|
|
 | | | |
- close
- close
- close
- close
MBIA 10-K 2008 Documents found in this filing:
Table of Contents
United States SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
Form 10-K
For the fiscal year ended December 31, 2007 or
For the transition period from to Commission File Number 1-9583 MBIA INC. (Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (914) 273-4545 Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨ Indicate by check mark whether the Registrant is shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 30, 2007 was $7,873,594,683. As of February 15, 2008, 236,137,048 shares of Common Stock, par value $1 per share, were outstanding. Documents incorporated by reference. Portions of the Definitive Proxy Statement of the Registrant, which will be filed on or before March 31, 2008, are incorporated by reference into Parts I and III.
Table of Contents
TABLE OF CONTENTS
Table of ContentsPart I Item 1. Business MBIA Inc. (“MBIA” or the “Company”) was incorporated as a business corporation under the laws of the state of Connecticut in 1986. The Company provides financial guarantee insurance and other forms of credit protection as well as investment management services to public finance and structured finance issuers, investors and capital market participants on a global basis. The Company’s financial guarantee insurance provides an unconditional and irrevocable guarantee of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that the Company has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon such acceleration by the Company. The Company conducts its financial guarantee business through its wholly owned subsidiary MBIA Insurance Corporation (“MBIA Corp.”) and provides investment management products and financial services through its wholly owned subsidiary MBIA Asset Management, LLC (“MBIA Asset Management”). MBIA Corp. is the successor to the business of the Municipal Bond Insurance Association (the “Association”), which began writing financial guarantees for municipal bonds in 1974. MBIA Corp. is the parent of MBIA Insurance Corp. of Illinois (“MBIA Illinois”) and Capital Markets Assurance Corporation (“CapMAC”), both financial guarantee insurance companies that were acquired by MBIA Corp. At present, no new financial guarantee insurance is being offered by MBIA Illinois or CapMAC, but it is possible that either of those entities may insure transactions in the future. MBIA Corp. also owns MBIA Assurance S.A. (“MBIA Assurance”), a French insurance company, and MBIA UK Insurance Limited (“MBIA UK”), a financial guarantee insurance company licensed in the United Kingdom. On December 28, 2007, MBIA Assurance was restructured with MBIA UK (by way of dissolution or winding-up without liquidation) and governed by the terms of article 1844-5 of the French Civil Code. The restructuring involved (i) the transfer of all of MBIA Assurance’s assets and liabilities to MBIA UK; (ii) the simultaneous transfer of the portfolio of MBIA Assurance’s financial guarantees to MBIA UK; and (iii) the dissolution without liquidation of MBIA Assurance. Consequently, all previously insured MBIA Assurance policies are now insured by MBIA UK. MBIA UK writes financial guarantee insurance in the member countries of the European Union and other regions outside the United States. In February 2007, MBIA Corp. incorporated a new subsidiary, MBIA México, S.A. de C.V. (“MBIA Mexico”), through which it writes financial guarantee insurance in Mexico. Generally, throughout the text, references to MBIA Corp. include the activities of its subsidiaries, MBIA UK, MBIA Mexico, MBIA Illinois and CapMAC. MBIA Corp. primarily insures financial obligations which are sold in the new issue and secondary markets. It also provides financial guarantees for debt service reserve funds. As a result of the triple-A ratings assigned to insured obligations, the principal economic value of financial guarantee insurance is the lower interest cost of an insured obligation relative to the same obligation on an uninsured basis. We receive insurance premiums as compensation for issuing our insurance policies. In addition, for complex financings and for obligations of issuers that are not well-known by investors, insured obligations generally receive greater market acceptance than uninsured obligations. MBIA Corp. guarantees:
MBIA Corp. has triple-A financial strength ratings from Standard and Poor’s Corporation (“S&P”), which the Association received in 1974; from Moody’s Investors Service, Inc. (“Moody’s”), which the Association received in 1984; from Fitch, Inc. (“Fitch”), which MBIA Corp. received in 1995; and from Rating and Investment Information, Inc. (“RII”), which MBIA Corp. received in 1998. Both MBIA Mexico and MBIA UK have triple-A financial strength ratings from S&P, Moody’s and Fitch. Obligations which are guaranteed by MBIA Corp., MBIA Mexico and MBIA UK are rated triple-A primarily based on these financial strength ratings. Both S&P and Moody’s have also continued the triple-A rating on MBIA Illinois and CapMAC guaranteed bond issues. On January 17, 2008, Moody’s placed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates on watch list negative. On January 31, 2008, S&P placed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates on CreditWatch negative. On February 5, 2008, Fitch placed the AAA insurer financial strength ratings of MBIA Corp. and its
1
Table of ContentsItem 1. Business (continued) insurance affiliates on rating watch negative. On February 25, 2008, S&P affirmed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the AA- rating of MBIA Inc.’s senior debt and the AA ratings of MBIA Corp.’s North Castle Custodial Trusts I-VIII, with a negative outlook. On February 26, 2008, Moody’s affirmed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the Aa2 ratings of MBIA Corp.’s Surplus Notes and the Aa3 ratings of the junior obligations of MBIA Corp. and the senior debt of MBIA Inc., with a negative rating outlook. MBIA Corp.’s ability to attract new business and to compete with other financial guarantors has been adversely affected by these rating agency actions. MBIA Corp’s ability to attract new business and to compete with other triple-A rated financial guarantors and its results of operations and financial condition would be materially adversely affected by any actual reduction, or additional suggested possibility of a reduction, in its ratings. MBIA Asset Management provides an array of products and services to the public, not-for-profit and corporate sectors. These products and services are provided primarily through wholly owned subsidiaries of MBIA Asset Management and include cash management, discretionary asset management and fund administration services and investment agreement, medium-term note and commercial paper programs related to funding assets for third-party clients and for investment purposes. The investment management services operations are comprised of three operating segments:
The asset/liability products segment raises funds for investment management through the issuance of investment agreements, which are issued by MBIA Investment Management Corp. (“IMC”) and the Company. These investment agreements are guaranteed by MBIA Corp. They are issued to public and corporate entities and as part of asset-backed or structured finance transactions for the purpose of investing bond proceeds and other funds. This segment also raises funds through the issuance of MTNs which are issued by MBIA Global Funding, LLC (“GFL”) and guaranteed by MBIA Corp. MBIA Asset Management invests the proceeds of the investment agreements and MTNs in high quality eligible investments both in the United States and abroad. Because the yields on invested assets are generally in excess of our funding costs, we earn a spread from this business. The advisory services segment of MBIA Asset Management offers cash management, customized asset management and investment consulting services to local governments, school districts and other institutional clients on a fee for services basis. It offers fixed-income asset management services for the investment portfolios of the Company, MBIA Corp. and other affiliates and also for third-party clients and investment structures. MBIA Asset Management offers these services through MBIA Municipal Investors Service Corporation (“MBIA-MISC”), MBIA Capital Management Corp. (“CMC”) and MBIA Asset Management UK Limited (“AM-UK”). MBIA Asset Management also owns and administers two conduit financing vehicles, Triple-A One Funding Corp. and Meridian Funding Company, LLC (together, the “Conduits”). A third conduit, Polaris Funding Company, LLC, ceased operations in 2007 after its only remaining transaction matured. The Conduits provide funding for multiple customers through special purpose vehicles that issue primarily commercial paper and MTNs. The Company is compensated with administrative fees for this service. On February 25, 2008, the Company announced a plan to implement several initiatives in connection with the restructuring of MBIA’s business over the next few years. A significant aspect of the plan will be the creation of separate legal operating entities for MBIA’s public, structured and asset management businesses. This is intended to be accomplished as soon as feasible, with a goal of within five years. The objective behind this initiative is to retain the highest ratings possible for both the public finance and structured finance businesses. The implementation of this initiative is subject to various contingencies, including regulatory approval. There are also a number of other initiatives that are effective immediately, including: (i) the suspension of writing new structured finance business for an estimated six month period in order to both increase capital safety margins and to evaluate and revise the credit and risk management criteria and policies; (ii) the ceasing of issuing insurance policies for new credit derivative transactions except in transactions related to the reduction of existing derivative exposure; and (iii) the elimination of the current MBIA dividend to provide an additional $174 million of capital flexibility per year. In addition, the Company will now declare dividends on an annual basis rather than a quarterly basis. Statements included in this Form 10-K which are not historical or current facts are “forward-looking statements” made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “believe,” “anticipate,” “project,” “plan,” “expect,” “intend,” “will likely result,” or “will continue,” and similar expressions identify forward-looking statements. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of their respective dates. The following are some of the factors that could cause actual results to differ materially from estimates contained in or underlying the Company’s forward-looking statements: (1) changes in the Company’s credit ratings; (2) the possibility that the Company will experience severe losses due to the continued deterioration in the performance of residential mortgage-backed securities and collateralized debt obligations; (3) fluctuations in the economic, credit, interest rate or foreign currency environment in the United States or abroad; (4) level of activity within the national and international credit markets; (5) competitive conditions and pricing levels; (6) legislative or regulatory developments; (7) technological developments; (8) changes in tax laws; (9) the effects of mergers, acquisitions and divestitures; and (10) uncertainties that have not been identified at this time. The Company undertakes no obligation to publicly correct or update any forward-looking statement if it later becomes aware that such result is not likely to be achieved. INSURANCE OPERATIONS MBIA Corp. offers financial guarantee insurance and other forms of credit protection in the United States, Europe, Asia, Latin America and other regions outside the United States. We are compensated for our policies from insurance premium payments made up-front or on an installment basis by the insured. Municipal Obligations The municipal obligations that MBIA Corp. insures include tax-exempt and taxable indebtedness of Unites States political subdivisions, as well as utility districts, airports, health care institutions, higher educational facilities, housing authorities and other similar agencies and obligations issued by private entities that finance projects that serve a substantial public purpose. Municipal bonds and privately issued bonds used for the financing of public purpose projects are generally supported by taxes, assessments, fees or tariffs related to use of projects, lease payments or other similar types of revenue streams. The financing of public purpose projects through privately issued bonds primarily occurs overseas, and these projects include toll roads, bridges, airports, public transportation facilities and other types of infrastructure projects that serve a substantial public purpose. While in the United States projects of this nature are financed through the issuance of tax-exempt bonds by special purpose, government sponsored tax-exempt entities, the general absence of tax-advantaged financing overseas, among other reasons, has led to the operation of many such public purpose projects being transferred to the private sector. Generally, the private entities operate under a concession agreement with the sponsoring government agency, which maintains a level of regulatory oversight and control over the project.
2
Table of ContentsItem 1. Business (continued) Structured Finance and Asset-Backed Obligations The asset-backed and structured finance obligations insured by MBIA Corp. typically consist of securities that are payable from or which are tied to the performance of a specified pool of assets that have an expected cash flow, such as residential and commercial mortgages, insurance policies, a variety of consumer loans, corporate loans and bonds, trade and export receivables, equipment, aircraft and real property leases, and infrastructure projects. Structured finance obligations are either undivided interests in the related assets or debt obligations collateralized by the related assets. In addition, the Company insures payments due under credit and other derivatives, including termination payments that may become due upon the occurrence of certain events at the Company’s discretion. Structured finance transactions are often structured such that the insured obligations benefit from some form of credit enhancements such as over-collateralization, subordination, excess cash flow or first loss protection, to cover credit risks. Structured finance obligations contain risks including asset risk, which relates to the amount and quality of asset coverage, structural risk, which relates to the extent to which the transaction structure protects the interests of the investors from the bankruptcy of the originator of the underlying assets or the issuer of the securities, and servicer risk, which relates to problems with the transaction servicer (the entity which is responsible for collecting the cash flow from the asset pool) that could affect the servicing of the underlying assets. In general, the asset risk is addressed by sizing the asset pool and its associated protection level based on the historical and expected future performance of the assets. Structural risks primarily involve bankruptcy risks, such as whether the sale of the assets by the originator to the issuer would be upheld in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be required to delay the remittance of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings. Structured finance transactions are usually structured to reduce the risk to the investors from the bankruptcy or insolvency of the entity that originated the underlying assets, as well as from the bankruptcy or insolvency of the servicer, and to minimize the likelihood of the bankruptcy or insolvency of the issuer of the obligation. The ability of the servicer to properly service and collect on the underlying assets is also a factor in determining future asset performance. MBIA Corp. addresses servicer risk through its servicer due diligence and underwriting guidelines, its formal credit review and approval process and its post-closing servicing review and monitoring. On February 25, 2008, the Company announced that it has suspended the writing of all new structured finance business for approximately six months. International Obligations Outside of the United States, sovereign and sub-sovereign issuers, structured finance issuers, utilities and other issuers, including private issuers who are financing projects with a substantial public purpose, also use financial guarantee insurance to guarantee their public finance and structured finance obligations. As noted above, on February 25, 2008, the Company announced that it has suspended the writing of all new structured finance business for approximately six months. Ongoing privatization efforts have shifted the burden of financing new projects from the government to the capital markets, where investors can benefit from the security of financial guarantee insurance. There is also growing interest in asset-backed securitization. While the principles of securitization have been increasingly applied in overseas markets, the rate of development in particular countries has varied due to the sophistication of the local capital markets and the impact of financial regulatory requirements, accounting standards and legal systems. MBIA expects that securitization volume will decline in the near-term and then gradually increase over time at varying rates in each country. MBIA Corp. insures both structured finance and public finance obligations in selected international markets. MBIA Corp. believes that the risk profile of the international business it insures is similar to that in the United States, but recognizes that there are particular risks related to each country and region. These risks include the legal, economic and political situation, the varying levels of sophistication of the local capital markets and currency exchange risks. MBIA Corp. evaluates and monitors these risks carefully. Primary and Secondary Markets MBIA Corp. offers financial guarantee insurance in both the new issue and secondary markets on a global basis. Transactions in the new issue market are sold either through negotiated offerings or competitive bidding. In negotiated transactions, either the issuer or
3
Table of ContentsItem 1. Business (continued) the underwriter purchases the insurance policy directly from MBIA Corp. For municipal bond issues involving competitive bidding, the insurance is offered as an option to the underwriters bidding on the transaction. The successful bidder would then have the option to purchase the insurance, or at times the issuer can purchase the insurance. In the secondary market, MBIA Corp. provides credit enhancement for both municipal and structured products. MBIA Corp. guarantees the payment of principal and interest on municipal obligations which trade in the secondary market upon the request of an existing holder of uninsured bonds. The premium is generally paid by the owner of the obligation. The “RAPSS” program (“Rapid Asset Protection for Secondary Securities”) guarantees the payment of principal and interest on an individual structured finance security or class of such securities traded in the secondary market in response to requests from bond traders and investors. Securities insured in the RAPSS program have the benefit of MBIA Corp.’s guarantee until maturity. The “Portfolio Insurance” program enables an investor to insure a specific portfolio of structured finance bonds and is offered as an ongoing program with investment banks, financial service companies and conduit sponsors. For each insured portfolio, MBIA Corp. establishes specific underwriting criteria for the inclusion of new assets in the program portfolio. The Portfolio Insurance program is a “while-in-trust” program which provides the benefits of an MBIA Corp. guarantee to securities only during the time they are held in a particular insured portfolio, although in some cases, MBIA Corp. may offer insurance to maturity for an additional premium. Currently, as a result of the existing market volatility caused by the deterioration in the subprime mortgage market, the tightening of available liquidity, and the recent rating agency actions described herein, the demand for our product is the lowest it has been and we are writing very little new business. At the same time, our exposure to the existing credits in our insured portfolio continues to decline as such obligations mature, thereby increasing our available capital. MBIA Corp. Insured Portfolio MBIA Corp. seeks to maintain a diversified insured portfolio and has designed the insured portfolio to manage and diversify risk based on a variety of criteria including revenue source, issue size, type of asset, industry concentrations, type of bond and geographic area. As of December 31, 2007, MBIA Corp. had 26,997 policies outstanding. In addition, MBIA Corp. has issued 1,077 policies relating to MBIA Asset Management transactions. These policies are diversified among 10,934 “credits,” which MBIA Corp. defines as any group of issues supported by the same revenue source. Virtually all of the insurance policies issued by MBIA Corp. provide an unconditional and irrevocable guarantee of the payment to a designated paying agent for the holders of the insured obligations of an amount equal to the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that the Company has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon such acceleration by the Company. In addition, certain of MBIA Corp.’s insurance policies guarantee payments due under credit or other derivatives, including termination payments that may become due upon the occurrence of certain events. On February 25, 2008, the Company announced that it ceased insuring new credit derivative contracts within its insurance operations except in transactions related to the reduction of existing derivative exposure. In the event of a default in payment of principal, interest or other insured amounts by an issuer, MBIA Corp. promises to make funds available in the insured amount generally on the next business day following notification. MBIA Corp. generally has an agreement with a bank which provides for this payment upon receipt of proof of ownership of the obligations due, as well as upon receipt of instruments appointing the insurer as agent for the holders and evidencing the assignment of the rights of the holders with respect to the payments made by the insurer. Because MBIA Corp. generally guarantees to the holder of the underlying obligation the timely payment of amounts due on such obligation in accordance with its original payment schedule, in the case of a default on an insured obligation, payments under the insurance policy cannot be accelerated against MBIA Corp., except in certain limited circumstances, unless MBIA Corp. consents to the acceleration. In the event of a default, however, MBIA Corp. may have the right, in its sole discretion, to accelerate the obligations and pay them in full. Otherwise, MBIA Corp. is required to pay principal, interest or other amounts only as originally scheduled payments come due. Typically, even if the holders are permitted by the terms of the insured obligations to have the full amount of principal, accrued interest or other amounts due, declared due and payable immediately in the event of a default, MBIA Corp. is required to pay only the amounts scheduled to be paid, but not in fact paid, on each originally scheduled payment date. MBIA Corp.’s payment obligations after a default vary by deal and by insurance type. There are three primary types of policy payment requirements: i) timely interest and ultimate principal; ii) ultimate principal only at final maturity; and iii) payments upon settlement of individual collateral losses as they occur upon erosion of deal deductibles. At December 31, 2007, the net par amount outstanding on MBIA Corp.’s insured obligations (including insured obligations of MBIA Illinois, MBIA UK, MBIA Mexico and CapMAC, but excluding $25.5 billion of MBIA insured investment agreements and MTNs for MBIA Asset Management) was $678.7 billion. Net insurance in force, which includes all insured debt service, at December 31, 2007 was $1,022 billion. Net insurance in force, which is net of cessions to reinsurers, is also net of other reimbursement agreements that relate to certain contracts under which MBIA Corp. is entitled to reimbursement of losses on its insured portfolio but which do not qualify as reinsurance under accounting principles generally accepted in the United States of America (“GAAP”).
4
Table of ContentsItem 1. Business (continued) The table below sets forth information with respect to the original par amount insured per issue in MBIA Corp.’s portfolio as of December 31, 2007: MBIA Corp. Original Par Amount Per Issue as of December 31, 2007 (1)(2)
MBIA Corp. underwrites its policies on the assumption that the insurance will remain in force until maturity of the insured obligations. MBIA Corp. estimates that the average life of its insurance policies in force at December 31, 2007 was 10.4 years. The average life was determined by applying a weighted-average calculation, using the remaining years to contractual maturity for municipal insured obligations and estimated maturity for structured insured obligations and weighting them on the basis of the remaining debt service insured. No assumptions were made for any future refundings of insured issues. Average annual insured debt service on the portfolio at December 31, 2007 was $64.2 billion. The table below shows the diversification by type of insurance written by MBIA Corp. in each of the last three years: MBIA Corp. Net Par Amount Written by Bond Type (1)
5
Table of Contents
MBIA Corp. underwriting guidelines limit the net insurance in force for any one insured credit. In addition, MBIA Corp. is subject to both rating agency and regulatory single-risk limits with respect to any insured bond issue. As of December 31, 2007, MBIA Corp.’s net par amount outstanding for its ten largest insured public finance credits totaled $23.2 billion, representing 3.4% of MBIA Corp.’s total net par amount outstanding, and the net par outstanding for its ten largest structured finance credits (without aggregating common issuers), was $24.2 billion, representing 3.6% of the total. Risk Management Risk Management is an enterprise-wide function responsible for the identification, assessment, measurement and management of credit, market and operational risks across the Company. The most significant risk that the Company takes is credit risk. MBIA also tracks and manages legal, financial and business risks through consultation and oversight mechanisms at different levels enterprise-wide. MBIA’s risk tolerance is established and reviewed annually by the Company’s Board of Directors. The Credit, Finance and Audit Committees of the Company’s Board of Directors also review, on an ongoing basis, the risk management framework for credit, market, and operational risks, respectively. MBIA Corp. has four
6
Table of ContentsItem 1. Business (continued) senior executive risk committees that review and approve specific policies, criteria and procedures: the Risk Oversight Committee, the Executive Credit Committee, the Executive Market/Investment Committee and the Loss Reserve Committee. Monitoring of insured transactions is performed by the Insured Portfolio Management Division. For more information on loss reserving policy and procedures, see Part I, Item 1 “Losses and Reserves—Remediation”. The Risk Oversight Committee is responsible for overall risk policies and the risk management framework and provides a consultation role on a broad variety of risk issues across all of the Company’s businesses, including remediation, capital models and transaction capital usage and inter-company relationships. Its members include the Company’s Chief Executive Officer, Chief Risk Officer, Chief Financial Officer, General Counsel and the head of Insured Portfolio Management. The Executive Credit Committee considers global credit risk throughout all of MBIA Corp.’s businesses, including credit and market risks associated with transactions, structures, country exposures, assets and risk types, as well as aggregate portfolio risk across risk types and businesses. The Executive Credit Committee consists of the Chief Executive Officer, Chief Risk Officer, heads of the Global Structured Finance, Global Public Finance and International Divisions, the head of the Insured Portfolio Management Division, the head of Credit, and the heads of the Public Finance, and Structured Finance and International Credit. The Executive Market/Investment Committee oversees financial market risk across all businesses and investment activities of the Company and its subsidiaries. Its members include the Company’s Chief Executive Officer, Chief Risk Officer, Chief Financial Officer, Chief Investment Officer, Treasurer, General Counsel and the head of Market Risk. The Chief Risk Officer chairs the Risk Oversight, Executive Credit and Executive Market/Investment Committees and runs the Risk Management Division with responsibility for the Credit, Credit Analytics, Market Risk, Portfolio Management, Risk Syndication, and Operational Risk units. We continually monitor portfolio and transaction data and adjust our credit risk models to reflect changes in expected and stressed outcomes over time. We use internal models based on individual deal attributes and structures for ongoing portfolio monitoring and to estimate case basis loss reserves and, where applicable, to mark our obligations under our contracts to market and may supplement such models with third party models or use third party experts to consult with our internal modeling specialists. When using third party models, we perform the same review and analysis of the collateral, deal structure, performance triggers and cash flow waterfalls as when using our internal models. However, both internal and external models are subject to model risk and there can be no assurance that these models are accurate or comprehensive in estimating our potential future paid claims and related loss reserves. In addition, we assess our risk management policies and procedures on a periodic basis. As a result of such assessment, we may take steps to change our internal risk assessment capabilities and procedures, our portfolio management policies, systems and processes and our policies and procedures for monitoring and assessing the performance of our insured portfolio in changing market conditions. Credit and Credit Analytics Since the largest risk the Company takes on is credit risk, the largest unit in the division is Credit, which is led by the head of Credit. This area is responsible for MBIA Corp.’s underwriting criteria, policies and procedures, as well as managing the risk assessment and approval process for insured transactions. The Credit unit works closely with the Credit Analytics, Market Risk and Portfolio Management units to underwrite transactions using risk selection criteria covering those aspects of credit important for each of the types of risks being considered for insurance. This includes transaction specific terms and conditions and exposure limits. For public finance transactions, the risk selection criteria used to underwrite transactions may include economic and social trends, debt management, financial management, adequacy of anticipated cash flows, satisfactory legal structure and other security provisions, viable tax and economic bases, adequacy of loss coverage and project feasibility, including a satisfactory consulting engineer’s report, if applicable. Some risk types within public finance also require cash flow sensitivity testing to analyze cash flow coverage under various scenarios. For structured finance transactions, the risk selection criteria, analysis and due diligence focus on counterparty credit and operational quality, the historical and projected performance of the collateral and the strength of the structure, including legal segregation of the assets, the size and source of first loss protection, asset performance triggers and financial covenants and cash flow analysis and sensitivity testing using a scenario-based analysis, “Monte Carlo” probability analysis, or both, to examine the impact of remote events on credit performance.
7
Table of ContentsItem 1. Business (continued) The Credit Analytics unit analyzes and monitors MBIA Corp.’s embedded exposure to financial institutions and corporate entities in the form of counterparty, asset manager, and servicer exposure or as obligors or counterparties on investment contracts, letters of credit, derivatives, liquidity facilities or other features supporting MBIA Corp. insured issues. The unit recommends terms and conditions and capacity limits for all such exposures. All transactions involving non-U.S. issuers, non-U.S. assets, non-U.S. sources of cash flows or that are not denominated in U.S. dollars also include an assessment of country risk and the potential impact of foreign exchange risk on transaction cash flows and MBIA Corp.’s payment obligation. The credit risk profile of the Company is regularly reported to the Risk Oversight Committee and the Credit Risk Committee of the Company’s Board of Directors. Market Risk, Portfolio Analytics and Risk Syndication The Market Risk unit measures and assesses market risk factors across the Company, which occurs primarily in the asset management business. Key market risks are changes in interest rates and credit spreads, with lesser risks of liquidity, derivatives, counterparty quality and foreign exchange. The Market Risk unit measures and monitors such risks using various models and methodologies to test economic exposure under market stress, including parallel and non-parallel shifts in the yield curve, changes in credit spreads, stressed liquidity scenarios and stressed counterparty exposures. The unit also reviews guidelines for investment portfolios within the Company’s asset management business. Market Risk analysis and stress testing is reported in a Market Risk Report to the Executive Market/Investment Committee and the Finance Committee of the Company’s Board of Directors. Included in the Market Risk unit is the Portfolio Management unit, which analyzes MBIA’s insured portfolio using various quantitative tools to test for diversity, credit quality, liquidity and other portfolio characteristics and recommends limits for risk concentrations and for internal capital usage. Portfolio tools include an internal economic capital model that measures risk-adjusted capital by transaction, by sector and for the aggregate portfolio as well as concentrations by obligor, country and counterparty and compliance with the applicable regulatory, rating agency and internal guidelines. The Portfolio Management unit is also responsible for monitoring model risk, including the testing and validation of key models in the transaction process. Also included in the Market Risk unit is Risk Syndication, which is responsible for the development of risk syndication strategies through different forms of reinsurance and the capital markets. Operational Risk The Operational Risk unit is responsible for the identification and assessment of potential loss caused by execution factors in processes, systems, or staff responsibilities, as well as identifying vulnerabilities to operational disruptions caused by external events across the Company. The unit uses a self-assessment process across all divisions to monitor and track the execution of key processes. The Operational Risk unit reports periodically to the Risk Oversight Committee and the Audit Committee of the Company’s Board of Directors. New Business Origination The world-wide insurance operations of MBIA Corp. are conducted through the Global Public Finance Division, the Global Structured Finance Division, the Risk Management Division, and the Insured Portfolio Management Division. Public finance and structured finance operations outside of the United States are conducted in coordination with the International Division. In the three business divisions, Public Finance, Structured Finance and International, all insurance products follow a screening and analysis process followed by a formal underwriting committee decision that draws on expertise from the business, risk and insured portfolio management staff. All such decentralized underwriting committees have eligible underwriting voters that are reviewed and appointed annually. Larger, complex, or unique transactions and most international transactions are also reviewed for approval by the Executive Credit Committee. Global Public Finance underwriting is decentralized for many categories of business up to specified amounts based on a risk ranking system. This decentralized process is overseen by Risk Management, which participates in the majority of underwriting committees based on the risk ranking system.
8
Table of ContentsItem 1. Business (continued) For almost all transactions underwritten by the Global Structured Finance Division, MBIA Corp.’s decentralized underwriting approval is performed by a risk committee consisting of the head of the applicable business unit, one officer from Risk Management and an officer from either the Risk Management or the Insured Portfolio Management Division. International transactions follow a similar process to the Global Structured Finance Division, with a preliminary screening by business and risk staff followed by an underwriting committee consisting of international and domestic officers from Risk Management, Insured Portfolio Management and the applicable business managers. Premium rates for the Global Public Finance, Global Structured Finance and International Divisions are established by a Pricing Committee with representation from the relevant business unit and from the Pricing Group, which provides pricing and other market analysis. Insured Portfolio Management The Insured Portfolio Management Division (“IPM” or the “IPM Division”) is responsible for monitoring MBIA Corp.’s outstanding insured obligations. This group’s first function is to detect any deterioration in credit quality or changes in the economic, regulatory or political environment which could adversely affect an MBIA Corp. insured obligation, including interrupting the timely payment of debt service. If a problem is detected, the group works with the issuer, trustee, bond counsel, servicer, underwriter and other interested parties in an attempt to alleviate or remedy the problem in order to minimize potential defaults. The IPM Division works closely with Risk Management and the applicable business unit to analyze insured obligation performance and credit risk parameters, both before and after an obligation is insured. Once an obligation is insured, MBIA Corp. typically requires the issuer, servicer (if applicable) and the trustee to furnish periodic financial and asset related information, including audited financial statements, to the IPM Division for review. Potential problems uncovered through this review, such as poor financial results, low fund balances, covenant or trigger violations, trustee or servicer problems, or excessive litigation, could result in an immediate surveillance review and an evaluation of possible remedial actions. The IPM Division also monitors general economic and regulatory conditions, state and municipal finances and budget developments and evaluates their impact on issuers. During the underwriting process, each insured transaction is assigned an internal credit rating. Credits are monitored according to a frequency of review schedule that is based on risk type, internal rating, performance and credit quality. Issues that experience financial difficulties, deteriorating economic conditions, excessive litigation or covenant or trigger violations are placed on the appropriate review list and are subject to surveillance reviews at intervals commensurate to the problem which has been detected. If IPM identifies concerns with respect to the performance of an insured issue it may designate such insured issue as “Caution List-Low,” “Caution List-Medium” or “Caution List-High” based on the nature and extent of these concerns. It may also require increased monitoring and, if needed, a remediation plan be implemented for the related insured issue. The Company does not establish any case basis reserves for credits that are listed as “Caution List-Low,” “Caution List-Medium” or “Caution List-High.” In the event MBIA Corp. determines that it must pay a claim or that a claim is probable and estimable with respect to an insured issue, it places the issue on its “Classified List” and establishes a case basis reserve for that insured issue. See “Losses and Reserves; Remediation” below. IPM’s monitoring responsibilities are divided among four groups: Domestic Public Finance, Global Structured Finance, International and Special Situations. Domestic Public Finance oversees domestic municipal issues such as general obligation, tax-backed, utility, health care, transportation and special revenue bonds, as well as investor-owned utility, military and FHA/VA housing and project finance transactions. Global Structured Finance oversees domestic and international structured finance transactions, including future flow transactions and collateralized debt obligations. International oversees all types of international sovereign, public finance and project issues for a range of obligors that include utilities, airports, toll roads, water systems and hospitals. Each group is responsible for processing waiver and consent requests and other deal modifications within their areas of responsibility. The fourth area, the Special Situations Group, is described below. IPM personnel supporting the International and Domestic Public Finance Divisions review and report on the major credit quality factors, evaluate the impact of new developments on weaker insured credits and carry out remedial activity. In addition, this group performs analysis of financial statements and key operating data on a large-scale basis and maintains various databases for research purposes. This group is also responsible for preparing special reports which include analyses of regional economic trends, proposed tax limitations, the impact of employment trends on local economies, legal developments affecting bond security and the potential impact of events, such as natural disasters or headline events, on the insured portfolio.
9
Table of ContentsItem 1. Business (continued) The IPM unit supporting the Global Structured Finance Division monitors insured structured finance issues, focusing on asset and servicer performance and transaction cash flows. Monitoring of insured issues typically involves review of monthly trustee, servicer and portfolio manager statements, compliance reviews with transaction documents and analysis of cash flow adequacy. Review of issuer and/or servicer performance can include site visits, forensic audits, management meetings and financial statement reviews. For problem credits, the team performs additional specialized cash flow analyses, conducts best practice reviews with servicers and facilitates loss mitigation strategies. The Special Situations Group assists in addressing insured exposures experiencing significant stress. The Special Situations Group is staffed with personnel with expertise in impaired credit situations. For issues that experience financial difficulties, deteriorating economic conditions, excessive litigation or covenant or trigger violations, the Special Situations Group works in conjunction with the related IPM personnel to assess and monitor the situation and determine the appropriate course of action, including, if necessary, developing and implementing a remediation strategy. Losses and Reserves; Remediation MBIA Corp. establishes both loss and loss adjustment expense reserves to cover non-specific unallocated losses on its entire non-derivative insured portfolio and specific case basis reserves with respect to actual and potential losses under specific insurance policies. The unallocated loss and loss adjustment expense reserve and specific case basis reserves are established by MBIA Corp.’s Loss Reserve Committee, which includes the Company’s Chief Executive Officer, Chief Financial Officer, Chief Risk Officer, Head of IPM and other members of senior management. The Company’s Chief Financial Officer is the Chair of the Loss Reserve Committee. The unallocated loss reserve is established on an undiscounted basis with respect to MBIA Corp.’s entire insured portfolio. MBIA Corp.’s unallocated loss reserve represents its estimate of losses that have occurred or are probable to occur as a result of credit deterioration in MBIA Corp.’s insured portfolio but which have not yet been specifically identified and applied to specific insured obligations. The unallocated loss reserve is increased on a quarterly basis using a formula that applies a “loss factor” to MBIA Corp.’s scheduled net earned premium for the respective quarter. Each quarter MBIA Corp. calculates its provision for the unallocated loss reserve as a fixed percent of scheduled net earned premium. Annually, the Loss Reserve Committee evaluates the appropriateness of the loss factor. In performing this evaluation, the Loss Reserve Committee considers the composition of MBIA Corp.’s insured portfolio by municipal sector, structured asset class, remaining maturity and credit quality, along with the latest industry data, including historical default and recovery experience for the relevant sectors of the fixed-income market, in order to determine if a trend is developing that indicates the loss factor should be increased or decreased. In addition, the Company considers its own historical loss activity and how those losses develop over time. The Loss Reserve Committee reviews the results of its annual evaluation over a period of several years to determine whether any long-term trends are developing. Therefore, case basis reserves established in any year may be above or below the loss factor without requiring an increase or decrease to the loss factor. Since 2002, the Company calculated its provision for unallocated loss reserve as 12% of scheduled net earned premium. The Company’s additions to specific case basis reserves in the year ended December 31, 2005 exceeded the 12% loss factor currently used by the Company. However, additions to specific case basis reserves in the year ended December 31, 2006 were less than the 12% loss factor. In 2007, the Company incurred $900.3 million in loss and loss adjustment expenses (“LAE”), compared with $80.9 million in 2006. The 2007 expenses consist of MBIA’s loss reserving formula of 12% of scheduled premiums earned or $86.8 million, and two fourth quarter additions to reserves totaling $813.5 million. Total fourth quarter loss and LAE amounted to $836.7 million. The Company’s loss reserving formula of 12 percent of scheduled premiums earned resulted in an unallocated loss reserve addition of $23.1 million for the quarter. The Company also added $613.5 million in case loss activity, which represents MBIA’s assessment of probable and reasonably estimable losses for the Company’s insured exposure to prime, second-lien RMBS transactions consisting of home equity lines of credit and closed-end second-lien mortgages. The Company also established a special addition of $200 million to the unallocated loss reserve to reflect MBIA’s estimate of probable losses as a result of the adverse developments in the residential mortgage market related to prime, second-lien mortgage exposure, but which have not yet been specifically identified to individual policies. After the fourth quarter loss reserving activity, MBIA’s unallocated loss reserve totaled $434.5 million at December 31, 2007. The Loss Reserve Committee is continuing to monitor any trends and evaluate whether an adjustment to the Company’s current loss factor is appropriate. If a catastrophic or very unusual loss occurred, as it did in 2007, the Loss Reserve Committee would consider taking an immediate charge through “Losses and loss adjustment expenses” and possibly also increasing the loss factor in order to maintain an adequate level of loss reserves. For a further discussion of loss reserving and the assumptions used in the assessment of the adequacy of the loss factor, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Losses and Loss Adjustment Expenses” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates—Losses and Loss Adjustment Expenses,” each in Part II, Item 7. Typically, when a case basis reserve is established, MBIA Corp. reclassifies the estimated amount from its unallocated loss reserve in an amount equal to the specific case basis loss reserve. Therefore, the amount of available unallocated loss reserve at the end of each period is
10
Table of ContentsItem 1. Business (continued) reduced by the actual case basis reserves established in the same period. In the event that case basis reserves develop at a significantly faster or slower rate than anticipated by applying the loss factor to net scheduled earned premium, MBIA Corp. will perform a qualitative evaluation with respect to the adequacy of the remaining unallocated loss reserve. In performing this evaluation, MBIA Corp. considers the anticipated amounts of future transfers to existing case basis reserves, as well as the likelihood those policies for which case basis reserves have not been established will require case basis reserves at a faster or slower rate than initially expected. MBIA Corp. establishes new case basis reserves with respect to a specific insurance policy when the Loss Reserve Committee determines that (i) a claim has been made or is probable in the future with respect to such policy based on specific credit events that have occurred and (ii) the amount of the ultimate loss that MBIA will incur under such policy can be reasonably estimated. The amount of the case basis reserve with respect to any policy is based on the net present value of the expected ultimate losses and loss adjustment expense payments that MBIA Corp. expects to pay with respect to such policy, net of expected recoveries under salvage and subrogation rights. The amount of the expected loss, net of expected recoveries, is discounted based on a discount rate equal to the actual yield of the fixed-income portfolio held by the Company’s insurance subsidiaries at the end of the preceding fiscal quarter. MBIA Corp. believes this yield is an appropriate rate of return for calculating the present value of its reserves as it reflects the rate of return on the assets supporting future claim payments by MBIA Corp. When a case basis reserve is established for an insured obligation, MBIA Corp. continues to record premium revenue until it believes that premiums will no longer be collected on that obligation. A number of variables are taken into account in establishing specific case basis reserves for individual policies. These variables include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured and the expected recovery rates on the insured obligation, the projected cash flow or market value of any assets that support the insured obligation and the historical and projected loss rates on such assets. Factors that may affect the actual ultimate realized losses for any policy include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. The methodology used by the Company for determining when a case basis reserve is established may differ from other financial guarantee insurance companies, as well as from other property and casualty insurance enterprises. The Financial Accounting Standards Board (“FASB”) staff has considered whether additional guidance with respect to accounting for financial guarantee insurance should be provided and has agreed to consider the accounting by insurers for financial guarantee insurance. As part of this project, the FASB will consider several aspects of the insurance accounting model for financial guarantee insurers, including loss recognition and reserve methodology. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Losses and Loss Adjustment Expenses (LAE)” in Part II, Item 7. In the event MBIA Corp. determines that it must pay a claim or that a claim is probable and estimable with respect to an insured issue, it places the issue on its “Classified List” and establishes a case basis reserve for that policy. As of December 31, 2007, MBIA Corp. had 47 issues on the Classified List for which it has established $829 million in aggregate net case reserves. Both MBIA Illinois and CapMAC currently do not write new business. MBIA Corp. has reinsured their respective net liabilities on financial guarantee insurance business and maintains required reserves in connection therewith. Management believes that MBIA Corp.’s reserves are adequate to cover the ultimate net cost of claims. However, because the reserves are based on management’s judgment and estimates, there can be no assurance that the ultimate liability will not exceed such estimates. In an effort to mitigate losses, IPM is regularly involved in the ongoing remediation of credits that may involve, among other things, waivers or renegotiations of financial covenants or triggers, waivers of contractual provisions, the granting of consents, and the taking
11
Table of ContentsItem 1. Business (continued) of various other remedial actions. The nature of any remedial action is based on the type of the insured issue and the nature and scope of the event giving rise to the remediation. In most cases, as part of any such remedial activity, MBIA Corp. is able to improve its security position and to obtain concessions from the issuer of the insured bonds. From time to time, the issuer of an MBIA Corp. insured bond may, with the consent of MBIA Corp., restructure the insured bonds by extending the term, increasing or decreasing the par amount or decreasing the related interest rate, with MBIA Corp. insuring the restructured bonds. If, as the result of a restructuring, MBIA Corp. estimates that it will suffer an ultimate loss on the restructured issue, MBIA Corp. will record a case basis reserve for the restructured issue or, if it has already recorded a case basis reserve, it will re-evaluate the impact of the restructuring on the posted reserve and adjust the size of the reserve accordingly. From inception, MBIA Corp. has had 107 insured issues requiring claim and/or liquidity payments. There are currently 14 additional insured issues for which case loss reserves have been established for expected future claims but for which claims have not yet been paid. The Company’s experience is that early detection and continued involvement by IPM are crucial in avoiding or minimizing potential draws on the related insurance policy. There can be no assurance, however, that there will be no material losses in the future in respect of any issues guaranteed by MBIA Corp. or its subsidiaries or that the amount of reserves will be adequate to cover such losses. Reinsurance State insurance laws and regulations, as well as the rating agencies who rate MBIA Corp., impose minimum capital requirements on financial guarantee companies, limiting the aggregate amount of insurance and the maximum size of any single risk exposure which may be written. MBIA Corp. decreases the insured exposure in its portfolio and increases its capacity to write new business by using treaty and facultative reinsurance to reduce its gross liabilities on an aggregate and single risk basis. Additionally, MBIA Corp. has entered into agreements under which it is entitled to reimbursement of losses on its insured portfolio but which do not qualify as reinsurance under GAAP. MBIA Corp.’s net retention on the policies it writes varies from time to time depending on its own business needs and the capacity available in the reinsurance market. From its reorganization in December 1986 through December 1987, MBIA Corp. reinsured a portion of each policy through quota and surplus share reinsurance treaties. Each treaty provides reinsurance protection with respect to policies written by MBIA Corp. during the term of the treaty, for the full term of the policy. Under its quota share treaty, MBIA Corp. ceded a fixed percentage of each policy insured. Since 1988, MBIA Corp. has entered into primarily surplus share treaties under which a variable percentage of risk over a minimum size is ceded, subject to a maximum percentage specified in the related treaty. Reinsurance ceded under the treaties is for the full term of the underlying policy. MBIA Corp. also enters into facultative reinsurance arrangements from time to time primarily in connection with issues which, because of their size, require additional capacity beyond MBIA Corp.’s retention and treaty limits. Under these facultative arrangements, portions of MBIA Corp.’s liabilities are ceded on an issue-by-issue basis. MBIA Corp. may also use facultative arrangements as a means of managing its exposure to single issuers or counterparties to comply with regulatory and rating agency requirements, as well as internal underwriting and portfolio management criteria. As a primary insurer, MBIA Corp. is required to honor its obligations to its policyholders whether or not its reinsurers and others perform their agreement obligations to MBIA Corp. The financial position and financial strength rating of all its reinsurers are monitored by MBIA Corp. on a regular basis. The downgrade or default of one or more of the Company’s reinsurers may have a material adverse impact on the Company’s ratings, financial condition or results of operations.
12
Table of ContentsItem 1. Business (continued) The following table shows the reinsurers providing reinsurance to MBIA measured by outstanding par ceded to and reinsurance recoverables from reinsurers by rating levels at December 31, 2007:
In May 2006, MBIA sold its 11.4% equity interest in RAM Holdings Inc., the holding company of RAM Reinsurance Company, Ltd., as part of RAM Holdings Inc.’s initial public offering. In February 2004, the Company, together with Renaissance Re Holdings, Ltd., Koch Financial Re, Ltd. and Partner Reinsurance Company Ltd., formed Channel Re, a new Bermuda-based financial guarantee reinsurance company rated triple-A by S&P and Moody’s. The Company invested $63.7 million for a 17.4% ownership interest in Channel Re. In February 2004, MBIA Corp. and Channel Re entered into arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA Corp. at least through June 30, 2008, a date which was later extended to June 30, 2010. Under treaty and facultative reinsurance arrangements MBIA Corp. agreed to cede to Channel Re and Channel Re agreed to assume from MBIA Corp. varying percentages of designated policies issued by MBIA Corp. The amount of any policy subject to the committed reinsurance arrangements is based on the type of risk insured and on other factors. The reinsurance arrangements provide Channel Re with certain preferential terms, including those related to ceding commissions. The treaty reinsurance arrangement was renewed in 2006. In June 2007, S&P revised its outlook on Channel Re from negative to stable. In February 2008, S&P placed Channel Re’s AAA rating on CreditWatch with negative implications. In February 2008, Moody’s downgraded Channel Re to Aa3 from Aaa, with negative outlook. For the year ended December 31, 2007, the Company expects that Channel Re will report negative shareholder’s equity on a GAAP basis as a result of fair valuing its insured credit derivatives. As a result, in the fourth quarter of 2007, the Company recorded an adjustment to the carrying value of its equity ownership interest in Channel Re from $85.7 million at September 30, 2007 to zero. In February 2004, MBIA Corp. and Channel Re entered into arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA Corp. at least through June 30, 2008, a date which was later extended to June 30, 2010. Under treaty and facultative reinsurance arrangements MBIA Corp. agreed to cede to Channel Re and Channel Re agreed to assume from MBIA Corp. varying percentages of designated policies issued by MBIA Corp. The amount of any policy subject to the committed reinsurance arrangements is based on the type of risk insured and on other factors. The reinsurance arrangements provide Channel Re with certain preferential terms, including those related to ceding commissions. The treaty reinsurance arrangement was renewed in 2006. As of December 31, 2007, the Company had $708.1 million of derivative assets related to insured credit derivatives ceded to Channel Re and a $13.1 million reinsurance recoverable from Channel Re. The Company has assessed Channel Re’s ability to pay these amounts to MBIA if they were to be settled and has concluded that Channel Re had sufficient liquidity supporting its business to settle such amounts, inclusive of approximately $495 million that Channel Re had on deposit in trust accounts as of December 31, 2007 for the benefit of MBIA. Although the trusts limit the potential for Channel Re to default on its obligations to MBIA, there can be no assurance that Channel Re will not default on its obligations to MBIA that exceed the amounts already established in the trust accounts. If, in the future, MBIA determines that Channel Re does not have sufficient liquidity to settle its obligations to MBIA, MBIA will record reserves against such amounts.
13
Table of ContentsItem 1. Business (continued) Several of the Company’s other financial guarantee reinsurers, including RAM Reinsurance Company, Ltd. (“RAM”), Ambac Assurance Corporation, XL Financial Assurance Ltd. and XL Capital Assurance Inc., have had their credit ratings either downgraded or put on negative watch by one or more of the major rating agencies between December 2007 and February 2008. RAM has deposited $104 million of assets in a trust for the benefit of MBIA as of December 31, 2007. Although there was no material impact on the Company for any of the rating agency actions through February 2008 relating to its reinsurers, a further downgrade of one or more of the Company’s reinsurers could increase the amount of capital required to maintain MBIA Corp.’s triple-A ratings and may require the establishment of reserves against any receivables due from the such reinsurers. MBIA Corp. may also look to reduce risks embedded in its insured portfolio on an individual and portfolio-wide basis by entering into derivative transactions or other types of hedging arrangements. In December 2004, MBIA Corp. executed a $550.8 million capital markets transaction in which it hedged a portion, $275.8 million at closing, of the credit and market risk associated with its synthetic CDO portfolio. In 2004, MBIA Corp. received approval from the New York State Insurance Department for a derivative use plan which authorizes MBIA Corp. to hedge certain risks through the use of derivative instruments. In 2006, MBIA Corp. entered into a fixed to floating swap arrangement pursuant to the derivative use plan related to a troubled housing credit in Texas. Interest expense savings resulting from the swap were reinvested into the credit to improve the value of the underlying collateral and reduce financial stress on the borrower. AHERF Arrangements In 1998, three reinsurers, Converium Reinsurance (North America) Inc. (“Converium”), AXA Re Finance S.A. (“ARF”) and Muenchener Rueckversicherungs-Gesellshaft (“Munich Re”) paid MBIA Corp. $170 million under three separate agreements (each, an “Excess-of-Loss Agreement” and, collectively, the “Excess-of-Loss Agreements”) in connection with losses MBIA Corp. incurred on $265 million of MBIA-insured bonds issued by the Pittsburgh-based Alleghany Health, Education and Research Foundation (“AHERF”). The Excess-of-Loss Agreements were structured as three successive excess-of-loss facilities that aggregated to $170 million. Under the Excess-of-Loss Agreements, Converium paid MBIA Corp. $70 million and Munich Re and ARF each paid MBIA Corp. $50 million. In connection with the arrangements for the Excess-of-Loss Agreements, MBIA Corp. entered into quota share agreements with Munich Re, ARF and Converium (each a “Quota Share Agreement” and, collectively, the “Quota Share Agreements”). Under the Quota Share Agreements, MBIA Corp. agreed to cede to the three reinsurers new business written with an aggregate par sufficient to generate $297 million in gross premiums over a six year period ending October 1, 2004. Of the $297 million in premiums to be ceded under the Quota Share Agreements, MBIA Corp. agreed to cede to Converium cash premiums equal to $102 million, to ARF adjusted gross premiums of $97 million and to Munich Re adjusted gross premiums of $98 million over this period. Under separate agreements, to which MBIA Corp. was not a party, Converium reinsured directly and indirectly to ARF (the “Converium-ARF Retrocession Agreements”) the risk that it had assumed from MBIA Corp. under its Quota Share Agreements with MBIA Corp. for losses in excess of $13.1 million. ARF contended that, in connection with its agreement to assume this risk from Converium under the Converium-ARF Retrocession Agreements, there was an oral agreement with MBIA Corp. under which MBIA Corp. would replace ARF as a reinsurer to Converium by no later than October 2005. In October 2004, MBIA Corp. commuted and assumed from ARF the policies that ARF had assumed directly under its Quota Share Agreements with MBIA Corp. discussed above (the “MBIA-ARF Agreements”). At the same time, MBIA Corp. also assumed from ARF all of the risk that ARF assumed from Converium under the Converium-ARF Retrocession Agreements. AXA RE, S.A (“AXA RE”), ARF’s parent, in turn agreed to reinsure MBIA Corp. for all losses in excess of $96.9 million assumed by MBIA Corp. from ARF under the Converium-ARF Retrocession Agreements up to an aggregate amount of $90 million. ARF paid MBIA Corp. $10 million for assuming from it the risk under the Converium-ARF Retrocession Agreements, and MBIA Corp. paid AXA RE $1 million for reinsuring MBIA Corp. for all losses in excess of $96.9 million assumed by MBIA Corp. from ARF under the Converium-ARF Retrocession Agreements up to an aggregate amount of $90 million. In addition to the $10 million that MBIA Corp. received as described above, MBIA Corp. received approximately $19.5 million related to the commutation of the MBIA-ARF Agreement, consisting of statutory unearned premium reserves of $42.5 million less refunded ceding commissions of $13.9 million and fees of $9.1 million. In addition, MBIA Corp. will receive future installment premiums with a present value of approximately $21.5 million in connection with the commuted policies. As a result of this transaction, MBIA Corp. reassumed $21.3 billion in aggregate insured par. The commutation of the MBIA-ARF Agreement and the assumption by MBIA Corp. from ARF of the risk under the Converium-ARF Retrocession Agreements were done in order, among other reasons, to settle and resolve the disputes with ARF regarding the alleged oral agreement. In addition, MBIA Corp. entered into
14
Table of ContentsItem 1. Business (continued) these agreements and agreed to assume the related policies due to the fact that it no longer received rating agency capital credit in connection with the exposures ceded to ARF and Converium because ARF no longer has a financial strength rating and the financial strength rating of Converium had been downgraded. In October 2004, the Company’s management recommended that the Audit Committee of the Company’s Board of Directors undertake an investigation of the Excess-of-Loss Agreements and the Quota Share Agreements, including whether an oral agreement existed between MBIA Corp. and ARF that MBIA Corp. would assume the risk that Converium retroceded to ARF under the Converium-ARF Retrocession Agreements. The Audit Committee retained outside counsel and initiated an investigation in October 2004. On March 8, 2005, the Company announced that it was restating its financial statements for 1998 and subsequent years to correct the accounting for the transactions with Converium based on, among other considerations, a determination by the outside counsel investigation that it appeared likely that an oral agreement or understanding with ARF was made in 1998. The Company reflected this correction in the consolidated financial statements of its original Annual Report on Form 10-K for the year ended December 31, 2004. At that time, the Company believed that the accounting for the Excess-of-Loss Agreements and Quota Share Agreements with Munich Re and ARF was appropriate under SFAS 113. On November 8, 2005, the Company announced its decision to correct and restate its previously issued financial statements for 1998 and subsequent years in connection with then-pending settlements of investigations by the SEC and the NYAG regarding the Excess-of-Loss Agreements and the Quota Share Agreements entered into with Munich Re and ARF. On January 25, 2007, the Company filed a Current Report on Form 8-K with the SEC in which the Company disclosed that it had concluded civil settlements with the SEC, the NYAG and the NYSID regarding these investigations. See “Legal Proceedings” in Part I, Item 3 for more information on the regulatory investigation. Intercompany Reinsurance Arrangements MBIA Corp. has entered into a reinsurance agreement with MBIA UK providing for MBIA Corp.’s reimbursement of the losses incurred by MBIA UK in excess of a specified threshold and a net worth maintenance agreement in which MBIA Corp. agrees to maintain the net worth of MBIA UK, to remain its sole shareholder and not to pledge its shares. Under the reinsurance agreement, MBIA Corp. has agreed to reimburse MBIA UK on an excess-of-loss basis for losses incurred in each calendar year for net retained insurance liability, subject to certain contract limitations. Under the net worth maintenance agreement, MBIA Corp. agrees to maintain a minimum capital and surplus position at MBIA UK in accordance with United Kingdom and New York State legal requirements. MBIA Corp. and MBIA Illinois have entered into a reinsurance agreement under which MBIA Corp. reinsured 100% of all business written by MBIA Illinois, net of cessions by MBIA Illinois to third-party reinsurers, in exchange for MBIA Illinois’ transfer of the assets underlying the related unearned premium and contingency reserves. Pursuant to such reinsurance agreement, MBIA Corp. reinsured all of the net exposure of $30.9 billion, or approximately 68% of the gross debt service outstanding, of the municipal bond insurance portfolio of MBIA Illinois, the remaining 32% having been previously ceded to treaty and facultative reinsurers of MBIA Illinois. In 1990, 10% of this portfolio was ceded back to MBIA Illinois to comply with regulatory requirements. Effective January 1, 1999, MBIA Corp. and MBIA Illinois entered into a replacement reinsurance agreement whereby MBIA Corp. agreed to accept as reinsurance from MBIA Illinois 100% of the net liabilities and other obligations of MBIA Illinois, for losses paid on or after that date, thereby eliminating the 10% retrocession arrangement previously in place. MBIA Corp. and CapMAC have entered into a reinsurance agreement, effective April 1, 1998, under which MBIA Corp. has agreed to reinsure 100% of the net liability and other obligations of CapMAC in exchange for CapMAC’s payment of a premium equal to the ceded reserves and contingency reserves. Pursuant to such reinsurance agreement with CapMAC, MBIA Corp. reinsured all of CapMAC’s then-current net exposure of $31.6 billion, or approximately 78% of CapMAC’s gross debt service then outstanding, the remaining 22% having been previously ceded to treaty and facultative reinsurers of CapMAC. MBIA Corp. entered into a reinsurance agreement and net worth maintenance agreement with MBIA Mexico pursuant to which MBIA Corp. reinsures 100% of the business underwritten by MBIA Mexico and agrees to maintain the amount of capital required by applicable law or regulation. Insurance Regulation MBIA Corp. is licensed to do insurance business in, and is subject to insurance regulation and supervision by, the State of New York (its state of incorporation), the 49 other states, the District of Columbia, Guam, the Northern Mariana Islands, the U.S. Virgin
15
Table of ContentsItem 1. Business (continued) Islands, Puerto Rico, the Kingdom of Spain and the Republic of France. MBIA UK is licensed to do insurance business in the United Kingdom and is subject to the insurance regulation and supervision of the United Kingdom’s Financial Services Authority. MBIA UK has used the provisions of the EC Third Non-life Insurance Directive to provide cross border services in all jurisdictions in the European Economic Area. MBIA Mexico is licensed to do insurance business in, and is subject to regulation and supervision by, the Mexican Ministry of Finance and Public Credit (Secretaría de Hacienda y Crédito Público or “SHCP”) and the Mexican Insurance and Bonds Commission (Comisión Nacional de Seguros y Fianzas or “CNSF”). The extent of state insurance regulation and supervision varies by jurisdiction, but New York, Illinois, the United Kingdom, Mexico and most other jurisdictions have laws and regulations prescribing minimum standards of solvency, including minimum capital requirements, and business conduct which must be maintained by insurance companies. These laws prescribe permitted classes and concentrations of investments. In addition, some state laws and regulations require the approval or filing of policy forms and rates. MBIA Corp. is required to file detailed annual financial statements with the NYSID, the CNSF and similar supervisory agencies in each of the other jurisdictions in which it is licensed. The operations and accounts of MBIA Corp. are subject to examination by these regulatory agencies at regular intervals. MBIA Corp. is licensed to provide financial guarantee insurance under Article 69 of the New York Insurance Law. Article 69 defines financial guarantee insurance to include any guarantee under which loss is payable upon proof of occurrence of financial loss to an insured as a result of certain events. These events include the failure of any obligor on or any issuer of any debt instrument or other monetary obligation to pay principal, interest, premium, dividend or purchase price of or on such instrument or obligation when due. Under Article 69, MBIA Corp. is permitted to transact financial guarantee insurance, surety insurance and credit insurance and such other kinds of business to the extent necessarily or properly incidental to the kinds of insurance which MBIA Corp. is authorized to transact. In addition, MBIA Corp. is empowered to assume or reinsure the kinds of insurance described above. As a financial guarantee insurer, MBIA Corp. is required by the laws of New York, California, Connecticut, Florida, Illinois, Iowa, Maryland, New Jersey and Wisconsin to maintain contingency reserves on its municipal bond, asset-backed securities and other financial guarantee liabilities. Under New Jersey, Illinois and Wisconsin regulations, contributions by such an insurer to its contingency reserves are required to equal 50% of earned premiums on its municipal bond business. Under New York law, such an insurer is required to contribute to contingency reserves 50% of premiums as they are earned on policies written prior to July 1, 1989 (net of reinsurance), and, with respect to policies written on and after July 1, 1989, must make contributions over a period of 15 or 20 years (based on issue type), or until the contingency reserve for such insured issues equals the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed, varying from 0.55% to 2.5%, depending upon the type of obligation guaranteed (net of collateral reinsurance, refunding, refinancings and certain insured securities). California, Connecticut, Florida, Iowa and Maryland laws impose a generally similar requirement, and in California the insurance commissioner can require an insurer to maintain additional reserves if the commissioner determines that the insurer’s reserves are inadequate. In each of these states, MBIA Corp. may apply for release of portions of the contingency reserves in certain circumstances. The laws and regulations of these states also limit both the aggregate and individual securities risks that MBIA Corp. may insure on a net basis based on the type of obligations insured. California, Connecticut, Florida, Illinois, Maryland and New York, among other things, limit insured average annual debt service on insured municipal bonds with respect to a single entity and backed by a single revenue source (net of qualifying collateral and reinsurance) to 10% of policyholders’ surplus and contingency reserves. California, Connecticut, Florida, Illinois, Maryland and New York also limit the net insured unpaid principal on a municipal bond issued by a single entity and backed by a single revenue source to 75% of policyholders’ surplus and contingency reserves. California, Connecticut, Maryland and New York, among other things, require that the lesser of the insured average debt service and the insured unpaid principal (reduced by the extent to which unpaid principal of the supporting assets and, for New York and California, provided the insured risk is investment grade, exceed the insured unpaid principal), divided by nine, on each issue of asset-backed securities issued by a single entity shall not exceed 10% of policyholders’ surplus and contingency reserves, while Florida limits insured unpaid principal for any one risk to 10% of policyholders’ surplus and contingency reserves. In New Jersey, Virginia and Wisconsin, the average annual debt service on any single issue of municipal bonds (net of reinsurance) is limited to 10% of policyholders’ surplus. Other states that do not explicitly regulate financial guarantee or municipal bond insurance do impose single risk limits which are similar in effect to the foregoing. Under New York, California, Connecticut, Florida, Illinois, Maryland, New Jersey and Wisconsin law, aggregate insured unpaid principal and interest under policies insuring municipal bonds (in the case of New York, California, Connecticut, Florida, Illinois and Maryland, net of reinsurance) are limited to certain multiples of policyholders’ surplus and contingency reserves. New York, California, Connecticut, Florida, Illinois, Maryland and other states impose a 300:1 limit for insured municipal bonds, although more
16
Table of ContentsItem 1. Business (continued) restrictive limits on bonds of other types do exist. For example, New York, California, Connecticut, Florida and Maryland impose a 100:1 limit for certain types of non-municipal bonds. Under New York, California, Connecticut, Florida, Maryland and New Jersey law, aggregate insured unpaid principal and interest under policies insuring asset-backed securities (again, in the case of New York, California, Connecticut, Florida and Maryland, net of reinsurance) are limited to certain multiples of policyholders’ surplus and contingency reserves. New York, Maryland, California, Connecticut, and other states impose a 150:1 limit for insured investment grade asset-backed securities, although more restrictive limits on asset-backed securities of other types exist. For example, New York, California, Connecticut, Florida and Maryland impose a 50:1 limit for non-investment grade asset-backed securities. The Company, MBIA Corp., MBIA Illinois, and CapMAC also are subject to regulation under the insurance holding company statutes of New York and Illinois. The requirements of holding company statutes vary from jurisdiction to jurisdiction but generally require insurance holding companies, such as the Company, and their insurance subsidiaries, to register and file certain reports describing, among other information, their capital structure, ownership and financial condition. The holding company statutes also generally require prior approval of changes in control, of certain dividends and other inter-corporate transfers of assets, and of certain transactions between insurance companies, their parents and affiliates. The holding company statutes impose standards on certain transactions with related companies, which include, among other requirements, that all transactions be fair and reasonable and those transactions not in the ordinary course of business exceeding specified limits receive prior regulatory approval. MBIA Mexico may be required to register the financial guaranty insurance products it provides with the CNSF, and is currently required to file certain financial information and other reports with the CNSF periodically, as well as to comply with minimum capital requirements, and, in general, to comply with Mexican laws and regulations applicable to financial guaranty insurers. Prior approval by the NYSID is required for any entity seeking to acquire “control” of the Company, MBIA Corp., or CapMAC. Prior approval by the Illinois Department of Insurance is required for any entity seeking to acquire “control” of the Company, MBIA Corp. or MBIA Illinois. In many states, including New York and Illinois, “control” is presumed to exist if 10% or more of the voting securities of the insurer are owned or controlled by an entity, although the supervisory agency may find that “control” in fact does or does not exist when an entity owns or controls either a lesser or greater amount of securities. The United Kingdom Financial Services Authority also has a requirement for prior approval of any controlling person. MBIA Corp. would require the prior approval of the Mexican SHCP in order to transfer the shares it currently holds in MBIA Mexico. The laws of New York regulate the payment of dividends by MBIA Corp. and provide that a New York domestic stock property/casualty insurance company (such as MBIA Corp.) may not declare or distribute dividends except out of statutory earned surplus. New York law provides that the sum of (i) the amount of dividends declared or distributed during the preceding 12-month period and (ii) the dividend to be declared may not exceed the lesser of (a) 10% of policyholders’ surplus, as shown by the most recent statutory financial statement on file with the NYSID, or (b) 100% of adjusted net investment income for such 12-month period (the net investment income for such 12-month period plus the excess, if any, of net investment income over dividends declared or distributed during the two-year period preceding such 12-month period), unless the New York Superintendent of Insurance approves a greater dividend distribution based upon a finding that the insurer will retain sufficient surplus to support its obligations and writings. See “Note 16: Insurance Regulations and Dividends” in the Notes to Consolidated Financial Statements of MBIA Inc. and Subsidiaries in Part II, Item 8. The foregoing dividend limitations are determined in accordance with Statutory Accounting Practices (“SAP”), which generally produce statutory earnings in amounts less than earnings computed in accordance with GAAP. Similarly, policyholders’ surplus, computed on a SAP basis, will normally be less than net worth computed on a GAAP basis. See “Note 9: Statutory Accounting Practices” in the Notes to Consolidated Financial Statements of MBIA Inc. and Subsidiaries for additional information. MBIA Corp., MBIA Illinois, and CapMAC are exempt from assessments by the insurance guarantee funds in the majority of the states in which they do business. Guarantee fund laws in most states require insurers transacting business in the state to participate in guarantee associations, which pay claims of policyholders and third-party claimants against impaired or insolvent insurance companies doing business in the state. In most states, insurers licensed to write only municipal bond insurance, financial guarantee insurance and other forms of surety insurance are exempt from assessment by these funds and their policyholders are prohibited from making claims on these funds. In Mexico, no statutory guarantee funds or similar entities exist for insurance companies; therefore the obligations of MBIA Mexico under its policies are not covered by any guarantee funds in the event that it became insolvent. INVESTMENT MANAGEMENT SERVICES The Company’s investment management services operations provide an array of products and services to the public, not-for-profit and corporate sectors. Such products and services are provided primarily through wholly owned subsidiaries of MBIA Asset
17
Table of ContentsItem 1. Business (continued) Management and include cash management, discretionary asset management and fund administration services and investment agreement, medium-term note and commercial paper programs related to funding assets for third-party clients and for investment purposes. The investment management services operations are comprised of three operating segments: asset/liability products, which include investment agreements and MTNs not related to the conduit programs; advisory services, which consist of third-party and related-party fee-based asset management; and conduit programs. Asset/Liability Products MBIA Asset Management’s assets/liability products segment raises funds for investment management. IMC, along with MBIA Inc., provides customized investment agreements, guaranteed by MBIA Corp., for bond proceeds and other public funds for such purposes as construction, loan origination, escrow and debt service or other reserve fund requirements. It also provides customized products for funds that are invested as part of asset-backed or structured product transactions. MBIA Asset Management also raises funds through its affiliate GFL. GFL raises funds for management through the issuance of MTNs with varying maturities (“GFL MTNs”), which are in turn guaranteed by MBIA Corp. GFL lends the proceeds of these GFL MTNs issuances to the Company (“GFL Loans”). Under agreements between the Company and MBIA Corp., the Company invests the proceeds of the investment agreements and GFL Loans in eligible investments, which consist of investment grade securities with a minimum average Double-A credit quality rating. MBIA Inc. primarily purchases domestic securities, which are pledged to MBIA Corp. as security for its guarantees on investment agreements and MTNs. Additionally, MBIA Inc. loans a portion of the proceeds from investment agreements and MTNs to Euro Asset Acquisition Limited (“EAAL”), which primarily purchases foreign assets as permitted under the Company’s investment guidelines. MBIA Asset Management manages the programs within a number of risk and liquidity parameters monitored by the Risk Management Division, the Executive Market/Investment Committee and the rating agencies, and maintains backup liquidity in order to ensure sufficient funds are available to make all payments due on the investment agreement and MTN obligations and to fund operating expenses. In addition, the Company has made a capital investment in these programs, which is available at any time to fund cash needs. In the event that the value of the assets is insufficient to repay the investment agreement and MTN obligations when due, the Company, or MBIA Corp. as guarantor, may incur a loss. The Company manages its balance sheet to protect against a number of risks inherent in its business including liquidity risk, market risk (principally interest rate risk), credit risk, operational risk and legal risk. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market Risk” in Part II, Item 7. The assets supporting the MBIA Asset Management programs are managed with the goal of matching the duration of the invested assets, including hedges, to the duration of the investment agreement and MTN obligations in order to minimize market and liquidity risk. MBIA Asset Management uses derivative financial instruments to manage interest rate risk, credit risk and foreign currency risk. Credit default swaps are also used to replicate investment in cash assets consistent with the Company’s risk objectives and credit guidelines. The Company has established policies limiting the amount, type and counterparty concentration of such instruments. A source of liquidity risk arises from the ability of some investment agreement counterparties to withdraw monies on dates other than those specified in the related draw-down schedule. This liquidity risk is mitigated by (i) provisions in the investment agreements which do not allow discretionary withdrawals and limit an issuer’s withdrawal of funds to specific uses outlined in the agreements, and (ii) risk management procedures that require the regular re-evaluation and re-projection of drawdown schedules and the rebalancing of asset cashflows as needed to meet these drawdowns. Investments are restricted to fixed-income securities with an average credit quality rating of Double-A and minimum credit quality rating of investment grade. Based upon management’s projections, MBIA Asset Management maintains liquidity sources which are more than sufficient to meet its projected short-term and long-term cash requirements. Advisory Services In its advisory services segment, MBIA Asset Management offers cash management, customized asset management and investment consulting services to local governments, school districts and other institutional clients through MBIA-MISC, an SEC-registered investment adviser. MBIA Asset Management receives asset management fees as compensation for these services. MBIA Asset Management offers fixed-income asset management services for the investment portfolios of the Company, MBIA Corp. and other affiliates through CMC, an SEC-registered investment adviser and Financial Industry Regulatory Authority member firm and through AM-UK, a Financial Services Authority registered investment advisor based in London. CMC and AM-UK also provide
18
Table of ContentsItem 1. Business (continued) investment management services for third parties on a fee for service basis. Third-party clients include corporations, pension funds, municipalities, insurance companies and investment companies, as well as structured programs such as collateralized debt obligations (“CDOs”) and structured investment vehicles and funding vehicles. Structured programs are not guaranteed by the Company or MBIA Corp., and program profits are shared among the investors and the manager. In 2006, AM-UK structured two non-consolidated investment programs, Hudson-Thames Capital Limited (“Hudson-Thames”), a structured investment vehicle, and East-Fleet Finance Limited (“East-Fleet”), a funding conduit. For both of these entities, AM-UK provided fee-based asset management and administrative services, acting under approved management agreements and at the direction of independent boards of directors of the entities. In addition, the Company invested $15.75 million in the junior capital notes of Hudson-Thames, or 12% of total invested capital. The obligations issued by Hudson-Thames and East-Fleet are not guaranteed by the Company, and the Company has no liquidity obligations to Hudson-Thames or East-Fleet. Beginning in August 2007, adverse conditions in the asset-backed commercial paper markets (in particular the structured investment vehicle market) prevented Hudson-Thames from issuing new senior notes to repay maturing notes. At the direction of Hudson-Thames’ board of directors, all of the remaining assets of Hudson-Thames were sold and in December 2007 Hudson-Thames ceased operations. These adverse conditions also reduced demand by East-Fleet clients for financing and increased the cost of East-Fleet commercial paper funding, together causing the program size to decline. However, East-Fleet continued to operate normally throughout 2007. Due to the cash matched funding of assets and liabilities, East-Fleet is not exposed to liquidity risk. Conduits The Conduits, which issue commercial paper and MTNs, are reflected in the consolidated financial statements of the Company. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Investment Management Services” in Part II, Item 7. The Conduits are used by banks and other financial institutions to raise funds for their customers in the capital markets. The Conduits provide funding for multiple customers through special purpose vehicles that issue commercial paper and MTNs. The proceeds from these issuances are used to either make loans to customers which are secured by certain assets or to purchase the assets from the customers. All transactions in the Conduits are insured by MBIA Corp. and are subject to MBIA Corp.’s standard underwriting process. The Conduits receive an administrative fee as compensation for these services. It is the Company’s policy to obtain an underlying rating from both Moody’s and S&P for each new transaction prior to the execution of such transactions within the Conduits. An underlying rating is the implied rating for the transaction without giving consideration to the MBIA Corp. guarantee. All transactions must be rated investment grade by both S&P and Moody’s before they can be purchased into a Conduit. As a result of having to adhere to MBIA Corp.’s underwriting standards and criteria, Conduit transactions have similar underlying ratings to similar non-Conduit transactions guaranteed by MBIA Corp. at the time they are closed. Like all credits underwritten by MBIA Corp., the underlying ratings on Conduit transactions may be upgraded or downgraded by either one or both rating agencies after they are closed. The weighted-average underlying ratings for transactions currently funded in the Conduits were “A+” by S&P and “A1” by Moody’s at the time such transactions were funded in the Conduits. The Company estimates that the current weighted-average underlying ratings of all outstanding Conduit transactions were still “A+” by S&P and “A1” by Moody’s as of December 31, 2007. The Conduits enter into derivative instruments primarily as economic hedges against interest rate and currency risks. It is expected that any change in the market value of the derivative instruments will be offset by a change in the market value of the hedged assets or liabilities. However, because the investments are accounted for as held-to-maturity, no change in market value, with the exception of the change in value of foreign currency assets due to changes in foreign currency rates, is recorded in the Company’s financial statements. Any change in the market value of derivative instruments that are not accounted for as hedges under SFAS 133 will be recorded as net gains or losses on derivative instruments and foreign exchange in the Company’s consolidated income statement. The Conduits have no impact on the Company’s liquidity requirements because Triple-A One Funding Corp. has independently entered into liquidity agreements with third-party providers and because the assets and liabilities of Meridian are structured on a match-funded basis. At December 31, 2007, there were $4.3 billion of assets (the majority of which are investments valued at amortized cost) in the Conduits and $4.3 billion of liabilities issued through the Conduits.
19
Table of ContentsItem 1. Business (continued) Investments and Investment Policy The Finance Committee of the Board of Directors of the Company approves the Company’s general investment objectives and policies, and also reviews more specific investment guidelines. CMC manages all of MBIA Corp.’s domestic consolidated investment portfolios and substantially all of the Company’s investment portfolios, and AM-UK manages the foreign assets of MBIA Corp.’s subsidiaries and EAAL. Investment objectives, policies and guidelines related to CMC’s and AM-UK’s investment activity on behalf of MBIA Corp. and its insurance company affiliates are also subject to review and approval by the respective Investment Committees of the Boards of Directors of MBIA Corp. and each of its insurance company affiliates. To continue to provide adequate capital resources and claims-paying capabilities for its insurance operations, the investment objectives and policies for insurance operations set preservation of capital as the primary objective, subject to an appropriate degree of liquidity. Maximization of after-tax investment income and investment returns is an important but secondary objective. The insurance operations assets are managed by CMC and AM-UK subject to agreements between these asset management entities and MBIA Corp. and its subsidiaries. Investment objectives, policies and guidelines related to MBIA Asset Management’s asset/liability products segment are also subject to review and approval by the Finance Committee of the Board of Directors and the Executive Market/Investment Committee. The primary investment objectives of MBIA Asset Management in this segment is to preserve capital, to achieve an investment duration that closely approximates the expected duration of related liabilities, and to maintain appropriate liquidity. The Company’s consolidated investment portfolio as shown on its balance sheet at December 31, 2007 was $42.1 billion, of which $5.1 billion represented held-to-maturity investments at amortized cost. The duration of the insurance fixed-income portfolio was 5.2 and 4.9 years as of December 31, 2007 and December 31, 2006. The average maturity of the insurance fixed-income portfolio, excluding short-term investments, as of December 31, 2007 and December 31, 2006 was 9.3 years and 5.8 years, respectively. The Company’s investment portfolio includes investments that are insured by MBIA Corp. (“MBIA Insured Investments”). As of December 31, 2007, MBIA Insured Investments, excluding Conduit investments, at fair value represented $2.5 billion or 6% of the total investment portfolio. Conduit investments represented $4.3 billion or 10% of the total investment portfolio. Investment Management Services Regulation Subsidiaries of MBIA Asset Management are subject to various federal and state securities and investment regulations. As an SEC-registered investment adviser and a Financial Industry Regulatory Authority (“FINRA”) member firm, CMC is subject to the requirements of the Investment Advisers Act of 1940, a Federal statute which regulates registered investment advisers, and to National Association of Securities Dealers (“NASD”) rules and regulations. As an adviser to registered investment companies, CMC is also responsible for compliance with applicable provisions of the Investment Company Act of 1940. As sponsor/administrator of pooled investment programs, MBIA-MISC and Colorado Investor Services Corporation are subject to the requirements of the Investment Advisers Act of 1940, as well as certain state laws governing the operation of and permitted investments in local government investment pools. The activities of AM-UK are subject to supervision by the United Kingdom’s Financial Services Authority. COMPETITION The financial guarantee insurance business is highly competitive. Several other monoline insurance companies compete directly against MBIA Corp. in writing financial guarantee insurance. As a result of recent rating agency actions, the competitive landscape for monoline insurers has been changing. While a few competitors have not been downgraded by the rating agencies, several monoline insurers have either been downgraded or placed on negative watch. MBIA Corp.’s ability to attract new business and to compete with other triple-A rated financial guarantors is largely dependent on the triple-A financial strength ratings assigned to it by the major rating agencies and the financial enhancement rating assigned by S&P. MBIA Corp. intends to comply with the requirements imposed by the rating agencies to maintain such ratings; however, no assurance can be given that MBIA Corp. will successfully comply with these requirements, that these requirements will not change or that, even if MBIA Corp. complies with these requirements, one or more of such rating agencies will not lower or withdraw its financial strength ratings of MBIA Corp. or place MBIA Corp. on “negative outlook” or “rating watch negative” status indicating that a downgrade may be considered in the future. On January 17, 2008, Moody’s placed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates on watch list negative.
20
Table of ContentsItem 1. Business (continued) On January 31, 2008, S&P placed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates on CreditWatch negative. On February 5, 2008, Fitch placed the AAA insurer financial strength ratings of MBIA Corp. and its insurance affiliates on rating watch negative. On February 25, 2008, S&P affirmed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the “AA-” rating of MBIA Inc.’s senior debt and the “AA” ratings of MBIA Corp.’s North Castle Custodial Trust I-VIII, with a negative outlook. On February 26, 2008, Moody’s affirmed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the Aa2 ratings of MBIA Corp.’s Surplus Notes and the Aa3 ratings of the junior obligations of MBIA Corp. and the senior debt of MBIA Inc., with a negative rating outlook. MBIA Corp.’s ability to attract new business and to compete with other triple-A rated financial guarantors has been adversely affected by these rating agency actions. MBIA Corp.’s ability to attract new business and to compete with other triple-A rated financial guarantors and its results of operations and financial condition would be materially adversely affected by any actual reduction, or additional suggested possibility of a reduction, in its ratings. Financial guarantee insurance also competes with other forms of credit enhancement, including senior-subordinated structures, credit derivatives, over-collateralization, letters of credit and guarantees (for example, mortgage guarantees where pools of mortgages secure debt service payments) provided by banks and other financial institutions, some of which are governmental agencies or have been assigned the highest credit ratings awarded by one or more of the major rating agencies. Letters of credit are most often issued for periods of less than 10 years, although there is no legal restriction on the issuance of letters of credit having longer terms. Thus, financial institutions and banks issuing letters of credit compete directly with MBIA Corp. to guarantee short-term notes and bonds with a maturity of less than 10 years. To the extent that banks providing credit enhancement may begin to issue letters of credit with commitments longer than 10 years, the competitive position of financial guarantee insurers, such as MBIA Corp., could be adversely affected. Letters of credit are also frequently used to assure the liquidity of a short-term put option for a long-term bond issue. This assurance of liquidity effectively confers on such issues, for the short term, the credit standing of the financial institution providing the facility, thereby competing with MBIA Corp. and other financial guarantee insurers in providing interest cost savings on such issues. Other highly rated institutions, including pension funds and government sponsored entities, also offer third-party credit enhancement on asset-backed and municipal obligations. Financial guarantee insurance and other forms of credit enhancement also compete in nearly all instances with the issuer’s alternative of foregoing credit enhancement and paying a higher interest rate. If the interest savings from insurance or another form of credit enhancement are not greater than the cost of such credit enhancement, the issuer will generally choose to issue bonds without third-party enhancement. Certain characteristics of the triple-A rated financial guarantee insurance business act as barriers-to-entry to potential new competitors. For example, there are minimum capital requirements imposed on a financial guarantee insurance company by the rating agencies to obtain and maintain triple-A financial strength ratings and these capital requirements may deter other companies from entering this market. However, there can be no assurance that these capital requirements will deter potential competitors from entering this market or that the market may not increasingly accept guarantees provided by Double-A or lower rated insurers who have less stringent capital requirements. In addition, under New York law, multi-line insurers are prohibited from writing financial guarantee insurance in New York State. See “Part I, Item 1. Business—Insurance Regulation.” However, there can be no assurance that major multi-line insurers or other financial institutions will not participate in financial guarantee insurance in the future, either directly or through monoline subsidiaries. RATING AGENCIES Moody’s, S&P, Fitch and RII perform periodic reviews of MBIA Corp. and other companies providing financial guarantee insurance. In rating financial guarantee companies, rating agencies focus on qualitative and quantitative characteristics in five key areas. Those are (1) franchise value and business strategy; (2) insurance portfolio characteristics; (3) capital adequacy; (4) profitability; and (5) financial flexibility. Each agency has its own ratings criteria for financial guarantors and employs proprietary models to assess MBIA’s risk adjusted leverage, risk concentrations and financial performance relative to the agency’s triple-A standards. Several of the agencies also assess MBIA’s corporate governance and factor this into their rating assessment. MBIA Corp. has triple-A financial strength ratings from S&P, Moody’s, Fitch and RII. Both MBIA Mexico and MBIA UK have triple-A financial strength ratings from S&P, Moody’s and Fitch. Obligations which are guaranteed by MBIA Corp., MBIA Mexico and MBIA UK are rated triple-A primarily based on these financial strength ratings. Both S&P and Moody’s have also continued the triple-A rating on MBIA Illinois and CapMAC guaranteed bond issues. On January 17, 2008, Moody’s placed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates on watch list negative. On January 31, 2008, S&P placed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates on credit watch negative. On February 5, 2008, Fitch placed the AAA insurer financial strength ratings of MBIA Corp. and its insurance affiliates on rating watch negative. On February 25, 2008, S&P affirmed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the “AA-” rating of MBIA Inc.’s senior debt and the “AA” ratings of MBIA Corp.’s North Castle Custodial Trust I-VIII, with a negative outlook. On February 26, 2008, Moody’s affirmed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the Aa2 ratings of MBIA Corp.’s Surplus Notes and the Aa3 ratings of the junior obligations of MBIA Corp. and the senior debt of MBIA Inc., with a negative rating outlook. MBIA Corp.’s ability to attract new business and to compete with other triple-A rated financial guarantors has been adversely affected by these ratings actions. MBIA Corp’s ability to attract new business and to compete with other triple-A rated financial guarantors and its results of operations and financial condition would be materially adversely affected by any actual reduction, or additional suggested possibility of a reduction, in its ratings.
21
Table of ContentsItem 1. Business (continued) CAPITAL FACILITIES The Company has various soft capital credit facilities, such as lines of credit and equity-based facilities at its disposal, which further support its claims-paying resources. MBIA Corp. is party to a Credit Agreement, dated as of December 29, 1989 (the “Credit Agreement”), with various highly-rated banks to provide MBIA Corp. with an unconditional, irrevocable line of credit to cover losses in excess of a specified amount with respect to its public finance policies. The line of credit is available to be drawn upon by MBIA Corp., in an amount up to $450 million, after MBIA Corp. has incurred cumulative losses (net of any recoveries) in excess of $500 million and 5% of average annual debt service in respect of MBIA Corp.’s public finance policies. The obligation to repay loans made under the Credit Agreement is a limited recourse obligation of MBIA Corp. payable solely from, and secured by a pledge of, recoveries realized on defaulted insured public finance obligations, from certain pledged installment premiums and other collateral. Borrowings under the Credit Agreement are repayable on the expiration date of the Credit Agreement. The current expiration date of the Credit Agreement is March 31, 2015. The Credit Agreement contains covenants that, among other things, restrict MBIA Corp.’s ability to encumber assets or merge or consolidate with another entity. During 2007, there were no balances outstanding under the facility. MBIA Corp. has access to $400 million through a Money Market Committed Preferred Custodial Trust (“CPCT”) securities facility issued by eight trusts (the “Trusts”), which were created for the primary purpose of issuing CPCT securities and investing the proceeds in high-quality commercial paper or short-term U.S. Government obligations. The CPCT securities are remarketed every 28 days with the interest rate set by means of an auction and with two trusts remarketing each week. In the event that there are insufficient bids at any auction to remarket all of the CPCT securities of any trust, the rate is reset for the next 28 days at the maximum prescribed rate with the investors of the CPCT securities continuing to hold them until the next auction in which sufficient bids are received. The maximum prescribed rate is 30-day LIBOR plus 150 basis points if MBIA Corp. maintains a financial strength rating from S&P and Moody’s at or above AA- and Aa3, respectively, or 30-day LIBOR plus 200 basis points if MBIA Corp.’s financial strength rating falls below either AA- or Aa3. Due to the decline in the demand for short-term structured securities during the end of the third quarter of 2007 through the fourth quarter of 2007, all CPCT securities were unable to be remarketed at their most recent remarketing date, resulting in the current investors of the CPCT securities receiving the maximum prescribed interest rate from August 14, 2007 through December 31, 2007. MBIA Corp. has a put option to sell to the Trusts the perpetual preferred stock of MBIA Corp. If MBIA Corp. exercises its put option, the Trusts will transfer the proceeds to MBIA Corp. in exchange for the preferred stock that will be held by the Trusts. The Trusts are vehicles for providing MBIA Corp. the opportunity to access new capital at its sole discretion through the exercise of the put options. As of December 31, 2007, the Trusts were rated AA and Aa2 by S&P and Moody’s, respectively. However, in January 2008, the trusts were downgraded by S&P and Moody’s to AA- and Aa3, respectively. To date, MBIA Corp. has not exercised its put options under any of these arrangements. The Company continues to receive 100% capital credit for this facility. However, the Company anticipates incurring additional expense to maintain this facility if the CPCT securities continue to incur interest at the maximum prescribed rate. At December 31, 2007, MBIA maintained a revolving credit facility totaling $500 million with a group of highly rated global banks. During the second quarter of 2006, the Company negotiated more favorable terms of the facility, including an extension of the maturity from April 2010 to May 2011. The facility contains certain covenants including, among others, that the maintenance of a minimum net worth for MBIA Inc. and MBIA Corp. and a maximum debt to equity ratio for MBIA Inc. and MBIA Corp. This facility does not include any credit rating triggers or any provisions that could require the posting of collateral. The Company was in compliance with all of the revolving credit facility covenants as of December 31, 2007. During 2007, there were no balances outstanding under the facility. In January 2008, the Company amended the current credit facility to treat the Surplus Notes issued in January 2008 as equity in the net worth calculation.
22
Table of ContentsItem 1. Business (continued) From time to time, MBIA accesses the capital markets to support the growth of its businesses. As such, the Company filed a registration statement on Form S-3ASR with the SEC in June 2007 for an indeterminate amount which replaced and canceled remaining balances on all prior shelf registration statements filed with the SEC. This shelf registration permits the Company to issue various debt and equity securities described in the prospectus filed as part of the registration statement. Subsequent to year end, MBIA filed amendments to allow issuance of $1.15 billion of common stock in a public offering in February 2008. On January 30, 2008, the Company issued 16.1 million shares of MBIA common stock to Warburg Pincus at $31 per share per an investment agreement, subsequently amended on February 6, 2008, with Warburg Pincus. In addition, under the agreement with Warburg Pincus, the Company granted Warburg Pincus warrants to purchase 8.7 million shares of MBIA common stock at an exercise price of $40 per share and “B” warrants, which, upon obtaining certain approvals, will become exercisable to purchase 7.4 million shares of common stock at a price of $40 per share. On February 13, 2008, the Company completed a public offering of 94.65 million shares of MBIA common stock at $12.15 per share. Pursuant to the amended agreement with Warburg Pincus, Warburg Pincus was granted 4 million of “B2” warrants at a price of $16.20 per share. In addition, under anti-dilution provisions in the agreement with Warburg Pincus, the terms of the warrants issued to Warburg Pincus on January 30, 2008 were amended, which resulted in (a) the 8.7 million of warrants exercisable at $40 per share were revised to 11.5 million warrants exercisable at $30.25 per share and (b) the 7.4 million of “B” warrants exercisable at $40 per share were revised to 9.8 million “B” warrants exercisable at $30.25 per share. See Note 29, “Subsequent Events,” in the Notes to the Consolidated Financial Statements of MBIA, Inc. and Subsidiaries in Part II, Item 8 for additional information on the agreement with Warburg Pincus and the common stock offering. EMPLOYEES As of February 11, 2008, the Company had 486 employees, 367 in MBIA Corp. and 119 in MBIA Asset Management. None of the Company’s domestic employees is covered by a collective bargaining agreement. Certain of the Company’s employees outside the United States are governed by national collective bargaining or similar agreements. The Company considers its employee relations to be satisfactory. AVAILABLE INFORMATION The Company maintains a website at www.mbia.com. The Company is not including the information on its website as a part of, nor is it incorporating such information by reference into, this Form 10-K. The Company makes available through its website, free of charge, all of its SEC filings, including its annual Form 10-K, its quarterly filings on Form 10-Q and any current reports on Form 8-K, as soon as is reasonably practicable after these materials have been filed with the SEC. All such filings were timely posted to the website in 2007. EXECUTIVE OFFICERS The executive officers of the Company and their present ages and positions with the Company as of March 1, 2008 are set forth below.
Joseph W. Brown is Chairman, Chief Executive Officer and President, and Director of the Company. Mr. Brown assumed his roles in February 2008 after having retired as Executive Chairman of MBIA in May 2007. Until May 2004, Mr. Brown had served as Chairman and Chief Executive Officer of MBIA, and of its main operating unit, MBIA Insurance Corporation. Mr. Brown originally joined the Company as Chairman and CEO in January 1999 after having been a director since 1986. Prior to joining MBIA in 1999, Mr. Brown was Chairman and CEO of Talegen Holdings, Inc., an insurance holding company. Before his election as Chairman and CEO of Talegen, Mr. Brown was President and CEO of Fireman’s Fund Insurance Company. Mr. Brown joined Fireman’s Fund in 1974. He held numerous executive positions including Chief Financial Officer at the time of its IPO in 1985 from American Express and President and COO at the time of its sale to Allianz AG in 1990. Mr. Brown served on the board of Oxford Health Plans from 2000 to 2004 and on the Board of Fireman Fund Holdings prior to the sale of its insurance subsidiary to Allianz. He has served on the SAFECO board since 2001 and was elected Non-executive Chairman in January 2006. He steps down from that chairmanship in May 2008. Ram D. Wertheim is Vice President, General Counsel and Secretary of the Company. From February of 1998 until January, 2000, he served in various capacities in the Global Structured Finance Division. Mr. Wertheim was, until February of 1998, the General Counsel of CapMAC Holdings Inc.
23
Table of ContentsItem 1. Business (continued) Kevin D. Silva is Vice President and Chief Administrative Officer of the Company. He has been in charge of the Management Services Division of MBIA Corp. since joining the Company in late 1995. Ruth M. Whaley is Vice President and Chief Risk Officer of the Company. She was, until February of 1998, the Chief Underwriting Officer of CapMAC Holdings Inc. Mitchell I. Sonkin is Vice President of the Company and head of the IPM Division. Prior to joining the Company in April 2004, Mr. Sonkin was senior partner and co-chair of the Financial Restructuring Group of the international law firm of King & Spalding. Christopher E. Weeks is Vice President of the Company and head of the International Division. Mr. Weeks has served in various capacities since joining the Company in 1995, most recently as the business manager in MBIA Corp.’s Global Structured Finance Division responsible for CDO and secondary markets activity. Clifford D. Corso is Vice President of the Company, the Company’s Chief Investment Officer and the president of MBIA Asset Management. He joined the Company in 1994 and has served as Chief Investment Officer since 2000. Thomas G. McLoughlin is Vice President of the Company and head of the Global Public Finance Division. Since joining MBIA Corp. in 1994, he has been primarily involved in the public finance area. William C. Fallon is Vice President of the Company and head of the Global Structured Finance Division. From July 2005 to March 1, 2007, Mr. Fallon was Vice President of the Company and head of Corporate and Strategic Planning. Prior to joining the Company in 2005, Mr. Fallon was a partner at McKinsey & Company and co-leader of that firm’s Corporate Finance and Strategy Practice. C. Edward Chaplin is Vice President and Chief Financial Officer of the Company and Vice Chairman and Chief Financial Officer of MBIA Corp. Prior to becoming an officer of the Company in June 2006, Mr. Chaplin had served as a director of the Company from December 2002 to May 2006 and as Senior Vice President and Treasurer of Prudential Financial Inc. since November 2000, responsible for Prudential’s capital and liquidity management, corporate finance, and banking and cash management. Mr. Chaplin had been with Prudential since 1983. On January 11, 2007, the Company filed a Current Report on Form 8-K with the SEC announcing that Joseph W. Brown, who has served as Executive Chairman of the Company since May 2004 and was Chairman and Chief Executive Officer of the Company from 1999 until May 2004, informed the Board of Directors of the Company of his intention to not stand for re-election as a director of MBIA when his term expired at MBIA’s 2007 Annual Meeting of Stockholders (the “2007 Annual Meeting”), held in May 2007. Under the terms of Mr. Brown’s letter agreement with the Company, which he entered into in May 2004, Mr. Brown had agreed to serve as Executive Chairman until the earlier of the Company’s 2007 Annual Meeting or May 31, 2007. Mr. Brown was a member of the Board of Directors of the Company since 1990 and was previously a Board member from December 1986 through May 1989. At the 2007 Annual Meeting, the Board elected Mr. Gary C. Dunton as Chairman of the Board of Directors and designated Mr. David Clapp to continue to serve as lead director, in each case until the Company’s 2008 Annual Meeting of Stockholders. On February 16, 2008, the Board elected Daniel Kearny to replace Mr. Clapp as lead director, with effect at the 2008 Annual Meeting. On February 21, 2007, MBIA filed a Current Report on Form 8-K with the SEC announcing that Neil G. Budnick, President of MBIA Insurance Corporation and responsible for all new financial guarantee insurance business, and Mark S. Zucker, Managing Director and Head of Global Structured Finance, were leaving the Company. Mr. Budnick’s responsibilities were assumed by Gary C. Dunton, the Chief Executive Officer. William C. Fallon, Managing Director and Head of Corporate Strategy was named Head of Global Structured Finance, replacing Mr. Zucker effective March 1, 2007. Messrs. Budnick and Zucker left the Company by April 30, 2007. On August 6, 2007 the Company filed a Current Report on Form 8-K with the SEC announcing that on August 3, 2007, the Board of Directors of MBIA elected Richard C. Vaughan as a member of MBIA’s Board of Directors. Mr. Vaughan served as Executive Vice President and Chief Financial Officer of Lincoln Financial group from 1995 until his retirement in May 2005. Effective as of the date of his election to MBIA’s Board of Directors, Mr. Vaughan was appointed to serve as a member of the Audit Committee and the Compensation and Organization Committee. In addition, MBIA’s Board of Directors determined, in accordance with the independence standards set forth in the MBIA Inc. Board Corporate Governance Practices, that Mr. Vaughan is an Independent Director and does not have any material relationships with MBIA.
24
Table of ContentsItem 1. Business (continued) On January 25, 2008 the Board appointed David A. Coulter and Kewsong Lee as directors, effective January 30, 2008, each to serve until his successor shall have been appointed and qualified or until he shall have resigned or been removed. Mr. Coulter will serve as a member of the Compensation & Organization Committee, the Credit Risk Committee and the Executive Committee until the next annual meeting of shareholders. Mr. Lee will serve as a member of the Finance Committee and the Nominating/Corporate Governance Committee until the next annual meeting of shareholders. Mr. Coulter and Mr. Lee were appointed to the Board in accordance with the Investment Agreement (the “Investment Agreement”) dated as of December 10, 2007, between MBIA and Warburg Pincus. (“Warbug Pincus”), which required MBIA to cause two people nominated by Warburg Pincus to be elected or appointed to the Board on the closing date of the investment. Subject to the share ownership requirements described in the Investment Agreement, MBIA will be required to recommend to its stockholders the election of up to two directors nominated by Warburg Pincus at MBIA’s annual meeting, and Warburg Pincus’s nominees will be required to be MBIA’s and MBIA’s Nominating/Governance Committee’s nominees to serve on the Board. In addition MBIA will be required to use all reasonable best efforts to have Warburg Pincus’s nominees elected as directors of MBIA and MBIA will be required to solicit proxies for them to the same extent as it does for any of its other nominees to the Board. Subject to the share ownership requirement described in the Investment Agreement, Warburg Pincus has the right to proportionate representation on each committee of the Board (and the board of directors of any of MBIA’s subsidiaries), with at least one representative on each such committee, as permitted by applicable laws and New York Stock Exchange regulations. On January 31, 2008 the Company filed a Current Report on Form 8-K with the SEC announcing that Richard H. Walker resigned from the board of directors of MBIA, effective January 28, 2008, due to the possibility of an appearance of a conflict of interest in light of the ongoing discussions among the New York State Superintendent of Insurance, the banking industry and the monoline financial guarantee insurance industry. On February 19, 2008 the Company filed a Current Report on form 8-K with the SEC announcing that on February 16, 2008, the Board of Directors elected Joseph W. Brown, 59, to the Board and the offices of chairman, president and chief executive officer of MBIA, effective immediately. Mr. Brown will serve on the Executive and Finance Committees of the Board. Mr. Brown’s term as director expires at MBIA’s 2008 annual meeting.Mr. Brown had retired as Executive Chairman of MBIA in May 2007 and has served as Chairman and Chief Executive Officer of MBIA until May 2004. On February 19, 2008, the Company further announced that on February 16, 2008, Gary C. Dunton informed the Board of his resignation as President, Chief Executive Officer, Chairman, and Director of MBIA, effective immediately. Mr. Dunton served on the Executive and Finance Committees of the Board. Item 1A. Risk Factors References in the risk factors to the “Company” are to MBIA Inc., together with its domestic and international subsidiaries. References to “we,” “our” and “us” are to MBIA Inc. or the Company, as the context requires. Recent adverse developments in the credit markets and any potential negative impact on MBIA Corp.’s insured portfolio may materially and adversely affect our financial condition, results of operations and future business MBIA Corp. is exposed to credit risks in its portfolio that may arise from deterioration in the credit markets, wherein such deterioration in credit performance could lead to potential erosion in the quality of assets and also the collection of cash flows from such assets within structured securities that it has guaranteed. While MBIA Corp. has sought to underwrite direct RMBS and CDOs of ABS with levels of subordination and other credit enhancements designed to protect it from loss in the event of poor performance of the underlying assets collateralizing the securities in the insured portfolio, for the fourth quarter of 2007 we recorded case basis loss activity of $613.5 million and a special increase to our unallocated loss reserve of $200 million due to projected inadequacies of such credit enhancements in securities it has guaranteed. The case basis activity and special increase to unallocated loss reserve were in addition to MBIA Corp.’s regular quarterly addition of 12% of scheduled earned premiums, or approximately $23 million in the fourth quarter of 2007. No assurance can be given that such credit enhancements will prove to be adequate to protect MBIA Corp. from incurring additional material losses in view of the current significantly higher rates of delinquency, foreclosure and losses being observed among residential mortgages and home equity lines of credit. While further deterioration in performance of the subprime mortgage sector is generally expected, the extent and duration of any future continued deterioration of the credit markets is unknown, as is the impact, if any, on potential claim payments and ultimate losses of the securities within MBIA Corp.’s portfolio. In addition, there can be no assurance that any of the governmental or private sector initiatives designed to address such credit deterioration in the markets will be implemented, and there is no way to know the effect that any such initiatives could have on the credit performance over time of the actual securities that MBIA Corp. insures.
25
Table of ContentsItem 1. Business (continued) In addition, there can be no assurance that we would be successful, or that we would not be delayed, in enforcing the subordination provisions, credit enhancements or other contractual provisions of the RMBS, CMBS and CDOs of ABS that MBIA Corp. insures in the event of litigation or the bankruptcy of other transaction parties. Many of the subordination provisions, credit enhancements and other contractual provisions of the RMBS, CMBS and CDOs of ABS that MBIA Corp. insures are untested in the market and, therefore, it is uncertain how such subordination provisions, credit enhancements and other contractual provisions will be interpreted in the event of an action for enforcement. Individual credits in MBIA Corp.’s insured portfolio (including potential new credits) are assessed a rating agency “capital charge” based on a variety of factors, including the nature of the credits, their underlying ratings, their tenor and their expected and actual performance. In the event of an actual or perceived deterioration in creditworthiness, a reduction in the underlying rating or a change in the rating agency capital methodology, MBIA Corp. may be required to hold more of its capital in reserve against credits in its insured portfolio, regardless of whether losses actually occur, or against potential new business. Significant reductions in underlying ratings of credits in MBIA Corp.’s insured portfolio can produce significant increases in assessed “capital charges.” There can be no assurance that MBIA Corp.’s capital position will be adequate to meet such increased rating agency reserve requirements or that MBIA Corp. will be able to secure additional capital, especially at a time of actual or perceived deterioration in creditworthiness of new or existing credits. Unless MBIA Corp. was able to increase its amount of available capital, an increase in capital charges could reduce the amount of capital available to pay claims and support MBIA Corp.’s triple-A ratings and could have an adverse effect on MBIA Corp.’s ability to write new business. In recent weeks and months Fitch, Moody’s and S&P have announced the downgrade of, or other negative ratings actions with respect to, certain transactions that MBIA Corp. insures, as well as a large number of structured finance transactions that serve as collateral in structured finance transactions that MBIA Corp. insures. While less than 5% of MBIA Corp.’s insured portfolio as of December 31, 2007, has been downgraded as of February 5, 2008, in connection with the rating agencies’ recent downgrades of structured finance transactions, there can be no assurance that additional securities in MBIA Corp.’s insured portfolio will not be reviewed and downgraded in the future. Moreover, we do not know what portion of the securities in MBIA Corp.’s insured portfolio already have been reviewed by the rating agencies and if, and when, the rating agencies might review additional securities in MBIA Corp.’s insured portfolio or review again securities that have already been reviewed and/or downgraded. Downgrades of credits that MBIA Corp. insures will result in higher capital charges to MBIA Corp. under the relevant rating agency model or models. It is not known at the date of this Annual Report on Form 10-K how much additional capital, if any, will be required as a result of the Fitch rating actions announced on February 1, 2008, regarding RMBS tranches as described under “Business––Rating Agencies.” If the additional amount of capital required to support such exposures is significant, MBIA Corp. could look to raise additional capital, if available, on terms and conditions that may not be favorable to MBIA Corp., curtail current business writings, or pay to transfer a portion of its in-force business to generate capital for rating agency purposes to maintain its triple-A ratings. Such capital raising may not be possible. Accordingly, additional downgrades of MBIA insured credits could adversely affect the results of operations and financial condition of MBIA Corp. going forward. A reduction in MBIA Corp.’s financial strength ratings from any of the major rating agencies would materially and adversely affect our financial condition, results of operations and future business MBIA Corp.’s ability to attract new business and to compete with other triple-A rated financial guarantors is largely dependent on the triple-A financial strength ratings assigned to it by the major rating agencies and the financial enhancement rating assigned by S&P. MBIA Corp. intends to comply with the requirements imposed by the rating agencies to maintain such ratings; however, no assurance can be given that MBIA Corp. will successfully comply with these requirements, that these requirements will not change or that, even if MBIA Corp. complies with these requirements, one or more of such rating agencies will not lower or withdraw its financial strength ratings of MBIA Corp. or place MBIA Corp. on “negative outlook” or “rating watch negative” status indicating that a downgrade may be considered in the future. On January 17, 2008, Moody’s placed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates on watch list negative. On January 31, 2008, S&P placed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates on CreditWatch negative. On February 5, 2008, Fitch placed the AAA insurer financial strength ratings of MBIA Corp. and its insurance affiliates on rating watch negative. On February 25, 2008, S&P affirmed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the “AA-” rating of MBIA Inc.’s senior debt and the “AA” ratings of MBIA Corp.’s North Castle Custodial Trusts I-VIII, with a negative outlook. On February 26, 2008, Moody’s affirmed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the Aa2 ratings of MBIA Corp.’s Surplus Notes and the Aa3 ratings of the junior obligations of MBIA Corp. and the senior debt of MBIA Inc., with a negative rating outlook. MBIA Corp.’s ability to attract new business and to compete with other triple-A rated financial guarantors has been adversely affected by these rating agency actions. MBIA Corp.’s ability to attract new business and to compete with other triple-A rated financial guarantors and its results of operations and financial condition would be materially adversely affected by any actual reduction, or additional suggested possibility of a reduction, in its ratings. Requirements imposed by the rating agencies in order for MBIA Corp. to maintain its triple-A ratings are outside of our control, and such requirements may oblige us to raise additional capital or take other remedial actions in a relatively short timeframe in order to
26
Table of ContentsItem 1A. Risk Factors (continued) maintain MBIA Corp.’s triple-A ratings. We have implemented a capital plan in order to raise what we believe will be sufficient funds to meet or exceed the rating agency capital requirements. However, Moody’s and S&P have recently announced certain changes in their assumptions that could increase the amount that we estimate will be required, or that they have previously announced is required, to support MBIA Corp.’s ratings, and as of the date of this Annual Report on Form 10-K, we do not know how much additional capital, if any, we will be required to raise in respect of such changes. The capital plan primarily consists of our equity offering that closed on February 13, 2008, the initial $500 million Warburg Pincus investment, the Surplus Notes offering and capital formation and risk reduction through operations, elimination of dividends and the use of reinsurance. However, the rating agencies have recently announced potential sector-wide actions and a greater emphasis on non-quantitative factors in their analysis, so there can be no assurance that Fitch, Moody’s and S&P will change MBIA Corp.’s outlook to “stable” even if we successfully implement our capital plan. If the capital plan raises insufficient capital to meet what we anticipate will be the ratings agencies’ triple-A capital requirements or more stringent requirements they may implement in the future, MBIA Corp.’s financial strength ratings may be downgraded, which would materially adversely affect our financial condition, results of operations and future business. Changes in the rating agencies’ capital models and rating methodology with respect to financial guarantee insurers may materially adversely affect our business, results of operations and financial condition Changes in the rating agencies’ capital models and rating methodology with respect to financial guarantee insurers and the risks in MBIA Corp.’s investment portfolio and insured portfolio could require MBIA Corp. to hold more capital against specified credit risks in the insured portfolio. For example, the rating agencies have recently made changes to their capital models and rating methodology in response to the deterioration in the performance of certain securities. These requirements have placed stress on our ratings and require us to raise additional capital to maintain MBIA Corp.’s triple-A ratings. Since the original announcement of our capital plan, Fitch, Moody’s and S&P have announced additional changes in certain of their assumptions relating to our capital requirements that could increase the amount that we estimate will be required, or that they have previously announced is required, to support our ratings, which could further increase our need to raise capital. There can be no assurance that capital will be available to us on favorable terms and conditions or at all, and the failure to raise such capital could have a material adverse impact on our business, results of operations and financial condition. Loss reserve estimates are subject to uncertainties and loss reserves may not be adequate to cover potential claims The financial guarantees issued by MBIA Corp. insure the financial performance of the obligations guaranteed over an extended period of time, in some cases over 30 years, under policies that MBIA Corp. has, in most circumstances, no right to cancel. As a result of the lack of statistical paid loss data due to the low level of paid claims in MBIA Corp.’s financial guarantee business and in the financial guarantee industry in general, particularly, until recently, in the structured asset-backed area, MBIA Corp. does not use traditional actuarial approaches to determine its loss reserves. The establishment of the appropriate level of loss reserves is an inherently uncertain process involving numerous estimates and subjective judgments by management, and therefore, there can be no assurance that actual paid claims in MBIA Corp.’s insured portfolio will not exceed its loss reserves. Small changes in the assumptions underlying these estimates could significantly impact loss expectations. Additionally, MBIA Corp. uses both internal models as well as models generated by third party consultants and customized by MBIA Corp. to project future paid claims on MBIA Corp.’s insured portfolio and establish loss reserves. There can be no assurance that the future loss projections based on these models are accurate. We recorded case basis loss activity of $613.5 million and a special increase to our unallocated loss reserve of $200 million in the fourth quarter of 2007 related to such exposures. The case basis activity and special increase to our unallocated loss reserve were in addition to MBIA Corp.’s regular quarterly addition of 12% of scheduled earned premiums, or approximately $23 million in the fourth quarter of 2007. Additionally, further deterioration in the performance of RMBS, CDOs of ABS or other obligations MBIA Corp. insures or reinsures could lead to the establishment of additional loss reserves and further losses or reductions in income. There can be no assurance that the estimates of probable and estimable losses are accurate. Actual paid claims could exceed our estimate and could significantly exceed our loss reserves. If our loss reserves are not adequate to cover actual paid claims, MBIA Corp.’s results of operations and financial condition could be materially adversely affected. Credit risk modeling contains uncertainty over ultimate outcomes which make it difficult to estimate potential paid claims and loss reserves and mark-to-market The securities MBIA Corp. insures include highly complex structured transactions, the performance of which depends on a wide variety of factors outside of our control, and in such transactions we must rely on financial models, generated internally and supplemented by models generated by third parties, to estimate future credit performance of the underlying assets, and to evaluate
27
Table of ContentsItem 1A. Risk Factors (continued) structures, rights and our potential obligations over time. These estimates can vary materially based on relatively small changes in assumptions and the use of different modeling techniques. Also, for example, the modeling of multi-sector CDOs requires analysis of both direct ABS as well as CDO collateral within the multi-sector CDOs, known as “inner securitizations,” and we do not consistently have access to all the detailed information necessary to project every component of each inner securitization. Such “inner securitizations” may themselves include CDO collateral. Therefore, in some cases we put greater reliance on the models and analysis of third party market participants and are not able to fully, independently and precisely verify each data point. Moreover, the performance of the securities that MBIA Corp. insures and the underlying mark-to-market of our obligations depends on a wide variety of factors which are outside our control, including the liquidity and performance of the collateral underlying such securities, the correlation of assets within collateral pools, the performance or non-performance of other transaction participants (including third-party servicers) and the exercise of control or other rights held by other transaction participants. We continually monitor portfolio and transaction data and adjust these credit risk models to reflect changes in expected and stressed outcomes over time. We use internal models for ongoing portfolio monitoring and to estimate case basis loss reserves and, where applicable, to mark our obligations under our contracts to market and may supplement such models with third party models or use third party experts to consult with our internal modeling specialists. When using third party models, we perform the same review and analysis of the collateral, deal structure, performance triggers and cash flow waterfalls as when using our internal models. However, both internal and external models are subject to model risk and there can be no assurance that these models are accurate or comprehensive in estimating our potential future paid claims and related loss reserves or that they are similar to methodologies employed by our competitors, counterparties or other market participants. In addition, changes to our paid claims, loss reserve or mark-to-market models may be warranted in the future. These changes could materially impact our financial results. We are required to report credit derivatives at fair value, which subjects our results of operations to volatility and losses Any event causing credit spreads on an underlying security referenced in a credit derivative insured by MBIA Corp. to either widen or tighten will affect the fair value of the credit derivative and may increase the volatility of our earnings. We apply fair value accounting for the portion of our business executed in credit derivative form as required by SFAS 133 and changes in fair value are recognized immediately in earnings. Therefore, any increases or decreases in the fair value of these credit derivatives have an immediate corresponding impact on reported earnings. As changes in fair value can be caused by factors unrelated to the performance of MBIA Corp.’s business and credit portfolio, including general market conditions and perceptions of credit risk, as well as market use of credit derivatives for hedging purposes unrelated to the specific referenced credits in addition to events that affect particular credit derivative exposure, the application of fair value accounting may cause our earnings to be more volatile than would be suggested by the underlying performance of MBIA Corp.’s business operations and credit portfolio. In addition, due to the complexity of fair value accounting and the application of SFAS 133, future amendments or interpretations of derivative and fair value accounting may cause us to modify our accounting methodology in a manner which may have an adverse impact on our financial results. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates” in Part II, Item 7 for additional information on the valuation of derivatives. Current accounting standards mandate that we measure the fair value of our insurance policies of credit default swaps. At the present time, we do not have access to the fair value estimates of the insurance beneficiaries and there can be no assurance that those counterparties (or any other market participant’s) estimates would be the same as our fair values. In the fourth quarter of 2007, we observed a further widening of market spreads and credit ratings downgrades of collateral underlying certain MBIA Corp.-insured CDO tranches. The mark-to-market loss from September 30, 2007 to December 31, 2007 was $3.4 billion, or approximately $2.2 billion on an after-tax basis. This increase in our mark-to-market loss in the fourth quarter of 2007 compared to the pre-tax $342 million mark-to-market loss for the third quarter was a consequence of continued spread volatility, including a substantial widening in CMBS spreads and the deterioration of credit ratings in collateral underlying multi-sector CDOs. The mark-to-market amount disclosed above reflects a refinement to MBIA Corp.’s valuation modeling techniques that was implemented in the fourth quarter. Specifically, in light of extraordinary widening of the market spreads for the asset-backed security portion of the collateral underlying certain insured CDOs in the investment grade corporate CDO portfolio, for purposes of its valuation model, MBIA Corp. revised its approach and treated that ABS collateral as if it were in default. MBIA Corp. performs an internal analysis of the mark-to-market change each month. The mark-to-market position as of January 31, 2008, is not available at this time. However, in January 2008 we observed further widening of credit market spreads and, on January 30, 2008, S&P announced rating action on 6,389 U.S. subprime RMBS ratings and 1,953 CDO ratings and on February 1, 2008, Fitch announced a rating action on 2,972 RMBS ratings. It is expected that these developments will result in additional material mark-to-market losses for January 2008.
28
Table of ContentsItem 1A. Risk Factors (continued) Competition may have an adverse effect on MBIA Corp.’s business The businesses engaged in by MBIA Corp. are highly competitive. MBIA Corp. faces competition from other financial guarantee insurance companies, other providers of third-party credit enhancement, such as multi-line insurance companies, credit derivative and swap providers and banks, and alternative financing structures that do not employ third-party credit enhancement, and recently a new financial guarantee insurer has been licensed to operate in New York and is in the process of seeking licensing in other jurisdictions. Increased competition, either in terms of price, alternative structures, or the emergence of new providers of credit enhancement, could have an adverse effect on MBIA Corp.’s business. In addition, MBIA Corp.’s competitive position may suffer due to having been being placed on review for a possible downgrade by Fitch, Moody’s and S&P. Market and other factors may cause investors and/or issuers to decrease demand for MBIA Corp.’s products The demand for financial guarantee insurance depends upon many factors, some of which are beyond the control of MBIA Corp. The major rating agencies have recently changed the ratings outlook for certain financial guarantee insurers to “negative,” placed certain financial guarantee insurers on review for a possible downgrade, downgraded certain financial guarantee insurers and affirmed a “stable” outlook for other major financial guarantee insurers. Investors from time to time distinguish among financial guarantors on the basis of various factors, including rating agency assessment, size, insured portfolio concentration and financial performance. These distinctions may result in differentials in trading levels for securities insured by particular financial guarantors which, in turn, may provide a competitive advantage to those financial guarantors with better trading characteristics. In addition, various investors may, due to regulatory or internal guidelines, lack additional capacity to purchase securities insured by certain financial guarantors, which may provide a competitive advantage to guarantors with fewer insured obligations outstanding. Differentials in trading values or investor capacity constraints that do not favor MBIA Corp. would have an adverse effect on MBIA Corp.’s ability to attract new business at appropriate pricing levels, and in recent months MBIA Corp. has experienced a decline in new business which may be attributable to recent rating agency actions and their impact on investor perception. Additionally, in the face of the disruption in the credit markets and the recent announcements by Fitch, Moody’s and S&P concerning financial guarantee insurers generally and MBIA Corp. in particular, the price of our common stock has experienced a significant decline and there has been a widening of spreads on our credit default swaps. This recent widening of spreads on our credit default swaps could impact the perception of our financial condition by MBIA Corp.’s insured bondholders and counterparties and could affect their willingness to purchase MBIA Corp.’s insured bonds and to continue to enter into transactions with MBIA Corp. Changes in interest rates could adversely affect our financial condition and future business Increases in prevailing interest rate levels can adversely affect the value of MBIA’s investment portfolio and, therefore, our financial condition. In the event that investments must be sold in order to make payments on insured exposures, such investments would likely be sold at discounted prices. Additionally, increasing interest rates could lead to increased credit stress on transactions in MBIA Corp.’s insured portfolio. Prevailing interest rate levels can affect demand for financial guarantee insurance. Lower interest rates are typically accompanied by narrower spreads between insured and uninsured obligations. The purchase of insurance during periods of relatively narrower interest rate spreads will generally provide lower cost savings to the issuer than during periods of relatively wider spreads. These lower cost savings could be accompanied by a corresponding decrease in demand for financial guarantee insurance. Increased interest rates may decrease attractiveness for issuers to enter into capital markets transactions, resulting in a corresponding decreasing demand for financial guarantee insurance. Demand for financial guarantee insurance will decline if investors’ confidence in financial guarantors’ financial strength declines The perceived financial strength of financial guarantee insurers also affects demand for financial guarantee insurance. Recently, several major financial guarantee insurers have had their insurer financial strength ratings downgraded and others, including MBIA Corp., have had their insurer financial strength ratings placed on review for a possible downgrade and/or have had their outlooks changed to “negative,” which may be contributing to a recent decline in the demand for financial guarantee insurance generally. Should the reliability of one or more of the rating agency capital models be questioned or should the financial guarantee industry suffer from further downgrades in financial strength ratings or some other deterioration in investors’ confidence, demand for financial guarantee insurance would be reduced significantly. Regulatory change could adversely affect MBIA Corp.’s business The financial guarantee insurance industry has historically been and will continue to be subject to the direct and indirect effects of governmental regulation, including insurance laws, securities laws, tax laws and legal precedents affecting asset-backed and municipal
29
Table of ContentsItem 1A. Risk Factors (continued) obligations, as well as changes in those laws. Failure to comply with applicable laws and regulations could expose MBIA Corp. to fines, the loss of its insurance licenses, and the inability to engage in certain business activity. In addition, future legislative, regulatory or judicial changes could adversely affect MBIA Corp.’s ability to pursue its business, materially impacting our financial results. The New York State Insurance Department has indicated that they are undertaking a review of the laws and regulations that are applicable to MBIA Corp. and to other monoline financial guarantee insurance companies. As a result of any changes to such laws and regulations or the Department’s interpretation thereof, MBIA could become subject to further restrictions on the type of business that it is authorized to insure, especially in the structured finance area. Any such restrictions could have a material effect on the amount of premiums that MBIA earns in the future. Additionally, any changes to such laws and regulations could subject MBIA Corp. to increased reserving and capital requirements or more stringent regulation generally, which could materially adversely affect our financial condition, results of operations and future business. Revenues would be adversely impacted due to a decline in realization of installment premiums Due to the installment nature of a significant percentage of its premium income, MBIA Corp. has an embedded future revenue stream. The amount of installment premiums actually realized by MBIA Corp. could be reduced in the future due to factors such as early termination of insurance contracts or accelerated prepayments of underlying obligations. Such a reduction would result in lower revenues. Potential impact of general economic and geopolitical conditions may adversely affect MBIA Corp.’s business prospects and insured portfolio Changes in general economic conditions can adversely impact the Company’s business. Recessions, increases in corporate, municipal or consumer default rates, changes in interest rates, changes in law or regulation and other general economic and geopolitical conditions could adversely impact the Company’s prospects for future business, as well as the performance of MBIA Corp.’s insured portfolio and the Company’s investment portfolio. For example, the recent deterioration of certain sectors of the credit markets has caused a significant decline in the number of structured finance securities that have been issued in recent months. There can be no assurance that the market for structured securities will recover, and if the market fails to recover there would be a decrease in the demand for financial guarantee insurance for these securities, which may adversely affect MBIA Corp.’s business prospects. General global unrest could disrupt the economy in this country and around the world and could have a direct material adverse impact on certain industries and on general economic activity. The Company has exposure in certain sectors that could suffer increased delinquencies and defaults as a direct result of these types of events. The Company’s exposure to domestic and international airports and to domestic enhanced equipment trust certificate aircraft securitizations have experienced increased stress as a result of global events since 2001, including a downgrading of the ratings and the bankruptcy of some of the underlying issuers, and could experience further stress in the event of general global unrest in the future. Other exposures that depend on revenues from business and personal travel, such as bonds backed by hotel taxes and car rental fleet securitizations, have experienced or may experience increased levels of delinquencies and default. In addition, certain other sectors in which the Company has insured exposure, such as consumer loan securitizations (e.g., home equity, auto loan and credit card transactions), have experienced increased delinquencies and defaults in the underlying pools of loans and could experience further defaults in the event of future global unrest. To the extent that certain corporate sectors may be vulnerable to credit deterioration and increased defaults in the event of future global unrest, CDOs backed by pools of corporate debt issuances in those stressed sectors could also be adversely impacted. The Company’s insurance operations underwrite exposures to the Company’s reasonable expectation of future performance as well as at various stress levels estimating defaults and other conditions at levels higher than are reasonably expected to occur. There can be no assurance, however, that the Company will not incur material losses if the economic stress and increased defaults in certain sectors caused by change in economic conditions, default rates, global unrest, terrorism, catastrophic events, natural disasters or similar events in the future is or will be more severe than the Company currently foresees and had assumed in underwriting its exposures. An inability to access capital could adversely impact MBIA Corp.’s ability to write new business and adversely affect our business, operating results and financial condition and ultimately adversely affect liquidity The Company’s access to external sources of financing, as well as the cost of such financing, is dependent on various factors, including the long term debt ratings of the Company and the insurance financial strength ratings and long term business prospects of MBIA Corp. and the perceptions of the financial strength of MBIA Corp. and MBIA Inc. Our debt ratings are influenced by numerous factors, either in absolute terms or relative to our peer group, such as financial leverage, balance sheet strength, capital structure and earnings trends. If we cannot obtain adequate capital on favorable terms or at all, our business, future growth, operating results and financial condition could be adversely affected.
30
Table of ContentsItem 1A. Risk Factors (continued) MBIA Corp. has entered into credit facilities with third-party providers in order to supplement its capital position. When evaluating the Company’s overall capital position, the rating agencies evaluate the financial strength of these providers, as well as their perceived willingness to fund these facilities if drawn. In the event that the ratings of these capital providers are reduced or withdrawn, the amount of capital credit the Company receives for these facilities would decline. There can be no assurance that the ratings of such providers will not decline in the future, that replacement providers will be available or, in the absence of a rating decline, that the rating agencies would not decrease the amount of capital credit they assign to the Company for such “soft capital” facilities. The inability to obtain adequate replacement capital on favorable terms or at all could have an adverse impact on the Company’s business and financial condition. Because we are a holding company, our sources of liquidity primarily consist of dividend payments from MBIA Corp. and MBIA Asset Management, investment income and the issuance of debt. To the extent that the amount of capital credit we receive for credit facilities declines or we are otherwise unable to access capital, MBIA Corp. will have less capacity to write business and may not be able to pay dividends to us without experiencing adverse rating agency action. Accordingly, our inability to maintain access to capital on favorable terms could have an adverse impact on our ability to pay dividends on our capital stock, to pay principal and interest on our indebtedness, to pay our operating expenses and to make capital investments in our subsidiaries. See “—Our holding company structure and certain regulatory and other constraints could affect our ability to pay dividends and make other payments.” A reduction in the financial strength ratings of or a default by one or more of MBIA Corp.’s key reinsurers could adversely impact our capital position, financial strength rating and ability to write new business MBIA Corp. uses reinsurance to cede exposure for purposes of syndicating risk and increasing its capacity to write new business while complying with its single risk and credit guidelines. When a reinsurer is downgraded by one or more of the rating agencies, less capital credit is given to MBIA Corp. under rating agency models. Over the past several years, most of MBIA Corp.’s reinsurers have been downgraded and others remain under review. The downgrade of one of MBIA Corp.’s key reinsurers could adversely impact MBIA Corp.’s capital position under rating agency models, and affect MBIA Corp.’s financial strength rating and ability to write new business accordingly. MBIA’s largest reinsurer, Channel Re, was downgraded by Moody’s in February 2008 and the Company’s second largest reinsurer, RAM Reinsurance Company Ltd. (“RAM”), has been placed under review for downgrade by Moody’s. However, Channel Re has deposited assets in two trusts and RAM has deposited assets in one trust for the benefit of MBIA Corp. in support of their respective reinsurance obligations. The combined value of the assets in the Channel Re trusts was approximately $495 million and the value of the assets in the RAM trust was approximately $100 million, in each case at December 31, 2007. Although such trusts limit the potential for such reinsurers to default on their respective obligations and may partially offset the effect of a downgrade on MBIA’s capital position there can be no assurance that a further downgrade of Channel Re or a downgrade of RAM would not materially reduce MBIA Corp.’s capital position under rating agency models or that there will not be a default on their respective obligations to MBIA Corp. Also, if Channel Re were further downgraded or RAM was downgraded, MBIA Corp. would need to establish an accounting reserve for receivables from them. Currently, $43 billion of par is reinsured with Channel Re and $11 billion is reinsured with RAM. As with all reinsurers, MBIA Corp. continually assesses Channel Re’s and RAM’s ability to settle all amounts due to MBIA Corp. under reinsurance or other agreements, including settling ceded derivative contracts at their fair value. MBIA Corp. generally retains the right to recapture the business ceded to reinsurers under certain circumstances, including rating downgrades of its reinsurers. Additionally, reinsurers and counterparties under other reimbursement agreements may default on their obligations to us due to bankruptcy, insolvency, lack of liquidity, adverse economic conditions, operational failure, fraud or other reasons. Such defaults could have a material adverse effect on our business or profitability or require us to raise additional capital. MBIA Corp. remains liable on a primary basis for all reinsured risk, and although MBIA Corp. believes that its reinsurers remain capable of meeting their obligations, there can be no assurance of such in the future. In addition to reliance on key financial guarantee reinsurers, MBIA has certain other exposures to financial guarantee insurance companies. Portions of MBIA Corp.’s investment portfolio, as well as the investments held in relation to our asset management businesses, are insured by other monoline financial guarantee insurance companies. Further, we own a small amount of direct investments in debt and other securities of the holding companies of other monoline financial guarantee insurance companies. A downgrade of one or more of those companies could impact the market value of investments and increase the amount of capital required to maintain MBIA Corp.’s triple-A ratings.
31
Table of ContentsItem 1A. Risk Factors (continued) Our holding company structure and certain regulatory and other constraints could affect our ability to pay dividends and make other payments We are a holding company and have no substantial operations of our own or assets other than our ownership of MBIA Corp., our principal operating subsidiary, MBIA Asset Management, and certain other smaller subsidiaries. As such, we are largely dependent on dividends or advances in the form of intercompany loans from MBIA Corp. to pay dividends on our capital stock, to pay principal and interest on our indebtedness, to pay our operating expenses and to make capital investments in our subsidiaries. Our insurance company subsidiaries are subject to various statutory and regulatory restrictions, applicable to insurance companies generally, that limit the amount of cash dividends, loans and advances that those subsidiaries may pay to us. Regulations relating to capital requirements affecting some of our other subsidiaries may also restrict their ability to pay dividends and other distributions and make loans to us. Under New York law, MBIA Corp. may pay stockholder dividends only out of statutory earned surplus. In addition, New York law limits the payment of dividends during any twelve month period without the prior approval of the Superintendent to the lesser of (i) 10% of policyholder surplus and (ii) 100% of adjusted net investment income, as described in “Item 1. Business—Insurance Regulation” and “Item 8. Financial Statements and Supplementary Data—Notes to Consolidated Financial Statements—Note 16: Insurance Regulations and Dividends” of this Annual Report on Form 10-K. In April 2007, MBIA Corp. paid a special dividend of $500 million to MBIA Inc. with the prior approval of the Superintendent. As of December 31, 2007, including the effect of the April 2007 $500 million dividend, MBIA Corp. will not be able to pay dividends without prior approval by the Superintendent until April 2008. In addition, in connection with recent discussions with the Department, MBIA Corp. committed to provide the Department with advance notice of, and to discuss with the Department, certain matters, including the payment of dividends, including ordinary dividends. Additionally, under New York law, the Superintendent may apply for an order directing him to rehabilitate or liquidate a domestic insurance company under certain circumstances, including upon the insolvency of the company, if the company has willfully violated its charter or New York law or if the company is found, after examination, to be in such condition that further transaction of business would be hazardous to its policyholders, creditors or the public. The Superintendent may also suspend an insurer’s license, restrict its license authority, or limit the amount of premiums written in New York if, after a hearing, he determines that the insurer’s surplus to policyholders is not adequate in relation to its outstanding liabilities or financial needs. If the Superintendent were to take any such action with respect to MBIA Corp., it would likely result in the reduction or elimination of the payment of dividends to us. The inability of MBIA Corp. to pay dividends in an amount sufficient to enable us to meet our cash requirements at the holding company level could affect our ability to repay our debt and to continue to pay a dividend on our common stock and have a material adverse effect on our operations. Regulatory regimes and changes to accounting rules may adversely impact financial results irrespective of business operations Accounting standards and regulatory changes may require modifications to our accounting methodology, both prospectively and for prior periods and such changes could have an adverse impact on our financial results. The Financial Accounting Standards Board, or “FASB,” is considering the accounting methodology to be applied by financial guarantee industry participants for claims liability recognition and premium recognition. When the FASB reaches a conclusion on this project, MBIA Corp. and other financial guarantors may be required to change some aspects of their respective loss reserving policies and the potential changes could extend to premium and expense recognition. We cannot currently assess how the FASB staff’s ultimate resolution of this project will impact our loss reserving policy or the effect it might have on recognizing premium revenue. Until final guidance is issued, we intend to apply our existing methodology. There can be no certainty, however, that the FASB will not require us to modify our current methodology, either on a going-forward basis or for prior periods. Any required modification of our existing methodology, either with respect to these issues or other issues in the future, could have an impact on our results of operations, including increased volatility of our earnings. Our risk management policies and procedures may not prevent future losses We assess our risk management policies and procedures on a periodic basis. As a result of such assessment, we may take steps to change our internal risk assessment capabilities and procedures, our portfolio management policies, systems and processes and our policies and procedures for monitoring and assessing the performance of our insured portfolio in changing market conditions. There can be no assurance, however, that these steps will be adequate to avoid future losses.
32
Table of ContentsItem 1A. Risk Factors (continued) Regulatory proceedings or private litigation claims could materially adversely affect our business, results of operations and financial condition We have recently had discussions with and have provided information on a voluntary basis to the Department and the SEC in response to inquiries with respect to certain matters, including the Warburg Pincus transaction, our announcement of preliminary loss reserve estimates related to our RMBS exposure and disclosures relating to our CDO exposure. On January 22, 2008, we received a Subpoena from the Securities Division of the Secretary of the Commonwealth of Massachusetts dated January 18, 2008. The Subpoena seeks information regarding the “Massachusetts Public Issuer Bonds” insured by MBIA Corp. from January 1, 2006 to the present, and requires production of related offering materials and written disclosures pertaining to MBIA and provided by MBIA to the underwriters or issuers of such Massachusetts Public Issuer Bonds. We may continue to receive additional subpoenas and other information requests from the Department, the SEC or other regulatory agencies regarding similar issues. Although no regulatory action has been initiated against us in connection with the matters described above, it is possible that one or more regulatory agencies may pursue action against us with respect to these or other similar matters. If such an action is brought, it could materially adversely affect our business, results of operations and financial condition. Recently, several plaintiff lawyers have announced plans to file shareholder lawsuits against MBIA in connection with the decline in our stock price, and one such lawsuit has been filed and served on MBIA. On January 11, 2008, a putative shareholder class action lawsuit against MBIA and certain of its officers, Schmalz v. MBIA, Inc. et al., No. 08-CV-264, was filed in the United States District Court for the Southern District of New York, alleging violations of the federal securities laws. Plaintiff seeks to represent a class of shareholders who purchased MBIA stock between January 30, 2007 and January 9, 2008. The complaint alleges that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Among other things, the complaint alleges that defendants issued false and misleading statements with respect to MBIA’s exposure to losses stemming from MBIA’s insurance of CDOs and RMBS, including its exposure to so-called “CDO-squared” securities, which caused MBIA’s stock to trade at inflated prices. Although we intend to vigorously defend against this and other potential actions, we cannot provide assurance that the ultimate outcome of these actions will not materially adversely affect our business, results of operations and financial condition. Adverse results from investment management services activities can adversely affect our financial position Our Investment Management Services businesses have grown as a proportion of our overall business. Events that negatively affect the performance of the Investment Management Services businesses could have a negative effect on the overall performance of the Company, separate and distinct from the performance of the Company’s financial guarantee business. Our Investment Management Services businesses manage several asset-liability programs which enable us to earn a spread between the income earned on a portfolio of assets and the interest costs associated with the liabilities incurred to fund the purchase of such assets. These asset-liability programs are managed within a number of risk and liquidity parameters, but there can be no assurance that such parameters are adequate to prevent a decline in the value of the assets or a decline in investment income such that the programs will be unable to service outstanding liabilities. Any resulting loss could have an adverse impact on our financial position. Ownership Change under Section 382 of the Internal Revenue Code can have adverse tax consequences In connection with our equity offering that closed on February 13, 2008, the Warburg Pincus investments and other transactions in our shares from time to time, we may experience an “ownership change” within the meaning of Section 382 of the Internal Revenue Code. In general terms, an ownership change may result from transactions increasing the aggregate ownership of certain stockholders in our stock by more than 50 percentage points over a testing period (generally three years). If an ownership change were to occur, our ability to use certain tax attributes, including certain losses, credits, deductions or tax basis, may be limited. We cannot give any assurance that we will not undergo an ownership change at a time when these limitations would have a significant effect. Servicer risk could adversely impact performance of Structured Finance transactions Structured finance obligations contain certain risks including servicer risk, which relates to problems with the transaction servicer (the entity which is responsible for collecting the cash flow from the asset pool) that could affect the servicing of the underlying assets. Structural risks primarily involve bankruptcy risks, such as whether the servicer of the assets may be required to delay the remittance of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings. Structured finance transactions are usually structured to reduce the risk to the investors from the bankruptcy or insolvency of the servicer. The ability of the servicer to properly service and collect on the underlying assets is a factor in determining future asset performance. MBIA Corp. addresses these issues through its servicer due diligence and underwriting guidelines, its formal credit review and approval process and its post-closing servicing review and monitoring, however, no assurance can be given that the servicer will properly effect its duties. Exposure to the asset-backed commercial paper market may have an adverse affect on our liquidity Triple-A One Funding Corporation (“Triple-A One”), an MBIA-administered multi-seller conduit consolidated in the Company’s conduit segment, issues commercial paper to fund the purchase of assets from structured finance clients. Assets purchased by Triple-A One are insured by MBIA Corp. Triple-A One maintains backstop liquidity facilities for each transaction, covering 100% of the face
33
Table of ContentsItem 1A. Risk Factors (continued) amount of commercial paper outstanding, with banks rated A-1/P-1 or better by S&P and Moody’s, respectively. These liquidity facilities are designed to allow Triple-A One to repay investors in the event of a market disruption in which Triple-A One is unable to issue new commercial paper to replace maturing commercial paper. Over the last eight months funding in the commercial paper market has been restricted and sometimes difficult to obtain at longer maturities. Through January 2008, no borrowings have been made under any of Triple-A One’s liquidity facilities. In February 2008, Triple-A One borrowed $15 million for one day under its liquidity facilities to repay maturing commercial paper. The borrowing under the facility was repaid by issuing new commercial paper. The financial guarantee policies issued by MBIA Corp. to insure the assets of Triple-A One cannot be accelerated to repay maturing commercial paper or borrowings under liquidity facilities and only guarantee ultimate payments over time relating to the assets. Item 1B. Unresolved Staff Comments None. Item 2. Properties MBIA Corp. owns the 273,417 square foot office building on approximately 38 acres of property in Armonk, New York, in which the Company, MBIA Corp. and MBIA Asset Management have their headquarters. MBIA Corp. also has offices with approximately 29,905 square feet of rental space in New York, New York; San Francisco, California; Paris, France; Madrid, Spain; Sydney, Australia; London, England; Milan, Italy; Tokyo, Japan; and Mexico City, Mexico. MBIA Asset Management has 7,607 square feet of office space in Denver, Colorado. The Company believes that these facilities are adequate and suitable for its current needs. Item 3. Legal Proceedings In the normal course of operating its businesses, the Company may be involved in various legal proceedings. In July 2002, MBIA Corp. filed suit against Royal Indemnity Company (“Royal”) in the United States District Court for the District of Delaware, to enforce insurance policies that Royal issued on certain vocational student loan transactions that MBIA Corp. insured. To date, claims in the amount of approximately $355 million have been made under the Royal policies with respect to loans that have defaulted. MBIA Corp. expects that there will be additional claims made under the policies with respect to student loans that may default in the future. Royal had filed an action seeking a declaration that it is not obligated to pay on its policies. In October 2003, the court granted MBIA Corp.’s motion for summary judgment and ordered Royal to pay all claims under its policies. Royal appealed the order, and, in connection with the appeal, pledged $403 million of investment grade collateral to MBIA Corp. to secure the entire amount of the judgment, with interest, and has agreed to post additional security for future claims and interest.
34
Table of ContentsItem 3. Legal Proceedings (continued) On October 3, 2005, the U.S. Court of Appeals for the Third Circuit upheld the decision of the United States District Court for the District of Delaware insofar as it enforced the Royal insurance policies, but remanded the case to the District Court for a determination of whether the Royal policies cover all losses claimed under the policies. In particular, the Court of Appeals directed the District Court to consider whether the Royal policies would cover losses resulting from the misappropriation of student payments rather than from defaults by students. MBIA Corp. believes that the Royal policies would cover losses even if they result from misappropriation of student payments, but in any event it appears that all or substantially all of the claims made under the Royal policies relate to defaults by students rather than misappropriation of funds. Therefore, MBIA Corp. expects Royal to be required to pay all or substantially all of the claims made under its policies and to be reimbursed for any payments MBIA Corp. made under its policies. Royal filed a petition with the Third Circuit requesting that the case be reheard, which was denied in April 2006. In April 2006, Royal filed a motion with the District Court seeking a release of the collateral it pledged in connection with its appeal of the District Court judgment against it in 2003. On April 2, 2007, MBIA announced that MBIA Corp. reached an agreement with Royal to settle the outstanding litigation. The amount paid by Royal under the terms of the settlement was sufficient to repay the approximately $362 million of outstanding par amount of the bonds insured by MBIA as well as to reimburse MBIA for a portion of the claims that MBIA has paid to date under its insurance policies. As a result of the settlement, MBIA incurred approximately $20 million in losses in the first quarter of 2007. The loss represents a reduction to MBIA’s expected recoveries for claims it has paid to date under its policies and was covered by MBIA’s unallocated loss reserves. The District Court in Delaware entered a final judgment in the case implementing the settlement on March 30, 2007. The approximately $362 million of outstanding par amount of the bonds insured by MBIA were repaid in full during the second quarter of 2007. In November 2004, the Company received identical document subpoenas from the SEC and the NYAG requesting information with respect to non-traditional or loss mitigation insurance products developed, offered or sold by the Company to third parties from January 1, 1998 to the present. While the subpoenas did not identify any specific transaction, subsequent conversations with the SEC and the NYAG revealed that the investigation included the arrangements entered into by MBIA Corp. in 1998 in connection with the bankruptcy of the Delaware Valley Obligated Group, an entity that is part of AHERF. On March 9, 2005, the Company received a subpoena from the U.S. Attorney’s Office for the Southern District of New York (U.S. Attorney) seeking information related to the agreements it entered into in connection with the AHERF loss. Thereafter, the Company has received additional subpoenas, substantively identical to each other, and additional informal requests, from the SEC and the NYAG for documents and other information. On August 19, 2005, the Company received a “Wells Notice” from the SEC indicating that the staff of the SEC is considering recommending that the SEC bring a civil injunctive action against the Company alleging violations of federal securities laws “arising from MBIA’s action to retroactively reinsure losses it incurred from the AHERF bonds MBIA had guaranteed, including, but not limited to, its entering into excess of loss agreements and quota share agreements with three separate counterparties.” On January 29, 2007, the Company announced that it and its principal operating subsidiary MBIA Corp. (together with MBIA, the “Companies”) had concluded civil settlements with the SEC, the NYAG, and the NYSID with respect to transactions entered into by the Companies in 1998 following defaults on insured bonds issued by AHERF. The terms of the settlements, under which the Companies neither admit nor deny wrongdoing, include:
35
Table of ContentsItem 3. Legal Proceedings (continued)
The foregoing summary description of the terms of the settlements is qualified in its entirety by reference to the documents attached hereto as Exhibits 10.82-10.85. The Company was named as a defendant in private securities actions consolidated in the United States District Court for the Southern District of New York as In re MBIA Inc. Securities Litigation; (Case No. 05 CV 03514(LLS); S.D.N.Y.) (filed October 3, 2005). Joseph W. Brown, the Company’s Chairman and Chief Executive Officer, Gary C. Dunton, the Company’s former Chairman, Chief Executive Officer, and President, Nicholas Ferreri, the Company’s former Chief Financial Officer, Neil G. Budnick, a former Vice President and Chief Financial Officer of the Company and Douglas C. Hamilton, the Company’s Controller were also named as defendants in the suit, as were former Chairman and Chief Executive Officer David H. Elliott and former Executive Vice President, Chief Financial Officer and Treasurer Juliette S. Tehrani. The plaintiffs asserted claims under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act. The lead plaintiffs purport to be acting as representatives for a class consisting of purchasers of the Company’s stock during the period from August 5, 2003 to March 30, 2005 (the “Class Period”). The allegations contained in the lawsuit included, among other things, violations of the federal securities laws arising out of the Company’s allegedly false and misleading statements about its financial condition and the nature of the arrangements entered into by MBIA Corp. in connection with the AHERF loss, and about the effectiveness of the Company’s internal controls. The plaintiffs alleged that, as a result of these misleading statements or omissions, the Company’s stock traded at artificially inflated prices throughout the Class Period. The defendants, including the Company, filed motions to dismiss this lawsuit on various grounds. On February 13, 2007, the Court granted those motions, and dismissed the lawsuit in its entirety, on the grounds that these claims are barred by the applicable statute of limitations. The Court did not reach the other grounds for dismissal argued by the Company and the other defendants. The plaintiffs have appealed that decision to the United States Court of Appeals for the Second Circuit. The plaintiffs argue that the dismissal should be reversed on several grounds. The appeal has been fully briefed. No date for arguing the appeal has been set. The Company does not expect the outcome of the private securities litigation to have a material adverse affect on its financial condition, although the outcome is uncertain and no assurance can be given that the Company will not suffer a loss. Certain current and former officers of the Company and certain members of the Company’s Board of Directors were named as defendants in a shareholder derivative action filed in the Supreme Court of New York, Westchester County on November 9, 2005: Robert Purvis, Derivatively on Behalf of Nominal Defendant MBIA, Inc. v. Joseph W. Brown, Neil G. Budnick, C. Edward Chaplin, David C. Clapp, Clifford D. Corso, Gary C. Dunton, Claire L. Gaudiani, Daniel P. Kearney, Laurence H. Meyer, Debra J. Perry, John A. Rolls, and Ruth M. Whaley (Case No. 20099-05) (the “Purvis Litigation”). The plaintiff asserted claims for the benefit of the Company to redress injuries suffered by the Company as a result of alleged breaches of fiduciary duties by the named defendants in connection with the Company’s accounting for certain transactions, including the AHERF loss. In addition, the plaintiff alleged that the officer defendants were unjustly enriched as a result of such alleged breach. The lawsuit was dismissed with prejudice on December 21, 2006, pursuant to court order and an agreement among all parties. Certain current and former officers of the Company and certain current and former members of the Company’s Board of Directors have been named as defendants in a shareholder derivative action filed in the United States District Court, Southern District on April 24, 2006: J. Robert Orton Jr., Derivatively on Behalf of Nominal Defendant MBIA, Inc. v. Joseph (Jay) W. Brown, Gary C. Dunton, Neil G. Budnick, Nicholas Ferreri, Douglas C. Hamilton, Juliette S. Tehrani, Richard L. Weill, David H. Elliott, Claire L. Gaudiani, Daniel P. Kearney, David C. Clapp, John A. Rolls, C. Edward Chaplin, Debra J. Perry, Laurence Meyer, Jeffrey W. Yabuki, Pierre-Henri Richard, William H. Gray III, Freda S. Johnson and James A. Lebenthal (Case No. 06 CV 3146) (the “Orton Litigation”). The plaintiff asserts claims for the benefit of the Company to redress injuries suffered by the Company as a result of alleged breaches of fiduciary
36
Table of ContentsItem 3. Legal Proceedings (continued) duties, insider trading, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and violations of the Sarbanes-Oxley Act of 2002 by some or all of the named defendants in connection with alleged false statements in the Company’s financial statements arising from improper accounting for certain transactions, including agreements to reinsure the AHERF loss. The lawsuit seeks relief on behalf of the Company that includes disgorgement of certain compensation granted to such officers, unspecified damages, restitution of profits and compensation, legal costs, an order directing the Company to implement certain governance procedures and other equitable relief. The lawsuit was dismissed with prejudice on September 18, 2007, pursuant to court order and an agreement among the parties. On January 11, 2008, a putative shareholder class action lawsuit against the Company and certain of its officers, Schmalz v. MBIA, Inc. et al., No. 08-CV-264, was filed in the United States District Court for the Southern District of New York, alleging violations of the federal securities laws. Plaintiff seeks to represent a class of shareholders who purchased MBIA stock between January 30, 2007 and January 9, 2008. The complaint alleges that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Among other things, the complaint alleges that defendants issued false and misleading statements with respect to the Company’s exposure to losses stemming from the Company’s insurance of CDOs and RMBS, including its exposure to so-called “CDO-squared” securities, which allegedly caused the Company’s stock to trade at inflated prices. Defendants’ deadline to respond to the complaint has been extended pending the resolution of lead counsel status and the possible filing of an amended and/or consolidated complaint. The Company has received subpoenas or informal inquiries from a variety of regulators, including the U.S. Securities and Exchange Commission (“SEC”), the Securities Division of the Secretary of the Commonwealth of Massachusetts, and other states’ regulatory authorities, regarding a variety of subjects, including disclosures made by the Company to underwriters and issuers of certain bonds, the Warburg Pincus transaction, the Company’s announcement of preliminary loss reserve estimates on December 10, 2007 related to the Company’s residential mortgage-backed securities exposure, and disclosures regarding the Company’s CDO exposure, the Company’s communications with rating agencies, and the methodologies used by rating agencies for determining the credit rating of municipal debt. The Company is cooperating fully with each of these regulators and is in the process of satisfying all such requests. The Company may receive additional inquiries from these or other regulators and expects to provide additional information to such regulators in response to any inquiries with respect to these or other matters in the future. On February 22, 2008, another putative shareholder class action lawsuit against the Company and certain of its officers, Teamsters Local 807 Labor Management Pension Fund v. MBIA Inc. et al., No. 08-CV-1845, was filed in the United States District Court for the Southern District of New York, alleging violations of the federal securities laws. The allegations of the Teamsters complaint are substantially similar to the allegations of the Schmalz complaint, except that the class period in the Teamsters complaint runs from October 6, 2006 to January 9, 2008. The Company has not yet responded to the Teamsters complaint, but anticipates that it will be consolidated with the Schmalz complaint and responded to in that context. On February 13, 2008, a shareholder derivative lawsuit against certain of the Company’s present and former directors, and against the Company, as nominal defendant, Trustees of the Police and Fire Retirement System of the City of Detroit v. Clapp et al., 08 CV 1515 (the “Detroit Complaint”), was filed in the United States District Court for the Southern District of New York. The gravamen of the Detroit Complaint is similar to the aforementioned Schmalz and Teamsters class actions, except that the legal claims are against the directors for breach of fiduciary duty and related claims. The board has formed a special litigation committee to evaluate the claims in the Detroit Complaint. There are no other material lawsuits pending or, to the knowledge of the Company, threatened, to which the Company or any of its subsidiaries is a party. Item 4. Submission of Matters to a Vote of Security Holders None.
37
Table of ContentsPart II Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is listed on the New York Stock Exchange under the symbol “MBI.” As of February 15, 2008 there were 875 shareholders of record of the Company’s common stock. The information concerning dividends on the Company’s common stock is under “Item 1. Business—Insurance Regulation” in this annual report. The high and low stock prices and dividends with respect to the Company’s common stock for the last two years are set forth below:
On January 9, 2008, the Company announced that its Board of Directors authorized a revised shareholder dividend policy, pursuant to the Company’s capital strengthening plan, which was expected to reduce quarterly shareholder dividends from $.34 per share to $.13 per share. On February 25, 2008, the Company announced that its Board of Directors authorized the elimination of quarterly shareholder dividends to further strengthen the Company’s resources and to increase its operating flexibility. On January 30, 2008, the Company issued 16.1 million shares of MBIA common stock to Warburg Pincus at $31 per share per an investment agreement, subsequently amended on February 6, 2008, with Warburg Pincus. In addition, under the agreement with Warburg Pincus, the Company granted Warburg Pincus warrants to purchase 8.7 million shares of MBIA common stock at an exercise price of $40 per share and “B” warrants, which, upon obtaining certain approvals, will become exercisable to purchase 7.4 million shares of common stock at a price of $40 per share. On February 13, 2008, the Company completed a public offering of 94.65 million shares of MBIA common stock at $12.15 per share. Pursuant to the amended agreement with Warburg Pincus, Warburg Pincus was granted 4 million of “B2” warrants at a price of $16.20 per share. In addition, under anti-dilution provisions in the agreement with Warburg Pincus, the terms of the warrants issued to Warburg Pincus on January 30, 2008 were amended, which resulted in (a) the 8.7 million of warrants exercisable at $40 per share were revised to 11.5 million warrants exercisable at $30.25 per share and (b) the 7.4 million of “B” warrants exercisable at $40 per share were revised to 9.8 million “B” warrants exercisable at $30.25 per share. See Note 29, “Subsequent Events,” in the Notes to the Consolidated Financial Statements of MBIA, Inc. and Subsidiaries in Part II, Item 8 for additional information on the agreement with Warburg Pincus and the common stock offering. In July 2004, the Company received authorization from its Board of Directors to repurchase 1 million shares of common stock under a share repurchase program. On August 5, 2004, the Company’s Board of Directors authorized the repurchase of an additional 14 million shares of common stock in connection with this program. As of December 31, 2006, the Company had repurchased a total of 10 million shares under the program. On February 1, 2007, the Company’s Board of Directors authorized the repurchase of common stock up to $1 billion under a new share repurchase program, which superseded the previously authorized program. As of December 31, 2007, the Company repurchased 10 million shares under the program at an average price of $66.30 per share. The Company’s ability to repurchase common stock is largely dependent on the amount of dividends paid by MBIA Corp. to MBIA Inc. Repurchases of common stock may be made from time to time in the open market or in private transactions as permitted by securities laws and other legal requirements. We believe that share repurchases can be an appropriate deployment of capital in excess of amounts needed to maintain the triple-A claims-paying ratings of MBIA Corp. and support the growth of MBIA’s businesses. In the third quarter of 2007, the Company decided to suspend share repurchases under the program in light of concerns and uncertainties regarding the housing markets, the structured finance sector and the U.S. economy, leaving $340 million available under our $1 billion share buyback program. The Company may reevaluate this decision from time to time and resume share repurchases when it deems appropriate.
38
Table of Contents
The table below sets forth repurchases made by the Company in each month during the fourth quarter of 2007, all of which were purchased by the Company for settling awards under the Company’s long-term incentive plans. See “Note 24: Long-term Incentive Plans” in the Notes to the Consolidated Financial Statements of MBIA, Inc. and Subsidiaries in Part II, Item 8 for a further discussion on long-term incentive plans.
Stock Performance Graph The following graph compares the cumulative total shareholder return (rounded to the nearest whole dollar) of our common stock, the S&P 500 Stock Index (“S&P 500 Index”) and the S&P 500 Diversified Financials Index (“S&P Financials Index”) for the last five fiscal years. The graph assumes a $100 investment at the closing price on December 31, 2002 and reinvestment of dividends on the respective dividend payment dates without commissions. This graph does not forecast future performance of our common stock.
39
Table of ContentsItem 6. Selected Financial Data
40
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations FORWARD-LOOKING AND CAUTIONARY STATEMENTS This annual report of MBIA Inc. (“MBIA” or the “Company”) includes statements that are not historical or current facts and are “forward-looking statements” made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “believe,” “anticipate,” “project,” “plan,” “expect,” “intend,” “will likely result,” “looking forward” or “will continue,” and similar expressions identify forward-looking statements. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. MBIA cautions readers not to place undue reliance on any such forward-looking statements, which speak only to their respective dates. The following are some of the factors that could affect financial performance or could cause actual results to differ materially from estimates contained in or underlying the Company’s forward-looking statements:
The Company undertakes no obligation to publicly correct or update any forward-looking statement if it later becomes aware that such results are not likely to be achieved. OVERVIEW MBIA is a leading provider of financial guarantee products and specialized financial services. MBIA provides innovative and cost-effective products and services that meet the credit enhancement, financial and investment needs of its public- and private-sector clients worldwide. MBIA manages its activities primarily through two principal business operations: insurance and investment management services. The Company’s corporate operations include revenues and expenses that arise from general corporate activities. Insurance Operations MBIA’s insurance operations are principally conducted through MBIA Insurance Corporation and its subsidiaries (“MBIA Corp.”). MBIA Corp. issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public-purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and pools of corporate and asset-backed bonds, and bonds backed by other revenue sources such as corporate franchise revenues, both in the new issue and secondary markets. Additionally, MBIA Corp. has insured credit default swaps primarily on pools of collateral, which it considered part of its core financial guarantee business. The financial guarantees issued by MBIA Corp. provide an unconditional and irrevocable guarantee of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that MBIA Corp. has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon such acceleration by MBIA Corp. On February 25, 2008, the Company announced that it has ceased insuring new credit derivative contracts except in transactions related to the reduction of existing derivative exposure. In addition, the Company announced that it has suspended the writing of all new structured finance business for approximately six months. Investment Management Services Operations MBIA’s investment management services operations provide an array of products and services to the public, not-for-profit and corporate sectors. Such products and services are provided primarily through wholly owned subsidiaries of MBIA Asset Management, LLC (“MBIA Asset Management”) and include cash management, discretionary asset management and fund administration services and investment agreement, medium-term note and commercial paper programs related to funding assets for third-party clients and for investment purposes.
41
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Discontinued Operations In December 2006, MBIA completed the sale of Capital Asset Holdings GP, Inc. and certain affiliated entities (“Capital Asset”), a servicer of delinquent tax liens, to a third party company that is engaged in tax lien servicing and collection and that had been overseeing the servicing operations of Capital Asset since July 2006. The sale of Capital Asset also included three variable interest entities (“VIEs”) established in connection with MBIA-insured securitizations of Capital Asset tax liens, which were consolidated within the Company’s insurance operations in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 46(R), “Consolidation of Variable Interest Entities (Revised).” In the third quarter of 2006, MBIA finalized a plan to sell MBIA MuniServices Company and certain of its wholly owned subsidiaries (“MuniServices”) to an investor group led by the management of MuniServices. MuniServices provides revenue enhancement services and products to public-sector clients nationwide consisting of discovery, audit, collections/recovery and information services. The Company completed the sale of MuniServices in December 2006. MBIA’s municipal services operations consisted of the activities of MuniServices and Capital Asset. As a result of the sale of MuniServices and Capital Asset, the Company no longer reports municipal services operations and the assets, liabilities, revenues and expenses of these entities have been reported within discontinued operations for 2006 and 2005 in accordance with Statement of Financial Accounting Standards No. (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” See “Note 15: Discontinued Operations” in the Notes to Consolidated Financial Statements for information relating to the Company’s discontinued operations. The Company’s results of operations for the years ended December 31, 2007, 2006 and 2005 are discussed in the “Results of Operations” section included herein. Financial Strength Credit Ratings Prior to the fourth quarter of 2007, MBIA Corp. and its insurance subsidiaries had triple-A financial strength ratings with stable outlook from Standard and Poor’s Corporation (“S&P”), Moody’s Investors Service, Inc. (“Moody’s”), Fitch, Inc. (“Fitch”) and Rating and Investment Information, Inc. Following the recent stress in the collateralized debt obligations (“CDOs”) and mortgage sectors and the increased risk that more underlying credit ratings of transactions insured by MBIA will be downgraded by S&P, Moody’s and Fitch, the three major rating agencies took the following actions: S&P On November 26, 2007, S&P’s Global Bond Insurance Group announced that it was preparing a comment on bond insurers’ subprime exposure. S&P’s comments on this topic from August 2, 2007 included a stress scenario for the primary bond insurers that reflected an opinion that conservative theoretical deterioration of subprime residential mortgage-backed securities (“RMBS”) and CDOs with subprime collateral would not impair the bond insurer’s capital adequacy. On December 19, 2007, S&P released ratings announcements concerning a number of financial guarantee insurers, including MBIA Corp., resulting from worsening expectations for the performance of insured subprime RMBS and CDOs of asset-backed securities. S&P affirmed MBIA Corp.’s insurance financial strength rating at “AAA” but changed its outlook for MBIA Corp. to “negative” from “stable”, while confirming the outlook of two of MBIA Corp.’s competitors as “stable.” S&P indicated in its announcement that its “research has led S&P to the conclusion that the potential for further mortgage market deterioration remains uncertain and will challenge the ability of the insurers to accurately gauge their ongoing additional capital needs in the near term. As a result, S&P is effectively adopting a negative outlook for those firms with significant exposure to domestic subprime mortgages and/or meaningful lower credit quality exposures. The assignment of a negative outlook also reflects Standard & Poor’s assessment with regard to the strength of a company’s capital position when weighted against projected stress case losses as well as the comprehensiveness and degree of completion of projected capitalization strengthening efforts underway.” On January 15, 2008, S&P announced that it had revised its surveillance assumptions for U.S. RMBS, in particular that it increased the expected loss assumption for 2006 vintage subprime collateral to 19% from 14%. The change in assumptions was driven by negative trends in monthly performance data for subprime mortgages as well as certain macroeconomic factors driving U.S. home prices. On January 17, 2008, S&P released updated results to its Bond Insurance Stress Test for financial guarantors in light of its revised assumptions for subprime-related exposures. In its report, S&P concluded that the increased stress losses resulting from the revised
42
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) assumptions was not significant for MBIA in the context of its capital position and intended capital plan. As such, MBIA Corp.’s ratings and outlook, as well as those of all other financial guarantee companies, remained unchanged from their previous position announced by S&P on December 19, 2007. On January 30, 2008, S&P announced that it placed on CreditWatch with negative implications or downgraded its ratings on 6,389 classes from U.S. RMBS transactions backed by U.S. first-lien subprime mortgage collateral rated between January 2006 and June 2007. At the same time, S&P placed on CreditWatch negative 1,953 ratings from 572 global CDO of asset-backed securities (“ABS”) and CDO of CDO transactions. The rating actions were primarily driven by S&P’s revised surveillance assumptions for subprime RMBS and their related impact on ABS CDOs and CDOs of CDOs, which had been announced on January 15, 2008. On January 31, 2008, S&P placed the “AAA” insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the “AA-” rating of MBIA Inc.’s senior debt and the “AA” ratings of MBIA Corp.’s North Castle Custodial Trusts I-VIII on CreditWatch with negative implications. This rating action by S&P was the result of S&P’s most recent review of MBIA’s capital plan. S&P stated in its announcement regarding the change that “Although MBIA succeeded in accessing $1.5 billion of additional capital, the magnitude of projected losses underscores our view that time is of the essence in the completion of capital-raising efforts.” On February 25, 2008, S&P affirmed the AAA insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the “AA-” rating of MBIA Inc.’s senior debt and the “AA” ratings of MBIA Corp.’s North Castle Custodial Trusts I-VIII, with a negative outlook. S&P stated in its announcement regarding the change that “MBIA’s success in accessing $2.6 billion of additional claims-paying resources is a strong statement of management’s ability to address the concerns relating to the capital adequacy of the Company.” Moody’s On December 5, 2007, Moody’s published a comment intended to update the market about Moody’s analytic work as well as to offer additional details about the methods and process underlying their assessment of the continuing deterioration in the RMBS market on their ratings of financial guarantee insurers, including MBIA Corp. In its comment, Moody’s indicated three factors that would largely determine whether Moody’s takes rating actions on those financial guarantee insurers most exposed to deterioration in the mortgage markets: (1) current capital adequacy—whether the guarantor meets Moody’s capital adequacy benchmarks for its rating: (2) prospective capital adequacy—whether the guarantor will meet Moody’s capital adequacy benchmark in the near and medium term, and (3) strength of the franchise and business model—whether the guarantor will be able to access, going forward, attractive business opportunities consistent with its rating level. Moody’s further indicated that, based on additional analysis of MBIA Corp.’s RMBS portfolio, Moody’s believed that MBIA Corp. was somewhat likely to exhibit a capital shortfall. On December 14, 2007, Moody’s released ratings announcements concerning a number of financial guarantee insurers, including MBIA Corp., resulting from Moody’s reassessment of such insurer’s capital adequacy. Moody’s affirmed MBIA Corp.’s insurance financial strength at “Aaa” but changed its outlook for MBIA Corp. to “negative” from “stable” while confirming the outlook of three of MBIA Corp.’s competitors as “stable”. Moody’s indicated that this action reflected the stress to MBIA Corp. from its mortgage-related exposures, as well as the steps already taken, and likely to be taken, by MBIA Corp. to strengthen its capital position. Moody’s also indicated that MBIA Corp.’s current capitalization was below the target Aaa level, and would be close to the minimum Aaa level under Moody’s stress scenario. Moody’s further indicated that while it believed that the investment by Warburg Pincus, as described in the “Capital Resources—Capital Strengthening Plan” section under “Warburg Pincus Agreement,” would address MBIA Corp.’s estimated shortfall in hard capital, the negative outlook reflects uncertainty concerning the performance of MBIA Corp.’s insured portfolio and the ultimate resolution of its total capital plan. In addition, Moody’s stated that it will evaluate any changes in MBIA Corp.’s governance, strategy and risk management made in response to the material stress faced by MBIA Corp. on its mortgage-related exposures. Moody’s stated in its announcement that it expected to revise MBIA Corp.’s outlook to “stable” to the extent MBIA Corp. executed an overall capital plan that reestablished a robust capital position. On January 17, 2008, Moody’s placed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the Aa2 ratings of MBIA Corp.’s $1.0 billion of 14% fixed-to-floating rate surplus notes (“Surplus Notes”) issued on January 16, 2008, and the Aa3 ratings of the junior obligations of MBIA Corp. and the senior debt of MBIA Inc. on review for possible downgrade. Moody’s stated in its announcement that “the rating action reflects Moody’s growing concern about the potential volatility in ultimate performance of mortgage and mortgage-related CDO risks, and the corresponding implications for MBIA’s risk-adjusted capital adequacy.” On January 31, 2008, Moody’s published its preliminary views about the financial guarantee insurance industry. It stated that its estimate of the capital needed to support the mortgage-related risk of some guarantors has risen significantly, and that some existing firms may be unable to restore financial strength to levels consistent with a Aaa rating, which could possibly lead them to pursue a more narrow business focus or enter into runoff. Moody’s indicated that a Aaa guarantor needs an adequate level of capital, a risk management and underwriting framework commensurate with that capital, and a viable business plan. Moody’s suggested that if any
43
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) one of these characteristics were judged by it to be inadequate, it would expect to lower the guarantor’s rating. Moody’s added that the business orientation and underwriting guidelines of firms in this sector might require meaningful change in order to retain Aaa ratings. On February 26, 2008, Moody’s affirmed the Aaa insurance financial strength ratings of MBIA Corp. and its insurance affiliates, the Aa2 ratings of MBIA Corp.’s Surplus Notes and the Aa3 ratings of the junior obligations of MBIA Corp. and the senior debt of MBIA Inc., with a negative rating outlook. Moody’s stated in its announcement regarding the change that “MBIA has completed transactions to raise $1.6 billion in equity and $1 billion in Surplus Notes, demonstrating a strong commitment to its policyholders.” Fitch On December 20, 2007, Fitch placed the AA ratings of MBIA Inc. and AAA ratings of MBIA Corp. and its subsidiaries on rating watch negative pending MBIA Inc.’s raising additional capital, while confirming the outlook of two of MBIA Corp.’s competitors as “stable.” In its press release, Fitch identified a shortfall of approximately $1 billion and stated that “If at any time during the next four-to-six weeks, MBIA is able to obtain capital commitments and/or put in place reinsurance or other risk mitigation measures, on top of the $1 billion capital commitment the company received from Warburg Pincus, that would help improve MBIA’s Matrix result at an ‘AAA’ rating stress, Fitch would anticipate affirming MBIA’s ratings with a Stable Rating Outlook.” Fitch also noted that if MBIA Inc. was unable to obtain capital commitments or put into place reinsurance or other risk mitigation measures to address its capital shortfall in the noted timeframe, Fitch would expect to downgrade MBIA Corp.’s insurer financial strength ratings by one notch to “AA+.” In connection with the completion of MBIA Corp.’s Surplus Notes, as discussed in the “Capital Resources—Capital Strengthening Plan” section, on January 16, 2008, Fitch announced that it reaffirmed MBIA Corp.’s AAA ratings with a “Stable Outlook.” Due to the continued deterioration in the performance of U.S. subprime mortgages, on February 1, 2008, Fitch announced that it placed on rating watch negative approximately $139 billion of 2,972 rated classes of 2006 and 2007 subprime RMBS. Fitch also increased its loss expectations for U.S. subprime RMBS backed predominantly by first-lien mortgages originated in 2006 and the first half of 2007, with average cumulative loss expectations as a percentage of the initial securitized balance of 21% and 26%, respectively. On February 5, 2008, Fitch placed the AAA insurer financial strength ratings of MBIA Corp. and its insurance affiliates, the AA ratings of MBIA Corp.’s Surplus Notes and the AA long-term debt rating of MBIA Inc. on rating watch negative. Fitch announced that it was updating certain modeling assumptions in its ongoing analysis of the financial guaranty industry, specifically related to exposures to structured finance collateralized debt obligations (“SF CDOs”). Fitch expects that simulated capital model losses and expected losses will increase materially for MBIA Corp. due to its exposure to SF CDOs and that these losses may be inconsistent with its AAA rating standards for financial guarantors. Fitch noted that MBIA’s addition of $1.5 billion of new capital with a further $500 million equity investment through a rights offering backstopped from Warburg Pincus “may not be sufficient to address the necessary capital needed to maintain MBIA’s ‘AAA’ insurer financial strength rating.” MBIA Inc.’s and MBIA Corp.’s current financial strength ratings from the major rating agencies are summarized below:
To enable the Company to maintain appropriate claims-paying resources in order to sustain the triple-A financial strength ratings assigned to MBIA Corp., a comprehensive capital strengthening plan was announced on January 9, 2008. See “Capital Resources—Capital Strengthening Plan” for additional information. We believe that the Company’s consolidated capital resources, inclusive of the capital strengthening actions taken through February 2008, are adequate to support our ongoing businesses, fund our growth and meet the rating agencies’ requirements for the triple-A claims-paying ratings of MBIA Corp. If required and subject to market conditions, we believe that MBIA could raise additional capital and/or take measures to preserve capital necessary to maintain its triple-A ratings. The triple-A ratings are important to the operation of the Company’s business and any reduction in these ratings could have a material adverse effect on MBIA Corp.’s ability to compete and could also have a material adverse effect on the business, operations and financial results of the Company. In addition to its announced capital strengthening plan, on February 25, 2008, the Company announced its intention to reorganize its insurance operations in a manner that would provide public finance and structured finance insurance from separate operating entities. This reorganization is expected to be completed within the next five years. See “Note 29: Subsequent Events” in the Notes to Consolidated Financial Statements for a discussion of the reorganization of the insurance operations.
44
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) CRITICAL ACCOUNTING ESTIMATES The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which requires the use of estimates and assumptions. The following accounting estimates are viewed by management to be critical because they require significant judgment on the part of management. Financial results could be materially different if alternate methodologies were used or if management modified its assumptions. Loss and Loss Adjustment Expenses The Company’s financial guarantee insurance provides an unconditional and irrevocable guarantee of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that the Company has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon such acceleration by the Company. Loss and loss adjustment expense (“LAE”) reserves are established by the Company’s Loss Reserve Committee, which consists of members of senior management, and require the use of judgment and estimates with respect to the occurrence, timing and amount of a loss on an insured obligation. The Company establishes two types of loss and LAE reserves for non-derivative financial guarantees: an unallocated loss reserve and case basis reserves. The unallocated loss reserve is established with respect to the Company’s entire non-derivative insured portfolio. The Company’s unallocated loss reserve represents the Company’s estimate of losses that have or are probable to occur as a result of credit deterioration in the Company’s insured portfolio but which have not yet been specifically identified and applied to specific insured obligations. Each quarter the Company calculates its provision for the unallocated loss reserve as a fixed percent of scheduled net earned premium of the insurance operations. Annually, the Loss Reserve Committee evaluates the appropriateness of this fixed percent loss factor. In performing this evaluation, the Loss Reserve Committee considers the composition of the Company’s insured portfolio by municipal sector, structured asset class, remaining maturity and credit quality, along with the latest industry data, including historical default and recovery experience for the relevant sectors of the fixed-income market. In addition, the Company considers its own historical loss activity and how those losses develop over time. The Loss Reserve Committee reviews the results of its annual evaluation over a period of several years to determine whether any long-term trends are developing that indicates the loss factor should be increased or decreased. Therefore, case basis reserves established in any year may be above or below the loss factor without requiring an increase or decrease to the loss factor. However, if a catastrophic or unusually large loss occurred in a single year, the Loss Reserve Committee would consider taking an immediate charge through “Losses and loss adjustment expenses” and possibly also increase the loss factor in order to maintain an adequate level of loss reserves. Significant changes to any variables on which the loss factor is based, over an extended period of time, would likely result in an increase or decrease in the Company’s loss factor with a corresponding increase or decrease in the amount of the Company’s loss and LAE provision. For example, as external and internal statistical data are applied to the various sectors of the Company’s insured portfolio, a shift in business written toward sectors with high default rates would likely increase the loss factor, while a shift toward sectors with low default rates would likely decrease the loss factor. Additionally, increases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or decreases in statistical recovery rates and in the Company’s actual recovery experience would likely increase the Company’s loss factor. Conversely, decreases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or increases in statistical recovery rates and in the Company’s actual recovery experience would likely decrease the Company’s loss factor. During the years ended December 31, 2007, 2006 and 2005, the Company’s loss and LAE provision for the unallocated loss reserve, based on a loss factor of 12%, was $86 million, $81 million and $84 million, respectively. The provisions recorded for each year represent loss and loss adjustment expenses as reported on the Company’s income statement. However, as a result of the continued stress in the mortgage markets and an increase in defaults on mortgage-backed securities, specific case basis reserve increases for the year ended December 31, 2007 significantly exceeded the 12% loss factor currently used by the Company. In the fourth quarter of 2007, the Company recorded $614 million of loss and LAE, in addition to the provision based on its loss factor, related to MBIA’s insured exposure to prime, second-lien RMBS transactions consisting of home equity lines of credit and closed-end second-lien mortgages. Additionally, in the fourth quarter of 2007, the Company recorded $200 million of loss and LAE to increase its unallocated loss reserve for probable losses on its RMBS exposure that have not been specifically identified to individual policies as of December 31, 2007. Therefore, loss and LAE for 2007 totaled $900 million. For the year ended December 31, 2006, the Company’s additions to specific case basis reserves were less than the 12% loss factor. However, additions to specific case basis reserves in the year ended December 31, 2005 exceeded the 12% loss factor. With the exception of the additional loss and LAE recorded in 2007, the
45
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Company has calculated its provision for the unallocated loss reserve as 12% of scheduled net earned premium of its insurance operations since 2002. MBIA continually monitors its insured portfolio and actual loss experience in order to identify trends that would indicate a reasonably likely significant change to one or more of the variables on which the loss factor is based. If MBIA determines that any changes to one or more of these variables is likely to have an impact on the level of probable losses in its insured portfolio, the Company will increase or decrease its loss factor accordingly, which will result in an increase or decrease in its loss and loss adjustment expenses. Given the increased level of specific case basis losses recorded in the last several years, if none of the other variables used in deriving the loss factor had changed, the Company’s loss factor would approximate 22% on a cumulative basis through December 31, 2007, which would have generated loss and LAE of $162 million, $152 million and $159 million for the years ended December 31, 2007, 2006 and 2005, respectively. Another variable that changed over the last several years, however, and that affects the determination of the loss factor is the mix of business among different sectors. During this period, the Company has ceased writing business in certain sectors in which loss experience has been high relative to its total portfolio, such as tax liens, lower rated high-yield collateralized bond obligations, manufactured housing and certain direct corporate obligations, which offset the impact that the higher case basis incurred activity would have on the loss factor. Excluding actual loss experience incurred in the sectors listed above and the reserves established for RMBS exposure in 2007 in addition to its loss factor, the Company’s cumulative loss factor through December 31, 2007 would approximate 7%, which would have generated loss and LAE of $51 million, $48 million and $51 million for the years ended December 31, 2007, 2006 and 2005, respectively. Also mitigating the impact of higher case basis incurred activity is the improvement in the overall credit quality of the insured portfolio, with a greater percentage of the insured portfolio rated A or above over the past few years, as well as a decline in the number of issues on the Company’s caution lists. Considering all of the assumptions used in the assessment of the adequacy of the loss factor, including the higher case basis incurred activity in 2007 and 2005 and the offsetting effect of observed changes in the variables described above, the Company believes that its current loss factor of 12% continues to represent a reasonable estimate of losses that have or are probable to occur as a result of credit deterioration in the Company’s insured portfolio but which have not yet been specifically identified and applied to specific insured obligations. In addition, the Company believes that the amount of unallocated loss reserves recorded on its balance sheet at December 31, 2007 are adequate to cover specific losses that may develop from its existing insured portfolio. The Company establishes specific reserves in an amount equal to the Company’s estimate of identified or case basis reserves with respect to specific policies. A number of variables are taken into account in establishing specific case basis reserves for individual policies that depend primarily on the nature of the underlying insured obligation. These variables include the nature and creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured and the expected recovery rates on the insured obligation, the projected cash flow or market value of any assets that support the insured obligation and the historical and projected loss rates on such assets. Factors that may affect the actual ultimate realized losses for any policy include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. In determining the case basis reserves of $614 million and the unallocated loss reserve of $200 million recorded in the fourth quarter of 2007 related to the Company’s RMBS exposure, the Company employed a multi-step process using a proprietary cash flow model and a commercially available model, which were used to analyze various collateral performance scenarios and assumptions. The cash flow models used current underlying loan delinquencies and assumptions about future loan delinquencies to project future loan defaults and ultimate cumulative net losses for transactions. The Company is assumed to realize a loss on an insured transaction to the extent that cumulative loan losses exceed available credit support. The Company’s loss reserves were calculated using the following assumptions with respect to the underlying loans within insured RMBS transactions. Loans reported as delinquent as of December 31, 2007 were assumed to default over the first six months of the projection period at rates that increase commensurate with the number of days past due (the “Roll Rate Default Methodology”). We assumed default rates of 45%, 60% and 100% for loans within a 30-day, 60-day and 90-day and over past due period, respectively. For loans that were not reported as delinquent as of December 31, 2007, a conditional default rate (“CDR”) was used to forecast losses beginning in month seven of the forecast. A CDR is an estimate of the percent of performing loans in a pool of loans that are expected to default during a given time period. For 2007 vintage transactions with more limited performance history, the assumed default rate was equal to the greater of the one- or three-month average CDR and a default rate determined using the Roll Rate Default Methodology. These CDRs were assumed to decrease over time at rates and over periods of time that vary by transaction vintage and underlying loan performance. Servicer advances for delinquent loans were assumed to be zero and all defaulted loans were assumed to result in a total loss of principal after a six-month liquidation period. In addition, for transactions secured by home equity lines of credit (“HELOCs”), the model considered borrower draws and repayment rates. For HELOCs, the current three-month average draw rate was used to project future line draws. For HELOCs and transactions secured by fixed rate closed-end second mortgages, the three-month average conditional repayment rate (“CRR”) was used to project voluntary principal repayments. A one-month average CRR was used when a three-month was not available. Cash flows also assumed a constant basis spread between floating rate assets and floating rate insured debt obligations (the difference between Prime and LIBOR interest rates, minus any applicable fees). For all transactions, cash flows considered allocations and other structural aspects of a transaction, including managed amortization periods, rapid amortization periods and claims against MBIA’s insurance policy consistent with such policy’s terms and conditions. The assumptions and cash flow structure referenced above resulted in a forecasted cumulative collateral loss that was added to existing actual cumulative collateral losses. The resulting estimated net claims on MBIA’s insurance policies were discounted to a net present value reflecting MBIA’s obligation to pay claims over time and not on an accelerated basis. The above assumptions represent MBIA’s best estimate of how transactions will perform over time. However, additional case basis loss and LAE reserves of approximately $270 million would be required in the event of a six-month increase in the forecasted CDR beyond our current estimates followed by a twelve-month lengthening of the period during which CDR rates are assumed to decrease.
46
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) As of December 31, 2007, the Company’s total net loss reserves of $1.3 billion represent 0.13% of its outstanding net debt service insured of $1,022 billion. We believe that these reserves are adequate to cover ultimate net losses. Given that the reserves are based on estimates, there can be no assurance that the ultimate liability will not exceed such estimates resulting in the Company recognizing additional loss and loss adjustment expense in earnings. While the underlying principles applied to loss reserving are consistent across the financial guarantee industry, differences exist with regard to the methodology and measurement of loss reserves. Alternative methods may produce different estimates than the method used by the Company. Additionally, the accounting for non-derivative financial guarantee loss reserves is possibly subject to change. See “Note 2: Significant Accounting Policies” in the Notes to Consolidated Financial Statements for a description of the Company’s loss and loss adjustment expense accounting policy. Premium Revenue Recognition Upfront premiums are earned in proportion to the expiration of the related principal balance of an insured obligation. Therefore, for transactions in which the premium is received upfront, premium earnings are greater in the earlier periods when there is a higher amount of principal outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. Accordingly, deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. When an MBIA-insured obligation is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company. Installment premiums are earned on a straight-line basis over each installment period, generally one year or less. As the outstanding principal of an installment-based policy is paid down by the issuer of an MBIA-insured obligation, less premium is collected and recognized by the Company. Both upfront and installment premium recognition methods recognize premiums over the term of an insurance policy in proportion to the remaining outstanding principal balance of the insured obligation. The effect of the Company’s upfront premium earnings policy is to recognize greater levels of upfront premiums in the earlier years of each policy insured, thus matching revenue recognition with exposure to the underlying risk. Recognizing premium revenue on a straight-line basis over the life of each policy without allocating premiums to the sinking fund payments would materially affect the Company’s financial results. Premium earnings would be more evenly recorded as revenue throughout the period of risk than under the current method, but the Company does not believe that the straight-line method would appropriately match premiums earned to the Company’s exposure to the underlying risk. Therefore, the Company believes its upfront premium earnings methodology is the most appropriate method to recognize its upfront premiums as revenue. The premium earnings methodology used by the Company is similar to that used throughout the financial guarantee industry. However, premium revenue recognition is subject to change as a result of the FASB project described in the “Results of Operations—Insurance Operations—Losses and Loss Adjustment Expenses” section included herein. Valuation of Financial Instruments The fair market values of financial instruments held or issued by the Company are determined through the use of observable market data when available. Market data is retrieved from a variety of third-party data sources, including direct dealer quotes, for input into the Company’s valuation systems. Valuation systems are determined based on the characteristics of transactions and the availability of market data. The fair values of financial assets and liabilities are primarily calculated using prices from an independent pricing service, which uses observable market-based inputs when available, direct dealer quotes or market data relevant to individual financial instruments. However, dealer market data may not be available for certain types of contracts that are infrequently purchased and sold. For these contracts, the Company may use alternate methods for determining fair values, such as dealer market quotes for similar contracts or cash flow modeling. Alternate valuation methods generally require management to exercise considerable judgment in the use of estimates and assumptions, and changes to certain factors may produce materially different values. In addition, actual market exchanges may occur at materially different amounts. The Company maintains an ongoing review of its valuation models and has formal procedures for the approval and control of data inputs. See “Note 26: Fair Value of Financial Instruments” in the Notes to Consolidated Financial Statements for additional information on the various types of instruments entered into by MBIA and a comparison of carrying values as reported in the Company’s balance sheet to estimated fair values.
47
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Financial Assets The Company’s financial instruments categorized as assets primarily comprise investments in debt and equity instruments. The majority of the Company’s debt and equity investments are accounted for in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS 115 requires that all debt instruments and certain equity instruments be classified in the Company’s balance sheet according to their purpose and, depending on that classification, be carried at either amortized cost or fair market value. The majority of the Company’s financial assets are valued using an independent pricing service, which uses observable market-based inputs when available. If a security cannot be priced by the pricing service, the Company receives a direct dealer quote which is used as the basis for recording fair value. Adverse credit market conditions during the second half of 2007 caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing service and dealers. Equity investments outside the scope of SFAS 115 are accounted for under cost or equity method accounting principles. Other financial assets that require fair value reporting or disclosures within the Company’s notes to the financial statements are valued based on underlying collateral or the Company’s estimate of discounted cash flows. MBIA regularly monitors its investments in which fair value is less than amortized cost in order to assess whether such a decline in value is other than temporary and, therefore, should be reflected as a realized loss in net income. Such an assessment requires the Company to determine the cause of the decline and whether the Company possesses both the ability and intent to hold the investment to maturity or until the value recovers to an amount at least equal to amortized cost. Additionally, this assessment requires management to exercise judgment as to whether an investment is impaired based on market conditions and trends and the availability of relevant data. See “Note 12: Investment Income and Gains and Losses” in the Notes to Consolidated Financial Statements for further information regarding other-than-temporary losses recorded in net income. Financial Liabilities The Company’s financial instruments categorized as liabilities primarily consist of obligations related to its asset/liability products and conduit segments within the Company’s investment management services operations, and debt issued for general corporate purposes. These liabilities are typically recorded at their face value adjusted for premiums or discounts. The fair values of such instruments are generally not reported within the Company’s financial statements, but rather disclosed in the accompanying notes. However, the carrying values of financial liabilities which qualify as part of fair value hedging arrangements under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, are adjusted in the Company’s balance sheet to reflect those risks being hedged. MBIA has instituted cash flow modeling techniques to estimate the value of its liabilities that qualify as hedged obligations under SFAS 133 based on current market data. Financial liabilities that the Company has elected to fair value under SFAS 155, “Accounting for Certain Hybrid Financial Instruments” or that require fair value reporting or disclosures within the Company’s notes to its financial statements are valued based on underlying collateral, the Company’s estimate of discounted cash flows or quoted market values for similar transactions. Derivative Instruments Through MBIA Corp. we issue insurance policies insuring payments due on derivative instruments and through the Company and other non-insurance subsidiaries we directly enter into derivative instruments for purposes of hedging risks associated with our assets and liabilities. We account for derivative instruments in accordance with SFAS 133, which requires that all such contracts be recorded on our balance sheet at fair value. The fair value of derivative instruments is determined as the amount that would be exchanged in a current transaction between willing parties. Changes in the fair value of derivative instruments are recorded each period in current earnings within “Net gains (losses) on financial instruments at fair value and foreign exchange” or in shareholders’ equity within “Accumulated other comprehensive income (loss),” depending on whether the derivative is designated as a hedge, and if so designated, the type of hedge. All of our derivative contracts are transacted as over-the-counter (“OTC”) derivatives. Through MBIA Corp., we regularly insure derivative instruments as part of our core financial guarantee business, which represent the majority of the Company’s notional derivative exposure. In most cases these derivative instruments do not qualify for the financial guarantee scope exception under SFAS 133 and, therefore, must be stated at fair value. In February 2008, we decided not to insure credit derivative instruments except in transactions related to the reduction of our existing insured derivative exposure. Prior to this decision, we insured credit derivatives that referenced primarily structured pools of cash securities and credit default swaps (“CDS”). We generally provided credit default swap protection on the most senior liabilities of structured finance transactions, and at inception of the contract our exposure generally had more subordination than needed to achieve triple-A ratings from credit rating agencies (referred to as “Super Triple-A” exposure). The collateral for the insured derivatives were cash securities and credit default swaps referencing primarily corporate, asset-backed, residential mortgage-backed, commercial mortgage-backed and collateralized debt obligation securities.
48
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) In determining the fair value, we use various valuation approaches with priority given to observable market prices when they are available. Market prices are generally available for traded securities and market standard credit default swaps but are less available or unavailable for highly-customized credit default swaps. Most of the derivative contracts we insure are structured credit derivative transactions that are not traded and do not have observable market prices. Typical market credit default swaps are standardized, liquid instruments that reference tradable securities such as corporate bonds that also have observable prices. These market standard credit default swaps also involve collateral posting, and upon a default of the reference bond, can be settled in cash. In contrast, our insured credit default swap contracts do not contain the typical CDS market standard features as described above but have been customized to replicate our financial guarantee insurance policies. Our insured derivative instruments provide protection on a specified or managed pool of securities or CDS with a deductible or subordination level. We are not required to post collateral, and upon default, we make payments on a “pay-as-you-go” basis after the subordination in a transaction is exhausted. Our payment obligations after a default vary by deal and by insurance type. There are three primary types of policy payment requirements:
Our insured credit derivative policies are structured to prevent large one-time claims upon an event of default and to allow for payments over time (i.e. “pay as you go” basis) or at final maturity. Also, each insured credit default swap we enter into is governed by a single transaction International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement relating only to that particular transaction/insurance policy. There is no requirement for mark-to-market termination payments, under most monoline standard termination provisions, upon the early termination of the insured credit default swap. However, some contracts have mark-to-market termination payments for termination events within our control. An additional difference between our CDS and the typical market standard CDS is that there is no acceleration of the payment to be made under our insured credit default swap contract unless we elect to accelerate at our option. Furthermore, by law, these contracts are unconditional and irrevocable, and cannot be transferred to most other capital market participants as they are not licensed to write insurance contracts. Through reinsurance, the risk of loss (but not counterparty risk) on these contracts can be transferred to other financial guarantee insurance and reinsurance companies. Historically, there has not been a market for the transfer of such highly structured insured credit derivative contracts, in part because of the contractual differences noted above. As a result, we believe there are no relevant third party “exit value” market observations for these contracts. If we were to affect a transfer of these contracts, we believe the most likely counterparties would be other financial guarantee insurers and reinsurers. In the absence of an actual financial market, we value these insured credit derivatives at the estimated amount that financial guaranty insurers with comparable credit ratings as us would require to assume these contracts. Since there are no active market transactions in our exposures, we generally use vendor-developed and proprietary models, depending on the type and structure of the contract, to estimate the fair value of our derivative contracts. In limited instances, we do execute transactions with reinsurers that reduce our exposure to insured credit derivatives. In those instances, we consider the transactions to be good indicators of fair value when the transaction is negotiated independently of other transactions and when it is executed at or near the measurement date. In such cases, the premiums we pay to the reinsurers are used to fair value the derivative contract, after adjusting for reinsurance contract terms that differ from our underlying insured credit derivative. As a result of our decision in February 2008 to not insure credit derivative instruments and the potential that other market participants stop insuring credit derivative contracts, coupled with the lack of exchange transactions in the current market place, it may become more difficult to obtain observable market inputs for our valuations in the future. As a result, the assumptions about market participants or their assumptions that are used in estimating fair value may change in the future. We will continually monitor these developments as conditions warrant. Our insured CDS valuation model simulates what a bond insurer would charge to guarantee the transactions on the measurement date, based on the market-implied default risk of the underlying collateral and the subordination. Implicit in this approach is the notion that bond insurers would be willing to accept these contracts from us at a price equal to what they could issue them for in the current market. The majority of our transactions are valued using a probabilistic approach to price the risk associated with our exposure on the credit derivative contract. We apply a Binomial Expansion Technique (“BET”) based model to the transaction structures to derive a probabilistic measure of expected loss for our exposure using market pricing on the underlying collateral within the transaction. At any point in time, the mark-to-market gain or loss on a transaction is the difference between the original price of risk (the original market-implied expected loss) and the current price of the risk. The BET was developed and published by Moody’s and provides an alternative to simulation models in estimating a probability distribution of losses on a diverse pool of assets. The model that we use has been modified from the Moody’s version as described below. The distribution of expected losses can then be applied to a specific transaction structure in order to size the expected losses of different risk exposure tranches within a structured transaction. We use the BET model, together with the market price for the underlying collateral to estimate fair value of our insured credit derivatives. This approach is used to value almost all of the credit default swaps on tranched portfolios of credits (“portfolio CDS”) or on senior tranches of collateralized debt obligations (“CDOs”) of the insured portfolio. There are various inputs and assumptions that are key within this approach and these are listed below.
49
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Assumptions The key assumptions of the BET model include:
The main modifications we have made to the BET developed by Moody’s are that a) we use market credit spreads to determine default probability instead of using historical loss experience, and b) for collateral pools where the spread distribution is characterized by extremes we model each segment of the pool individually instead of using an overall pool average. Inputs The specific model inputs are listed below, including how we derive inputs for market credit spreads on the underlying transaction collateral, how we determine credit quality (using a Weighted Average Rating Factor), correlation/diversity estimation, and recovery rates.
We use the following spread hierarchy in determining which source of spread to use, with the rule being to use CDS spreads where available. If not available, then we use cash security spreads.
For example, if current market based spreads are not available then we utilize a generic spread from a published source like CMBX or a corporate cash spread table or a dealer published asset backed spread table. The generic spread utilized is based on the nature of the underlying collateral in the deal. Deals with corporate collateral use the corporate spread table. Deals with asset backed collateral use one or more of the dealer asset backed tables as discussed below. If there are no observable market spreads for the specific collateral, and sector-specific and corporate spread tables are not appropriate to estimate the spread of a given type of collateral, we use the fourth alternative in our hierarchy. An example is tranched corporate collateral. In that case we use corporate spreads as an input and estimate the spread on the tranched position based on an assumed relationship to take account of the tranched structure. In each case the priority is to use information for CDS spreads if available, and cash spreads as a second priority. Over time the data inputs can change as new sources become available or existing sources are discontinued or are no longer considered to be the most appropriate. It is the objective of the Company to move to higher levels on the hierarchy whenever possible, but it is sometimes necessary to move to lower priority inputs because of discontinued data sources or assessments that the higher priority inputs are no longer considered to be representative of market spreads for a given type of collateral. This can happen, for example, if transaction volume falls so a previously used spread index is no longer viewed as being reflective of current market levels. The process is a monthly update for the percentage of each type of collateral in each deal based on the most up-to-date reporting received from the respective trustees. Using the most recent monthly applicable market spread data based on the hierarchy above, we then calculate a weighted average spread to be used in the valuation process (i.e., the spread for each component of collateral is weighted by its percentage of total collateral to calculate the weighted average spread). If collateral-specific spreads are not available, the Weighted Average Rating Factor (“WARF”) is used to determine the credit rating which is used to determine the appropriate spread. This is a 10,000 point scale designed by Moody’s where lower numbers indicate better ratings. Because the difference in default probability between AA1 and AA2 is much less than between B1 and B2, the ratings are not spaced equally on this scale. The WARF is obtained from the most recent trustee’s report or calculated by us based on the credit ratings of the collateral in the transaction. In determining WARF, Moody’s ratings are used for collateral if they are available, and if not, then S&P and then Fitch ratings are used.
The aggregate market value of the entire collateral pool is specified by market spreads. The BET model uses market inputs (collateral spreads, diversity score and recovery rates) along with the transaction structure and subordination level to allocate value between the different tranches of the transaction. There can often be several tranches, including multiple subordinated tranches, and the BET can allocate values to each tranche. We only use the value ascribed to the most senior tranche that is insured by us. The level of subordination below our exposure or credit tranche is a very significant factor that affects the estimated fair values of our exposure as subordination below our exposure absorbs all losses in the transaction’s underlying portfolio before any claim is made on our insurance policy. Most of our insured structured credit derivatives have subordination at inception of the transaction that is in excess of that required for the most senior triple-A rating within a transaction. In the fourth quarter of 2007, we refined our approach to take account of trustee provided asset backed spreads that had widened to extremely high levels. In these limited situations, instead of using market spreads, MBIA assumed that all such collateral defaulted. The following table presents the net par outstanding as of December 31, 2007 and the related income statement net gain or loss for the year ended December 31, 2007 by fair value technique of all insured credit derivatives within our insurance portfolio.
Our investment management services operations and corporate operations enter into OTC derivatives, such as interest rate swaps, currency swaps, credit default swaps and total return swaps, which predominately trade in liquid markets. We mark these derivatives using industry standard models developed by vendors. The following table presents the net notional value outstanding as of December 31, 2007 and the related income statement net gain or loss for the year ended December 31, 2007 by fair value technique of all credit and other derivatives within the Company’s investment management services portfolio and corporate operations.
For further information regarding our derivative portfolio, see the “Market Risk” section included herein.
50
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Goodwill Under SFAS 142, “Goodwill and Other Intangible Assets,” goodwill and intangible assets with indefinite lives are tested for impairment at least annually. This test includes a two-step process aimed at determining the amount, if any, by which the carrying value of a reporting unit exceeds its fair value and should be charged as an expense through net income. In performing its impairment test, the Company determined that the best measure of the fair value of the insurance reporting segment is its book value adjusted for the after-tax effects of net deferred premium revenue less deferred acquisition costs, the present value of installment premiums and a provision for losses to arrive at an adjusted book value. Adjusted book value is a common measure used by security analysts to assess the value of financial guarantee companies. In performing the impairment test for the investment management services operations, the fair value of a reporting segment is determined using a multiple of earnings before income tax, depreciation and amortization (“EBITDA”), as this is a common measure of fair value in the investment management industry. The multiple was determined based on a review of current industry valuation practices. The Company performed its annual impairment testing of goodwill as of January 1, 2007 and January 1, 2008. On both dates, the fair values of the reporting segments exceeded their carrying values indicating that goodwill was not impaired. Alternate valuation methods would have likely produced different fair values. However, the Company believes that the valuation methods used provided the best estimates of fair value. Deferred Income Taxes Deferred income taxes are recorded with respect to the temporary differences between the tax bases of assets and liabilities and the reported amounts in the Company’s financial statements that will result in deductible or taxable amounts in future years when the reported amounts of assets and liabilities are recovered or settled. Such temporary differences relate principally to premium revenue recognition, deferred acquisition costs, unrealized appreciation or depreciation of investments and derivatives, and MBIA Corp.’s statutory contingency reserve. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized. Determining whether to establish a valuation allowance and, if so, the amount of the valuation allowance requires management to exercise judgment and make assumptions regarding whether tax benefits will be realized in future periods. As of December 31, 2007, MBIA recorded a net deferred tax asset of $1.2 billion, which principally comprised a $1.1 billion tax benefit related to losses on financial instruments at fair value and foreign exchange. The Company estimates that it is more likely than not the entire amount of such benefit will be realized in future periods and has not established a valuation allowance. If the Company was to establish a valuation allowance against its deferred tax asset, it would reduce its asset and increase its provision for income taxes in its statement of operations.
51
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) RESULTS OF OPERATIONS Summary of Consolidated Results The following table presents highlights of the Company’s consolidated financial results for 2007, 2006 and 2005. Items listed under “Other per share information (effect on net income)” are items that we commonly identify for the readers of our financial statements because they are a by-product of the Company’s operations or due to general market conditions beyond the control of the Company.
Consolidated revenues from continuing operations decreased to a loss of $283 million in 2007 compared with income of $2.7 billion in 2006. The decline in insurance revenues resulted from a $3.6 billion loss on financial instruments at fair value and foreign exchange which was primarily the result of adverse changes in the fair value of the Company’s insurance credit derivative portfolio and an adjustment to the Company’s carrying value of its investment in Channel Reinsurance Ltd. (“Channel Re”), partially offset by a mark-to-market gain on the Company’s Money Market Committed Preferred Custodial Trust (“CPCT”) securities facility. The investment management services operations’ revenues increased primarily due to an increase in interest income resulting from growth in the asset/liability products segment, higher fees in the advisory services segment due to growth in assets under management and an increase in gains on financial instruments at fair value and foreign exchange due to gains on total return swaps resulting from declines in underlying bond prices. Consolidated expenses from continuing operations increased 77% to $2.8 billion in 2007 from $1.6 billion in 2006. This increase was principally due to an increase in loss and LAE incurred in the insurance operations reflecting $614 million of specific case basis reserves and $200 million of non-specific unallocated reserves related to MBIA’s prime, second-lien RMBS exposure. In addition, investment management services’ interest expense increased due to growth in the asset/liability products segment, commensurate with the increase in interest income. The Company recorded a net loss for 2007 of $1.9 billion compared with net income of $819 million for 2006. Net loss per diluted share was $15.17 for 2007 compared with net income per diluted share of $5.99 for 2006. In 2006, consolidated revenues from continuing operations increased 18% to $2.7 billion from $2.3 billion in 2005. Growth in insurance revenues resulted from an increase in net investment income and net realized gains from investment securities. An increase in investment management services’ interest income resulting from growth in the asset/liability products segment was partially offset by a decrease in investment management services’ net gains on derivative instruments and foreign exchange. Consolidated expenses from continuing operations increased 23% to $1.6 billion in 2006 from $1.3 billion in 2005. This increase was principally due to an
52
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) increase in investment management services’ interest expense due to growth in the asset/liability products segment and insurance interest expense, both of which were commensurate with the increase in interest income. Offsetting the increase in consolidated expenses was a reduction in corporate expenses resulting from $75 million of estimated penalties and disgorgement recorded in the third quarter of 2005 in connection with the settlement of regulatory investigations of the Company. Net income for 2006 of $819 million was up 15% from $711 million for 2005. Net income per diluted share was $5.99 for 2006 compared with $5.18 per diluted share for 2005, a 16% increase. The slightly larger percent increase in net income per diluted share compared with net income resulted from an approximately 526,000 decrease in the average number of diluted shares outstanding as a result of share repurchases the Company made in the first half of 2005. The Company’s book value at December 31, 2007 was $29.16 per share, down 45% from $53.43 per share at December 31, 2006. The decrease was principally driven by net losses from operations, an increase in treasury stock as a result of share repurchases by the Company, and unrealized losses recorded on the Company’s investment portfolio in 2007. Insurance Operations The Company’s insurance operations principally comprise the activities of MBIA Corp. MBIA Corp. issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and pools of corporate and asset-backed bonds, both in the new issue and secondary markets. Additionally, MBIA Corp. insures credit default swaps primarily on pools of collateral, which it considers part of its core financial guarantee business. The municipal obligations that MBIA Corp. insures include tax-exempt and taxable indebtedness of states, counties, cities, utility districts and other political subdivisions, as well as airports, higher education and healthcare facilities and similar authorities and obligations issued by private entities that finance projects which serve a substantial public purpose. The asset-backed and structured finance obligations insured by MBIA Corp. typically consist of securities that are payable from or which are tied to the performance of a specified pool of assets that have an expected cash flow. Securities of this type include residential and commercial mortgages, a variety of consumer loans, corporate loans and bonds, trade and export receivables, aircraft, equipment and real property leases, and infrastructure projects. In certain cases, the Company may be required to consolidate entities established as part of securitizations when it insures the assets or liabilities of those entities. These entities typically meet the definition of a VIE under FIN 46(R). We do not believe there is any difference in the risks and profitability of financial guarantees provided to VIEs compared with other financial guarantees written by the Company. Additional information relating to VIEs is contained in the “Variable Interest Entities” section included herein. The following table presents the financial results of the insurance operations for 2007, 2006 and 2005. The results include revenues and expenses from transactions with the Company’s investment management services and corporate operations.
n/m—Percentage change not meaningful.
53
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) In 2007, total revenues from the Company’s insurance operations were a loss of $2.1 billion compared with income of $1.5 billion in 2006. The decrease in insurance operations’ revenues in 2007 compared with 2006 resulted from a $3.6 billion loss on financial instruments at fair value and foreign exchange, which was primarily the result of adverse changes in the fair value of the Company’s insurance credit derivative portfolio and a $85.7 million adjustment in the Company’s carrying value of its investment in Channel Re. The adjustment in the Company’s carrying value of its investment in Channel Re contributed to the loss on financial instruments at fair value and foreign exchange as a result of eliminations the Company was required to make under the equity method of accounting. These losses were partially offset by a $110 million mark-to-market gain on the Company’s CPCT facility. In addition, there was a decline in fees and reimbursements and net investment income in 2007 compared with 2006. Partially offsetting the impact of the decreases in insurance revenues were increases in net realized gains and premiums earned. Total insurance expenses increased 212% to $1.2 billion in 2007 from $379 million in 2006. The increase in insurance expenses was due to the $614 million of case basis reserves and $200 million of non-specific unallocated reserves related to MBIA’s prime, second-lien RMBS exposure. Partially offsetting the increase in losses and LAE was a decrease in operating expenses due to an increase in costs allocated from the insurance segment to other segments and a decline in loss prevention expenses. Gross operating expenses (expenses before ceding commission income and the deferral or amortization of acquisition costs) decreased 8% in 2007 compared with 2006 as a result of an increase in costs allocated to our investment management services and corporate operations and a decrease in loss prevention costs. In 2006, total revenues from the Company’s insurance operations increased 7% to $1.5 billion from $1.4 billion in 2005. The increase in insurance operations’ revenues was primarily the result of an increase in VIE net investment income and, to a lesser extent, net realized gains from investment securities, net gains on financial instruments at fair value and foreign exchange and increased fee and reimbursement income. Total insurance expenses increased 19% to $379 million in 2006 from $318 million in 2005. The increase in insurance expenses was primarily the result of an increase in VIE interest expense, commensurate with the increase in net investment income, and an increase in operating expenses resulting from increased compensation costs. Gross operating expenses (expenses before ceding commission income and the deferral or amortization of acquisition costs) increased 2% in 2006 compared with 2005 as a result of an increase in compensation costs. Gross premiums written (“GPW”), net premiums written (“NPW”) and net premiums earned for the last three years are presented in the following table:
GPW reflects premiums received and accrued for in the period and does not include the present value of future cash receipts expected from installment premium policies originated during the period. GPW was $999 million in 2007, up 8% from 2006 due to increases in U.S. public finance and global structured finance business written, as discussed in the respective sections below. NPW, which represents gross premiums written net of premiums ceded to reinsurers, increased 10% to $892 million in 2007 from $815 million in 2006. The increase in 2007 was a result of the increase in GPW and a reduction in premiums ceded to reinsurers. Premiums ceded to reinsurers from all insurance operations as a percentage of GPW were 11% and 12% for 2007 and 2006, respectively. Reinsurance enables the Company to cede exposure and comply with its single risk and other credit guidelines, although the Company continues to be primarily liable on the insurance policies it underwrites.
54
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Net premiums earned include scheduled premium earnings as well as premium earnings from refunded issues. Net premiums earned in 2007 of $856 million was slightly higher versus 2006 due to a 6% increase in scheduled premiums earned, offset by a 25% decrease in refunded premiums earned. The increase in scheduled premiums earned resulted from an increase in business written and lower refunding activity in 2007. In 2006, GPW decreased 9% compared with 2005, reflecting declines in U.S. public finance and global structured finance business written. NPW decreased 7% compared with 2005, resulting from the decline in GPW, slightly offset by a reduction in premiums ceded to reinsurers. Premiums ceded to reinsurers from all insurance operations for 2006 declined to 12% of GPW from 14% for 2005. Net premiums earned declined 1% in 2006 compared with 2005 due to a 5% decrease in scheduled premiums earned offset by a 15% increase in refunded premiums earned. The decrease in scheduled premiums earned resulted from declining business production since 2003 and the effects of heavy refunding activity over the same period. MBIA evaluates the premium rates it charges for insurance guarantees through the use of internal and external rating agency quantitative models. These models assess the Company’s premium rates and return on capital results on a risk adjusted basis. In addition, market research data is used to evaluate pricing levels across the financial guarantee industry for comparable risks, when available. Since 2005, domestic municipal spreads contracted to tighter levels through mid-2007. Since mid-2007, in light of credit market volatility, we have also noticed spreads moving wider, in particular in the domestic municipal sectors. We expect that over time this may result in an increase in premium rates. CREDIT QUALITY Financial guarantee insurance companies use a variety of approaches to assess the underlying credit risk profile of their insured portfolios. MBIA uses both an internally developed credit rating system as well as third-party rating sources in the analysis of credit quality measures of its insured portfolio. In evaluating credit risk, the Company obtains, when available, the underlying rating of the insured obligation before the benefit of its insurance policy from nationally recognized rating agencies (Moody’s, S&P and Fitch). All references to insured credit quality distributions contained herein reflect the underlying rating levels from these third-party sources. Other companies within the financial guarantee industry may report credit quality information based upon internal ratings that would not be comparable to MBIA’s presentation. During 2007, total net par insured rated A or above, before giving effect to MBIA’s guarantee, was 82% compared with 77% during 2006 and 81% during 2005. These percentages reflect a change in the mix of business written during each year. At December 31, 2007, 83% of the Company’s outstanding net par insured was rated A or above before giving effect to MBIA’s guarantee compared with 81% at December 31, 2006. The following table presents the credit quality distribution of MBIA’s outstanding net par insured as of December 31, 2007 and 2006. All ratings are as of the period presented and represent S&P ratings. If transactions are not rated by S&P, a Moody’s equivalent rating is used. If transactions are not rated by either S&P or Moody’s, a MBIA equivalent rating is used. As of January 31, 2008, the credit quality distribution of MBIA’s net par insured did not materially change from December 31, 2007.
55
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) GLOBAL PUBLIC FINANCE MARKET MBIA’s premium writings and premium earnings in both the new issue and secondary global public finance markets are presented in the following table:
Global public finance GPW increased 5% in 2007 to $538 million from $511 million in 2006. This increase was due to a 29% increase in U.S. business written primarily in the transportation, higher education and military housing sectors, as well as three credits insured in Puerto Rico. Partially offsetting this increase was a 26% decrease in non-U.S. business written primarily due to the impact of a $55 million non-U.S. public finance upfront policy written in the second quarter of 2006 with no comparatively large upfront policy written in 2007. Non-U.S. business written in the second half of 2007 was adversely affected by growing concerns about the U.S. mortgage and housing markets. NPW increased 5% in 2007 to $504 million from $479 million in 2006 as a result of the increase in GPW. The global public finance cession rate for business written during 2007 and 2006 was 6%. Global public finance net premiums earned decreased 7% to $470 million in 2007 compared with $504 million in 2006. A 27% decrease in refunded premiums earned was partially offset by a 2% increase in scheduled premiums earned. Refunded premiums declined primarily due to an increase in interest rates on new tax exempt issuances in 2007 as compared to 2006. In 2006, global public finance GPW decreased 10% to $511 million from $569 million in 2005. This decrease was due to a decline in U.S. business written resulting from lower debt issuance, weak market conditions and strong competition. Partially offsetting this decline was an increase in non-U.S. business written primarily resulting from transportation and utility transactions in the Latin American and Australian markets. NPW decreased 7% in 2006 compared with 2005 as a result of the decrease in GPW, partially offset by a lower cession rate. The global public finance cession rate for business written during 2006 was 6% compared with 10% during 2005. The decrease in the overall cession rate was due to a decline in both U.S. and non-U.S. business ceded. Global public finance net premiums earned increased 2% to $504 million from $495 million in 2005. An 11% increase in refunded premiums earned was offset by a 2% decline in scheduled premiums earned. Refunded premiums earned increased as a result of the continued low interest rate environment in the U.S. and several international transactions that had significant unearned premium at the time of their refunding. Scheduled premiums earned were adversely affected by high refunding levels in 2006 and prior years. Global public finance net par insured rated A or above, before giving effect to the Company’s guarantee, represented 88% of global public finance business written by the Company during 2007, compared with 84% during 2006 and 91% during 2005. During 2006, a higher percentage of business was written in sectors that typically have a lower credit quality rating. At December 31, 2007, 84% of the outstanding global public finance net par insured was rated A or above before the Company’s guarantee, up from 82% at December 31, 2006. While we fully expect to continue to insure transactions in the global public finance markets during 2008, we believe that global public finance business written by MBIA will be well below our 2007 levels. We also believe that the Company’s continued insurance activity in the first two months of 2008 validates the fundamental benefits that bond insurance provides to the municipal market despite the turbulence throughout the credit markets, the rating agencies’ recent rating actions and the publicity around these issues and around monoline financial guarantors in general.
56
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) GLOBAL STRUCTURED FINANCE MARKET MBIA’s premium writings and premium earnings in both the new issue and secondary global structured finance markets are presented in the following table:
Global structured finance GPW increased 12% in 2007 to $460 million from $410 million in 2006 as a result of increases in both U.S. and non-U.S. business written. The increase in U.S. business written was primarily from CMBS pools, investment-grade corporate CDO, multi-sector CDO and direct RMBS transactions. The increase in non-U.S. business written was primarily from investment-grade CDO transactions. NPW in 2007 increased 15% to $388 million from $336 million in 2006 due to the increase in GPW and a lower cession rate. The global structured finance cession rate for business written during 2007 was 16% compared with 18% for 2006. Global structured finance net premiums earned of $386 million in 2007 were 11% higher than 2006. As structured finance policies are typically collected on an installment basis, the increase in net premiums earned was commensurate with the increase in U.S. and non-U.S. NPW in 2007. Global structured finance GPW decreased 9% in 2006 to $410 million compared with $449 million 2005, resulting primarily from a decrease in non-U.S. business written. In 2006, the global structured finance sector was adversely affected by increased competition, tight credit spreads and greater investor demand for uninsured transactions. NPW in 2006 decreased 8% compared with 2005 due to the decrease in GPW. The global structured finance cession rate for business written during 2006 was 18% compared with 19% for 2005. Global structured finance net premiums earned in 2006 of $349 million were 6% below 2005. The decrease in net premiums earned resulted from the decline in business written in 2006 and prepayments and maturities of business written in prior years. Global structured finance net par insured rated A or above, before giving effect to the Company’s guarantee, represented 78% of global structured finance business written by the Company during 2007, compared with 71% during 2006 and 69% during 2005. At December 31, 2007, 80% of the outstanding global structured finance net par insured was rated A or above before giving effect to the Company’s guarantee, up from 78% as of December 31, 2006. On February 25, 2008, the Company announced that it has suspended the writing of all new structured finance business for approximately six months and has ceased insuring new credit derivative contracts except in transactions related to the reduction of existing derivative exposure. For the years ended December 31, 2007, 2006 and 2005, the Company’s net premiums written on insured credit derivative transactions were $117 million, $73 million and $74 million, respectively, and the Company’s net premiums earned on insured credit derivative transactions were $116 million, $80 million and $73 million, respectively. As a result, we expect that our structured finance business written during 2008 will be significantly less than 2007 levels.
57
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) INVESTMENT INCOME The Company’s insurance-related net investment income for the last three years and ending investment asset balances at amortized cost as of December 31, 2007 and 2006 are presented in the following tables:
The Company’s insurance-related pre-tax net investment income, excluding net realized gains and losses, decreased 1% in 2007 to $573 million from $581 million in 2006. After-tax net investment income also decreased 1% in 2007 as the proportion of taxable investments remained relatively consistent with 2006. The decline in pre-tax net investment income reflects a decrease in average invested assets in 2007 compared with 2006 as well as an $11 million decrease in investment income related to Northwest Airlines’ enhanced equipment trust certificates, which the Company received in connection with a remediation and subsequently sold in the second quarter of 2007. See the Risk Management section for additional information on the Northwest Airlines’ enhanced equipment trust certificates. However, pre-tax net investment income benefited from a $16 million increase in VIE interest income. VIE interest income is generated from interest bearing assets held by such entities and supports the payment of interest expense on debt issued by these entities. Excluding interest income related to VIEs and the Northwest Airlines’ enhanced equipment trust certificates and interest received on reimbursed expenses, insurance-related net investment income decreased 1% on a pre-tax and after-tax basis in 2007 compared with 2006. These decreases were attributable to a decline in average invested assets as a result of dividends paid from MBIA Corp. to MBIA Inc. in December 2006 and April 2007 and claim payments made in the fourth quarter of 2006 to call two MBIA–insured transactions. Average investment yields decreased slightly in 2007 compared with 2006. Ending asset balances at amortized cost, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, were $10.1 billion and $9.6 billion at December 31, 2007 and 2006, respectively. Tax-exempt investments represented 58% and 55% of ending asset balances, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, at December 31, 2007 and 2006, respectively. In 2006, the Company’s insurance-related net investment income, excluding net realized gains and losses, increased 18% to $581 million from $493 million in 2005. After-tax net investment income increased 16% in 2006 as the proportion of taxable investments remained relatively consistent with 2005. Growth in pre-tax investment income reflects an increase in consolidated VIE interest income of $34 million. Additionally, pre-tax investment income for 2006 included $17 million related to Northwest Airlines’ enhanced equipment trust certificates and $6 million related to non-recurring interest on reimbursed expenses received in connection with the remediation of a private label credit card securitization, with no comparable amounts recorded in 2005. In 2006, excluding interest income related to VIEs and the Northwest Airlines’ enhanced equipment trust certificates and interest received on reimbursed expenses, insurance-related net investment income increased 7% on a pre-tax and after-tax basis compared with 2005. These increases were attributable to growth in average invested assets as a result of premium growth and slightly higher average investment yields. Growth in average invested assets was primarily due to the accumulation of premium receipts, partially offset by an increase in dividends paid by MBIA Corp. to MBIA Inc. during 2006 compared with 2005. Ending asset balances at
58
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) amortized cost, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, were $9.6 billion and $9.9 billion at December 31, 2006 and 2005, respectively. Tax-exempt investments represented 55% and 54% of ending asset balances, excluding VIE and Northwest Airlines’ enhanced equipment trust certificates assets, at December 31, 2006 and 2005, respectively. FEES AND REIMBURSEMENTS The Company collects fees for services performed in connection with certain transactions. In addition, the Company may be entitled to reimbursement of third-party expenses that it incurs in connection with certain transactions. Depending upon the type of fee received and whether it is related to an insurance policy, the fee is either earned when it is received or deferred and earned over the life of the related transaction. Work, waiver and consent, termination, administrative and management fees are earned when the related services are completed and the fee is received. Structuring fees and commitment fees are earned on a straight-line basis over the life of the related insurance policy. Expense reimbursements are earned when received. In 2007, fees and reimbursements decreased 38% from 2006 to $21 million, primarily resulting from a decrease in expense reimbursements associated with loss prevention efforts. In 2006, fees and reimbursements increased 19% from 2005 to $33 million, primarily resulting from an increase in expense reimbursements associated with two remediated transactions. Due to the transaction-specific nature inherent in fees and reimbursements, these revenues can vary significantly from year to year. NET REALIZED GAINS AND LOSSES Net realized gains in our insurance operations were $56 million in 2007 compared with net realized gains of $6 million in 2006 and net realized losses of $3 million in 2005. Net realized gains and losses are largely due to sales of investment securities. Net realized gains in 2007 included $32 million of gains related to the disposition of Delta and Northwest Airlines’ enhanced equipment trust certificates the Company received from insurance remediations. Net realized gains in 2006 included an $11 million gain related to the sale of the Company’s investment in RAM Holdings, Inc., the holding company of RAM Reinsurance Company Ltd. and a $25 million impairment loss recorded on a salvage receivable. In 2005, net realized losses were primarily due to $19 million of impairment losses on receivables the Company recorded through salvage and subrogation rights. Partially offsetting the impairment losses were net gains from sales of investment securities. NET GAINS AND LOSSES ON FINANCIAL INSTRUMENTS AT FAIR VALUE AND FOREIGN EXCHANGE Net gains and losses on financial instruments at fair value and foreign exchange in our insurance operations primarily represents changes in the market value of the Company’s insured structured credit derivative portfolio, its CPCT facility and changes in the U.S. dollar value of non-U.S. dollar assets and liabilities. Gains and losses on structured credit derivatives are largely driven by movements in credit spreads and collateral ratings. Net losses on financial instruments at fair value and foreign exchange were $3.6 billion in 2007 and primarily consisted of mark-to-market net losses of $3.7 billion on insured structured credit derivative contracts resulting from the widening of underlying reference obligation credit spread levels and changes in credit quality ratings of the underlying reference obligations. Of the $3.7 billion in mark-to-market net losses on insured structured credit derivative contracts in 2007, $200 million represents estimated credit impairment related to three CDO-squared transactions for which the Company expects to incur actual claims in the future. In the absence of further credit impairment, the cumulative marks should reverse over the remaining life of the insured credit derivatives. These credit derivative contracts have similar terms and conditions to the Company’s non-derivative insurance contracts and are evaluated for impairment under the same monitoring process. Additionally, the Company is not required to post collateral to counterparties of these contracts, thereby avoiding liquidity risks typical of standard credit derivative contracts. Included in the mark-to-market net losses on insured credit derivative contracts are mark-to-market losses relating to exposure ceded to Channel Re, which resulted in an adjustment to the carrying value of MBIA’s equity ownership interest in Channel Re from $85.7 million at September 30, 2007 to zero under the equity method of accounting. While MBIA’s carrying value of its investment in Channel Re reflects losses ceded to Channel Re by MBIA, the benefit of these cessions are eliminated in our statements of operations up to the amount of our ownership resulting in higher net losses on our insured credit derivative contracts. See the “Reinsurance” section included herein for additional information on Channel Re. Approximately two-thirds of the mark-to-market loss in 2007 on the insured credit derivatives portfolio resulted from wider spreads for commercial mortgage-backed securities and residential mortgage-backed securities collateral and the remaining one-third was primarily due to ratings downgrades of the collateral comprising insured credit derivatives for multi-sector CDO structures. The following table estimates the attribution of the mark-to-market loss by sector:
The Company continues to monitor current market conditions including market spreads, credit quality ratings and subordination levels. In January and February 2008, the Company has observed a further widening of market spreads and credit quality ratings downgrades of certain tranches within MBIA’s insured CDOs. As a result of the further market spread widening and the deterioration of asset credit quality ratings, the Company could suffer additional mark-to-market losses in the first quarter of 2008 and in subsequent quarters, although the ultimate amount of such losses will depend on future market developments. In some cases, the downgrade of tranches subordinate to the tranche that the Company insures could trigger the diversion of cash to the insured tranche thereby shortening the tenor of the Company’s insured tranche and substantially reducing the Company’s exposure to actual claims and losses and reducing the related mark-to-market loss. For further information on the fair value of derivative instruments, see the preceding “Critical Accounting Estimates” section. In 2007, in addition to the aforementioned mark-to-market losses on insured structured credit derivative contracts, the Company recorded a $110 million mark-to-market gain on its CPCT facility. This soft capital facility constitutes a financial instrument which
59
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) is required to be recorded on the Company’s balance sheet at fair value. The gain was due to an increase in the differential between the Company’s credit default swap spreads and the yield applicable to the CPCT facility. In 2006, the Company recorded net gains on financial instruments at fair value and foreign exchange of $1 million. The net gains in 2006 were largely due to foreign exchange gains related to the sale of foreign securities offset by derivative losses on deals that were terminated early. In 2005, the Company recorded net losses on financial instruments at fair value and foreign exchange of $4 million. The 2005 net losses primarily resulted from the reversal of gains recorded in prior years on credit derivatives as transactions approach their maturity and that terminated in 2005, net of foreign currency gains. LOSSES AND LOSS ADJUSTMENT EXPENSES The following table presents the case-specific, reinsurance recoverable and unallocated components of the Company’s total loss and LAE reserves, as well as its loss provision and case basis activity, at December 31, 2007, 2006 and 2005.
The Company recorded $900 million in losses and LAE in 2007, an $819 million increase from 2006. In 2007, the Company recorded $86 million of losses and LAE based on the Company’s policy of applying a 12% loss factor to the insurance segment’s scheduled net premiums earned. In addition, in 2007 the Company recorded $814 million of losses and LAE representing $614 million of specific case basis reserves and $200 million of non-specific unallocated reserves related to MBIA’s prime, second-lien RMBS exposure. In 2006 and 2005, the Company recorded $81 million and $84 million in losses and LAE, respectively, based on the Company’s 12% loss factor reserving policy. At December 31, 2007, the Company had $435 million in unallocated loss reserves, which represent the Company’s estimate of losses associated with credit deterioration that has occurred in the Company’s insured portfolio and are available for future case-specific activity. See “Critical Accounting Estimates—Loss and Loss Adjustment Expenses” for a discussion of the Company’s loss reserving methodology. Total case basis activity transferred from the Company’s unallocated loss reserve was $678 million in 2007, $75 million in 2006 and $189 million in 2005. During 2007, case basis activity primarily consisted of the aforementioned $614 million of case basis reserves related to the Company’s prime, second-lien RMBS exposure and loss reserves for insured obligations related to the Student Loan Finance Corporation (“SFC”) and a multi-sector CDO executed in the cash market, as well as insured obligations within the home equity loan (pre 2005 vintage) and manufactured housing sectors. Partially offsetting these loss reserves were reversals of previously established case basis reserves within the aircraft enhanced equipment trust certificates (“EETCs”) sector. During 2006, case basis activity primarily consisted of insured obligations within the CDO, equipment lease pools and home equity loan sectors, MBIA’s guaranteed tax lien portfolio and insured obligations issued by Allegheny Health, Education and Research Foundation (“AHERF”). Case basis activity related to AHERF was partially the result of a reduction in expected litigation recoveries from the AHERF bankruptcy estate. Partially offsetting this activity were reversals of previously established case basis reserves relating to the aircraft EETCs and manufactured housing sectors. During 2005, case basis activity primarily consisted of loss reserves for insured obligations within the EETCs, CDO and manufactured housing sectors and within MBIA’s guaranteed tax lien portfolios. In July 2002, MBIA Corp., together with Wells Fargo Bank N.A. in its capacity as trustee, filed suit in Delaware federal district court against Royal Indemnity Corporation (“Royal”) to enforce insurance policies that Royal issued guaranteeing vocational loans originated by SFC. MBIA Corp. insured eight securitizations that were collateralized by the SFC vocational student loans guaranteed by Royal. On April 2, 2007, MBIA announced that MBIA Corp. reached an agreement with Royal to settle its outstanding litigation against Royal related to SFC. The District Court in Delaware entered a final judgment in the case implementing the settlement on March 30, 2007. In the second quarter of 2007, under the terms of the settlement Royal paid an amount sufficient to repay the approximately $362 million of outstanding par amount of the bonds insured by MBIA as well as to reimburse MBIA for a portion of
60
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) the claims that MBIA has paid to date under its insurance policies. As a result of the settlement, MBIA recorded a $20 million case basis loss in the first quarter of 2007. The loss represents a reduction to MBIA’s expected recoveries for claims it has paid to date under its policies. The approximately $362 million of outstanding par amount of the bonds insured by MBIA were repaid in full during the second quarter of 2007. In July 2006, Eurotunnel petitioned the Paris Commercial Court for protection from its creditors under a safeguard procedure, a new French reorganization statute with limited similarities to a U.S. Chapter 11 reorganization. On August 2, 2006, the commercial court granted Eurotunnel protection under the safeguard procedure. On January 15, 2007, following approval of a safeguard plan by its creditors, bondholders, vendors and employees, the commercial court approved the safeguard plan and ordered the implementation of the safeguard plan. On June 28, 2007, Eurotunnel implemented the safeguard plan. Under Eurotunnel’s safeguard plan, holders of Eurotunnel senior debt received cash in full for their claims and, accordingly, MBIA’s exposure to Eurotunnel senior debt was reduced to zero. Additionally, MBIA recovered claim payments it had made with respect to Eurotunnel senior debt. Under the safeguard plan, holders of Eurotunnel Tier 1A debt received cash in full for their claims and, on June 29, 2007, Fixed-Link Finance 2, B.V. (“FLF2”) used that cash to repay all of its outstanding notes and to reimburse MBIA for the 18 million British pound claim payment it made in the first quarter of 2007. MBIA’s exposure to Eurotunnel through FLF2 and to FLF2 debt was reduced to zero. Under the safeguard plan, holders of Eurotunnel Tiers 1 and 2 debt received cash in full for their claims and holders of Eurotunnel Tier 3 debt received approximately 62% of their claims in cash. Fixed-Link Finance, B.V. (“FLF1”) will use the cash received on account of its Tiers 1, 2 and 3 claims to make scheduled interest payments through February 1, 2009, at which time all available cash will be used to repay FLF1’s outstanding notes in order of priority. As a result of this development, S&P raised its ratings on the FLF1 Class A and B notes to AAA/Stable, noting that the recoveries of the Class A and B notes are wholly secured by cash. The Class A and B notes are pari passu with the Class G notes guaranteed by MBIA and recoveries of the Class G notes are also wholly secured by cash. Accordingly, although FLF1 no longer owns any Eurotunnel debt, MBIA remains exposed to FLF1 through February 1, 2009. At December 31, 2007, MBIA’s exposure to FLF1 debt on account of the Class G notes was approximately $759 million in net par outstanding. MBIA has not paid and does not expect to pay any claims with respect to its exposure to FLF1. The Company believes that it will not incur an ultimate loss on its Eurotunnel exposure and, therefore, has not established a case basis loss reserve for this credit. MBIA insures mortgage-backed securities backed by subprime mortgages directly through residential mortgage-backed securities securitizations and indirectly through CDOs, in which MBIA guarantees the triple-A rated portion of such transactions. Over the last two quarters, there has been growing stress in the subprime mortgage market, particularly related to mortgage loans originated during 2005, 2006, and 2007. As of December 31, 2007, the Company had $4.3 billion of net par outstanding from direct exposure to the subprime mortgage sector. While transactions guaranteed by MBIA include collateral consisting of mortgages originated during 2005, 2006 and 2007, given the amount of subordination below MBIA’s insured portion of such transactions available to absorb any losses from collateral defaults, MBIA currently does not expect material ultimate losses on these transactions. As of December 31, 2007, there are no insured subprime mortgage transactions with 2005, 2006, and 2007 subprime mortgage collateral appearing on the Company’s Classified List or Caution Lists. An explanation of the Company’s “Classified List” and “Caution Lists” is provided below. MBIA also insures mortgage-backed securities backed by prime and near prime mortgages, including revolving home equity loans and closed-end second mortgages. In the fourth quarter of 2007, the Company observed deterioration in the performance of several of its prime and near prime home equity transactions and established $614 million of case basis reserves for future payments. During the fourth quarter of 2007, the Company paid $44 million in claims, net of reinsurance, on seven credits in this sector. Additionally, in the fourth quarter of 2007, the Company established $200 million of non-specific unallocated loss reserves to reflect MBIA’s estimate of probable losses as a result of the adverse developments in the residential mortgage market related to prime, second-lien mortgage exposure, but which have not yet been specifically identified to individual policies. The Company expects that loss payments on its prime, second-lien mortgage exposure during 2008 will amount to a significant portion of its current reserves for such exposure. MBIA continues to closely monitor the manufactured housing sector, which has experienced stress during the last several years. MBIA ceased writing business in this sector, other than through certain CDO transactions, in 2000. At December 31, 2007, the Company had $30 million in case basis reserves, net of reinsurance, covering net insured par outstanding of $119 million on three credits within the manufactured housing sector. The Company had additional manufactured housing exposure of $1.8 billion in net insured par outstanding as of December 31, 2007, of which approximately 23% has been placed on the Company’s “Caution List-Medium” and “Caution List-High.”
61
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) In the fourth quarter of 2006, the Company redeemed all of the remaining $117 million in principal outstanding of MBIA-insured notes backed by tax liens originated by Capital Asset. During 2006, the Company recorded $41 million in net losses related to this exposure. The Company no longer has any exposure to guaranteed tax lien securitizations originated by Capital Asset. In October 2006, MBIA exercised a call right with respect to MBIA-insured notes issued by a 2000 vintage static multi-sector CDO in order to reduce future interest costs under its guarantee. Under the terms of the trust agreement, MBIA had the right to call the notes at par as a result of the occurrence of an event of default. In connection with its call of the notes, in October 2006 the Company made a claim payment of $177 million representing the insured outstanding principal, the proceeds of which were used by the trustee to repay the insured notes. The payment, net of estimated salvage, was applied against MBIA’s previously established case basis reserve for this transaction. MBIA established a case loss reserve of $76 million in the fourth quarter of 2005 in connection with $686 million of net par exposure under four insured EETCs secured by 64 aircraft financed by Northwest Airlines. Northwest Airlines filed for bankruptcy protection in September 2005 and, subsequently, did not make scheduled payments on leases supporting outstanding senior debt for 31 aircraft in three of the four MBIA-insured EETCs. MBIA established the case loss reserve based on projected lower lease income related to these leases, the projected revenue from the potential redeployment of certain aircraft and estimated valuations for the aircraft subject to the defaulted leases. During the second quarter of 2006, the Company reduced its previously established case loss reserves relating to Northwest Airlines primarily as a result of claim payments it made, the sale of unsecured claims against Northwest Airlines, which provided unanticipated proceeds, the sale of selected collateral (aircraft) from one of the securitizations and an agreement to sell collateral from another securitization. The reduction of these case loss reserves, net of claim payments and salvage receipts, contributed $55 million to the Company’s unallocated loss reserve in 2006. MBIA’s Insured Portfolio Management (“IPM”) Division is responsible for monitoring MBIA insured issues. The level and frequency of MBIA’s monitoring of any insured issue depends on the type, size, rating and performance of the insured issue. If IPM identifies concerns with respect to the performance of an insured issue it may designate such insured issue as “Caution List-Low,” “Caution List-Medium” or “Caution List-High.” The designation of any insured issue as “Caution List-Medium” or “Caution List-High” is based on the nature and extent of these concerns and requires that an increased monitoring and, if needed, a remediation plan be implemented for the related insured issue. In the event MBIA determines that it must pay a claim or that a claim is probable and estimable with respect to an insured issue, it places the issue on its “Classified List” and establishes a case basis reserve for that insured issue. As of December 31, 2007, MBIA had 47 open case basis issues on its “Classified List” that had $829 million in aggregate case reserves, net of reinsurance. The Company does not establish any case basis reserves for issues that are listed as “Caution List-Low,” “Caution List-Medium” or “Caution List-High” until such issues are placed on the Company’s “Classified List.” Included in the Company’s case basis reserves are both loss reserves for insured obligations for which a payment default has occurred and MBIA has already paid a claim and also for which a payment default has not yet occurred but a claim is probable and estimable in the future. At December 31, 2007, case basis reserves consisted of the following:
When MBIA becomes entitled to the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment, it records salvage and subrogation as an asset. Such amounts are included in the Company’s balance sheet within “Other assets.” As of December 31, 2007 and 2006, the Company had salvage and subrogation assets of $108 million and $180 million, respectively. The decrease in salvage and subrogation assets principally resulted from collections of salvage amounts due to the
62
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) Company. The amount the Company records as salvage and subrogation may be influenced by several factors during any period, such as the level of claim payments made for which the Company is entitled to reimbursements, amounts collected and impairment write-downs. On April 18, 2007, the FASB issued an Exposure Draft (“ED”) entitled “Accounting for Financial Guarantee Insurance Contracts”, an interpretation of SFAS 60, with a 60-day comment period. The comment period ended on June 18, 2007. On September 4, 2007, the FASB Board held a public roundtable meeting with respondents to the ED to discuss significant issues raised in the comment letters. Since the roundtable, the FASB Board re-deliberated on some of the issues raised. The ED clarifies how SFAS 60 applies to financial guarantee insurance contracts issued by insurance enterprises, including the methodologies to account for premium revenue and claim liabilities, as well as related disclosures. The proposals contained in the ED are not considered final accounting guidance until the FASB completes its due process procedures and issues a final statement, which could differ from the ED. Under the ED or the re-deliberated meetings, MBIA would be required to recognize premium revenue by applying a fixed percentage of premium to the amount of exposure outstanding at each reporting period (referred to as the level-yield approach). The proposed recognition approach for a claim liability would require MBIA to recognize a claim liability when there is an expectation that a claim loss will exceed the unearned premium revenue (liability) on a policy basis based on the present value of expected cash flows. Additionally, the ED would require MBIA to provide expanded disclosures relating to factors affecting the recognition and measurement of financial guarantee contracts. MBIA is in the process of evaluating how the exposure draft will impact its financial statements. Until final guidance is issued by the FASB and is effective, MBIA will continue to apply its existing policies with respect to the establishment of both case basis and unallocated loss reserves and the recognition of premium revenue. A further description of the Company’s loss reserving and premium recognition policies are included in “Note 2: Significant Accounting Policies” in the Notes to Consolidated Financial Statements. RISK MANAGEMENT In an effort to mitigate losses, MBIA is regularly involved in the ongoing remediation of credits that may involve, among other things, waivers or renegotiations of financial covenants or triggers, waivers of contractual provisions, the granting of consents, and the taking of various other remedial actions. The nature of any remedial action is based on the type of the insured issue and the nature and scope of the event giving rise to the remediation. In most cases, as part of any such remedial activity, MBIA is able to improve its security position and to obtain concessions from the issuer of the insured bonds. From time to time, the issuer of an MBIA-insured obligation may, with the consent of MBIA, restructure the insured obligation by extending the term, increasing or decreasing the par amount or decreasing the related interest rate with MBIA insuring the restructured obligation. If, as the result of the restructuring, MBIA estimates that it will incur an ultimate loss on the restructured obligation, MBIA will record a case basis loss reserve for the restructured obligation or, if it has already recorded a case basis loss reserve, it will re-evaluate the impact of the restructuring on the recorded reserve and adjust the amount of the reserve as appropriate. In the first quarter of 2006 and in connection with its remediation efforts, MBIA exercised a call right with respect to $411 million of MBIA-insured Northwest Airlines’ enhanced equipment trust certificates issued by Northwest Airlines Pass Through Trust 2000-1G (the “Certificates”). Under the terms of the trust agreement relating to the Certificates, MBIA had the right to call the Certificates at par as a result of the bankruptcy filing by Northwest Airlines. MBIA entered into an agreement with a third party under which the third party financed the call of the Certificates and purchased the Certificates from MBIA as part of a planned future securitization of the Certificates. MBIA’s insurance policy guaranteeing payment of the Certificates remains in effect. Due to certain continuing rights MBIA possesses with respect to the Certificates, MBIA recorded the Certificates and the related financing on its balance sheet under the requirements of SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The Certificates were included within “Short-term investments” and the related financing was included within “Payable for investments purchased” on the Company’s consolidated balance sheets. During the second quarter of 2007, MBIA no longer possessed its continuing rights with respect to the Certificates and, therefore, removed the Certificates and related financing from its consolidated balance sheet as of June 30, 2007. REINSURANCE Reinsurance enables the Company to cede exposure for purposes of syndicating risk and increasing its capacity to write new business while complying with its single risk and credit guidelines. When a reinsurer is downgraded by one or more of the rating agencies, less capital credit is given to MBIA under rating agency models. As a result, a downgrade of one or more of MBIA’s key reinsurers could affect MBIA Corp.’s financial strength rating and ability to write new business. Over the past several years, most of MBIA’s reinsurers have been downgraded and others remain under review. The Company generally retains the right to reassume the business ceded to reinsurers under certain circumstances, including rating downgrades of its reinsurers. Additionally, MBIA requires certain unauthorized reinsurers to maintain bank letters of credit or establish trust accounts to cover liabilities ceded to such reinsurers under reinsurance contracts. The Company remains liable on a primary basis for all reinsured risk, and although MBIA believes that its reinsurers remain capable of meeting their obligations, there can be no assurance of such in the future.
63
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) As of December 31, 2007, the aggregate amount of insured par ceded by MBIA to reinsurers under reinsurance agreements was $79.7 billion. Additionally, the Company has other reimbursement agreements not accounted for as reinsurance, primarily with a reinsurer rated AA- by S&P and Aa3 by Moody’s, covering $4.1 billion of insured par. The following table presents the percentage of outstanding par ceded to and reinsurance recoverable from reinsurers by rating levels as of December 31, 2007:
Channel Re is a reinsurer of MBIA. Additionally, MBIA owns a 17.4% equity interest in Channel Re. In June 2007, S&P revised its outlook on Channel Re from negative to stable. In February 2008, S&P placed Channel Re’s AAA rating on CreditWatch with negative implications. In February 2008, Moody’s downgraded Channel Re to Aa3 from Aaa, with negative outlook. For the year ended December 31, 2007, the Company expects that Channel Re will report negative shareholder’s equity on a GAAP basis as a result of fair valuing its insured credit derivatives. As a result, in the fourth quarter of 2007, the Company recorded an adjustment to the carrying value of its equity ownership interest in Channel Re from $85.7 million at September 30, 2007 to zero. As of December 31, 2007, the Company had $708.2 million of derivative assets related to credit derivatives ceded to Channel Re and a $13.1 million reinsurance recoverable from Channel Re. The Company has assessed Channel Re’s ability to pay these amounts to MBIA if they were to be settled and has concluded that Channel Re had sufficient liquidity supporting its business to settle such amounts, inclusive of approximately $495 million that Channel Re had on deposit in trust accounts as of December 31, 2007 for the benefit of MBIA. Although the trusts limit the potential for Channel Re to default on its obligations to MBIA, there can be no assurance that Channel Re will not default on its obligations to MBIA that exceed the amounts already established in the trust accounts. If, in the future, MBIA determines that Channel Re does not have sufficient liquidity to settle its obligations to MBIA, MBIA will record reserves against such amounts. Several of the Company’s other financial guarantee reinsurers, including RAM Reinsurance Company, Ltd. (“RAM”), Ambac Assurance Corporation, XL Financial Assurance Ltd. and XL Capital Assurance Inc., have had their credit ratings either downgraded or put on negative watch by one or more of the major rating agencies between December 2007 and February 2008. RAM has deposited $104 million of assets in a trust for the benefit of MBIA as of December 31, 2007. Although there was no material impact on the Company for any of the rating agency actions through February 2008 relating to its reinsurers, a further downgrade of one or more of the Company’s reinsurers could increase the amount of capital required to maintain MBIA Corp.’s triple-A ratings and may require the establishment of reserves against any receivables due from the such reinsurers. POLICY ACQUISITION COSTS AND OPERATING EXPENSES Expenses that vary with and are primarily related to the production of the Company’s insurance business (policy acquisition costs) are deferred and recognized over the period in which the related premiums are earned. If an insured issue is refunded and the related premium is earned early, the associated acquisition costs previously deferred are also recognized early. Annually, MBIA reviews its insurance-related expenses to determine if there have been any changes in its business or cost structure that would materially change the amount of costs accounted for as policy acquisition costs. If so, the Company conducts a policy acquisition cost study to determine the amount of insurance costs that relate to acquiring new non-derivative insurance policies and that are deferrable under GAAP. MBIA completed its latest study in July 2005 and expects to complete a study during 2008. If, as a
64
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) result of its study, MBIA determines that fewer costs are attributable to acquiring new insurance business, assuming a consistent gross expense level, operating expenses reported by the Company will increase. MBIA will recognize a premium deficiency if the sum of the expected loss and LAE and unamortized policy acquisition costs exceed the related unearned premiums. If MBIA was to have a premium deficiency that is greater than unamortized acquisition costs, the unamortized acquisition costs would be reduced by a charge to expense and a liability would be established for any remaining deficiency. Although GAAP permits the inclusion of anticipated investment income when determining a premium deficiency, MBIA currently does not include this in making its determination. The Company’s insurance expenses, as well as its expense ratio, are presented in the following table:
Gross insurance expenses decreased 8% in 2007 compared with 2006 as a result of an increase in costs allocated to our investment management services and corporate operations and a decrease in loss prevention efforts. In 2006, gross insurance expenses increased 2% compared with 2005 primarily as a result of an increase in compensation costs. In 2007, the amortization of deferred acquisition costs increased 1% compared with 2006, in line with the increase in insurance premiums earned. At December 31, 2007, 2006 and 2005 there was an increase in the ratio of deferred expenses carried as assets on the balance sheet to deferred revenues carried as liabilities on the balance sheet plus the present value of future installment premiums. The increasing ratio reflects higher costs associated with acquiring new policies relative to a smaller growth in deferred and future installment premiums. Operating expenses decreased 15% to $133 million in 2007 from $156 million in 2006. The decrease in operating expenses in 2007 compared with 2006 was due to the aforementioned increase in costs allocated to our investment management services and corporate operations and a decrease in loss prevention efforts. For 2006, operating expenses increased 10% to $156 million from $141 million in 2005. The increase in operating expenses in 2006 compared with 2005 was due to an increase in compensation costs primarily related to the acceleration of expenses associated with certain existing long-term incentive compensation awards and the adoption of new employee retirement benefits. Additionally, operating expenses increased as a result of the decrease in the rate at which costs are deferred as policy acquisition costs, which was effective in the third quarter of 2005. Financial guarantee insurance companies use the expense ratio (expenses divided by net premiums earned) as a measure of expense management. The decrease in the expense ratios presented in the preceding table are principally due to a lower level of operating expenses in 2007 and higher levels of operating expenses during 2006 and 2005. INTEREST EXPENSE Interest expense from MBIA’s insurance operations, which primarily consists of interest related to debt issued by consolidated VIEs, the financing of the Northwest Airlines Pass Through Trust 2000-1G certificates and agreements accounted for as deposits, increased to $82 million in 2007 from $76 million in 2006. The increase primarily related to a $16 million increase in interest expense associated with consolidated VIEs, offset by an $8 million decrease in interest related to the Northwest Airlines Pass Through Trust 2000-1G certificates. For 2006, interest expense increased 193% compared with 2005 due to additional VIEs being consolidated by the Company during 2005 and the financing of the Northwest Airlines Pass Through Trust 2000-1G certificates in 2006. Interest expense related to consolidated VIEs was $74 million, $58 million and $25 million in 2007, 2006 and 2005, respectively. VARIABLE INTEREST ENTITIES The Company provides credit enhancement services to global finance clients through third-party special purpose vehicles (“SPVs”). Third-party SPVs are used in a variety of structures guaranteed by MBIA. The Company has determined that such SPVs fall within the definition of a VIE under FIN 46(R). Under the provisions of FIN 46(R), MBIA must determine whether it has a variable interest in a VIE and if so, whether that variable interest would cause MBIA to be the primary
65
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) beneficiary. The Company would be required to consolidate VIEs if it was determined to be the primary beneficiary of the VIEs. The primary beneficiary is the entity that will absorb the majority of the expected losses, receive the majority of the expected residual returns, or both, of a VIE. The Company conducts consolidation analyses under the provisions of FIN 46(R) upon the inception of its guarantees to the third-party SPVs and upon the occurrence of certain reconsideration events. The Company consolidates certain third-party VIEs as a result of financial guarantees provided by the insurance operations. Third-party VIEs’ assets and liabilities are primarily reported in “Investments held-to-maturity” and “Variable interest entity floating rate notes,” respectively, on the face of the Company’s balance sheet. The assets and liabilities of these VIEs each totaled $1.4 billion at December 31, 2007 and $1.5 billion at December 31, 2006. Revenues and expenses related to third-party VIEs are primarily recorded in “Net investment income” and “Interest expense”, respectively, on the Company’s statements of operations and substantially net to zero. Consolidation of such VIEs does not increase MBIA’s exposure above that already committed to in its insurance policies. Additionally, consolidation of the insured VIEs does not affect the capital ratios, debt covenants, dividends or credit ratings of the Company. The Company consolidated two VIEs in the third quarter of 2004 and a third VIE in the fourth quarter of 2006 that were established in connection with the securitizations of Capital Asset tax liens and to which the Company provided financial guarantees. In December 2006, the Company sold its interest in all of these consolidated VIEs. MBIA held a variable interest in these entities, which resulted from its insurance policies, and had determined that it was the primary beneficiary under FIN 46(R). COLLATERALIZED DEBT OBLIGATIONS AND RELATED INSTRUMENTS As part of its insurance operations, the Company provides guarantees on CDO tranches, as well as protection on structured CMBS and corporate credit pools. The Company’s $130.6 billion CDO portfolio comprised 19.2% of the Company’s total insured net par of $678.7 billion as of December 31, 2007. The Company’s aggregate CDO book is diversified by vintage and collateral type. Ninety percent of this exposure, or $117.3 billion, was insured via credit default swaps. The distribution of the Company’s insured CDO and related instruments portfolio by collateral type is presented in the following table:
Multi-sector CDOs Multi-Sector CDOs are transactions that include a variety of structured finance asset classes in their collateral pools. As of December 31, 2007, $30.1 billion, or approximately 4%, of the Company’s total insured net par outstanding of $678.7 billion and 23% of the Company’s $130.6 billion CDO portfolio insured net par outstanding, was comprised of Multi-Sector CDOs. The collateral in the Company’s Multi-Sector CDOs includes ABS (e.g. securitizations of auto receivables, credit cards, etc.), CMBS, CDOs and various types of RMBS including prime and subprime RMBS. Within the multi-sector CDOs, the next four tables will show further breakdowns of the collateral composition and ratings of sub-prime RMBS collateral, non-sub-prime RMBS collateral, and CDOs of ABS collateral by vintage year. CDOs of ABS may contain exposure to various types of collateral, including RMBS. For the Multi-Sector CDO portfolio, the collateral composition is presented in the following table. The collateral level detail for each year insured was calculated using a weighted average of the net par written for deals closed during that particular year. The total collateral amount of the portfolio exceeds the net par written as a result of credit enhancement (such as overcollateralization and subordination) and reinsurance.
66
Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
