Radian Group, Inc. - Form 10-Q
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                   

Commission File Number 1-11356

 

 

Radian Group Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   23-2691170

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

1601 Market Street, Philadelphia, PA   19103
(Address of principal executive offices)   (Zip Code)

(215) 231-1000

(Registrant’s telephone number, including area code)

 

 

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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the 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  ¨
    (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 80,429,462 shares of common stock, $0.001 par value per share, outstanding on May 5, 2008.

 

 

 


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Radian Group Inc.

INDEX

 

     Page
Number

Forward Looking Statements—Safe Harbor Provisions

   i

PART I—FINANCIAL INFORMATION

  

Item 1.

   Financial Statements (Unaudited)   
  

Condensed Consolidated Balance Sheets

   1
  

Condensed Consolidated Statements of Operations

   2
  

Condensed Consolidated Statements of Changes in Common Stockholders’ Equity

   3
  

Condensed Consolidated Statements of Cash Flows

   4
  

Notes to Unaudited Condensed Consolidated Financial Statements

   5

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   29

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk    71

Item 4.

   Controls and Procedures    73

PART II—OTHER INFORMATION

  

Item 1.

   Legal Proceedings    75

Item 1A.

   Risk Factors    75

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    79

Item 6.

   Exhibits    80

SIGNATURES

   81

EXHIBIT INDEX

   82


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Forward Looking Statements—Safe Harbor Provisions

All statements in this report that address events, developments or results that we expect or anticipate may occur in the future are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the U.S. Private Securities Litigation Reform Act of 1995. In most cases, forward-looking statements may be identified by words such as “may,” “should,” “expect,” “intend,” “plan,” “goal,” “contemplate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue” or the negative or other variations on these words and other similar expressions. These statements, which include, without limitation, projections regarding our future performance and financial condition are made on the basis of management’s current views and assumptions with respect to future events. Any forward-looking statement is not a guarantee of future performance and actual results could differ materially from those contained in the forward looking information. The forward-looking statements, as well as our prospects as a whole, are subject to risks and uncertainties, including the following:

 

   

actual or perceived changes in general financial and political conditions, such as extended national or regional economic recessions, changes in housing demand or mortgage originations, changes in housing values (in particular, further deterioration in the housing, mortgage and related credit markets, which would harm our future consolidated results of operations and could cause losses for our mortgage insurance business to be worse than expected), changes in the liquidity in the capital markets and the further contraction of credit markets, population trends and changes in household formation patterns, changes in unemployment rates, changes or volatility in interest rates or consumer confidence, changes in credit spreads, changes in the way investors perceive the strength of private mortgage insurers or financial guaranty providers, investor concern over the credit quality and specific risks faced by the particular businesses, municipalities or pools of assets covered by our insurance;

 

   

actual or perceived economic changes or catastrophic events in geographic regions (both domestic and international) where our mortgage insurance or financial guaranty insurance in force is more concentrated;

 

   

our ability to successfully obtain additional capital to support our long-term liquidity needs and to protect our credit and financial strength ratings;

 

   

a decrease in the volume of home mortgage originations due to reduced liquidity in the lending market, tighter underwriting standards and a deterioration in housing markets throughout the U.S.;

 

   

a decrease in the volume of the municipal bonds, and other public finance and structured finance transactions that we insure, or a decrease in the volume of such transactions for which issuers or investors seek or demand financial guaranty insurance;

 

   

the loss of a customer for whom we write a significant amount of mortgage insurance or financial guaranty insurance or the influence of large customers;

 

   

reduction in the volume of reinsurance business available to us from one or more of our primary financial guaranty insurer customers due to adverse changes in their ability to generate new profitable direct financial guaranty insurance or their need for us to reinsure their risk;

 

   

disruption in the servicing of mortgages covered by our insurance policies;

 

   

the aging of our mortgage insurance portfolio and changes in severity or frequency of losses associated with certain of our products that are riskier than traditional mortgage insurance or financial guaranty insurance policies;

 

   

the performance of our insured portfolio of higher risk loans, such as Alternative-A (“Alt-A”) and subprime loans, and adjustable rate products, such as adjustable rate mortgages and interest-only mortgages, which have resulted in increased losses in 2007 and 2008 and may result in further losses;

 

   

reduced opportunities for loss mitigation in markets where housing values fail to appreciate or begin to decline;

 

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changes in persistency rates of our mortgage insurance policies caused by changes in refinancing activity, in the rate of appreciation or depreciation of home values and changes in the mortgage insurance cancellation requirements of mortgage lenders and investors;

 

   

downgrades or threatened downgrades of, or other ratings actions with respect to, our credit ratings or the insurance financial strength ratings assigned by the major rating agencies to any of our rated insurance subsidiaries at any time (in particular, our credit rating and the financial strength ratings of our mortgage insurance subsidiaries that are currently under review for possible downgrade), which risk is discussed in more detail below in Item 1A of Part II of this report on Form 10-Q;

 

   

heightened competition for our mortgage insurance business from others such as the Federal Housing Administration and the Veterans’ Administration or other private mortgage insurers (in particular those that have been assigned higher ratings from the major ratings agencies), from alternative products such as “80-10-10” loans or other forms of simultaneous second loan structures used by mortgage lenders, from investors using forms of credit enhancement other than mortgage insurance as a partial or complete substitution for private mortgage insurance and from mortgage lenders that demand increased participation in revenue sharing arrangements such as captive reinsurance arrangements;

 

   

changes in the charters or business practices of Federal National Mortgage Association and Freddie Mac, the largest purchasers of mortgage loans that we insure, and our ability to retain our “Top Tier” eligibility requirement from both Freddie Mac and Fannie Mae;

 

   

failure to bring the amendment to our credit facility, dated April 30, 2008, effective by May 15, 2008, which would result in a reinstatement of the ratings covenant under our credit facility as discussed in more detail below in Item 1A of Part II of this report on Form 10-Q;

 

   

heightened competition for financial guaranty business from other financial guaranty insurers, including those recently downgraded to ratings equal to or lower than our ratings, from other forms of credit enhancement such as letters of credit, guaranties and credit default swaps provided by foreign and domestic banks and other financial institutions and from alternative structures that may permit insurers to securitize assets more cost-effectively without the need for the types of credit enhancement we offer, or result in our having to reduce the premium we charge for our products;

 

   

the application of existing federal or state consumer, lending, insurance, securities and other applicable laws and regulations, or changes in these laws and regulations or the way they are interpreted; including, without limitation: (i) the possibility of private lawsuits or formal investigations by state insurance departments and state attorneys general alleging that services offered by the mortgage insurance industry, such as captive reinsurance, pool insurance and contract underwriting, are violative of the Real Estate Settlement Procedures Act and/or similar state regulations, (ii) legislative and regulatory changes affecting demand for private mortgage insurance or financial guaranty insurance, or (iii) legislation and regulatory changes limiting or restricting our use of (or requirements for) additional capital, the products we may offer, the form in which we may execute the credit protection we provide or the aggregate notional amount of any product we may offer for any one transaction or in the aggregate;

 

   

the possibility that we may fail to estimate accurately the likelihood, magnitude and timing of losses in connection with establishing loss reserves for our mortgage insurance or financial guaranty businesses, or the premium deficiency for our second-lien mortgage insurance business, or to estimate accurately the fair value amounts of derivative contracts in our mortgage insurance and financial guaranty businesses in determining gains and losses on these contracts;

 

   

changes in accounting guidance from the Securities and Exchange Commission (“SEC”) or the Financial Accounting Standards Board;

 

   

our ability to profitably grow our insurance businesses in international markets, which depends on a number of factors such as foreign governments’ monetary policies and regulatory requirements, foreign currency exchange rate fluctuations, and our ability to develop and market products appropriate to foreign markets;

 

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legal and other limitations on the amount of dividends we may receive from our subsidiaries; and

 

   

vulnerability to the performance of our strategic investments, including in particular, our investment in Sherman Financial Group LLC.

For more information regarding these risks and uncertainties as well as certain additional risks that we face, you should refer to the Risk Factors detailed in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2007 as well as the material changes to these risks discussed in Item 1A of Part II below. We caution you not to place undue reliance on these forward-looking statements, which are current only as of the date on which we filed this report. We do not intend to, and we disclaim any duty or obligation to, update or revise any forward-looking statements made in this report to reflect new information or future events or for any other reason.

 

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PART I—FINANCIAL INFORMATION

 

Item 1. Financial Statements.

Radian Group Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

 

($ in thousands)   March 31
2008
    December 31
2007
 

ASSETS

   

Investments

   

Fixed maturities held to maturity—at amortized cost (fair value $49,668 and $55,021)

  $ 47,951     $ 53,310  

Fixed maturities available for sale—at fair value (amortized cost $4,653,018 and $4,571,998)

    4,659,048       4,644,724  

Trading securities—at fair value (amortized cost $447,034 and $158,087)

    435,746       153,634  

Equity securities available for sale—at fair value (cost $208,304 and $196,068)

    245,551       254,869  

Hybrid securities—at fair value (amortized cost $569,102 and $525,607)

    571,919       584,373  

Short-term investments

    576,610       697,271  

Other invested assets (cost $21,341 and $21,087)

    23,122       22,868  
               

Total investments

    6,559,947       6,411,049  

Cash

    181,038       200,787  

Investment in affiliates

    116,969       104,354  

Deferred policy acquisition costs

    239,400       234,955  

Prepaid federal income taxes

    536,343       793,486  

Accrued investment income

    70,909       65,362  

Accounts and notes receivable (less allowance of $50,115 and $50,391)

    90,721       130,773  

Property and equipment, at cost (less accumulated depreciation of $84,037 and $81,930)

    22,799       24,567  

Derivative assets

    232,759       43,214  

Other assets

    203,140       201,642  
               

Total assets

  $ 8,254,025     $ 8,210,189  
               

LIABILITIES AND STOCKHOLDERS’ EQUITY

   

Unearned premiums

  $ 1,074,589     $ 1,094,710  

Reserve for losses and loss adjustment expenses

    1,902,128       1,598,756  

Reserve for second-lien premium deficiency

    213,736       195,646  

Long-term debt and other borrowings

    959,244       953,524  

Variable interest entity debt

    100,219       —    

Deferred income taxes payable

    52,360       26,705  

Derivative liabilities

    703,405       1,305,665  

Accounts payable and accrued expenses

    380,988       314,447  
               

Total liabilities

    5,386,669       5,489,453  
               

Commitments and Contingencies (Note 13)

   

Stockholders’ equity

   

Common stock: par value $.001 per share; 200,000,000 shares authorized; 97,631,763 shares issued at March 31, 2008 and December 31, 2007; 80,460,406 and 80,412,974 shares outstanding at March 31, 2008 and December 31, 2007, respectively

    98       98  

Treasury stock, at cost: 17,171,357 and 17,218,789 shares at March 31, 2008 and December 31, 2007, respectively

    (888,643 )     (889,478 )

Additional paid-in capital

    1,334,854       1,331,790  

Retained earnings

    2,375,189       2,181,191  

Accumulated other comprehensive income

    45,858       97,135  
               

Total stockholders’ equity

    2,867,356       2,720,736  
               

Total liabilities and stockholders’ equity

  $ 8,254,025     $ 8,210,189  
               

See notes to unaudited condensed consolidated financial statements.

 

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Radian Group Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

 

     Three Months Ended
March 31
 
(In thousands, except per-share amounts)    2008     2007  

Revenues:

    

Premiums written—insurance:

    

Direct

   $ 262,606     $ 260,022  

Assumed

     24,271       24,531  

Ceded

     (42,571 )     (36,123 )
                

Net premiums written

     244,306       248,430  

Increase in unearned premiums

     (2,385 )     (33,923 )
                

Net premiums earned—insurance

     241,921       214,507  

Net investment income

     65,979       60,996  

Net (losses) gains on securities

     (54,884 )     13,745  

Change in fair value of derivative instruments

     707,809       48,417  

Other income

     3,614       3,818  
                

Total revenues

     964,439       341,483  
                

Expenses:

    

Provision for losses

     582,711       107,042  

Provision for second-lien premium deficiency

     18,090       —    

Policy acquisition costs

     23,906       28,254  

Other operating expenses

     55,141       57,695  

Interest expense

     12,493       13,056  
                

Total expenses

     692,341       206,047  
                

Equity in net income of affiliates

     12,526       22,772  
                

Pretax income

     284,624       158,208  

Income tax provision

     88,986       44,741  
                

Net income

   $ 195,638     $ 113,467  
                

Basic net income per share

   $ 2.45     $ 1.43  
                

Diluted net income per share

   $ 2.44     $ 1.42  
                

Weighted average number of common shares outstanding—basic

     79,930       79,428  
                

Weighted average number of common and common equivalent shares outstanding—diluted

     80,040       80,080  
                

Dividends per share

   $ 0.02     $ 0.02  
                

See notes to unaudited condensed consolidated financial statements.

 

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Radian Group Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCKHOLDERS’ EQUITY (UNAUDITED)

 

                            Accumulated Other
Comprehensive Income (Loss)
       
(In thousands)    Common
Stock
   Treasury
Stock
    Additional
Paid-in
Capital
    Retained
Earnings
    Foreign Currency
Translation
Adjustment
   Unrealized
Holding Gains
(Losses)
    Other     Total  

BALANCE prior to implementation effects JANUARY 1, 2007

   $ 97    $ (931,012 )   $ 1,347,205     $ 3,489,290     $ 9,796    $ 151,934     $ 247     $ 4,067,557  

Cumulative effect of adoption of FIN No. 48

     —        —         —         (21,214 )     —        —         —         (21,214 )

Cumulative effect of adoption of SFAS No. 155

     —        —         —         9,844       —        (9,844 )     —         —    
                                                              

BALANCE, JANUARY 1, 2007, as adjusted

     97      (931,012 )     1,347,205       3,477,920       9,796      142,090       247       4,046,343  

Comprehensive income:

                  

Net income

     —        —         —         113,467       —        —         —         113,467  

Unrealized foreign currency translation adjustment, net of tax of $459

     —        —         —         —         851      —         —         851  

Unrealized holding losses arising during period, net of tax benefit of $34

     —        —         —         —         —        (62 )     —      

Less: Reclassification adjustment for net gains included in net income, net of tax of $5,597

     —        —         —         —         —        (10,394 )     —      
                        

Net unrealized gain on investments, net of tax of $5,630

     —        —         —         —         —        (10,456 )     —         (10,456 )
                        

Comprehensive income

                     103,862  

Issuance of common stock under incentive plans

     —        41,347       4,900       —         —        —         —         46,247  

Issuance of restricted stock

     —        —         (21,721 )     —         —        —         —         (21,721 )

Amortization of restricted stock

     —        —         1,174       —         —        —         —         1,174  

Stock-based compensation expense-options

     —        —         4,455       —         —        —         —         4,455  

Treasury stock purchased

     —        (3,980 )     —         —         —        —         —         (3,980 )

Dividends declared

     —        —         —         (1,604 )     —        —         —         (1,604 )
                                                              

BALANCE, MARCH 31, 2007

   $ 97    $ (893,645 )   $ 1,336,013     $ 3,589,783     $ 10,647    $ 131,634     $ 247     $ 4,174,776  
                                                              

BALANCE, JANUARY 1, 2008,

   $ 98    $ (889,478 )   $ 1,331,790     $ 2,181,191     $ 12,142    $ 86,619     $ (1,626 )   $ 2,720,736  

Comprehensive income:

                  

Net income

     —        —         —         195,638       —        —         —         195,638  

Unrealized foreign currency translation adjustment, net of tax of $3,206

     —        —         —         —         5,953      —         —         5,953  

Unrealized holding losses arising during the period, net of tax benefit of $(34,271)

     —        —         —         —         —        (63,646 )     —         —    

Less: Reclassification adjustment for net losses included in net income, net of tax benefit of $3,455

     —        —         —         —         —        6,416       —         —    
                        

Net unrealized loss on investments, net of tax of $30,816

     —        —         —         —         —        (57,230 )     —         (57,230 )
                        

Comprehensive income

     —        —         —         —         —        —         —         144,361  

Repurchases of common stock under incentive plans

     —        835       (550 )     —         —        —         —         285  

Issuance of restricted stock

     —        —         78       —         —        —         —         78  

Amortization of restricted stock

     —        —         2,392       —         —        —         —         2,392  

Stock-based compensation expense

     —        —         1,144       —         —        —         —         1,144  

Dividends declared

     —        —         —         (1,640 )     —        —         —         (1,640 )
                                                              

BALANCE, MARCH 31, 2008

   $ 98    $ (888,643 )   $ 1,334,854     $ 2,375,189     $ 18,095    $ 29,389     $ (1,626 )   $ 2,867,356  
                                                              

See notes to unaudited condensed consolidated financial statements.

 

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Radian Group Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

     Three Months Ended
March 31
 
(In thousands)    2008     2007  

Cash flows (used in) provided by operating activities

   $ (62,031 )   $ 204,187  
                

Cash flows from investing activities:

    

Proceeds from sales of fixed-maturity investments available for sale

     71,452       111,104  

Proceeds from sales of equity securities available for sale

     3,623       5,096  

Proceeds from sales of hybrid securities

     89,188       61,977  

Proceeds from redemptions of fixed-maturity investments available for sale

     45,984       51,695  

Proceeds from redemptions of fixed-maturity investments held to maturity

     5,841       5,906  

Proceeds from redemptions of hybrid securities

     15,672       28,767  

Purchases of fixed-maturity investments available for sale

     (167,188 )     (217,339 )

Purchases of equity securities available for sale

     (15,781 )     (830 )

Purchases of hybrid securities

     (134,618 )     (92,344 )

Sales (purchases) of short-term investments, net

     120,915       (92,933 )

Purchases of other invested assets, net

     (260 )     (6,167 )

Purchases of property and equipment, net

     (344 )     (2,142 )
                

Net cash provided by (used) in investing activities

     34,484       (147,210 )
                

Cash flows from financing activities:

    

Dividends paid

     (1,640 )     (1,604 )

Proceeds from issuance of common stock under incentive plans

     —         16,005  

Excess tax benefits from stock-based awards

     —         4,334  

Purchase of treasury stock

     —         (3,980 )

Proceeds from termination of interest-rate swap

     12,800       —    
                

Net cash provided by financing activities

     11,160       14,755  
                

Effect of exchange rate changes on cash

     (3,362 )     2,972  

(Decrease) increase in cash

     (19,749 )     74,704  

Cash, beginning of period

     200,787       57,901  
                

Cash, end of period

   $ 181,038     $ 132,605  
                

Supplemental disclosures of cash flow information:

    

Income taxes received

   $ (250,337 )   $ (15,674 )
                

Interest paid

   $ 9,334     $ 8,057  
                

Supplemental disclosures of non-cash items:

    

Stock-based compensation, net of tax

   $ 2,999     $ 3,658  
                

See notes to unaudited condensed consolidated financial statements.

 

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Radian Group Inc

Notes to Unaudited Condensed Consolidated Financial Statements

1. Condensed Consolidated Financial Statements—Basis of Presentation

Our condensed consolidated financial statements include the accounts of Radian Group Inc. and its subsidiaries, including its principal mortgage insurance operating subsidiaries, Radian Guaranty Inc. (“Radian Guaranty”), Amerin Guaranty Corporation (“Amerin Guaranty”) and Radian Insurance Inc. (“Radian Insurance”), and its principal financial guaranty operating subsidiaries, Radian Asset Assurance Inc. (“Radian Asset Assurance”) and Radian Asset Assurance Limited (“RAAL”). We refer to Radian Group Inc. together with its consolidated subsidiaries as “Radian,” “we,” “us” or “our,” unless the context requires otherwise. We generally refer to Radian Group Inc. alone, without its consolidated subsidiaries, as the “parent company.” We own a 46% interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”) and a 21.8% interest in Sherman Financial Group LLC (“Sherman”), each of which are credit-based consumer asset businesses.

Our condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of all wholly-owned subsidiaries. We have condensed or omitted certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with GAAP pursuant to the SEC’s rules and regulations.

The financial information presented for interim periods is unaudited; however, such information reflects all adjustments that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations, and cash flows for the interim periods. These interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007. The results of operations for interim periods are not necessarily indicative of results to be expected for the full year or for any other period. The year-end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. While the amounts included in our condensed consolidated financial statements include our best estimates and assumptions, actual results may vary.

Basic net income per share is based on the weighted average number of common shares outstanding, while diluted net income per share is based on the weighted average number of common shares outstanding and common share equivalents that would be issuable upon the exercise of stock options and other stock-based compensation.

We adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurement” (“SFAS No. 157”) effective January 1, 2008 with respect to financial assets and liabilities measured at fair value. SFAS No. 157, (i) defines fair value, (ii) establishes a framework for measuring fair value in GAAP and (iii) expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007 on a prospective basis. There was no cumulative impact on retained earnings as a result of the adoption. The impact of SFAS No. 157 is included in the change in fair value of derivative instruments. See Note 2. In accordance with Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”) SFAS No. 157-2, “Effective Date of FASB Statement No. 157,” we have elected to defer the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities until January 1, 2009.

 

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We adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”) effective January 1, 2008. SFAS No. 159 permits entities to choose to measure financial instruments and certain other items at fair value. Items eligible for fair value measurement by this statement are (i) recognized financial assets and financial liabilities (with some exceptions), (ii) firm commitments that would otherwise not be recognized at inception and that involve only financial instruments, (iii) nonfinancial insurance contracts and warranties that an insurer can settle by paying a third party to provide those goods or services and (iv) host financial instruments resulting from separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument. We elected to fair value the consolidated net interest margin securities (“NIMS”) variable interest entity (“VIE”) debt at the date the VIEs were consolidated during the first quarter of 2008.

We adopted FSP FASB Interpretation (“FIN”) No. 39-1 in the first quarter of 2008. FSP FIN No. 39-1, an amendment of FASB Interpretation No. 39, “Offsetting of Amounts Related to Certain Contracts” (“FSP FIN No. 39-1”) replaces the terms “conditional contracts” and “exchange contracts” with the term “derivative instruments” and permits a reporting entity to offset fair value amounts recognized for the right to reclaim cash collateral (a receivable), or the obligation to return cash collateral (a payable), against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement that have been offset in the statement of financial position. The implementation of FSP FIN No. 39-1 did not have a material impact on our condensed consolidated financial statements at January 1, 2008.

Certain other prior period balances have been reclassified to conform to the current period presentation. Specifically, effective January 1, 2008, derivative premiums earned are now included in the change in fair value of derivative instruments. This reclassification is being adopted after agreement with member companies of the Association of Financial Guaranty Insurers (“AFGI”) in consultation with the staffs of the Office of the Chief Accountant and the Division of Corporate Finance of the SEC. This reclassification is being implemented in order to increase comparability of our financial statements with other financial guaranty companies with derivative contracts. The 2007 amounts have been revised to reflect this reclassification. The unrealized loss on the fair value of the long-term debt, previously included in long-term debt at December 31, 2007, has been reclassified to other liabilities.

2. Fair Value of Financial Instruments

Effective January 1, 2008, we adopted SFAS No. 157, which as discussed in Note 1, defines fair value, establishes a fair value hierarchy and requires additional disclosures for financial assets and liabilities measured at fair value. Financial instruments reported in investments (excluding held-to-maturity securities and equity-method investments) and derivative assets and liabilities are measured at fair value. In the first quarter of 2008, we elected to also measure at fair value our variable interest entity debt, as allowed by the provisions of SFAS No. 159.

SFAS No. 157 defines fair value as the current amount that would be exchanged to sell an asset or transfer a liability, other than in a forced liquidation or transfer, and regardless of whether an observable liquid market price exists. SFAS No. 157 requires that a fair value measurement reflect actual or hypothetical assumptions market participants would use in pricing an asset or liability based on the best information available at the measurement date. In addition, SFAS No. 157 explicitly requires that we reflect our own non-performance risk in our fair value measurements of liabilities. We use the parent company credit spreads as our primary market-based input in estimating non-performance risk. The provisions of SFAS No. 157 are reflected prospectively in earnings beginning January 1, 2008.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

As required by SFAS No. 157, we established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to financial instruments using unadjusted quoted prices in active markets for identical assets or liabilities (Level I measurements) and the lowest priority to fair value measurements using unobservable inputs (Level III measurements). The three levels of the fair value hierarchy under SFAS No. 157 are described below:

 

    Level I – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

 

    Level II – Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly;

 

    Level III – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

 

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A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. The following is a list of those assets and liabilities that are measured at fair value by hierarchy level as of March 31, 2008:

 

(In millions)     
Assets and Liabilities at Fair Value (1)    Level I    Level II    Level III    Total

Investment Portfolio:

           

U.S. government and agency securities

   $ —      $ 164.5    $ —      $ 164.5

Municipal and state securities

     —        4,351.2      —        4,351.2

Money market instruments

     489.7      —        —        489.7

Corporate bonds

     —        125.4      —        125.4

Asset-backed securities

     —        319.2      —        319.2

Foreign government securities

     —        143.9      —        143.9

Hybrid securities

     —        571.9      —        571.9

Equity securities

     228.1      52.0      0.1      280.2

Other

     —        —        9.3      9.3
                           

Total Investments

     717.8      5,728.1      9.4      6,455.3
                           

Derivative Assets:

           

Put options on committed preferred securities (“CPS”)

     —        —        78.0      78.0

NIMS VIE derivative assets (2)

     —        —        16.5      16.5

Financial Guaranty credit derivative assets:

           

Corporate collateralized debt obligation (“CDO”) assets

     —        —        81.3      81.3

Non-Corporate CDO assets

     —        —        56.1      56.1

Assumed financial guaranty credit derivative assets

     —        —        0.8      0.8
                           

Total Financial Guaranty credit derivative assets

     —        —        138.2      138.2
                           

Total Derivative Assets

     —        —        232.7      232.7
                           

Total Assets at Fair Value

   $ 717.8    $ 5,728.1    $ 242.1    $ 6,688.0
                           

Derivative Liabilities:

           

NIMS credit derivatives

   $ —      $ —      $ 232.1    $ 232.1

Financial Guaranty credit derivative liabilities:

           

Corporate CDO liabilities

     —        —        57.7      57.7

Non-Corporate CDO liabilities

     —        —        272.1      272.1

Assumed financial guaranty credit derivative liabilities

     —        —        20.1      20.1
                           

Total Financial Guaranty credit derivative liabilities

     —        —        349.9      349.9

Mortgage Insurance domestic and international credit default swaps (“CDS”)

     —        —        121.4      121.4
                           

Total Derivative Liabilities

     —        —        703.4      703.4
                           

Variable interest entity debt (3)

     —        —        100.2      100.2
                           

Total Liabilities at Fair Value

   $ —      $ —      $ 803.6    $ 803.6
                           

 

(1) Excludes fixed maturities held-to-maturity and other invested assets accounted for as equity-method investments as these investments are not measured at fair value.
(2) Represents consolidated derivative assets related to the residual interests held by the VIE utilized to structure our NIMS credit derivatives that required consolidation due to control provisions in our guarantee contracts.
(3) Represents consolidated debt issued by the VIE utilized to structure our NIMS credit derivatives that require consolidation upon our becoming the primary beneficiary of the VIE.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

The fair value of our financial instruments is determined from market pricing when available; otherwise, fair value is based on estimates using present value or other valuation methodologies. Liability amounts include adjustments related to our own non-performance risk. These estimates result in a fair value estimate of the amount that would be exchanged to transfer the liability to a third party with a similar credit rating in an orderly market, if one existed. Considerable judgment is required to interpret available market data to develop the estimates of fair value. Where market pricing is not available, fair value estimates are reconciled or calibrated to market-based information, if available to us. The estimates presented herein are not necessarily indicative of the amount we could actually realize in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on our estimated fair value amounts. Also, changes in our credit spreads over time will have a material effect on our liability fair values. Following is a description of our valuation methodologies for financial assets and liabilities measured at fair value.

Investments

U.S. Government and agency securities—The fair value of U.S government and agency securities is estimated using observed market transactions, including broker-dealer quotes and actual trade activity as a basis for valuation. U.S government and agency securities are categorized in Level II of the fair value hierarchy.

Municipal and state securities—The fair value of municipal and state securities is estimated using recently executed transactions, market price quotations and pricing models that factor in, where applicable, interest rate yield curves and credit spreads for similar bonds. These securities are categorized in Level II of the fair value hierarchy.

Money market instruments—The fair value of money market instruments is based on daily prices which are published and available to all potential investors. These securities are categorized in Level I of the fair value hierarchy.

Corporate bonds—The fair value of corporate bonds is estimated using recently executed transactions and market quotes. In addition, a spread model is used to incorporate early redemption features, when applicable. These securities are generally categorized in Level II of the fair value hierarchy.

Asset-Backed Securities (“ABS”), Commercial Mortgage-Backed Securities (“CMBS”) and Collateralized Mortgage Obligations (“CMOs”) —The fair value of ABS, CMBS and CMOs is estimated based on prices of comparable securities and spreads obtained from dealers and observable prepayment speeds. These securities are generally categorized in Level II of the fair value hierarchy.

Foreign government securities—The fair value of foreign government securities is estimated using observed market yields used to create a maturity curve and observed credit spreads from market makers and broker dealers. These securities are categorized in Level II of the fair value hierarchy.

Hybrid securities—These instruments are convertible securities measured at fair value based on observed trading activity and daily quotes. In addition, on a daily basis, dealer quotes are marked against the current price of corresponding underlying stock. These securities are categorized in Level II of the fair value hierarchy. For certain securities, the underlying security price may be adjusted to account for changes in the conversion and investment value from the time the quote was obtained. Such securities are categorized in Level III of the fair value hierarchy.

Equity securities—The fair value of these securities is generally estimated using observable market data and bid prices from market makers and broker dealers. Generally, these securities are categorized in Level I of the fair value hierarchy as observable market data is available on these securities and are frequently traded. Other securities that are not as liquid are categorized as Level II of the fair value hierarchy

 

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Other investments—The fair value of these securities is generally estimated by discounting estimated future cash flows. Also included in this category are residential mortgage-backed securities (“RMBS”) bonds valued using internally-generated models. These securities are categorized in Level III of the fair value hierarchy.

Derivative Assets and Liabilities

We determine the fair value of our derivative assets and liabilities using internally-generated models. We reconcile or calibrate key inputs to market-based information, when available. Beginning in the first quarter of 2008, in accordance with SFAS No. 157, we made an adjustment to our derivative liabilities valuation methodology to account for our own non-performance risk by incorporating the observable credit default swap spread of the parent company into the determination of the fair value of our credit derivatives. Our five-year credit default swap spread widened by 1,058 basis points to 1,095 basis points from January 1, 2007 to March 31, 2008. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of amounts we could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a significant effect on the estimated fair value amounts.

Put Options on Committed preferred securities (“CPS”) The fair value of our put options on CPS is estimated based on a spread difference between the maximum rate on the underlying CPS securities and the estimated market rate of the perpetual security. This amount is discounted using a rate that incorporates our CDS spread. The put options on CPS are categorized in Level III of the fair value hierarchy.

NIMS credit derivatives and NIMS VIE derivative assets—NIMS credit derivatives are financial guarantees we have issued on NIMS which we are required to account for as derivatives. NIMS VIE derivative assets represent derivative assets in the NIMS trusts that we are required to consolidate in accordance with FIN No. 46R “Consolidation of Variable Interest Entities”(“FIN No. 46R”). See Note 4. The gains and losses on these financial instruments are derived from internally-generated models. We use market-based roll rates and internally-developed loss assumptions to estimate losses in each securitization underlying either the NIMS credit derivatives or the NIMS VIE derivative assets. We then project prepayment speeds on the underlying collateral in each securitization, incorporating actual and historical prepayment experience. The estimated loss and prepayment speeds are used to estimate the cash flows for each underlying securitization and NIMS bond, and ultimately, to produce the projected credit losses for each NIMS bond. In addition to expected credit losses, the fair value for each NIMS credit derivative is approximated by incorporating future expected premiums to be received from the NIMS trust. The projected net losses are discounted using a rate of return that incorporates our own non-performance risk, and based on our current credit default swap spread level, results in a significant reduction of the derivative liability. Because NIMS guarantees are not market-traded instruments, considerable judgment is required in estimating fair value. The use of different assumptions and/or methodologies could have a significant effect on estimated fair values. The NIMS credit derivatives are categorized in Level III of the fair value hierarchy. As a result of having to consolidate several NIMS structures, the derivative assets held by the NIMS VIE are also fair valued using the same internally-generated valuation model. The NIMS VIE derivative assets are also categorized in Level III of the fair value hierarchy.

Corporate CDOs—The estimated fair value of these direct derivative financial guaranty contracts is derived from internally-generated models. Estimated fair value amounts are determined by using market information to the extent available, the most significant of which is the credit default swap index (“CDX”), which is an industry standard credit default swap index. Credit spreads on individual names in our collateral pool are used to derive an equivalent risk tranche on the CDX index. When credit spreads on individual names are not available, the average

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

credit spread of similar companies is used. This observable market information must be combined with unobservable market inputs in order to estimate fair value. These unobservable market inputs are required to consider differences that exist in the collateral underlying our contracts, for example, not having to post collateral for changes in value, and the collateral underlying the standard market index, the structural features of our contracts and our non-performance risk. In order to adjust for our non-performance risk, we accounted for differences between our derivative contracts and similar derivative contracts executed by other primary market participants, the primary difference being the lack of a requirement to post collateral with our counterparties when our contracts are in a liability position. We utilized the parent company’s CDS spread curve, along with other assumptions regarding the correlation of underlying collateral default to our default as of the end of the valuation period, in order to adjust the fair market value to reflect the market’s perception of our non-performance risk. These credit derivatives are categorized in Level III of the fair value hierarchy.

Non-Corporate CDOs—The fair value of non-corporate CDOs includes fair value estimates on Trust Preferred securities (“TRUPS”), RMBS CDOs, CMBS CDOs and CDOs backed by other asset classes such as credit card receivables and auto loans. The fair value is estimated using dealer quotes on similarly structured transactions or relevant market indices as inputs when available. In instances where dealer quotes are not available and market indices are not appropriate, we utilize an internal model, similar to those used by other monoline insurers, to estimate fair value. This model estimates fair values based on a market rate of return that would be required on an internally developed risk-based capital amount. In determining the fair value of RMBS CDOs, and CMBS CDOs, we utilize a market spread derived from the ABX, TABX and CMBX indices. The spread utilized is based on the nature of the underlying collateral in each deal. The gains and losses on TRUPS deals are derived from internally-generated models utilizing observable CDS spreads of a group of investment grade and high-yield financial institutions. Because our collateral does not directly track market indices that are available, adjustments to account for differences in term, credit quality and diversification of underlying collateral are made in our internal models. In addition, in accordance with SFAS No. 157, we factored our own non-performance risk related to derivative contracts in a liability position. As noted above, a significant spread widening has a material impact on the estimated fair value of our non-corporate CDOs. These credit derivatives are categorized in Level III of the fair value hierarchy.

Assumed financial guaranty credit derivatives—Asset classes underlying our assumed financial guaranty contracts are comprised of those described above in both corporate and non-corporate CDOs. Fair value estimates are based on a reinsurance exit market and rely on fair value information from ceding insurers, as they are the primary obligors. The fair value methodologies are similar to those described above in determining fair values, including market-based indices, where available.

Mortgage Insurance domestic and international CDS—The fair value of our mortgage insurance CDS is based on quotes obtained from the counterparty. These quotes are validated by internally-developed models using loss assumptions and projections based on the performance of the underlying collateral. We also incorporated an adjustment to account for our non-performance risk. These credit derivatives are categorized in Level III of the fair value hierarchy.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

The following is a list of Level III assets and liabilities measured at fair value as of March 31, 2008:

 

(In millions)   Beginning
Balance at
January 1,
2008
    Realized Gains/
(Losses)
    Unrealized
Gains/(Losses)
    Purchases, Sales,
Issuances &
Settlements
    Transfers Into
(Out of) Level III
    Ending
Balance at
March 31,
2008
 

Level III Assets

           

Investments:

           

Hybrid securities

  $ 6.7     $ —       $ —       $ —       $ (6.7 )   $ —    

Equity securities

    0.1       —         —         —         —         0.1  

Other investments

    12.1       (3.7 )     0.3       0.6       —         9.3  
                                               

Total Investments

    18.9       (3.7 )     0.3       0.6       (6.7 )     9.4  

NIMS derivative assets

    —         —         —         16.5       —         16.5  

Put options on CPS

    35.2       (1.4 )     42.8       1.4       —         78.0  
                                               

Total Level III assets, net

  $ 54.1     $ (5.1 )   $ 43.1     $ 18.5     $ (6.7 )   $ 103.9  
                                               

Level III liabilities

           

NIMS credit derivatives

  $ (433.9 )   $ 6.8     $ 98.7     $ 96.3 (1)   $ —       $ (232.1 )

Variable interest entity debt

    —         —         —         (100.2 )     —         (100.2 )

Mortgage Insurance domestic and international CDS

    (86.2 )     2.4       (32.3 )     (5.3 )(2)     —         (121.4 )

Financial Guaranty credit derivatives, net:

           

Corporate CDOs

    (485.5 )     11.1       522.8       (24.8 )(3)     —         23.6  

Non-Corporate CDOs

    (277.7 )     2.6       63.0       (3.9 )(4)     —         (216.0 )

Assumed financial guaranty contracts

    (14.4 )     —         (4.9 )     —         —         (19.3 )
                                               

Total Financial Guaranty credit derivatives, net

    (777.6 )     13.7       580.9       (28.7 )     —         (211.7 )
                                               

Total Level III liabilities, net

  $ (1,297.7 )   $ 22.9     $ 647.3     $ (37.9 )   $ —       $ (665.4 )
                                               

 

(1) Included in this amount is $4.0 million of unearned premium and a $21.5 million reduction related to our purchase of NIMS bonds that we guarantee, which is part of loss mitigation efforts. These unearned premiums relate to the reclassification in accordance with AFGI and SEC guidance.

 

(2) Amount represents unearned premium as referred to in (1) above.

 

(3) Included in this amount is $14.3 million of unearned premium as referred to in (1) above.

 

(4) Included in this amount is $1.4 million of unearned premium as referred to in (1) above.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. At March 31, 2008, our total Level III assets approximated 4% of total assets measured at fair value and total Level III liabilities accounted for 100% of total liabilities measured at fair value. In the first quarter of 2008, credit spreads on underlying collateral, both corporate credit spreads and asset-backed spreads, widened significantly during the quarter, which resulted in large unrealized losses on these positions. Offsetting these losses, due to the incorporation of our non-performance risk into our fair value measurements as required by SFAS No. 157, the fair value of our liabilities was reduced by approximately $2.1 billion, in the aggregate. The largest component of this reduction in value related to the valuation of our Corporate CDOs. The credit protection we offer on Corporate CDOs is generally senior investment grade debt, which carries a weighted average spread of approximately 88 basis points. Based on the March 31, 2008 parent company CDS spread of 1,095 basis points, the market valuation of our credit protection of these highly rated underlying tranches is minimal at March 31, 2008, resulting in a very low fair premium amount.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

At March 31, 2008, we also consolidated certain NIMS transactions for which we reversed an $83.7 million NIMS credit derivative liability and recorded VIE debt of $100.2 million and NIMS derivative assets of $16.5 million. During the first quarter of 2008, we transferred some of our hybrid securities from Level III to Level II due to the fact that at the time the securities were purchased there was no active market or observable inputs. At March 31, 2008, these securities were more frequently traded, which provided observable inputs for our valuation. Realized and unrealized gains and losses on other investments included in Level III are generally recorded in net gains (losses) on securities; changes in fair value of certain RMBS securities included in other investments were reflected in change in fair value of derivative instruments. Realized and unrealized gains and losses on our Level III derivative assets and liabilities are recorded in change in fair value of derivatives.

SFAS No. 159 permits certain financial assets and liabilities to be measured at fair value. In the first quarter of 2008, we elected to fair value the consolidated NIMS VIE debt. We elected to fair value these instruments in order to achieve a value that reflects our financial guaranty obligations associated with the NIMS. The face value of our consolidated liability is $149.6 million and includes $36.9 million that has been issued by our consolidated trusts, but is not guaranteed by us.

3. Derivative Instruments and Hedging Activities

We account for derivatives under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), as amended and interpreted. In general, SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their respective fair values and changes in fair value recorded in net income unless the derivatives qualify as hedges. If the derivatives qualify as hedges, depending on the nature of the hedge, changes in the fair value of the derivatives are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings, or are recognized in accumulated other comprehensive income (loss) until the hedged item is recognized in earnings.

All our derivative instruments are recognized in our condensed consolidated balance sheets as either derivative assets or derivative liabilities, depending on the rights or obligations under the contracts. The interest-rate swaps that we had entered into qualified as hedges and were accounted for as fair value hedges. Our credit protection in the form of credit default swaps and other credit derivatives within both our mortgage insurance and financial guaranty segments and NIMS are not designated as hedges under SFAS No. 133, so changes in their fair value are included in current earnings in our condensed consolidated statements of operations. Net unrealized gains and losses on credit default swaps and certain other derivative contracts are included in either derivative assets or derivative liabilities on our condensed consolidated balance sheets.

We apply the guidance of SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”), an amendment of SFAS Nos. 133 and 140, which (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and (v) amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS No.140”) to eliminate the exemption from applying the requirements of SFAS No. 133 on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.

Accordingly, certain securities that were previously classified as trading securities or fixed maturities available for sale on our condensed consolidated balance sheets were reclassified to hybrid securities on our condensed consolidated balance sheets at the date of adoption. In addition, as allowed under the provisions of SFAS No. 155, we

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

elected to record convertible securities at fair value with changes in the fair value recorded as net gains or losses on securities. At adoption, on January 1, 2007, we recorded an after-tax reclassification, which increased retained earnings and decreased other comprehensive income by $9.8 million, which represented the cumulative adjustment to fair value.

A summary of our derivative assets and liabilities, as of and for the periods indicated, is as follows:

 

Balance Sheets (In millions)

   March 31
2008
    December 31
2007
 

Derivative assets:

    

Financial Guaranty credit derivative assets

   $ 138.2     $ 8.0  

NIMS VIE derivative assets

     16.5       —    

Put options on CPS (1)

     78.0       35.2  
                

Total derivative assets

     232.7       43.2  
                

Derivative liabilities:

    

Financial Guaranty credit derivative liabilities

     349.9       785.6  

NIMS

     232.1       433.9  

Mortgage Insurance domestic and international CDS

     121.4       86.2  
                

Total derivative liabilities

     703.4       1,305.7  
                

Total derivative liabilities, net

   $ (470.7 )   $ (1,262.5 )
                

These amounts represent gross unrealized gains and gross unrealized losses on derivative assets and liabilities.

The notional value of our derivative contracts at March 31, 2008 and December 31, 2007 was $59,021 million and $57,707 million, respectively.

The components of the gain (loss) included in change in fair value of derivative instruments are as follows:

 

     Three Months Ended
March 31
 

Statements of Operations (In millions)

       2008             2007      

Net premiums earned – derivatives (2)

   $ 25.2     $ 34.6  

Financial Guaranty credit derivative liabilities

     580.9       25.1  

NIMS

     96.5       1.4  

Mortgage Insurance domestic and international CDS

     (32.3 )     (12.7 )

Put options on CPS (1)

     41.4       —    

Other

     (3.9 )     —    
                

Change in fair value of derivative instruments

   $ 707.8     $ 48.4  
                

 

(1) Prior to the fourth quarter of 2007, this amount was immaterial to the condensed consolidated financial statements.
(2) In previous periods, net premiums earned on derivatives were reported in premiums earned in our condensed consolidated statements of operations. This reclassification is the result of a financial guaranty industry-wide effort, in consultation with the SEC, to present the results from credit derivative transactions consistently.

The application of SFAS No. 133, as amended, could result in volatility from period to period in gains and losses as reported on our condensed consolidated statements of operations. Generally, these gains and losses result from changes in corporate credit or asset-backed spreads and changes in the creditworthiness of underlying corporate entities or the credit performance of the assets underlying an asset-backed security. Any incurred gains or losses on our financial guaranty contracts that are accounted for as derivatives are recognized as a change in the fair value of derivative instruments. Beginning in the first quarter of 2008, as required by the provisions of

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

SFAS No. 157, we also incorporated factors to include our own non-performance risk. This change in methodology resulted in a one-time increase in the change in fair value of derivative instruments of $2.1 billion. We cannot predict the effect the volatility potentially created by the application of SFAS No. 157 may have on our financial position or results of operations for future periods.

4. Variable Interest Entities

As a provider of credit enhancement, we periodically transact with entities that may be VIEs. VIEs are corporations, trusts or partnerships that are established for a limited purpose and must be evaluated in accordance with the guidance in FASB Interpretation No. 46, “Consolidation of Variable Interest Entities (revised)—an interpretation of ARB No. 51” (“FIN No. 46R”). Special purpose entities (“SPEs”), by their nature, are generally not controlled by their equity owners, as the establishing documents govern all material decisions. In accordance with FIN No. 46R, we consolidate VIEs in which we are the primary beneficiary of the variable interests, or a combination of variable interests, that will either (i) absorb a majority of the VIE’s expected losses, (ii) receive a majority of the VIE’s expected residual returns or (iii) both. To determine if we are the primary beneficiary of a VIE, we review, among other factors, the VIE’s design, capital structure, contractual terms, which interests create or absorb variability and related party relationships, if any. Additionally, we may calculate our share of the VIE’s expected losses and expected residual returns based upon the VIE’s contractual arrangements and/or our position in the VIE’s capital structure.

Mortgage Insurance—We guarantee the payment of principal and interest on NIMS which are structured as qualifying special purpose entities. There are certain control provisions in our guarantee contracts that give us the ability to call the NIMS upon certain events of contractual non-performance of third parties. Under these circumstances, the VIE would not be exempt from consolidation considerations under FIN No. 46R. At March 31, 2008, there were 12 such transactions requiring consolidation in our condensed consolidated balance sheets. The amount included in other assets and variable interest entity debt related to these trusts was $16.5 million and $100.2 million, respectively. The consolidated NIMS assets are treated as derivatives in accordance with SFAS No. 133, and recorded at fair value. The consolidated NIMS VIE debt is recorded at fair value as allowed by the provisions of SFAS No. 159.

The following is summary information related to NIMS trusts as of the dates indicated:

 

     March 31, 2008

(in millions)

VIE Assets

   Trust
Assets
   Subordination
Below Our
Exposure
   Average
Rating of
Collateral
at Inception
   NIMS
Exposure

NIMS

   $ 607.6    $ 85.3    BBB to BB    $ 522.3

 

     December 31, 2007

(in millions)

VIE Assets

   Trust
Assets
   Subordination
Below Our
Exposure
   Average
Rating of
Collateral
at Inception
   NIMS
Exposure

NIMS

   $ 704.0    $ 100.0    BBB to BB    $ 604.0

Financial Guaranty—Our involvement with VIEs has a material role in our financial guaranty business as a guarantor of beneficial interests held by third party investors. Our guarantees in the financial guaranty business generally are structured as financial guarantees or credit default swaps guaranteeing principal and interest payments to beneficial interest holders. In certain of these VIEs, we could potentially be the primary beneficiary of the entity’s variable interests through our participation in the VIE and certain beneficial interests. Consequently, we would be required to consolidate the assets and liabilities of the VIE. At March 31, 2008, there were no VIEs that required consolidation in our financial guaranty business.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

5. Investments

We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments classified as available for sale are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. Investments classified as trading securities are reported at fair value, with unrealized gains and losses reported as a separate component of income. Amortization and accretion are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method.

In accordance with SFAS No. 155, effective January 1, 2007, all changes in the fair value of the entire convertible security are recorded as net gains or losses on securities in our condensed consolidated statements of operations. Our transition adjustment related to the adoption of SFAS No. 155 increased retained earnings at January 1, 2007 by $9.8 million, and reduced accumulated other comprehensive income by the same amount. The transition amount includes unrealized gains of $14.1 million (net of tax) and unrealized losses of $4.3 million (net of tax) related to convertible securities at December 31, 2006.

For securities in our investment portfolio, we conduct a quarterly evaluation of declines in market value of the securities to determine whether the decline is other-than-temporary. If a security’s fair value is below the cost basis, and it is judged to be an other-than-temporary decline, the cost basis of the individual security is written down to fair value through earnings as a realized loss and the fair value becomes the new basis for the security. During the first quarter of 2008, we recorded approximately $14.0 million of charges related to declines in the fair value of securities (primarily municipal securities and taxable bonds) considered to be other-than-temporary compared to $0.6 million in the first quarter of 2007. At March 31, 2008 and 2007, there were no other investments held in the portfolio that were determined to be other-than-temporarily impaired.

Our evaluation of market declines for other-than-temporary impairment is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors regarding the issuer of the security and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by us in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost, (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties, (iii) the potential for impairments in an entire industry sector or sub-sector, (iv) the potential for impairments in certain economically depressed geographic locations, (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources, (vi) our ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost, (vii) unfavorable changes in forecasted cash flows on asset-backed securities and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired (in thousands), aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2008.

 

     Less Than 12 Months    12 Months or Greater    Total

Description of Securities

   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses

U.S. government securities

   $ —      $ —      $ 201    $ 2    $ 201    $ 2

State and municipal obligations

     1,369,333      87,179      173,377      19,577      1,542,710      106,756

Corporate bonds and notes

     34,844      1,593      11,532      587      46,376      2,180

Asset-backed securities

     42,909      713      43,007      760      85,916      1,473

Private placements

     4,495      118      2,217      73      6,712      191

Foreign governments

     16,562      131      74,729      1,972      91,291      2,103

Equity securities

     37,770      3,732      —        —        37,770      3,732
                                         

Total

   $ 1,505,913    $ 93,466    $ 305,063    $ 22,971    $ 1,810,976    $ 116,437
                                         

U.S. government securities

The unrealized losses of 12 months or greater duration as of March 31, 2008 on our investments in U.S. Treasury obligations were caused by interest rate movement. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2008.

State and municipal obligations

The unrealized losses of 12 months or greater duration as of March 31, 2008 on our investments in tax-exempt state and municipal securities were caused primarily by interest rate movement. Certain securities, mainly those insured by monoline insurance companies, experienced credit spread widening during 2007 and 2008 as a result of recent events in the subprime residential mortgage market. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2008.

Corporate bonds and notes

The unrealized losses of 12 months or greater duration as of March 31, 2008 on the majority of the securities in this category were caused by market interest rate movement. Certain securities, mainly those issued by financial firms with exposure to subprime residential mortgages, experienced spread widening during 2007 and 2008. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2008.

Asset-backed securities

The unrealized losses of 12 months or greater duration as of March 31, 2008 on the securities in this category were caused by market interest rate movement. The ABS in our investments are primarily AAA-rated senior tranche positions, collateralized by pools of credit card, auto loan and equipment lease receivables. The ratings of these investments are supported by credit enhancements which include financial guarantor insurance, subordination, over-collateralization and reserve accounts. Most of our ABS investments have retained AAA-ratings; however, two securities now carry Standard & Poor’s Ratings Service (“S&P”) ratings of A+ and A-, respectively, due to recent ratings downgrades of the financial guarantors for these securities. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at March 31, 2008.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

Private placements

The unrealized losses of 12 months or greater duration as of March 31, 2008 on the majority of the securities in this category were caused by market interest rate movement. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at March 31, 2008.

Foreign governments

The unrealized losses of 12 months or greater duration as of March 31, 2008 on the majority of the securities in this category were caused by market interest rate movement. We believe that credit quality did not impact security pricing due to the relative high quality of the holdings (i.e., the majority of the securities were highly-rated governments and government agencies or corporate issues with minimum ratings of single-A). Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2008.

For all investment categories, unrealized losses of less than 12 months in duration were generally attributable to interest rate movement. In addition, certain securities experienced spread widening due to issuers’ exposure to subprime residential mortgages. All securities were evaluated in accordance with our impairment recognition policy covering various time and price decline scenarios. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at March 31, 2008.

The contractual maturity of securities in an unrealized loss position at March 31, 2008 was as follows:

 

(In thousands)

   Fair Value    Amortized
Cost
   Unrealized
Loss

2009

   $ 40,774    $ 41,051    $ 277

2010 – 2013

     60,423      61,253      830

2014 – 2018

     73,985      75,630      1,645

2019 and later

     1,597,973      1,707,918      109,945

Equity securities

     37,821      41,561      3,740
                    

Total

   $ 1,810,976    $ 1,927,413    $ 116,437
                    

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

6. Segment Reporting

We have three reportable segments: mortgage insurance, financial guaranty and financial services. We allocate corporate income and expenses to each of the segments. We evaluate operating segment performance based principally on net income. Summarized financial information concerning our operating segments, as of and for the year-to-date periods indicated, are as follows:

 

     March 31, 2008  
(In thousands)    Mortgage
Insurance
    Financial
Guaranty
    Financial
Services
    Consolidated  

Net premiums written—insurance (1)

   $ 211,251     $ 33,055     $ —       $ 244,306  
                                

Net premiums earned—insurance

   $ 204,265     $ 37,656     $ —       $ 241,921  

Net investment income

     38,845       27,120       14       65,979  

Net losses on securities

     (36,733 )     (18,149 )     (2 )     (54,884 )

Change in fair value of derivative instruments

     71,769       636,040       —         707,809  

Other income

     3,491       121       2       3,614  
                                

Total revenues

     281,637       682,788       14       964,439  
                                

Provision for losses

     571,008       11,703       —         582,711  

Provision for second-lien premium deficiency

     18,090       —         —         18,090  

Policy acquisition costs

     13,460       10,446       —         23,906  

Other operating expenses

     34,170       20,738       233       55,141  

Interest expense

     7,090       5,154       249       12,493  
                                

Total expenses

     643,818       48,041       482       692,341  
                                

Equity in net income of affiliates

     —         —         12,526       12,526  
                                

Pretax (loss) income

     (362,181 )     634,747       12,058       284,624  

(Benefit) provision for income taxes

     (135,725 )     219,219       5,492       88,986  
                                

Net (loss) income

   $ (226,456 )   $ 415,528     $ 6,566     $ 195,638  
                                

Total assets

   $ 5,001,689     $ 3,133,958     $ 118,378     $ 8,254,025  

Total investments

     4,051,596       2,508,351       —         6,559,947  

Deferred policy acquisition costs

     62,860       176,540       —         239,400  

Reserve for losses and loss adjustment expenses

     1,741,169       160,959       —         1,902,128  

Derivative liabilities

     353,559       349,846       —         703,405  

Unearned premiums

     365,161       709,428       —         1,074,589  

Stockholders’ equity

     1,328,594       1,412,429       126,333       2,867,356  

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

     March 31, 2007
(In thousands)    Mortgage
Insurance
   Financial
Guaranty
    Financial
Services
    Consolidated

Net premiums written—insurance (1)

   $ 206,411    $ 42,019     $ —       $ 248,430
                             

Net premiums earned—insurance

   $ 180,243    $ 34,264     $ —       $ 214,507

Net investment income

     35,559      25,437       —         60,996

Net gains (losses) on securities

     11,123      2,824       (202 )     13,745

Change in fair value of derivative instruments

     4,338      44,079       —         48,417

Other income

     2,849      140       829       3,818
                             

Total revenues

     234,112      106,744       627       341,483
                             

Provision for losses

     112,854      (5,812 )     —         107,042

Policy acquisition costs

     16,523      11,731       —         28,254

Other operating expenses

     39,600      14,235       3,860       57,695

Interest expense

     6,854      4,596       1,606       13,056
                             

Total expenses

     175,831      24,750       5,466       206,047
                             

Equity in net income of affiliates

     —        —         22,772       22,772
                             

Pretax income

     58,281      81,994       17,933       158,208

Provision for income taxes

     13,579      24,078       7,084       44,741
                             

Net income

   $ 44,702    $ 57,916     $ 10,849     $ 113,467
                             

Total assets

   $ 4,774,210    $ 2,757,800     $ 592,898     $ 8,124,908

Total investments

     3,567,581      2,378,387       —         5,945,968

Deferred policy acquisition costs

     67,835      157,762       —         225,597

Reserve for losses and loss adjustment expenses

     676,691      175,771       —         852,462

Unearned premiums

     277,135      697,633       —         974,768

Stockholders’ equity

     2,322,374      1,457,712       394,690       4,174,776

 

(1) With the exception of trade credit reinsurance products, net premiums written in our financial guaranty reinsurance business are recorded using actual information received from cedants on a one month lag basis. Accordingly, the net premiums written for any given period, exclude those from the last month of that period and include those from the last month of the immediately preceding period. The use of information from cedants does not require us to make significant judgments or assumptions because historic collection rates and counterparty strength make collection of all assumed premiums highly likely. There were no material trade credit reinsurance premiums written for the three months ended March 31, 2008 or 2007.

A reconciliation of segment net (loss) income to consolidated net (loss) income is as follows:

 

     Three Months Ended
March 31
Consolidated (In thousands)    2008     2007

Net (loss) income:

    

Mortgage Insurance

   $ (226,456 )   $ 44,702

Financial Guaranty

     415,528       57,916

Financial Services

     6,566       10,849
              

Total

   $ 195,638     $ 113,467
              

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

For the quarters ended March 31, 2008 and 2007, our domestic premiums earned from all of our segments were $255.7 million and $238.9 million, respectively, and our premiums earned attributable to foreign countries were approximately $11.4 million and $10.2 million, respectively. In addition, long-lived assets located in foreign countries were immaterial for the periods presented.

In the mortgage insurance segment, the highest state concentration of primary risk in force at March 31, 2008, was California at 9.1%, compared to 7.9% at March 31, 2007. At March 31, 2008, California accounted for 11.8% of the mortgage insurance segment’s total direct primary insurance in force, compared to 11.9% at March 31, 2007, and 11.4% of the mortgage insurance segment’s total pool risk in force at March 31, 2008, compared to 11.2% at March 31, 2007. California also accounted for 11.6% of the mortgage insurance segment’s primary new insurance written in the first quarter of 2008 compared to 30.0% for the first quarter of 2007.

The largest single customer of our mortgage insurance segment (including branches and affiliates of such customer), measured by primary new insurance written, accounted for 18.1% of primary new insurance written in the first quarter of 2008 compared to 44.2% in the first quarter of 2007.

The financial guaranty segment derives a substantial portion of its premiums written from a small number of direct primary insurers. In the first quarter of 2008, two primary insurers accounted for approximately $19.8 million or 42.6% of the financial guaranty segment’s gross written premiums. In the first quarter of 2007, two primary insurers accounted for approximately $20.2 million or 36.4% of the financial guaranty segment’s gross written premiums. No other primary insurer accounted for more than 10% of the financial guaranty segment’s gross written premiums during the first quarter of 2008 or 2007. Gross written premiums and net written premiums are not materially different because we do not cede a material amount of business to reinsurers.

7. Investment in Affiliates

We have a 46.0% equity interest in C-BASS and a 21.8% equity interest in Sherman.

The following table shows the components that make up the investment in affiliates balance:

 

(In thousands)    March 31
2008
   December 31
2007

C-BASS

   $ —      $ —  

Sherman

     116,929      104,315

Other

     40      39
             

Total

   $ 116,969    $ 104,354
             

C-BASS

Historically, C-BASS had principally been engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages. As a result of the disruption in the subprime mortgage market during 2007, C-BASS ceased purchasing mortgages and mortgage securities and its securitization activities in the third quarter of 2007 and sold its loan servicing portfolio in the fourth quarter of 2007. On July 29, 2007, we concluded that there were indicators that a material charge for impairment of our investment in C-BASS was required under GAAP. In November 2007, we received financial statements from C-BASS as of September 30, 2007, at which point we made a final determination with respect to impairment.

 

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Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

We account for our investment in C-BASS under the equity method of accounting in accordance with APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (“APB Opinion No. 18”). During the third quarter of 2007, C-BASS incurred a loss of $935 million and in accordance with APB Opinion No. 18, we recognized our portion of losses of approximately $441 million. This resulted in a reduction in our equity investment in C-BASS from $468 million to $27 million at September 30, 2007. In addition to the recognition of losses, we completed an impairment analysis which resulted in the charge-off of the remaining carrying value of $27 million in the equity investment in C-BASS at September 30, 2007.

EITF No. 98-13, “Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee” (“EITF No. 98-13”), requires that when the recognition of equity losses reduces our equity investment to zero, we should continue to report our share of equity method losses in our income statement and should apply those equity method losses to our other investments in C-BASS. As a result of the additional losses at C-BASS, and continued application of APB Opinion No. 18 and EITF No. 98-13, we recorded a full write-off of our $50 million credit facility with C-BASS. The ultimate collectibility of this loan is uncertain.

Sherman

2007 Sale of Partial Interest.    On September 19, 2007, we sold to Sherman Capital, L.L.C. (“Sherman Capital”), an entity owned by the management of Sherman: (1) all of our preferred interests in Sherman and (2) 1,672,547 Class A Common Units in Sherman, representing approximately 43.4% of our total common interests in Sherman, for a cash purchase price of approximately $277.6 million, plus a future contingent payment. The amount of the contingent payment, if any, will depend on the extent that Sherman Capital’s after-tax return on 1,425,335 of the Class A Common Units acquired in the transaction exceeds approximately 16% annually. The contingent payment is payable to us on December 31, 2013 or earlier upon the closing of a sale of Sherman. We recorded a gain of $181.7 million on the sale of our interest in Sherman in the third quarter of 2007.

2007 Option Granted to Sherman’s Management.    On September 19, 2007, in connection with the sale of a portion of our equity interests in Sherman, we entered into an Option Agreement with Meeting Street Investments LLC (“MS LLC”), an entity owned by Sherman’s management. Under the Option Agreement, we granted to MS LLC an irrevocable option (the “Call Option”) to require us to sell to MS LLC all of our interests in Sherman at any time during the one year period following September 19, 2007. The purchase price under the Call Option, if exercised, will be equal to: (1) the product of (a) our ownership percentage in Sherman as of the date of sale under the Option Agreement and (b) $1.5 billion, minus (2) 50% of all future distributions made by Sherman with respect to our remaining interests in Sherman through the date of sale under the Option Agreement. The Option Agreement terminates one year from September 19, 2007. We estimated that this call option had a fair value of $0 at March 31, 2008 and December 31, 2007.

 

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Radian Group Inc.

Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

     Three Months Ended
March 31
 
     2008    2007  
(In thousands)            

Investment in Affiliates-Selected Information:

     

C-BASS

     

Balance, beginning of period

   $ —      $ 451,395  

Share of net loss for period

     —        (6,804 )

Dividends received

     —        —    
               

Balance, end of period

   $ —      $ 444,591  
               

Sherman

     

Balance, beginning of period

   $ 104,315    $ 167,412  

Share of net income for period

     12,526      29,576  

Dividends received

     —        51,512  

Other comprehensive income

     88      (1,778 )
               

Balance, end of period

   $ 116,929    $ 143,698  
               

Portfolio Information:

     

Sherman

     

Total assets

   $ 2,383,119    $ 1,234,046  

Total liabilities

     1,897,620      1,001,137  

Summary Income Statement:

     

Sherman

     

Income

     

Revenues from receivable portfolios—net of amortization

   $ 285,965    $ 251,955  

Other revenues

     12,177      5,516  
               

Total revenues

     298,142      257,471  
               

Expenses

     

Operating and servicing expenses

     192,490      140,161  

Interest

     23,582      13,583  

Other

     18,123      22,624  
               

Total expenses

     234,195      176,368  
               

Net income

   $ 63,947    $ 81,103  
               

 

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Radian Group Inc.

Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

8. Losses and Loss Adjustment Expenses (“LAE”)—Mortgage Insurance

The following table reconciles our mortgage insurance segment’s beginning and ending reserves for losses and LAE for the quarter ended March 31, 2008 (in thousands):

 

Mortgage Insurance

  

Balance at January 1, 2008

   $ 1,345,452

Less Reinsurance recoverables

     21,988
      

Balance at January 1, 2008, net

     1,323,464

Add total losses and LAE incurred in respect of default notices received

     571,008

Deduct total losses and LAE paid in respect of default notices received

     190,188
      

Balance at March 31, 2008, net

     1,704,284

Add Reinsurance recoverables

     36,885
      

Balance at March 31, 2008

   $ 1,741,169
      

9. Reserve for Second-Lien Premium Deficiency

The following table reconciles our mortgage insurance segment’s beginning and ending reserves for second-lien premium deficiency for the quarter ended March 31, 2008 (in thousands):

 

Balance at January 1, 2008

   $ 195,646  

Add:

  

Net increase in expected ultimate losses

     61,408  

Net decrease in expected ultimate premiums and unearned premium reserve

     15,736  

Deduct:

  

Increase in second-lien reserves

     (59,054 )
        

Balance at March 31, 2008

   $ 213,736  
        

The increase in expected loss was due to incremental deterioration in the seasoned portion of our second-lien portfolio, comprised of transactions written in 2005 or earlier.

10. Long-Term Debt and Other Borrowings

The composition of our long-term debt and other borrowings at March 31, 2008 and December 31, 2007 was as follows:

 

(In thousands)

   March 31
2008
   December 31
2007

5.625% Senior Notes due 2013

   $ 259,976    $ 254,292

7.75% Debentures due 2011

     249,611      249,585

5.375% Senior Notes due 2015

     249,657      249,647

Borrowings under unsecured revolving credit facility

     200,000      200,000
             
   $ 959,244    $ 953,524
             

 

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Radian Group Inc.

Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

In February 2003, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.625% per annum, payable semi-annually on February 15 and August 15. These notes mature in February 2013. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed. In April 2004, we entered into interest-rate swap contracts that effectively convert the interest rate on this fixed-rate debt to a variable rate based on a spread over the six-month London Interbank Offered Rate (“LIBOR”). We terminated these swaps in January 2008. The basis adjustment of $11.5 million that was recorded as an increase to the long-term debt carrying value is being amortized to interest expense.

We have a $400 million revolving credit facility, from which we have drawn down $200 million in principal amount. On April 30, 2008, we entered into an amendment to the credit facility, which will become effective following satisfaction of certain limited closing conditions. The amendment, upon effectiveness, will modify the credit agreement and related loan documents, among other things, by (a) reducing the commitment size from $400 million to $250 million (with further reductions to a minimum of $150 million to take place if certain repayment events occur), (b) increasing the pricing under the credit agreement, (c) eliminating the ratings covenant contained in Section 6.10 of the credit agreement, and (d) securing the credit agreement with a security interest in certain collateral.

The security interest would be affected primarily through a lien in favor of the lenders to the facility in (i) our ownership interests in certain of our first-tier subsidiaries and (ii) substantially all our other personal property. In addition, we would grant a lien in our ownership interest in Radian Guaranty in favor of the lenders to the facility and the holders of the securities issued under our public indentures.

Under the amended credit agreement, we and our material subsidiaries will be subject to a number of other business and financial covenants and events of default, including without limitation, maintaining at all times a Consolidated Net Worth (as defined in the amended credit agreement) of not less than $1,750,000,000, plus an amount equal to 75% of the net proceeds of any equity issuance following the effective date of the amendment, subject to certain limited qualifications. The credit agreement, as modified by the amendment, would upon effectiveness, contain limitations on indebtedness, liens, mergers, consolidations, liquidations and sales, payment of dividends, investments, loans and advances and optional payments and modifications of subordinated and other debt instruments.

Modifications by the amendment of certain events of default under the credit agreement include (a) the reduction of certain grace periods applicable to existing events of default, (b) the addition of a new event of default in the case of a default under any one or more of the security documents to be executed in connection with the amendment), (c) a cross-default to other indebtedness, and (d) the occurrence of certain events with respect to any of our material insurance subsidiaries.

On April 9, 2008, we entered into a Limited Conditional Waiver Agreement, in which the lenders to our credit agreement agreed to waive for a limited period of time the ratings covenant contained in Section 6.10 of the credit agreement. The temporary suspension of the rating covenant under the Waiver Agreement will end on the earliest to occur of: (i) effectiveness of the amendment referenced above, (ii) any event of default (other than one occurring as a result of the ratings covenant) under the credit agreement or (iii) May 15, 2008. We may not borrow any additional amounts under the credit agreement while the Waiver Agreement is in place. Under the Waiver Agreement, we must pay increased interest on amounts borrowed and pay an increased facility fee.

 

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Radian Group Inc.

Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

11. Recent Accounting Pronouncements

In March 2008, the FASB issued SFAS No.161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (“SFAS No.161”). SFAS No. 161 requires increased qualitative, quantitative and credit–risk disclosures including: (a) how and why an entity is using a derivative instrument or hedging activity, (b) how the entity is accounting for its derivative instrument and hedged items under SFAS No. 133 and (c) how the instrument affects the entity’s financial position, financial performance and cash flows. SFAS No. 161 also amends SFAS No. 107, “Disclosures about Fair Value of Financial Instruments” (“SFAS No. 107”) to clarify that derivative instruments are subject to SFAS No. 107’s concentration–of–credit–risk disclosures. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. Management currently is considering the impact and disclosure requirements that may result from the adoption of SFAS No. 161.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of APB No. 51” (“SFAS No. 160”). The objective of SFAS No. 160 is to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in consolidated financial statements by establishing accounting and reporting standards. These standards require that: (i) the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; (ii) the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of operations; (iii) changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently; (iv) when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value and (v) entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. Management currently is considering the impact and disclosure requirements that may result from the adoption of SFAS No. 160.

12. Selected Financial Information of Registrant—Radian Group Inc.

The following is selected financial information for the parent company:

 

(In thousands)

   March 31
2008
   December 31
2007

Investment in subsidiaries, at equity in net assets

   $ 3,660,843    $ 3,496,089

Total assets

     3,868,831      3,709,285

Long-term debt and other borrowings

     959,244      953,524

Total liabilities

     1,001,475      988,549

Total stockholders’ equity

     2,867,356      2,720,736

Total liabilities and stockholders’ equity

     3,868,831      3,709,285

13. Commitments and Contingencies

As previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007, in August and September 2007, two purported stockholder class action lawsuits, Cortese v. Radian Group Inc. and Maslar v. Radian Group Inc., were filed against Radian Group Inc. and individual defendants in the U.S. District Court for the Eastern District of Pennsylvania. The complaints, which are substantially similar, allege that we were aware of and failed to disclose the actual financial condition of C-BASS prior to our declaration of a material impairment to our investment in C-BASS. On January 30, 2008, the Court ordered that the cases be consolidated into In re Radian Securities Litigation and appointed the Institutional Investors Iron Workers Local

 

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Radian Group Inc.

Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

No. 25 Pension Fund (“Iron Workers”) and the City of Ann Arbor Employees’ Retirement System (“Ann Arbor”) Lead Plaintiffs in the case. On April 16, 2008, a consolidated and amended complaint was filed, adding one additional defendant. Our motion for summary judgment is due by June 1, 2008. While it is still very early in the pleadings stage, we do not believe that the allegations in the consolidated cases have any merit and we intend to defend against this action vigorously.

In April 2008, a purported class action lawsuit was filed against Radian Group Inc., the Compensation and Human Resources Committee of our board of directors and individual defendants in the U.S. District Court for the Eastern District of Pennsylvania. The complaint alleges violations of the Employee Retirement Income Securities Act as it relates to our Savings Incentive Plan. The named plaintiff is a former employee of Radian. Although discovery has not yet commenced, Radian believes that the allegations are without merit, and intends to defend this lawsuit vigorously.

In addition to the above litigation, we are involved in litigation that has arisen in the normal course of our business. We are contesting the allegations in each such pending action and believe, based on current knowledge and after consultation with counsel, that the outcome of all litigation will not have a material adverse effect on our condensed consolidated financial position and results of operations.

On October 3, 2007, we received a letter from the staff of the Chicago Regional Office of the Securities Exchange Commission stating that the staff is conducting an investigation involving Radian Group Inc. and requesting production of certain documents. We believe that the investigation generally relates to our proposed merger with MGIC and our investment in C-BASS. We are cooperating with the requests of the SEC. The SEC staff has informed us that this investigation should not be construed as an indication by the Commission or its staff that any violation of the securities laws has occurred, or as a reflection upon any person, entity or security.

Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of asset-backed (including mortgage-backed) securities. To allow our customers to comply with these regulations, we typically are required, depending on the amount of credit enhancement we are providing, to provide (1) audited financial statements for the insurance subsidiary participating in the transaction or (2) a full and unconditional holding-company-level guarantee for our insurance subsidiaries’ obligations in such transactions. To date, Radian Group Inc. has guaranteed two structured transactions for Radian Guaranty involving approximately $363.3 million of remaining credit exposure.

Funding of Rabbi Trusts. Under our change of control agreements with our executive officers, upon a change of control of Radian Group Inc. or Radian Asset Assurance, as the case may be, we are required to fund an irrevocable rabbi trust to the extent of our obligations under these agreements. The total maximum amount that we would be required to place in trust is approximately $17.0 million as of March 31, 2008.

As part of the non-investment-grade allocation component of our investment program, we have committed to invest $55 million in alternative investments ($23.8 million of unfunded commitment at March 31, 2008) that are primarily private equity securities. These commitments have capital calls over a period of at least six years, and certain fixed expiration dates or other termination clauses.

We also utilize letters of credit to back assumed reinsurance contracts, medical insurance policies and an excise tax-exemption certificate used for ceded premiums from our domestic operations to our international operations. These letters of credit are with various financial institutions, have terms of one-year and will automatically renew unless we specify otherwise. The letters of credit outstanding at March 31, 2008 and December 31, 2007 were $10.9 million and $10.8 million, respectively.

 

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Radian Group Inc.

Notes to Unaudited Condensed Consolidated Financial Statements—(Continued)

 

Our mortgage insurance business utilizes its underwriting skills to provide an outsourced underwriting service to its customers. We give recourse to our customers on loans we underwrite for compliance. Typically, we agree that if we make a material error in underwriting a loan, we will remedy, indemnify, make whole, repurchase, or place additional mortgage insurance coverage on the loan. Providing these remedies means we assume some credit risk and interest-rate risk if an error is found during the limited remedy period in the agreements governing these services. We paid losses for sales and remedies from reserves in the first quarter of 2008 of approximately $0.9 million, and our reserve for such expenses at March 31, 2008 was $2.3 million. We closely monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis.

Our financial guaranty insurance business has entered into reinsurance agreements with several monoline financial guaranty primary insurers. These reinsurance agreements generally are subject to termination (i) upon written notice by either party (ranging from 90 to 120 days) before the specified deadline for renewal, (ii) at the option of the ceding company if we fail to maintain applicable ratings or certain financial, regulatory and rating agency criteria, or (iii) upon certain changes of control. Upon termination under the conditions set forth in (ii) and (iii) above, we may be required (under some of our reinsurance agreements) to return to the ceding company all unearned premiums, less ceding commissions, attributable to reinsurance ceded pursuant to such agreements. Upon the occurrence of the conditions set forth in (ii) above, regardless of whether or not an agreement is terminated, we may be required to obtain a letter of credit or alternative form of security to collateralize our obligation to perform under such agreement or we may be obligated to increase the level of ceding commission paid.

A downgrade of the ratings assigned to our financial guaranty subsidiaries below certain levels (both A- and below investment grade for S&P and below A3 for Moody’s) would allow counterparties in seven of our synthetic credit default swap transactions, representing an aggregate notional amount of approximately $1.2 billion, to terminate these transactions. Upon the termination of any such transaction following a downgrade trigger, the transaction would be settled on a mark-to-market basis, meaning that if, based on third-party bids received, a replacement counterparty would require amounts in addition to the payments we receive under the transaction in order to take over our position in the transaction, we would be required to pay such amounts to our counterparty, and if such third party would pay our counterparty to take over our position, our counterparty would pay such amount to us upon termination. The maximum amount that we could be required to pay on all these transactions in the aggregate is: $61.2 million in the event of a downgrade below A- by S&P; $414.5 million in the event of a downgrade below investment grade by S&P; and $8.0 million in the event of a downgrade below A3 by Moody’s.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following analysis should be read in conjunction with our condensed consolidated financial statements and the notes thereto included in this report and our audited financial statements, notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Form 10-K for the fiscal year ended December 31, 2007 for a more complete understanding of our financial position and results of operations.

Business Summary

Our principal business segments are mortgage insurance, financial guaranty and financial services. The following table shows the allocation of our equity to our three business segments at March 31, 2008:

 

     Equity  

Mortgage Insurance

   46.3 %

Financial Guaranty

   49.3 %

Financial Services

   4.4 %

Mortgage Insurance

Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions located throughout the U.S. and in limited, select countries outside the U.S. We provide these products and services mainly through our wholly-owned subsidiaries, Radian Guaranty Inc., Amerin Guaranty Corporation, and Radian Insurance Inc. (which we refer to as “Radian Guaranty,” “Amerin Guaranty,” and “Radian Insurance,” respectively). Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made mostly to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to Freddie Mac and Federal National Mortgage Association (“Fannie Mae”). We refer to Freddie Mac and Fannie Mae as “Government Sponsored Enterprises” or “GSEs”.

Traditional Mortgage Insurance.    Our mortgage insurance segment, through Radian Guaranty, offers primary and pool mortgage insurance coverage on residential first-lien mortgages. At March 31, 2008, primary insurance on domestic first-lien mortgages made up approximately 91.6% of our total domestic first-lien mortgage insurance risk in force, and pool insurance on domestic first-lien mortgages made up approximately 8.4% of our total domestic first-lien mortgage insurance risk in force.

Non-Traditional Mortgage Credit Enhancement.    We have used Radian Insurance to provide credit enhancement for mortgage-related capital market transactions through credit default swaps (“CDS”) and to write credit insurance on mortgage-related assets, including net interest margin securities (“NIMS”), international insurance and reinsurance transactions, second-lien mortgages, home equity loans (collectively, we refer to the risk associated with these transactions as “other risk”). We also insured second-lien mortgages through Amerin Guaranty. We are no longer writing insurance on NIMS or second-lien mortgages, and are no longer using credit default swaps to insure mortgage collateral in our mortgage insurance business.

International Mortgage Insurance.    We have written our existing international mortgage insurance business through Radian Insurance. Standard & Poor’s Ratings Service (“S&P”) downgraded Radian Insurance from AA- to A- on February 26, 2008 and to BBB on April 8, 2008. Of the eight active international transactions, six have early termination clauses that have been triggered as a result of the downgrades, which allow our counterparties to terminate these transactions. On March 4, 2008, Standard Chartered Bank in Hong Kong informed us that they wished to terminate their contract with Radian Insurance, effective immediately. There is a possibility that Radian Insurance could be required to return to Standard Chartered Bank, or to transfer to another

 

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insurer, unearned premiums related to this transaction. Unless extended, this transaction was expected to expire at the end of 2009. If the remaining five transactions also are terminated, we could be required to return or transfer to another insurer, additional unearned premiums. We believe the S&P downgrades will make it difficult for us to continue to write international mortgage insurance business through Radian Insurance, and we are in the process of exploring other alternatives for writing such business.

Financial Guaranty

Our financial guaranty segment mainly insures and reinsures credit-based risks. Financial guaranty insurance typically provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due.

Our financial guaranty segment currently offers the following products:

 

   

Public Finance. Insurance of public finance obligations, including tax-exempt and taxable indebtedness of states, counties, cities, special service districts, other political subdivisions and tribal finance and for enterprises such as airports, public and private higher education and health care facilities, project finance and private finance initiative assets in sectors such as schools, healthcare and infrastructure projects. The issuers of public finance obligations we insure are typically rated investment-grade without the benefit of our insurance;

 

   

Structured Finance. Insurance of structured finance obligations, including asset-backed securities (“ABS”), consisting of funded and non-funded (“synthetic”) obligations that are payable from or tied to the performance of a specific pool of assets. Examples of the pools of assets that underlie structured finance obligations include corporate loans and bonds, residential and commercial mortgages, a variety of consumer loans, tax credits, equipment receivables and real and personal property leases. The structured finance obligations we insure are generally rated investment-grade at the time we issue our insurance policy, without the benefit of our insurance;

 

   

Financial Solutions. Financial solutions products (which we include as part of our structured finance business), including guaranties of securities exchange clearinghouses, excess-Securities Investor Protection Corporation (“SIPC”) insurance for customers of brokerage firms and excess-Federal Deposit Insurance Corporation (“FDIC”) insurance for customers of banks; and

 

   

Reinsurance. Reinsurance of domestic and international public finance obligations, including those issued by sovereign and sub-sovereign entities, as well as reinsurance of structured finance and financial solutions obligations.

In October 2005, we exited the trade credit reinsurance line of business. Accordingly, this line of business has been placed into run-off and we have ceased initiating new trade credit reinsurance contracts.

In March 2008, we decided to discontinue, for the foreseeable future, writing new insurance on synthetic collateralized debt obligations (“CDOs”) and have significantly reduced our structured products operations, primarily in areas related to CDOs. This decision was based on the deterioration and uncertainties in the credit markets in which we and other financial guarantors participate, which has significantly reduced the volume of CDOs and other structured products that are available for our insurance. We now plan to focus our structured finance efforts in the areas of infrastructure finance (providing credit protection on essential public finance initiatives, public-private partnerships and project finance projects), financial solutions and ABS involving target niche issuers in well understood sectors and strong credit in non-traditional sectors. Consequently, we expect the overall volume of structured finance business that we insure in 2008 to be significantly below the levels we insured in prior years. However, we continue to maintain a large insured portfolio of CDOs as discussed below under “Results of Operations—Financial Guaranty—Quarter Ended March 31, 2008 Compared to Quarter Ended March 31, 2007.”

 

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International Financial Guaranty Insurance. Radian Asset Assurance Limited (“RAAL”) accounted for $3.8 million (or 16.5%) of financial guaranty’s direct premiums written in the first quarter of 2008, compared to $3.6 million (or 11.6%) of financial guaranty’s direct premiums written in the first quarter of 2007.

Financial Services

Our financial services segment mainly consists of our 21.8% interest in Sherman Financial Group LLC (“Sherman”), a consumer asset and servicing firm. This segment also includes our 46% interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”), a mortgage investment company whose operations are currently in run-off.

Sherman. Sherman specializes in charged-off and bankruptcy plan consumer assets, which are generally unsecured. Sherman typically purchases these assets at deep discounts from national financial institutions and major retail corporations and subsequently seeks to collect upon them. In addition, Sherman originates subprime credit card receivables through its subsidiary CreditOne and has a variety of other similar ventures related to consumer assets. The management of Sherman currently holds an option to purchase our remaining equity interest in Sherman at any time before September 19, 2008. See Note 7 of Notes to Condensed Consolidated Financial Statements.

C-BASS. Historically, C-BASS had been principally engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages. As a result of the disruption in the subprime mortgage market during 2007, C-BASS ceased purchasing mortgages and mortgage securities and its securitization activities in the third quarter of 2007 and sold its loan-servicing platform in the fourth quarter of 2007. The orderly run-off of C-BASS’s business is dictated by an override agreement under which we and all of C-BASS’s owners and creditors are parties. The agreement provides the basis for the collection and distribution of cash generated from C-BASS’s whole loans and securities portfolio, as well as the sale of certain assets, including the loan-servicing platform. We recorded a full write-off of our entire equity interest in C-BASS in the third quarter of 2007 and wrote-off our $50 million credit facility with C-BASS in the fourth quarter of 2007. See Note 7 of Notes to Condensed Consolidated Financial Statements.

Overview of Business Results

As a seller of credit protection, our results are subject to macroeconomic conditions and specific events that impact the production environment and credit performance of our underlying insured assets. The current mortgage cycle, characterized by a continuing decline in home prices in certain markets, deteriorating credit performance of mortgage assets—particularly Alternative A (“Alt-A”) and subprime—and reduced liquidity for many participants in the mortgage industry, has had, and we believe will continue to have, a significant negative impact on the results of operations for each of our business segments.

Mortgage Insurance

Traditional Mortgage Insurance

 

   

Defaults.    Further deterioration in the U.S. housing and mortgage credit markets resulted in a 13.6% increase in first-lien defaults during the first quarter of 2008, which compares favorably to the 20.1% increase in first-lien defaults added during the fourth quarter of 2007. We believe the slowdown in the rate of defaults between the two quarters may be due to seasonal factors. Overall, the continuing trend of higher defaults continues to be driven by poor performance of the late 2005 through 2007 vintage books of business, a lack of refinance capacity in the current mortgage market, which has been forcing many borrowers into default, and from home price depreciation in many parts of the U.S. While losses generally have increased across all mortgage insurance product lines, a significant percentage of our increased losses are attributable to Alt-A mortgages. Markets in California and Florida, where housing values are expected to decline significantly and where Alt-A and adjustable rate mortgage (“ARM”) products are prevalent, continue to have a significant negative impact on our mortgage insurance business results.

 

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Loss Provision.    In addition to the increase in new defaults during the first quarter, our mortgage insurance loss provision at March 31, 2008, continued to be negatively impacted by higher loan balances on delinquent loans, higher rates of defaults moving into claim status, a decrease in the cure rate of defaults and an increase in claims paid. Claims paid increased in the first quarter of 2008 to $190.2 million, compared to $95.8 million and $164.7 million for the first and fourth quarters of 2007, respectively. We expect to pay total mortgage insurance claims (including second-liens) of approximately $240 million in the second quarter of 2008 and approximately $1 billion in total in 2008. We believe ultimate losses on our traditional mortgage insurance portfolio will continue to be driven by declining home prices over the next two years in much of the U.S.

 

   

Smart Home/Captives.    We have protected against some of the future losses that may occur related to non-prime and riskier products by reinsuring our exposure through transactions (referred to as “Smart Home”) that effectively transfer risk to investors in the capital markets. Approximately 5.2% of our primary mortgage insurance risk in force was included in Smart Home transactions at March 31, 2008. In these transactions, we reinsure the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions. Ceded premiums written and earned related to Smart Home for the first quarter of 2008 were $3.2 million, while ceded losses recoverable were $21.4 million. In addition to Smart Home, we transfer a substantial portion of our risk to captive reinsurance companies affiliated with our lender-customers. We had approximately 53 active captive reinsurance agreements in place at March 31, 2008, covering approximately 42.2% of our primary risk in force. Ceded premiums related to captives for the first quarter of 2008 were $35.7 million, while ceded losses for the quarter were $5.7 million. Although the amount of ultimate losses we expect to incur in our mortgage insurance business is uncertain, we expect to receive significant reinsurance recoveries from Smart Home and captive reinsurance, beginning in 2009.

 

   

New Insurance Written.    We experienced a 31.7% increase in traditional flow business during the first quarter of 2008 compared to the first quarter of 2007. Overall, primary new insurance written, which includes structured business, decreased by 22.2% in the first quarter of 2008 compared to the first quarter of 2007, largely due to the significant decline in structured business written in the current environment. The market turmoil in 2007 has led to a tightening of our customers’ mortgage underwriting standards as well as a decrease in the volume of mortgage originations. In the fourth quarter of 2007 and in the first quarter of 2008, we implemented a series of changes to our insurance guidelines aimed at improving the long-term profitability of our business. As a result of these changes, we have begun to see a positive shift in our overall business mix. In the first quarter of 2008, approximately 90% of our new business production was prime business, compared to 39% and 77% of new business generated in the first and fourth quarters of 2007, respectively.

 

   

Persistency.    The persistency rate, which is defined as the percentage of insurance in force that remains on our books after any twelve-month period was 77.5% for the twelve months ended March 31, 2008, compared to 69.5% for the twelve months ended March 31, 2007. This increase was mainly due to a decline in refinancing activity from the high levels in 2005 and 2006, as a result of home price depreciation, tighter underwriting standards and an overall decrease in the lending capacity among mortgage originators. In particular, we continue to see increased demand for our traditional mortgage insurance product as alternative products, such as 80-10-10 mortgages, which were a common alternative to mortgage insurance in 2005 and 2006, have declined significantly. The persistency rate for structured products during the twelve months ended March 31, 2008 was 74.3% compared to 78.7% for our flow business. We expect that persistency rates will continue to remain at elevated levels for as long as the current disruption in the housing and mortgage credit markets continues to persist.

Discontinued Non-Traditional Products

 

   

NIMS.    Our exposure to NIMS was $522 million at March 31, 2008, down from $604 million at December 31, 2007. The loans underlying the NIMS bonds that we insure continued to deteriorate

 

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during the first quarter of 2008. Of the $522 million in total exposure to NIMS, approximately $405 million represents the present value of our total expected principal credit losses related to NIMS. The carrying value of our total net liabilities related to NIMS as of March 31, 2008 was $316 million. Our current carrying value is less than the net present value of our total expected credit losses due to the incorporation of the market’s perception of our non-performance risk, in accordance with SFAS No. 157. We continued our loss-mitigation initiatives with respect to NIMS in the first quarter of 2008 by purchasing additional NIMS that we guarantee, which reduced our exposure by $33.9 million.

 

   

Second-lien Mortgages.    We experienced further deterioration in our second-lien insured portfolio during the first quarter of 2008. We increased mortgage insurance reserves related to second-liens by an additional $63 million during the first quarter to approximately $176 million. Our premium deficiency for second-liens also increased during the first quarter by approximately $18 million, resulting in a total premium deficiency reserve for second-liens of approximately $214 million at March 31, 2008. As of March 31, 2008, our total exposure to second-liens was approximately $843 million, down from $925 million at December 31, 2007. Of this amount, approximately $355 million represents a seasoned segment of our portfolio comprised of transactions written in 2005 or earlier, with prime collateral or in which we are in a second loss position. This portion of our second-lien portfolio has been performing generally within our expectations, however, there has been some incremental deterioration during the first quarter of 2008. As of March 31, 2008, we had reserves of approximately $121 million against this portion of the portfolio, or approximately 34% of the total exposure. The remaining $488 million in exposure relates to two groups of structured transactions that have been performing poorly. As of March 31, 2008, we held reserves of approximately $269 million against this portion of the portfolio or approximately 55% of the total exposure. We expect that our second-lien book of business will be almost entirely paid down by 2010.

 

   

Credit Default Swaps.    As of March 31, 2007 and 2008, our total exposure to domestic credit default swaps on residential mortgage-backed securities (“RMBS”) was approximately $212 million. Our current liability, which is recorded at fair value under SFAS No. 157, is $105 million, the substantial majority of which we believe will result in realized credit related losses. In the fourth quarter of 2005, we wrote $7.3 billion in notional value of credit protection in credit default swap form on two large AAA tranches of mortgage-backed securities, one in Germany and one in Denmark. As of March 31, 2008, we had $13 million of cumulative unrealized losses on these transactions. Despite the large notional exposure to this business, which has increased to $8.9 billion at March 31, 2008 due to foreign currency rate changes, our remaining subordination for these transactions is substantial, and we do not currently foresee any reasonable scenario under which we would be liable for credit losses with respect to such exposures.

Financial Guaranty

 

   

Business Environment.    The conditions that created a difficult and challenging business production environment for financial guaranty in the second half of 2007 continued to exist in the first quarter of 2008. These conditions include continued widening credit spreads, a lack of price transparency and illiquidity in some of the structured products obligations that we insure, losses by financial guarantors, including us, on RMBS, CDOs of ABS and other credit positions, uncertainty as to the extent of future losses among all financial guarantors, including us, and perceived instability in the franchise values and ratings of many of the financial guarantors, including us. These conditions have resulted in a material reduction to the financial benefit that our credit protection provides to issuers in the current market of both public and structured finance transactions that we insure and a reduced perceived benefit to holders of insured debt from the financial guaranty insurance we provide. Many transactions that would normally have been marketed with some form of financial guaranty insurance protection continue to either not go to market or be sold without the benefit of financial guaranty insurance. As a result, there is significant reduction in the volume of transactions for which financial guaranty insurance is a viable option, which makes it more difficult for us to write new business in the current credit environment, and reduces the volume of transactions written by companies that cede business to us. Consequently, new

 

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business production, especially in our structured products business remains challenging and volumes remain significantly reduced. If current market conditions continue or worsen, we will continue to face a very difficult and challenging business environment.

 

   

Credit Performance.    The overall credit performance of our financial guaranty portfolio has remained stable during the first quarter of 2008. In the first quarter of 2008, financial guaranty paid claims included $100 million related to our entire exposure on the one direct market value extendable note program in our financial guaranty portfolio, for which we had been fully reserved. See “Results of Operations—Financial Guaranty—Quarter Ended March 31, 2008 Compared to Quarter Ended March 31, 2007” below for a discussion of our exposure to RMBS and commercial mortgage-backed securities (“CMBS”).

Financial Services

Net income for Sherman was down by approximately 21% for the first quarter of 2008 compared to the first quarter of 2007. Higher revenues, particularly from the credit card origination business were more than offset by a higher loan loss provision and higher operating expenses. In addition, the decrease in our ownership percentage from a year ago as a result of the sale of a portion of our interest in Sherman contributed in reducing our equity in earnings from Sherman to $13.9 million for the first quarter of 2008, compared to $33.2 million for the first quarter of 2007.

Our investment in C-BASS, including our $50 million credit facility with C-BASS, has been fully written off as of December 31, 2007.

Results of Operations

Our financial results for the first quarter of 2008 were significantly impacted by unrealized gains and losses on our hybrid securities and our derivative assets and liabilities. Credit spreads on underlying collateral, both corporate credit spreads and asset-backed spreads, widened significantly during the quarter, which resulted in large unrealized losses on these positions. Offsetting these losses, however, is the impact of a change to our valuation methodology, adopted prospectively, that incorporates the market’s perception of our non-performance risk. This change in methodology is required under the provisions of SFAS No. 157. Given the significant widening of our credit default swap spread over the past year, the reduction in the valuation of our derivative liabilities related to our non-performance risk more than offset the credit spread widening on underlying collateral for the current quarter. Below is a table with the detail of the underlying collateral credit spread widening, along with the total impact of the incorporation of our non-performance risk. These two drivers of our fair values can move in tandem or opposite directions, which could result in significant continued volatility of our operating results.

The following table summarizes the pretax and after tax impact of unrealized gains and losses related to our derivatives and hybrid securities that are carried at fair value:

 

     Three Months
Ended

March 31
 
     2008     2007  

Hybrid securities

   $ (55.9 )   $ (3.6 )

Financial guaranty credit derivatives

     (1,330.0 )     25.1  

Mortgage insurance domestic and international CDS

     (32.3 )     (12.7 )

NIMS

     (50.8 )     1.4  

Soft capital put options on committed preferred securities (“CPS”)

     42.8       —    

Impact of cumulative SFAS No. 157 fair value methodology change related to non-performance risk

     2,058.3       —    
                

Pretax gain

     632.1       10.2  

Income tax provision

     221.2       3.6  
                

After-tax gain

   $ 410.9     $ 6.6  
                

 

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Results of Operations—Consolidated

Quarter Ended March 31, 2008 Compared to Quarter Ended March 31, 2007

The following table summarizes our consolidated results of operations for the quarters ended March 31, 2008 and 2007 (in thousands):

 

     Three Months Ended
March 31
   % Change  
     2008     2007    2008 vs. 2007  

Net income

   $ 195,638     $ 113,467    72.4 %

Net premiums written—insurance

     244,306       248,430    (1.7 )

Net premiums earned—insurance

     241,921       214,507    12.8  

Net investment income

     65,979       60,996    8.2  

Net (losses) gains on securities

     (54,884 )     13,745    n/m  

Change in fair value of derivative instruments

     707,809       48,417    n/m  

Other income

     3,614       3,818    (5.3 )

Provision for losses

     582,711       107,042    444.4  

Provision for second-lien premium deficiency

     18,090       —      n/m  

Policy acquisition costs

     23,906       28,254    (15.4 )

Other operating expenses

     55,141       57,695    (4.4 )

Interest expense

     12,493       13,056    (4.3 )

Equity in net income of affiliates

     12,526       22,772    (45.0 )

Income tax provision

     88,986       44,741    98.9  

 

n/m = not meaningful

Net Income.    Net income for the first quarter of 2008 was $195.6 million or $2.44 per share (diluted), compared to $113.5 million or $1.42 per share (diluted) for the first quarter of 2007. The increase in earnings for 2008 was mainly due to the change in fair value of derivative instruments, which incorporates our non-performance risk as a factor in the valuation of financial assets and liabilities as a result of the adoption of SFAS No. 157 on January 1, 2008. The net after-tax impact of unrealized gains and losses on derivatives and hybrid securities was $410.9 million. The on-going disruption in the housing and credit markets continued to negatively affect each of our operating segments during the first quarter of 2008. In particular, our results for 2008 have been negatively impacted by a significant increase in the provision for losses in our mortgage insurance segment, an increase in the premium deficiency for our second-lien product and an increase in net losses on securities due to a continued widening of credit spreads.

Net Premiums Written and Earned.    Consolidated net premiums written for the first quarter of 2008 were $244.3 million, a slight decrease from $248.4 million written in the first quarter of 2007. Consolidated net premiums earned for the first quarter of 2008 were $241.9 million, a $27.4 million or 12.8% increase from $214.5 million earned in the first quarter of 2007. Earned premiums increased as a result of the high volume of primary mortgage insurance written in 2007 and the higher persistency rates experienced in 2007, which have continued into 2008.

Net Investment Income.    Net investment income of $66.0 million for the first quarter of 2008 was up $5.0 million or 8.2% from $61.0 million in the first quarter of 2007. This increase was mainly due to an increase in investable assets.

Net (Losses) Gains on Securities.    Net losses on securities for the first quarter of 2008 were $54.9 million compared to $13.7 million of net gains for the first quarter of 2007. Included in 2008 was $62.7 million of net losses related to changes in the fair value of hybrid securities, primarily convertible bonds, and trading securities. Also included in 2008, was $15.0 million of net gains related to the sales of hybrid securities and $10.0 million of net losses on the sales of available-for-sale securities. We also wrote down $14.0 million of other-than-

 

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temporarily-impaired securities in the first quarter of 2008, which further contributed to the net loss on securities during the quarter. The first quarter of 2007 included $3.6 million of losses related to changes in the fair value of convertible securities.

Change in Fair Value of Derivative Instruments.    For the quarter ended March 31, 2008, the change in fair value of derivative instruments was a net gain of $707.8 million, compared to a net gain of $48.4 million for the quarter ended March 31, 2007. Change in fair value of derivative instruments reflects the impact of the adoption of SFAS No. 157. The increase in the change in fair value of derivative instruments in 2008 was mainly a result of a $580.9 million decrease in the cumulative unrealized loss on financial guaranty derivatives, a $96.5 million decrease in the cumulative unrealized loss related to our NIMS portfolio and a $41.4 million gain related to the value of the put options on our CPS. Offsetting these gains was a $32.3 million increase in the cumulative unrealized loss on credit default swaps. Earned premiums on derivatives were $25.2 million for the first quarter of 2008 compared to $34.6 million for the comparable period of 2007.

Other Income.    Other income decreased to $3.6 million for the first quarter of 2008 from $3.8 million for the first quarter of 2007, mainly due to a decrease in advisory fee income, partially offset by a slight increase in mortgage insurance contract underwriting income as a result of higher demand for the business.

Provision for Losses.    The provision for losses for the first quarter of 2008 was $582.7 million, an increase of $475.7 million from $107.0 million reported for the first quarter of 2007. Our mortgage insurance segment experienced a significant increase in claim rates and claims paid in the first quarter of 2008 compared to the same period a year ago, as well as an increase in delinquent loan sizes and a general aging of defaults and pending claims, which require a higher reserve. See “Results of Operations—Mortgage Insurance—Quarter Ended March 31, 2008 Compared to Quarter Ended March 31, 2007—Provision for Losses” below. The provision for losses for our financial guaranty segment increased in the first quarter of 2008 compared to the first quarter of 2007, due primarily to favorable loss development on the trade credit reinsurance business and structured finance business in 2007 that did not occur to the same extent in 2008. In addition, the 2008 provision for losses includes a higher provision as a result of assumed mortgage exposures.

Provision for Second-Lien Premium Deficiency.    The provision for second-lien premium deficiency was $18.1 million in the first quarter of 2008. There was no premium deficiency recorded in the first quarter of 2007. We reassess our expectations for premiums and losses and expenses for our second-lien business each quarter and update our premium deficiency accordingly. In the first quarter of 2008, we recorded an increase in the provision for second-lien premium deficiency as a result of an increase in expected losses and a decrease in expected premiums compared to our year end 2007 projections.

Policy Acquisition Costs.    Policy acquisition costs were $23.9 million for the first quarter of 2008, a decrease of $4.4 million or 15.4% from the $28.3 million reported for the first quarter of 2007. In our mortgage insurance segment, estimates of expected gross profit, which are driven in part by persistency and loss development for each underwriting year and product type, are used as a basis for amortization and are evaluated regularly. The total amortization recorded to date is adjusted by a charge or credit to our condensed consolidated statements of operations if actual experience or other evidence suggests that earlier estimates should be revised. During 2008 and 2007, amortization expense was impacted by both an increase in persistency rates and updates to our projected loss ratio assumptions in 2007.

Other Operating Expenses.    Other operating expenses were $55.1 million in the first quarter of 2008 compared to $57.7 million in the first quarter of 2007. We incurred $3.3 million in merger related expenses in the first quarter of 2007.

Interest Expense.    Interest expense for the first quarter of 2008 was $12.5 million, a decrease of $0.6 million or 4.3% from $13.1 million in the first quarter of 2007. Included in interest expense for 2008 was $2.0 million of interest related to the $200 million that we drew down from our unsecured revolving credit facility on

 

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August 15, 2007. On January 18, 2008, we terminated the interest rate swaps that we entered into in 2004, which converted the interest rate on our 5.625% Senior Notes due 2013 to a variable rate based on a spread over the London Interbank Offered Rate (“LIBOR”). The basis adjustment of $11.5 million that was recorded as an increase to the long-term debt carrying value is being amortized to interest expense.

Equity in Net Income of Affiliates.    Equity in net income of affiliates was $12.5 million in the first quarter of 2008, compared to $22.8 million in the first quarter of 2007. Sherman represents the only contribution to net income of affiliates for the first quarter of 2008. For the first quarter of 2007, Sherman contributed $29.6 million and C-BASS contributed a loss of $6.8 million. For more information, see “Results of Operations—Financial Services” below.

Income Tax Provision.    We recorded an income tax provision of $89.0 million for the first quarter of 2008 compared to $44.7 million for the first quarter of 2007. The consolidated effective tax rate was 31.3% for the first quarter of 2008, compared to 28.3% for the first quarter of 2007. The higher tax rate for the first quarter of 2008 reflects a decrease in the percentage of income generated from the tax-advantaged securities compared to income generated from operations.

Results of Operations—Mortgage Insurance

Quarter Ended March 31, 2008 Compared to Quarter Ended March 31, 2007

The following table summarizes our mortgage insurance segment’s results of operations for the quarters ended March 31, 2008 and 2007 (in thousands):

 

     Three Months Ended
March 31
   % Change  
     2008     2007    2008 vs. 2007  

Net (loss) income

   $ (226,456 )   $ 44,702    n/m  

Net premiums written—insurance

     211,251       206,411    2.3 %

Net premiums earned—insurance

     204,265       180,243    13.3  

Net investment income

     38,845       35,559    9.2  

Net (losses) gains on securities

     (36,733 )     11,123    n/m  

Change in fair value of derivative instruments

     71,769       4,338    n/m  

Other income

     3,491       2,849    22.5  

Provision for losses

     571,008       112,854    406.0  

Provision for second-lien premium deficiency

     18,090       —      n/m  

Policy acquisition costs

     13,460       16,523    (18.5 )

Other operating expenses

     34,170       39,600    (13.7 )

Interest expense

     7,090       6,854    3.4  

Income tax (benefit) provision

     (135,725 )     13,579    n/m  

 

n/m = not meaningful

Net (Loss) Income.    Our mortgage insurance segment’s net loss for the first quarter of 2008 was $226.5 million, compared to $44.7 million of net income for the first quarter of 2007. The first quarter 2008 loss was mainly due to the on-going deterioration in the U.S. housing and mortgage credit markets, which again has resulted in a significant increase in our provision for losses. Also affecting net income in the first quarter of 2008 was an increase in net losses on securities due to the write-down of other-than-temporarily-impaired securities and unrealized losses on convertible securities.

Net Premiums Written and Earned.    Net premiums written were $211.3 million for the first quarter of 2008, a $4.9 million or 2.3% increase compared to $206.4 million written in the first quarter of 2007. Net premiums earned in the first quarter of 2008 were $204.3 million, a $24.1 million or 13.3% increase compared to

 

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$180.2 million earned in the first quarter of 2007. The increase in premiums earned resulted from the higher volume of primary new insurance written during 2007 and the higher persistency rates experienced in 2007, which have continued into 2008. We ceased writing second-lien business in the second half of 2007, which resulted in a decrease in premiums written and earned from this product in 2008 as this business runs off.

The following table provides additional information related to premiums written and earned for the three month periods indicated:

 

     Three Months Ended
     March 31
2008
   March 31
2007

Premiums written (in thousands) (1)

     

Primary and Pool Insurance

   $ 200,477    $ 192,108

Seconds

     3,481      11,179

International

     7,293      3,124
             

Total Premiums written—insurance

   $ 211,251    $ 206,411
             

Premiums earned (in thousands) (1)

     

Primary and Pool Insurance

   $ 193,483    $ 167,155

Seconds

     6,164      9,172

International

     4,618      3,916
             

Total Premiums earned—insurance

   $ 204,265    $ 180,243
             

Smart Home (in thousands)

     

Ceded premiums written

   $ 3,240    $ 3,195

Ceded premiums earned

   $ 3,240    $ 2,858

 

(1) Excludes premiums written and earned on credit derivatives for the first quarter of 2008, which were $8.9 million and $11.5 million, respectively, compared to $15.9 million and $15.7 million, respectively, for the first quarter of 2007. These premiums are now reported in change in fair value of derivative instruments. In previous periods, these were reported as premiums written and earned in the condensed consolidated statements of operations. This reclassification is the result of an effort by the financial guaranty industry in consultation with the SEC to provide consistency in disclosure of credit derivative contracts.

Net Investment Income.    Net investment income attributable to our mortgage insurance segment for the first quarter of 2008 was $38.8 million, compared to $35.6 million for the first quarter of 2007. Investment income in the first quarter of 2008 reflects an increase in investable assets.

Net (Losses) Gains on Securities.    Net losses on securities in our mortgage insurance business were $36.7 million for the first quarter of 2008, compared to $11.1 million of net gains for the first quarter of 2007. Included in the first quarter of 2008 were losses related to changes in the fair value of hybrid securities and trading securities of $46.4 million offset by net gains related to the sale of hybrid securities of approximately $11.6 million. The first quarter of 2008 net losses also includes approximately $7.1 million of losses on investment securities that were other-than-temporarily impaired during the first quarter of 2008. The 2007 amount includes $1.6 million of losses related to changes in the fair value of convertible securities.

Change in Fair Value of Derivative Instruments.    The change in the fair value of derivative instruments was a gain of $71.8 million for the first quarter of 2008, compared to a gain of $4.3 million for the first quarter of 2007. The increase in the first quarter 2008 compared to 2007 was mainly due to a $96.5 million decrease in the cumulative unrealized loss on our NIMS credit derivatives. This decrease in our unrealized loss was primarily attributable to the incorporation of our non-performance risk under SFAS No. 157. In addition to NIMS, credit default swaps in our domestic and international mortgage insurance businesses incurred an additional cumulative unrealized loss of $32.3 million during the first quarter of 2008 as a result of further market deterioration.

 

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Other Income.    Other income for the first quarter of 2008 was $3.5 million, a $0.7 million increase from $2.8 million in the first quarter of 2007. Other income mostly includes income related to contract underwriting services, which was higher in the first quarter of 2008 as a result of an increase in contract underwriting volume.

Provision for Losses.    The provision for losses for the first quarter of 2008 was $571.0 million, compared to $112.9 million for the first quarter of 2007. The increase in 2008 was mainly attributable to increases in defaults and claims paid, the aging of existing defaults, larger loan balances, a higher ratio at which defaults are moving to claim and increased severity.

Provision for Second-Lien Premium Deficiency.    The provision for second-lien premium deficiency was $18.1 million for the first quarter of 2008, reflecting an increase in loss projections and a reduction in expected premiums. The increase in projected losses was due to incremental deterioration in the seasoned portion of our second-lien portfolio, comprised of transactions written in 2005 or earlier. There was no corresponding amount in the first quarter of 2007. See “Critical Accounting Policies—Reserve for Second-Lien Premium Deficiency” below.

Policy Acquisition Costs.    Policy acquisition costs were $13.5 million in the first quarter of 2008, a decrease from $16.5 million in the first quarter of 2007. During the first quarter of 2008, amortization expense was impacted by an increase in persistency rates and updates to our loss ratios assumptions during 2007, both of which contributed in reducing the asset to be amortized in 2008.

Other Operating Expenses.    Other operating expenses were $34.2 million for the first quarter of 2008, a decrease of $5.4 million or 13.7% compared to $39.6 million for the first quarter of 2007. Operating expenses for the first quarter of 2007 included $3.3 million of merger related expenses. Other than these expenses, the decrease in other operating expenses in 2008 was primarily due to a reduction in employee costs. Contract underwriting expenses for the quarters ended March 31, 2008 and 2007, including the impact of reserves for remedies included in other operating expenses, were $5.7 million and $5.1 million, respectively. During the first quarter of 2008, loans underwritten via contract underwriting for flow business accounted for 11.1% of applications, 10.6% of commitments for insurance and 9.1% of insurance certificates issued, compared to 13.1%, 12.6% and 10.5%, respectively, for the first quarter of 2007.

Interest Expense.    Interest expense attributable to our mortgage insurance segment for the first quarter of 2008 was $7.1 million compared to $6.9 million for the first quarter of 2007. Both periods include interest on our long-term debt that was allocated to the mortgage insurance segment. The 2007 amount includes the impact of interest-rate swaps that were terminated in January 2008.

Income Tax (Benefit) Provision.    We recorded an income tax benefit of $135.7 million for the first quarter of 2008 and an income tax provision of $13.6 million for the first quarter of 2007. The consolidated effective tax rate was 37.5% for the first quarter of 2008, compared to 23.3% for the first quarter of 2007. The higher tax rate for the first quarter of 2008 reflects a decrease in the percentage of income generated from tax-advantaged securities.

 

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The following tables provide selected information as of and for the periods indicated for our mortgage insurance segment. Certain statistical information included in the following tables is recorded based on information received from lenders and other third parties.

 

     Three Months Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Primary new insurance written (“NIW”)
($ in millions)

               

Flow

   $ 9,284    90.2 %   $ 10,422    76.7 %   $ 7,049    53.3 %

Structured

     1,013    9.8       3,174    23.3       6,178    46.7  
                                       

Total Primary

   $ 10,297    100.0 %   $ 13,596    100.0 %   $ 13,227    100.0 %
                                       

Flow

               

Prime

   $ 8,208    88.4 %   $ 8,629    82.8 %   $ 5,050    71.6 %

Alt-A

     583    6.3       832    8.0       1,401    19.9  

A minus and below

     493    5.3       961    9.2       598    8.5  
                                       

Total Flow

   $ 9,284    100.0 %   $ 10,422    100.0 %   $ 7,049    100.0 %
                                       

Structured

               

Prime

   $ 1,012    99.9 %   $ 1,795    56.6 %   $ 93    1.5 %

Alt-A

     1    0.1       1,378    43.4       5,905    95.6  

A minus and below

     —      0.0       1    0.0       180    2.9  
                                       

Total Structured

   $ 1,013    100.0 %   $ 3,174    100.0 %   $ 6,178    100.0 %
                                       

Total

               

Prime

   $ 9,220    89.5 %   $ 10,424    76.6 %   $ 5,143    38.9 %

Alt-A

     584    5.7       2,210    16.3       7,306    55.2  

A minus and below

     493    4.8       962    7.1       778    5.9  
                                       

Total Primary

   $ 10,297    100.0 %   $ 13,596    100.0 %   $ 13,227    100.0 %
                                       

During the first quarter of 2008, non-prime business accounted for $1.1 billion or 10.5% of new primary insurance written by our mortgage insurance segment, compared to $8.1 billion or 61.1% for the first quarter of 2007, largely reflecting a significant decrease in the amount of structured business written in 2008. Of the $1.1 billion of non-prime business written for the first quarter of 2008, $0.6 billion or 54.2% was Alt-A.

 

     Three Months Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Total Primary New Insurance Written by
FICO (a) Score
($ in millions)

               

Flow

               

<=619

   $ 265    2.9 %   $ 518    5.0 %   $ 486    6.9 %

620-679

     1,938    20.9       2,830    27.1       2,255    32.0  

680-739

     3,615    38.9       3,914    37.6       2,479    35.2  

>=740

     3,466    37.3       3,160    30.3       1,829    25.9  
                                       

Total Flow

   $ 9,284    100.0 %   $ 10,422    100.0 %   $ 7,049    100.0 %
                                       

Structured

               

<=619

   $ —      0.0 %   $ —      0.0 %   $ 126    2.0 %

620-679

     10    1.0       185    5.8       1,376    22.3  

680-739

     369    36.4       963    30.3       3,068    49.7  

>=740

     634    62.6       2,026    63.9       1,608    26.0  
                                       

Total Structured

   $ 1,013    100.0 %   $ 3,174    100.0 %   $ 6,178    100.0 %
                                       

 

40


Table of Contents
     Three Months Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Total

               

<=619

   $ 265    2.6 %   $ 518    3.8 %   $ 612    4.6 %

620-679

     1,948    18.9       3,015    22.2       3,631    27.5  

680-739

     3,984    38.7       4,877    35.9       5,547    41.9  

>=740

     4,100    39.8       5,186    38.1       3,437    26.0  
                                       

Total Primary

   $ 10,297    100.0 %   $ 13,596    100.0 %   $ 13,227    100.0 %
                                       

 

(a) Fair Isaac and Company (“FICO”) credit scoring model.

 

    Three Months Ended  
    March 31
2008
    December 31
2007
    March 31
2007
 

Percentage of primary new insurance written

              

Refinances

     40 %      27 %      51 %

95.01% LTV (b) and above

     20 %      32 %      16 %

ARMs

              

Less than 5 years

     1 %      1 %      42 %

5 years and longer

     6 %      14 %      5 %

Primary risk written ($ in millions)

              

Flow

  $ 2,316    89.7 %   $ 2,684    77.9 %   $ 1,746    90.0 %

Structured

    266    10.3       763    22.1       194    10.0  
                                      

Total

  $ 2,582    100.0 %   $ 3,447    100.0 %   $ 1,940    100.0 %
                                      

 

(b) Loan-to-value ratios: The ratio of the original loan amount to the original value of the property.

 

     Three Months Ended
     March 31
2008
   December 31
2007
   March 31
2007

Pool risk written (in millions)

   $ 31    $ 34    $ 89

Other risk written (in millions)

        

Seconds

        

1st loss

     —        —        3

2nd loss

     —        —        21

NIMS

     —        —        268

International

        

1st loss-Hong Kong primary mortgage insurance

     51      34      19

Reinsurance

     19      18      17
                    

Total other risk written

   $ 70    $ 52    $ 328
                    

 

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Table of Contents

In the last three years, we wrote a significant amount of pool risk where we are in a second-loss position. In these transactions, we will only pay claims if pool losses are greater than any applicable deductible.

 

     Period Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Primary insurance in force ($ in millions)

               

Flow

   $ 110,020    74.9 %   $ 105,246    73.6 %   $ 85,649    71.5 %

Structured

     36,929    25.1       37,820    26.4       34,063    28.5  
                                       

Total Primary

   $ 146,949    100.0 %   $ 143,066    100.0 %   $ 119,712    100.0 %
                                       

Prime

   $ 99,721    67.9 %   $ 93,577    65.4 %   $ 77,414    64.7 %

Alt-A

     34,949    23.8       37,031    25.9       31,023    25.9  

A minus and below

     12,279    8.3       12,458    8.7       11,275    9.4  
                                       

Total Primary

   $ 146,949    100.0 %   $ 143,066    100.0 %   $ 119,712    100.0 %
                                       

Primary risk in force ($ in millions)

               

Flow

   $ 27,751    84.6 %   $ 26,531    83.9 %   $ 21,267    82.7 %

Structured

     5,041    15.4       5,091    16.1       4,446    17.3  
                                       

Total Primary

   $ 32,792    100.0 %   $ 31,622    100.0 %   $ 25,713    100.0 %
                                       

Flow

               

Prime

   $ 21,810    78.6 %   $ 20,616    77.7 %   $ 16,653    78.3 %

Alt-A

     3,788    13.6       3,810    14.4       3,015    14.2  

A minus and below

     2,153    7.8       2,105    7.9       1,599    7.5  
                                       

Total Flow

   $ 27,751    100.0 %   $ 26,531    100.0 %   $ 21,267    100.0 %
                                       

Structured

               

Prime

   $ 2,577    51.1 %   $ 2,116    41.5 %   $ 1,797    40.4 %

Alt-A

     1,554    30.8       1,978    38.9       1,442    32.4  

A minus and below

     910    18.1       997    19.6       1,207    27.2  
                                       

Total Structured

   $ 5,041    100.0 %   $ 5,091    100.0 %   $ 4,446    100.0 %
                                       

Total

               

Prime

   $ 24,387    74.4 %   $ 22,732    71.9 %   $ 18,450    71.8 %

Alt-A

     5,342    16.3       5,788    18.3       4,457    17.3  

A minus and below

     3,063    9.3       3,102    9.8       2,806    10.9  
                                       

Total Primary

   $ 32,792    100.0 %   $ 31,622    100.0 %   $ 25,713    100.0 %
                                       

 

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Table of Contents

Direct primary insurance in force was $147.0 billion at March 31, 2008, compared to $143.1 billion at December 31, 2007 and $119.7 billion at March 31, 2007. At March 31, 2008, non-prime insurance in force was $47.2 billion or 32.1% of total primary mortgage insurance in force, compared to $42.3 billion or 35.3% at March 31, 2007. Of the $47.2 billion of non-prime insurance in force at March 31, 2008, $34.9 billion or 74% was Alt-A.

 

     Period Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Total Primary Risk in Force by FICO Score ($ in millions)

            

Flow

            

<=619

   $ 1,650     5.9 %   $ 1,639     6.2 %   $ 1,381     6.5 %

620-679

     8,262     29.8       8,059     30.4       6,574     30.9  

680-739

     10,269     37.0       9,773     36.8       7,733     36.4  

>=740

     7,570     27.3       7,060     26.6       5,579     26.2  
                                          

Total Flow

   $ 27,751     100.0 %   $ 26,531     100.0 %   $ 21,267     100.0 %
                                          

Structured

            

<=619

   $ 851     16.9 %   $ 936     18.4 %   $ 1,205     27.1 %

620-679

     1,380     27.4       1,490     29.3       1,539     34.6  

680-739

     1,517     30.1       1,488     29.2       1,130     25.4  

>=740

     1,293     25.6       1,177     23.1       572     12.9  
                                          

Total Structured

   $ 5,041     100.0 %   $ 5,091     100.0 %   $ 4,446     100.0 %
                                          

Total

            

<=619

   $ 2,501     7.6 %   $ 2,575     8.1 %   $ 2,586     10.0 %

620-679

     9,642     29.4       9,549     30.2       8,113     31.6  

680-739

     11,786     36.0       11,261     35.6       8,863     34.5  

>=740

     8,863     27.0       8,237     26.1       6,151     23.9  
                                          

Total Primary

   $ 32,792     100.0 %   $ 31,622     100.0 %   $ 25,713     100.0 %
                                          

Percentage of primary risk in force

            

Refinances

     31 %       31 %       33 %  

95.01% LTV and above

     24 %       24 %       19 %  

ARMs

            

Less than 5 years

     11 %       12 %       18 %  

5 years and longer

     9 %       10 %       9 %  

Total primary risk in force by LTV ($ in millions)

            

95.01% and above

   $ 7,926     24.2 %   $ 7,529     23.8 %   $ 4,795     18.6 %

90.01% to 95.00%

     10,079     30.7       9,674     30.6       7,965     31.0  

85.01% to 90.00%

     11,102     33.9       10,600     33.5       9,157     35.6  

85.00% and below

     3,685     11.2       3,819     12.1       3,796     14.8  
                                          

Total Primary

   $ 32,792     100.0 %   $ 31,622     100.0 %   $ 25,713     100.0 %
                                          

Total primary risk in force by policy year ($ in millions)

            

2004 and prior

   $ 8,408     25.6 %   $ 8,871     28.1 %   $ 10,851     42.2 %

2005

     4,805     14.6       5,112     16.2       6,137     23.9  

2006

     5,728     17.5       6,016     19.0       6,815     26.5  

2007

     11,300     34.5       11,623     36.7       1,910     7.4  

2008

     2,551     7.8       —       —         —       —    
                                          

Total Primary

   $ 32,792     100.0 %   $ 31,622     100.0 %   $ 25,713     100.0 %
                                          

 

43


Table of Contents
     Period Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Pool risk in force ($ in millions)

               

Prime

   $ 2,113    70.6 %   $ 2,111    70.2 %   $ 2,207    72.0 %

Alt-A

     292    9.7       293    9.8       301    9.8  

A minus and below

     590    19.7       600    20.0       558    18.2  
                                       

Total pool risk in force

   $ 2,995    100.0 %   $ 3,004    100.0 %   $ 3,066    100.0 %
                                       

 

 

 

     Period Ended
     March 31
2008
   December 31
2007
   March 31
2007

Other risk in force (in millions)

        

Seconds

        

1st loss

   $ 336    $ 377    $ 555

2nd loss

     507      548      605

NIMS

     522      604      783

International

        

1st loss-Hong Kong primary mortgage insurance

     517      465      353

Reinsurance

     125      103      61

Credit default swaps (1)

     8,872      8,202      7,875

Other

        

Domestic credit default swaps

     212      212      212
                    

Total other risk in force

   $ 11,091    $ 10,511    $ 10,444
                    

 

(1) Due to the foreign currency changes since we underwrote the risk on our international credit default swaps, the current U.S. dollar-denominated risk has increased.

 

     Period Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Default Statistics

      

Primary Insurance:

      

Flow

      

Prime

      

Number of insured loans

   582,261     565,563     504,941  

Number of loans in default

   22,806     20,632     14,013  

Percentage of total loans in default

   3.92 %   3.65 %   2.78 %

Alt-A

      

Number of insured loans

   73,672     74,559     65,075  

Number of loans in default

   10,014     7,980     4,513  

Percentage of total loans in default

   13.59 %   10.70 %   6.94 %

A minus and below

      

Number of insured loans

   64,193     63,853     53,379  

Number of loans in default

   10,411     10,087     6,704  

Percentage of total loans in default

   16.22 %   15.80 %   12.56 %

Total Flow

      

Number of insured loans

   720,126     703,975     623,395  

Number of loans in default

   43,231     38,699     25,230  

Percentage of total loans in default

   6.00 %   5.50 %   4.05 %

 

44


Table of Contents
     Period Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Structured

      

Prime

      

Number of insured loans

   72,264     64,789     59,194  

Number of loans in default

   5,434     4,707     3,231  

Percentage of total loans in default

   7.52 %   7.27 %   5.46 %

Alt-A

      

Number of insured loans

   87,325     97,526     84,050  

Number of loans in default

   12,056     8,783     3,922  

Percentage of total loans in default

   13.81 %   9.01 %   4.67 %

A minus and below

      

Number of insured loans

   26,342     28,747     34,429  

Number of loans in default

   8,404     8,659     7,971  

Percentage of total loans in default

   31.90 %   30.12 %   23.15 %

Total Structured

      

Number of insured loans

   185,931     191,062     177,673  

Number of loans in default

   25,894     22,149     15,124  

Percentage of total loans in default

   13.93 %   11.59 %   8.51 %

Total Primary Insurance

      

Prime

      

Number of insured loans

   654,525     630,352     564,135  

Number of loans in default

   28,240     25,339     17,244  

Percentage of total loans in default

   4.31 %   4.02 %   3.06 %

Alt-A

      

Number of insured loans

   160,997     172,085     149,125  

Number of loans in default

   22,070     16,763     8,435  

Percentage of total loans in default

   13.71 %   9.74 %   5.66 %

A minus and below

      

Number of insured loans

   90,535     92,600     87,808  

Number of loans in default

   18,815     18,746     14,675  

Percentage of loans in default

   20.78 %   20.24 %   16.71 %

Total Primary

      

Number of insured loans

   906,057     895,037     801,068  

Number of loans in default

   69,125 (1)   60,848 (1)   40,354 (1)

Percentage of loans in default

   7.63 %   6.80 %   5.04 %

Pool insurance

      

Number of loans in default

   26,983 (2)   26,526 (2)   17,989 (2)

 

(1) Includes approximately 1,504, 2,595 and 1,541 defaults at March 31, 2008, December 31, 2007 and March 31, 2007, respectively, where reserves had not been established because no claim payment was anticipated.
(2) Includes approximately 20,417, 20,193 and 13,036 defaults at March 31, 2008, December 31, 2007 and March 31, 2007, respectively, where reserves had not been established because no claim payment was anticipated.

The default and claim cycle in our mortgage insurance business begins with our receipt of a default notice from the insured. Generally, the insured notifies us of a default within 15 days after the loan has become 60 days past due. For reporting and internal tracking purposes, we do not consider a loan to be in default until the loan has been past due for 60 days. During the quarter, we learned that one of our largest servicers had not previously properly reported certain 60-day defaults to us and other private mortgage insurers, and that this omission would be corrected in April 2008. Based on the receipt of this new information, our first quarter 2008 results include approximately $39 million of additional incurred losses for the approximately 2,500 incremental primary defaults that we expect to receive from this service in the second quarter.

 

45


Table of Contents

The total number of loans in default increased from 96,203 at December 31, 2007 to 105,216 at March 31, 2008. The average loss reserve per default increased from $13,986 at December 31, 2007 to $16,549 at March 31, 2008. Primary and pool defaults at March 31, 2008 included approximately 1,504 and 20,417 defaults, respectively, on loans where reserves have not been established because no claim payment was anticipated. At December 31, 2007, primary and pool defaults included approximately 2,595 and 20,193 defaults, respectively, on loans where no reserve has been established. Excluding those defaults without a related reserve, the average loss reserve per default was $20,904 and $18,327 at March 31, 2008 and December 31, 2007, respectively. The loss reserve as a percentage of risk in force was 3.7% at March 31, 2008 and 3.0% at December 31, 2007.

 

     Three Months Ended
(In thousands)    March 31
2008
   December 31
2007
   March 31
2007

Direct claims paid:

        

Prime

   $ 60,658    $ 53,203    $ 33,125

Alt-A

     35,732      35,203      19,998

A minus and below

     48,361      46,966      29,080

Seconds

     45,437      29,295      13,621
                    

Total

   $ 190,188    $ 164,667    $ 95,824
                    

Average claim paid:

        

Prime

   $ 36.8    $ 35.0    $ 28.1

Alt-A

     49.6      49.0      39.7

A minus and below

     37.2      36.5      29.6

Seconds

     34.6      38.6      28.8

Total

   $ 38.2    $ 38.4    $ 30.6

Claim activity is not spread evenly throughout the coverage period of a book of business. Historically, relatively few claims on prime business are received during the first two years following issuance of a policy and on non-prime business during the first year. Claim activity on prime loans has historically reached its highest level in the third through fifth years after the year of policy origination, and on non-prime loans this level occurs in the second through fourth years. Based on these trends, approximately 66.2% of our primary risk in force and approximately 18.0% of our pool risk in force at March 31, 2008 had not yet reached its highest claim frequency years. The late 2005 through 2007 business has experienced default and claim activity sooner than has been the case for historical books of business. Because it is difficult to predict both the timing of originating new business and the cancellation rate of existing business, it is also difficult to predict, at any given time, the percentage of risk in force that will reach its highest claim frequency years on any future date.

 

     Three Months Ended  
($ in thousands)    March 31
2008
    December 31
2007
    March 31
2007
 

States with highest claims paid:

      

California

   $ 16,771     $ 11,580     $ 1,039  

Michigan

     15,466       13,889       10,262  

Georgia

     10,917       9,681       7,755  

Ohio

     10,032       10,190       8,645  

Texas

     9,268       9,260       8,789  

Percentage of total claims paid:

      

California

     8.8 %     7.0 %     1.1 %

Michigan

     8.1       8.4       10.7  

Georgia

     5.7       5.9       8.1  

Ohio

     5.3       6.2       9.0  

Texas

     4.9       5.6       9.2  

 

46


Table of Contents

A higher proportion of new defaults in 2007 were from loans in California and Florida, which would indicate that claims paid in those states will likely increase, perhaps significantly throughout 2008.

 

     Period Ended  
     March 31
2008
    December 31
2007
    March 31
2007
 

Primary risk in force: (in millions)