employees, the SERPs. Each deemed investment election with respect to these shares is irrevocable.
The Director Share Purchase Program enables the Company to purchase from Dexia Holdings, at the same price, the same number of shares of common stock purchased by directors through phantom investments under the DCPs or SERPs. Upon expiration of any applicable deferral period, the Company is obligated to pay out the phantom investments in shares of common stock, which must be held by the participant as if acquired directly from Dexia Holdings for generally a minimum of six months.
Sales under the program are not registered under the Securities Act of 1933, as amended, in reliance upon an exemption from registration under Section 4(2) of that Act. For more information regarding the directors' share ownership, see "Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
5% Shareholders
The following table sets forth certain information regarding beneficial ownership of the Company's equity at March 1, 2009 as to each person known by the Company to beneficially own, within the meaning of the Exchange Act, 5% or more of the outstanding shares of the common stock, par value $.01 per share, of the Company.
(1)Shares are held indirectly through a subsidiary of Dexia.
(2)For purposes of this table, Dexia is not deemed to be the beneficial owner of 158,224 shares acquired by the Company in connection with the Director Share Purchase Program described in "Item 11. Executive Compensation-Compensation of Directors-Director Share Purchase Program" or 13,778 other shares held by the Company. Ownership percentage is calculated based on 33,345,993 shares of common stock outstanding at March 1, 2009, which excludes such shares acquired by the Company. Directors and Executive Officers
Ownership of Company Common Stock
The following table sets forth certain information regarding beneficial and economic ownership of the Company's common stock at March 1, 2009 for (a) each director of the Company, (b) each named executive officer named in the "Summary Compensation Table" in Item 11, and (c) all executive officers and directors of the Company as a group.
Beneficial ownership is less than 1% for each executive officer and director listed, individually and as a group.
(1)Shares beneficially owned were acquired under the Company's Director Share Purchase Program described under "Item 11. Executive Compensation-Compensation of Directors-Director Share Purchase Program." To the extent shares economically owned exceed shares beneficially owned, such economic ownership is attributable to (a) deemed investments in the Company's common stock under the Director Share Purchase Program, and (b) performance shares, with each performance share treated as one share of common stock, in the amounts shown below (excluding fractional shares):
In December 2000, the Company acquired 304,757 shares of its common stock from Dexia Holdings to satisfy most of its obligations under the Director Share Purchase Program in an amount equal to the number of shares deemed invested by directors at the Program's inception date under the DCP and SERP. The Company held 164,211 of those shares as of December 31, 2008.
(2)Pursuant to the Director Share Purchase Program, Mr. Cochran put the 24,611 restricted shares he beneficially holds and Mr. Taylor put the 3,406 restricted shares he beneficially holds to Dexia Crédit Local in December 2008. They have not received payment for such shares.
(3)Ms. Colin and Messrs. Buysschaert, Joly, von Lowis, Piret, Poupelle and de Walque are directors of the Company and officers of Dexia or its subsidiaries. Dexia indirectly owns 99.9% of the Company's common stock.
(4)Pursuant to the Director Share Purchase Program, Mr. Downey put the 17,913 restricted shares he beneficially holds to Dexia Crédit Local in September 2008. He has not received payment for such shares. Ownership of Dexia Common Stock
The following table sets forth beneficial ownership of common shares of the Company's parent, Dexia, at March 1, 2009, for (a) each director of the Company, (b) each executive officer and (c) all executive officers and directors of the Company as a group. Beneficial ownership is less than 1% for each executive officer and director listed, individually and as a group.
(1)Dexia has provided the Company with information regarding shares owned by Ms. Colin and Messrs. Buysschaert, Joly, von Lowis, Piret, Poupelle and de Walque, and has advised the Company that:
(a)shares presented for those directors include only shares owned directly by such directors or shares for which those directors can cast a vote and exclude warrants, and
(b)at December 31, 2008, the total number of outstanding Dexia shares was 1,762,478,783, so that together the Company's executive officers and directors owned 0.09% of the Dexia shares and the maximum amount owned by any of the Company's executive officers and directors represents 0.03% of the Dexia shares.
A majority of the shares set forth above were acquired under the Dexia Employee Share Plans, as described in "Item 11. Executive Compensation-Compensation Discussion and Analysis-Components of Compensation Provided by the Company-Dexia Employee Share Plans." Under the Plans, the investment alternatives include a "classic option," under which U.S. resident employees may purchase Dexia shares at a 15% discount (up to a limit prescribed annually under Section 423 of the Internal Revenue Code), and three leveraged options. The following table
shows the number of leveraged shares beneficially held by each of the named executive officers as of March 1, 2009:
(2)Includes shares granted under the 2004 Equity Plan, as described in "Item 11. Executive Compensation-Compensation Discussion and Analysis-Components of Compensation Provided by the Company-Performance Share Units." Generally, one-third of an award of Dexia restricted stock vests after 2.5 years and two-thirds vests after 3.5 years, with transfer restrictions lapsing on one-third of each award after three years and on two thirds of each award after four years. Change in Control
In November 2008, Dexia and Assured entered into the Purchase Agreement providing for the purchase by Assured of all Company shares owned by Dexia (the "Acquisition"), subject to the satisfaction of specified closing conditions. Purchase Agreement closing conditions include (1) receipt of regulatory and Assured shareholder approvals; (2) confirmation from S&P, Moody's and Fitch that the acquisition of the Company would not result in a downgrade of the financial strength ratings of the insurance company subsidiaries of Assured or of the Company; and (3) segregation or separation of the Company's FP business such that the credit and liquidity risk of the FP business resides with Dexia, with FSA protected against any future Dexia credit impairment.
The Company cannot estimate whether or when the remaining closing conditions will be satisfied or relevant agreements negotiated, whether the Acquisition will be completed and, if completed, whether it will be structured as currently contemplated, or what the effects of the change in control or removal of the FP business will be on the Company and its results of operations. If the Acquisition is not completed, Dexia may explore other options with respect to the Company, including selling the Company or some of its operations to a third party or ceasing to write new business, which may have a material adverse effect on the Company.
Securities Available under Equity Compensation Plans
The following table sets forth information as of December 31, 2008 with respect to each compensation plan of the Company under which equity securities of the Company are authorized for issuance.
Equity Compensation Plan Information
(1)The Company currently maintains one such plan, the 2004 Equity Plan. A second plan, the Director Share Purchase Program, permits each director of the Company to purchase, directly from Dexia Holdings or through "phantom" investments in the Company's DCP or SERP, up to 126,958 shares of common stock. However, such shares are already issued and outstanding. At December 31, 2008, there were 1,446,300 shares available under the Director Share Purchase Program, based on the number of directors as of December 31, 2008 (13) and deducting shares that have already been purchased. See "Item 11. Executive Compensation-Compensation Discussion and Analysis-Components of Compensation Provided by the Company" and "-Compensation of Directors-Director Share Purchase Program" for further discussion of these plans.
(2)All of the Company's equity compensation plans have been approved by the Company's shareholders.
(3)Shares available for future issuance under the 2004 Equity Plan. Since its inception, up to 3,300,000 shares of common stock have been available for distribution under the 2004 Equity Plan in respect of performance shares. Such shares may be newly issued shares, treasury shares or shares purchased in the open market. If performance shares awarded under the 2004 Equity Plan are forfeited, the shares allocated to such awards are again available for distribution in connection with future awards under the Plan. So long as the Company's common stock is not registered under the Exchange Act, the Company expects to pay its performance shares in cash rather than stock.
Item 13.
Item 13. Certain Relationships and Related Transactions.
Dexia Transactions
Since the Company's merger with a subsidiary of Dexia in July 2000, various affiliates of Dexia, including certain wholly owned bank subsidiaries and/or their U.S. branches, have participated in transactions in which subsidiaries of the Company have provided financial guaranty insurance. For example, Dexia affiliates have provided liquidity facilities and letters of credit in FSA-insured transactions, have acted as the intermediary in CDS transactions and have been the beneficiaries of financial guaranty insurance policies issued by insurance company subsidiaries of the Company. In addition, in its FP segment the Company enters into transactions with various affiliates of Dexia in which Dexia acts as the counterparty in swap contracts. The Company invests short term assets in Dexia accounts and earns interest income on those accounts. In the opinion of management of the Company, the terms of these arrangements are no less favorable to the Company than the terms that could be obtained from unaffiliated parties.
During 2008, the Company and its subsidiaries FSA and FSAM entered into transactions with Dexia affiliates to address FP segment liquidity requirements and support the FP business:
•Pursuant to an agreement dated June 30, 2008, Dexia Crédit Local and Dexia Bank Belgium provided the First Dexia Line of Credit to FSAM. At March 2, 2009, the Company had outstanding draws of $2.7 billion under the First Dexia Line of Credit.
•In November 2008, FSA Holdings, FSA and Dexia Holdings entered into a Capital Commitment Agreement, pursuant to which Dexia Holdings has agreed to provide capital contributions to FSA Holdings up to $500 million in the aggregate, equal to the estimated economic losses on assets owned by FSAM for which OTTI has been determined for the quarter ending immediately prior to the contribution date, less certain realized tax benefits arising from those economic losses.
•In November 2008, Dexia Crédit Local, FSAM, FSA and FSA Insurance Company entered into the Securities Lending Agreement, pursuant to which Dexia Crédit Local has agreed to lend FSAM up to $3.5 billion of securities eligible to be pledged as collateral for GICs. As collateral for this loan, FSAM is obligated to post securities of the same market value but that are generally ineligible to act as collateral for GICs. FSA is obligated to insure FSAM's payment obligations under the Securities Lending Agreement.
•In November 2008, FSA, FSAM, Dexia Crédit Local and Dexia Bank Belgium entered into the Pledge Agreement, pursuant to which Dexia Crédit Local and Dexia Bank Belgium was provided a subordinated lien on the assets of FSAM to secure borrowings by FSAM under the First Dexia Line of Credit.
In February 2009 the parties entered into several additional agreements, which transfer credit and liquidity risk of the GIC operations to Dexia:
•FSAM and Dexia Crédit Local entered into a second revolving credit agreement (the "Second Dexia Line of Credit"), pursuant to which Dexia Crédit Local provides a $3.0 billion committed standby line of credit to FSAM.
•FSA, FSAM, the GIC Subsidiaries, Dexia Crédit Local and Dexia Bank Belgium entered into the Restated Pledge Agreement, pursuant to which FSAM granted security interests over substantially all its assets to (a) the GIC Subsidiaries, to secure FSAM's obligations to the GIC Subsidiaries under intercompany financing arrangements, and (b) Dexia Crédit Local, to secure borrowings under the Second Revolving Credit Agreement.
•Under the terms of the First Dexia Line of Credit, FSA guaranteed FSAM's repayment of any borrowings thereunder. FSA, FSAM, Dexia Crédit Local and Dexia Bank Belgium entered into a Guarantee Release Agreement pursuant to which such guarantee was released and terminated.
•FSA, FSAM and the GIC Subsidiaries entered into a Release and Termination Agreement, pursuant to which FSA's guaranty of certain assets held by FSAM and its guaranty of FSAM's obligations under certain intercompany financing arrangements between FSAM and the GIC Subsidiaries were released and terminated. FSAM and the GIC Subsidiaries were released from any further obligation to pay FSA any premium in respect of the terminated guaranties or other FSA guaranties that will remain outstanding in connection with the FP business.
For more information regarding these and related agreements, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-FP Segment Liquidity-Sources of Liquidity."
Certain notes held by FSA Global contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its own debt issuances that
relate to such notes, FSA Global has entered into several liquidity facilities with Dexia for $419.4 million.
For more information regarding the Company's transactions with Dexia and other related parties, see Note 24 to the consolidated financial statements in Item 8.
Director Share Purchase Program
At December 31, 2008, each director was entitled to purchase up to 126,958 actual or phantom shares of the Company's common stock, as described in "Item 11. Executive Compensation-Compensation of Directors-Director Share Purchase Program."
Other Relationships
Additional information relating to certain relationships and related transactions is set forth in "Item 11. Executive Compensation-Compensation Committee Interlocks and Insider Participation."
Review, Approval or Ratification of Transactions with Related Persons
The Company's ability to enter into related party transactions is limited by law. Under the New York Insurance Holding Company Act, the Company is required to obtain the prior approval of the New York Superintendent of the following transactions with related parties in amounts greater than 5% of the Company's admitted assets: sales, purchases, exchanges, loans or extensions of credits or investments. The Company must provide the New York Superintendent with 30 days' prior notice of such transactions with related parties in amounts equal to 0.5%-5% of the Company's admitted assets or involving reinsurance treaties or agreements or the rendering of services on a regular or systematic basis. For these purposes, an entity is presumed to be a "related party" if the direct or indirect voting control is 10% or greater. Absent a determination by the New York Superintendent of non-control, acquisition of a voting interest of 10% or more of Dexia would require prior approval of the New York Superintendent.
The Company provides an annual report to the New York Superintendant and the Board of Directors of the Company of all transactions with Dexia and its affiliates that are not members of the FSA group.
All directors and officers are subject to the Company's Code of Conduct, pursuant to which no director or officer may have, directly or indirectly:
•a personal or financial interest in any transaction adverse to the Company; or
•without prompt disclosure to the Board of Directors or Executive Management Committee of the Company, a financial interest in any insurance agency, brokerage business or other business enterprise (a) with which the Company engages in the purchase, sale or exchange of property, or the rental of real or personal property, or (b) to which it renders or from which it secures services.
For these purposes, "interest" includes the interest of the spouse or dependents of a director or officer, and "financial interest" does not include ownership of less than 1/10 of one percent of the outstanding stock of any corporation listed on a national securities exchange or less than $10,000 of the outstanding stock of any corporation whose stock is regularly sold at least once a week on the over-the-counter market in the U.S. In addition, pursuant to the bylaws of the Company, the Board of Directors must ratify any loans or debt of the Company. The Company does not have any other written policies and procedures for the review, approval or ratification of related party transactions.
As noted above, affiliates of Dexia have participated in transactions in which subsidiaries of the Company have provided financial guaranty insurance, including by providing liquidity facilities and
letters of credit in FSA-insured transactions, and have been beneficiaries of financial guaranty insurance policies issued by insurance company subsidiaries of the Company. Such transactions are the principal context in which affiliates of Dexia participate in transactions with the Company, and are subject to the same credit committee reviews as transactions in which no Dexia affiliates participate. In the opinion of management of the Company, the terms of these arrangements are no less favorable to the Company than the terms that could be obtained from unaffiliated parties.
Director Independence
Board members Robert N. Downey, James H. Ozanne, Roger K. Taylor and John W. Everets are independent within the meaning of Rule 10A-3 of the Exchange Act. Messrs. Ozanne (Chairman), Everets and Taylor comprise the Audit Committee of the Board of Directors and Messrs. Downey (Chairman) and Taylor are members of the Human Resources Committee of the Board of Directors.
In determining whether or not a director is independent, the Company uses the standards set out in Rule 10A-3(a)(b)(1) of the Exchange Act. Because the Company has only debt securities listed on the NYSE, it is not subject to the additional independence standards imposed by the NYSE, and is not subject to the NYSE requirement that a majority of the members of a board of directors and all members of a human resources committee be independent.
Item 14.
Item 14. Principal Accounting Fees and Services.
Aggregate fees for professional services by PricewaterhouseCoopers LLP for 2008 and 2007 were:
Professional Services by PricewaterhouseCoopers LLP
Audit fees for the years ended December 31, 2008 and 2007 were for professional services rendered for the audits of the Company's consolidated financial statements, audits of the Subsidiaries, and issuance of consents and in 2008 comfort letter procedures. Included in this amount is $6,000 and $108,000 in fees relating to consents that are reimbursed to the Company by the issuers of FSA-insured deals for the years ended December 31, 2008 and 2007, respectively.
Audit related fees for the years ended December 31, 2008 and 2007 were for assurance and related services related to the Company's retirement plans, actuarial certifications and consultations concerning financial accounting and reporting standards.
Tax fees for the years ended December 31, 2008 and 2007 were related to tax compliance.
Audit Committee Pre-Approval Policies and Procedures
The Audit Committee of the Company's Board of Directors pre-approves all audit and non-audit related fees paid to the Company's auditors.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
1. Consolidated Financial Statements
Item 8 sets forth the following financial statements of Financial Security Assurance Holdings Ltd. and Subsidiaries:
2. Financial Statement Schedules
The following financial statement schedule is filed as part of this Report.
3. Exhibits
The following are annexed as exhibits to this Report:
*Filed herewith.
**Furnished herewith.
Management contract of compensatory plan or arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
By:
/s/ ROBERT P. COCHRAN
Name: Robert P. Cochran
Title: Chairman and Chief Executive Officer
Dated: March 19, 2009
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
*Robert P. Cochran, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of himself and on behalf of each of the Directors and Officers of the Registrant named above after whose typed names asterisks appear pursuant to powers of attorney duly executed by such Directors and Officers and filed with the Securities and Exchange Commission as exhibits to this Report.
By:
/s/ ROBERT P. COCHRAN
Robert P. Cochran
Attorney in fact
Schedule I
Financial Security Assurance Holdings Ltd. (Parent Company)
Condensed Financial Information
Condensed Balance Sheets
(in thousands)
Condensed Statements of Income
(in thousands)
The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8.
Condensed Statements of Cash Flows
(in thousands)
In 2006, the Company's subsidiaries received a tax benefit of $1,200 by utilizing the Company's losses. These balances were recorded as capital contributions.
The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8.
Condensed Statement of Cash Flows (continued)
(in thousands)
The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8.
Financial Security Assurance Holdings Ltd. (Parent Company)
Notes to Condensed Financial Statements
1. Condensed Financial Statements
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed financial statements should be read in conjunction with the Company's Consolidated Financial Statements and the notes thereto. Certain reclassifications have been made to conform to the current year presentation.
2. Significant Accounting Policies
The Parent Company accounts for its investments in subsidiaries under the equity method.
3. Organization and Ownership
At December 31, 2008, Dexia Holdings Inc. ("Dexia Holdings") owned over 99% of outstanding Parent Company shares; the only other holders of Parent Company common stock were directors of Parent Company who owned shares of Parent Company common stock or economic interests therein under the Company's Director Share Purchase Program.
The Company is a subsidiary of Dexia Holdings which, in turn, is owned 90% by Dexia Crédit Local S.A. ("Dexia Crédit Local") and 10% by Dexia S.A. ("Dexia"). Dexia is a Belgian corporation primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia.
Expected Sale of the Company
Purchase Agreement with Assured Guaranty Ltd.
In November 2008, Dexia Holdings entered into a purchase agreement (the "Purchase Agreement") providing for the sale of all the Company shares owned by Dexia to Assured (the "Acquisition"), subject to the consummation of specified closing conditions, including regulatory approvals, absence of rating impairment and segregation or separation of the Company's FP operations from the Company's financial guaranty operations.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the "HSR Act") and the rules promulgated thereunder by the Federal Trade Commission (the "FTC"), the Acquisition may not be consummated until notifications have been given and certain information has been furnished to the FTC and the Department of Justice (the "DOJ") and specified waiting period requirements have been satisfied. The HSR Act waiting period expired on January 21, 2009. In addition, under the insurance holding company laws and regulations applicable to the insurance subsidiaries of the Company and Assured, before a person can acquire control of a U.S. insurance company, prior written approval must be obtained from the insurance commissioner of the state where the insurer is domiciled. Assured has informed the Company that Assured filed applications with the insurance departments of the States of New York and Oklahoma and the U.K. Financial Services Authority; that the applications to the New York Insurance Department and U.K. Financial Services Authority have been approved; and that it has made pre-acquisition filings regarding the potential competitive impact of the acquisition, which are deemed to have been approved. Dexia has informed the Company that it has filed an application with the U.K. Financial Services Authority in connection with its acquisition of Assured common shares pursuant to the Purchase Agreement, which has been approved, and that it has filed disclaimers of control with the insurance departments of the states of Maryland, New York, and Oklahoma.
Satisfying all three rating agencies that the necessary steps have or will be taken to transfer the FP segment credit and liquidity risk to Dexia is one of the last conditions to the Purchase Agreement closing. Rating agency confirmation that the Acquisition will not have a negative impact on the financial strength ratings of Assured's insurance company subsidiaries or the Company's insurance company subsidiaries is a condition for closing, and is beyond the Company's control.
The Company cannot estimate whether or when the remaining closing conditions will be satisfied or relevant agreements negotiated, whether the Acquisition will be completed and, if completed, whether it will be structured as currently contemplated, or what the effects of the change in control or removal of the FP business will be on the Company and its results of operations. If the Acquisition is not carried out, Dexia may explore other options with respect to the Company, including selling the Company or some of its operations to a third party or ceasing to write new business, which may have a material adverse effect on the Company.
Dexia's Retention of the FP Business
Under the Purchase Agreement, Dexia is expected to retain the Company's FP business after the Acquisition. The Purchase Agreement provides that Dexia will provide guarantees with respect to the FP business' assets and liabilities, including derivative contracts and anticipates that some of its guarantees will benefit from guarantees provided by the French and Belgian states. Dexia Holdings, the Company's parent, agreed that if such sovereign guarantees are provided, it will cause FSA Holdings to transfer the ownership interests of certain of the subsidiaries that conduct the FP business, or all the assets and liabilities of such subsidiaries, to Dexia Holdings or one of its affiliates in form reasonably acceptable to Assured.
Transfer of Credit and Liquidity Risk of the GIC Business
When the GIC Subsidiaries sold a GIC, they loaned the proceeds to FSAM. The terms governing FSAM's repayment of those proceeds to the GIC Subsidiaries match the payment terms under the related GIC. FSAM invests the proceeds in securities and enters into derivative transactions to convert any fixed-rate assets and liabilities into London Interbank Offered Rate ("LIBOR")-based floating rate assets and liabilities. Most of FSAM's assets consist of residential mortgage-backed securities ("RMBS") that have suffered significant market value declines and, in more limited cases, credit deterioration resulting in a shareholders' deficit for FSAM as of December 31, 2008. The market value declines of FSAM's assets subject FSAM to significant liquidity risk insofar as the GICs are in most cases subject to redemption or collateralization upon the downgrade of FSA below certain thresholds, with a significant number of GICs subject to redemption or collateralization should FSA be downgraded below Aa3 by Moody's (FSA's current Moody's rating) or below AA- by S&P. Dexia had previously announced its intention to assume the credit and liquidity risk associated with the Company's FP business, and provided significant support to the FP business in the course of 2008.
As a result of the significant decline in asset value and the November 2008 cessation of issuing GICs, the GIC business changed from a business model managed by the Company focused on attaining positive net interest margin, to a run-off business managed by Dexia seeking to minimize liquidity risk and optimize asset recovery values.
Subsequent Event
In February 2009, Dexia entered into several agreements that transfer credit and liquidity risk of the GIC operations to Dexia, (the "FSAM Risk Transfer Transaction"). Each of the agreements executed under the FSAM Risk Transfer Transaction directly affect (1) FSAM and (2) the entities that absorb the risks created by FSAM. These agreements provide for the (i) elimination of FSA's guaranty of repayment of FSAM's borrowings under the credit facilities provided by Dexia's bank subsidiaries;
(ii) elimination of FSA's guaranty of certain of FSAM's investments; and (iii) increase in the credit facilities provided to FSAM by Dexia's bank subsidiaries from $5 billion to $8 billion.
As a result, the FSAM Risk Transfer Transaction was deemed a reconsideration event for FSAM under FASB Interpretation 46 (R), "Consolidation of Variable Interest Entities" ("FIN 46"). There was no reconsideration event for any of the GIC Subsidiaries. Upon the reconsideration event, management determined that Dexia is now absorbing the majority of the variability of expected losses of FSAM, which resulted in deconsolidation of FSAM as of February 24, 2009, the effective date of the FSAM Risk Transfer Transaction.
The GIC subsidiaries, unlike FSAM, remain part of the Company's consolidated financial statements notwithstanding the FSAM Risk Transfer Transaction, which means that the GICs issued to third parties and the note receivable from FSAM will represent the primary liabilities and assets of the FP business in the Company's consolidated financial statements. Since some of the GICs were designated as fair value option, they will continue to be marked to market; however, derivatives are maintained within FSAM, so contracts meant to hedge the interest rate risk of those GICs will no longer be included in the Company's consolidated financial statements, increasing the volatility of the Company's net income (loss).
See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-FP Segment Liquidity-Sources of Liquidity" for more information on the FSAM Risk Transfer Transaction.
4. Long-Term Debt
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 5, 2066. The final repayment date of December 5, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption or, if greater, the make-whole redemption price. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings.
On July 31, 2003, FSA Holdings issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the Notes.
On November 26, 2002, FSA Holdings issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. The Company used a portion of the proceeds of this issuance to redeem in whole the Company's $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097.
On December 19, 2001, FSA Holdings issued $100.0 million of 67/8% notes due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
5. Taxes
In connection with Dexia's acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. ("WMH"). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains Insurance Group, Ltd. ("White Mountains") for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains. While the Company had no legal liability in connection with the indemnity payment, the payment was treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a tax benefit of $16.5 million. In addition, the Company shared 50% of the tax benefit with White Mountains when the required circumstances were satisfied in the third quarter of 2008.
6. Investment in subsidiaries
At December 31, 2008, FSA issued a surplus note to FSA Holdings in exchange for $300.0 million. At December 31, 2007, FSA Holdings held no FSA surplus notes. FSA repaid the balance of its surplus notes held by FSA Holdings in December 2007. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York. FSA Holdings previously employed surplus note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving dividend capacity of FSA.
FSA may repurchase shares of its common stock from FSA Holdings subject to the New York Superintendent's approval. The New York Superintendent has approved the repurchase by FSA of up to $500.0 million of its shares from FSA Holdings through December 31, 2008. In 2007 and 2006, the Company repurchased $180.0 million and $100.0 million, respectively, of shares of its common stock from FSA Holdings and retired such shares.
7. Legal proceedings
In November 2006, (i) the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs and other municipal derivatives and (ii) FSA received a subpoena from the SEC related to an ongoing industry-wide investigation concerning the bidding of municipal GICs and other municipal derivatives. Pursuant to the subpoenas the Company has furnished to the DOJ and SEC records and other information with respect to the Company's municipal GIC business. On February 4, 2008, the Company received a "Wells Notice" from the staff of the Philadelphia Regional Office of the SEC relating to the foregoing matter. The Wells Notice indicates that the SEC staff is considering recommending that the SEC authorize the staff to bring a civil injunctive action and/or institute administrative proceedings against the Company, alleging violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and Section 17(a) of the Securities Act. The Company has had ongoing discussions with the DOJ and the SEC. The ultimate loss that may arise from these investigations remains uncertain.
During 2008 nine putative class action lawsuits were filed in federal court alleging federal antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. These cases have been coordinated and consolidated for pretrial proceedings in the U.S. District Court for the Southern District of New York as MDL 1950, In re Municipal Derivatives Antitrust Litigation, Case No. 1:08-cv-2516 ("MDL 1950").
Five of these cases name both the Company and FSA: (a) Hinds County, Mississippi v. Wachovia Bank, N.A. (filed on or about March 13, 2008); (b) Fairfax County, Virginia v. Wachovia Bank, N.A.
(filed on or about March 12, 2008); (c) Central Bucks School District, Pennsylvania v. Wachovia Bank N.A. (filed on or about June 4, 2008); (d) Mayor & City Counsel of Baltimore, Maryland v. Wachovia Bank N.A. (filed on or about July 3, 2008); and (e) Washington County, Tennessee v. Wachovia Bank N.A. (filed on or about July 14, 2008). Four of the cases name only the Company and also allege that the defendants violated state antitrust law and common law by engaging in illegal bid-rigging and market allocation, thereby depriving the cities of competition in the awarding of GICs and ultimately resulting in the cities paying higher fees for these products: (a) City of Oakland, California, v. AIG Financial Products Corp. (filed on or about April 23, 2008); (b) County of Alameda, California v. AIG Financial Products Corp. (filed on or about July 8, 2008); (c) City of Fresno, California v. AIG Financial Products Corp. (filed on or about July 17, 2008); and (d) Fresno County Financing Authority v. AIG Financial Products Corp. (filed on or about December 24, 2008).
Interim lead counsel for the MDL 1950 plaintiffs filed a Consolidated Class Action Complaint ("Consolidated Complaint") in August 2008 alleging violations of the federal antitrust laws. Defendants filed motions to dismiss the Consolidated Complaint. The MDL 1950 court has determined that it will handle federal claims alleged in the Consolidated Complaint before addressing state claims. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
The Company and FSA also are named in five non-class actions originally filed in the California Superior Courts alleging violations of California law related to the municipal derivatives industry:
(a)City of Los Angeles v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of Los Angeles, Case No. BC 394944, removed to the U.S. District Court for the Central District of California ("C.D. Cal.") as Case No. 2:08-cv-5574, transferred to S.D.N.Y. as Case No. 1:08-cv-10351);
(b)City of Stockton v. Bank of America, N.A. (filed on or about July 23, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-477851, removed to the N.D. Cal. as Case No. 3:08-cv-4060, transferred to S.D.N.Y. as Case No. 1:08-cv-10350);
(c)County of San Diego v. Bank of America, N.A. (filed on or about August 28, 2008 in the Superior Court of the State of California in and for the County of Los Angeles, Case No. SC 99566, removed to C.D. Cal. as Case No. 2:08-cv-6283, transferred to S.D.N.Y. as Case No. 1:09-cv-1195);
(d)County of San Mateo v. Bank of America, N.A. (filed on or about October 7, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-480664, removed to N.D. Cal. as Case No. 3:08-cv-4751, transferred to S.D.N.Y. as Case No. 1:09-cv-1196); and
(e)County of Contra Costa v. Bank of America, N.A. (filed on or about October 8, 2008 in the Superior Court of the State of California in and for the County of San Francisco, Case No. CGC-08-480733, removed to N.D. Cal. as Case No. 4:08-cv-4752, transferred to S.D.N.Y. as Case No. 1:09-cv-1197).
These cases have been transferred to the S.D.N.Y. and consolidated with MDL 1950 for pretrial proceedings. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
The Company has received various regulatory inquiries and requests for information regarding a variety of subjects. These include subpoenas duces tecum and interrogatories from the State of
Connecticut Attorney General and the Attorney General of the State of California related to antitrust concerns associated with the methodologies used by rating agencies for determining the credit rating of municipal debt, including a proposal by Moody's to assign corporate equivalent ratings to municipal obligations, and the Company's communications with rating agencies. The Company is in the process of satisfying such requests. The Company may receive additional inquiries from these or other regulators and expects to provide additional information to such regulators regarding their inquiries in the future.
In December 2008 and January 2009, FSA and various other financial guarantors were named in three complaints filed in the Superior Court, San Francisco County: (a) City of Los Angeles Department of Water and Power v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CG-08-483689; Sacramento Municipal Utility District v. Ambac Financial Group et. al (filed on or about December 31, 2008), Case No. CGC-08-483691; and (c) City of Sacramento v. Ambac Financial Group Inc. et. al (filed on or about January 6, 2009), Case No. CGC-09-483862. These complaints alleged participation in a conspiracy in violation of California's antitrust laws to maintain a dual credit rating scale that misstated the credit default risk of municipal bond issuers and created market demand for municipal bond insurance and participation in risky financial transactions in other lines of business that damaged each bond insurer's financial condition (thereby undermining the value of each of their guaranties), and a failure to adequately disclose the impact of those transactions on their financial condition. These latter allegations form the predicate for five separate causes of action against each of the Insurers: breach of contract, breach of the covenant of good faith and fair dealing, fraud, negligence, and negligent misrepresentation. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss or range of loss that may arise from these lawsuits.
In August 2008 a number of financial institutions and other parties, including FSA, were named as defendants in a civil action brought in the circuit court of Jefferson County, Alabama relating to the County's problems meeting its debt obligations on its $3.2 billion sewer debt: Charles E. Wilson vs. JPMorgan Chase & Co et al (filed on or about August 8, 2008 in the Circuit Court of Jefferson County, Alabama), Case No. 01-CV-2008-901907.00, a putative class action. The action was brought on behalf of rate payers, tax payers and citizens residing in Jefferson County, and alleges conspiracy and fraud in connection with the issuance of the County's debt. The complaint in this lawsuit seeks unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss or range of loss that may arise from this lawsuit. FSA was also named as a defendant in a second civil action regarding Jefferson County, Alabama, but was dismissed from such action in January 2009.
The entitlements of the Chief Executive Officer and the President of the Company under their employment agreements with the Company are in dispute. In addition, holders of shares under the Director Share Purchase Program are in discussions with Dexia regarding the proper valuation of such shares, which may lead to mediation or arbitration of the dispute.
There are no other material legal proceedings pending to which the Company is subject.