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EXHIBIT 99.1
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
September 30, 2007
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
September 30, 2007
INDEX
| CONSOLIDATED FINANCIAL STATEMENTS (unaudited): | | |
| Consolidated Balance Sheets (unaudited) | | 1 |
| Consolidated Statements of Operations and Comprehensive Income (unaudited) | | 2 |
| Consolidated Statements of Cash Flows (unaudited) | | 3 |
| Notes to Consolidated Financial Statements (unaudited) | | 4 |
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (unaudited)
(in thousands, except share data)
| | September 30,
2007
| | December 31,
2006
|
|---|
| ASSETS | | | | | | |
| General investment portfolio: | | | | | | |
| | Bonds at fair value (amortized cost of $4,719,246 and $4,505,898) | | $ | 4,857,449 | | $ | 4,681,144 |
| | Equity securities at fair value (cost of $39,943 and $54,291) | | | 39,972 | | | 54,325 |
| | Short-term investments (cost of $109,232 and $85,980) | | | 111,609 | | | 86,503 |
| Financial products segment investment portfolio: | | | | | | |
| | Bonds at fair value (amortized cost of $1,114,144 and $1,127,698) | | | 1,129,907 | | | 1,128,255 |
| | Guaranteed investments contracts from GIC Affiliates at fair value (amortized cost of $767,771 and $962,815) | | | 772,360 | | | 962,815 |
| | Short-term investments | | | 2,699 | | | 19,478 |
| Assets acquired in refinancing transactions: | | | | | | |
| | Bonds at fair value (amortized cost of $26,798 and $40,133) | | | 27,645 | | | 41,051 |
| | Securitized loans | | | 188,669 | | | 241,785 |
| | Other | | | 48,698 | | | 55,036 |
| | |
| |
|
| | | Total investment portfolio | | | 7,179,008 | | | 7,270,392 |
| Cash | | | 43,472 | | | 29,660 |
| Deferred acquisition costs | | | 345,704 | | | 340,673 |
| Prepaid reinsurance premiums | | | 1,078,082 | | | 1,004,987 |
| Reinsurance recoverable on unpaid losses | | | 38,995 | | | 37,342 |
| Other assets | | | 1,248,006 | | | 1,496,170 |
| | |
| |
|
| | | TOTAL ASSETS | | $ | 9,933,267 | | $ | 10,179,224 |
| | |
| |
|
| LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS' EQUITY | | | | | | |
| Deferred premium revenue | | $ | 2,799,760 | | $ | 2,658,594 |
| Loss and loss adjustment expense reserve | | | 245,595 | | | 228,122 |
| Financial products segment debt | | | 2,677,532 | | | 3,067,745 |
| Deferred federal income taxes | | | 184,694 | | | 292,905 |
| Notes payable to affiliate | | | 246,556 | | | 321,370 |
| Surplus notes | | | 108,850 | | | 108,850 |
| Other liabilities and minority interest | | | 694,626 | | | 439,030 |
| | |
| |
|
| | | TOTAL LIABILITIES AND MINORITY INTEREST | | | 6,957,613 | | | 7,116,616 |
| | |
| |
|
| COMMITMENTS AND CONTINGENCIES | | | | | | |
| Preferred stock (5,000.1 and 0 shares authorized; 0 shared issued and outstanding; par value of $1,000 per share) | | | | | | |
| Common stock (355 and 380 shares authorized; issued and outstanding; par value of $42,254 and $39,474 per share) | | | 15,000 | | | 15,000 |
| Additional paid-in capital—common | | | 619,053 | | | 743,504 |
| Accumulated other comprehensive income (net of deferred income taxes of $50,278 and $63,063) | | | 93,344 | | | 117,087 |
| Accumulated earnings | | | 2,248,257 | | | 2,187,017 |
| | |
| |
|
| | TOTAL SHAREHOLDERS' EQUITY | | | 2,975,654 | | | 3,062,608 |
| | |
| |
|
| | TOTAL LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS' EQUITY | | $ | 9,933,267 | | $ | 10,179,224 |
| | |
| |
|
The accompanying Notes are an integral part of the Consolidated Financial Statements (unaudited).
1
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(in thousands)
| | Nine Months Ended
September 30,
| |
|---|
| | 2007
| | 2006
| |
|---|
| REVENUES | | | | | | | |
| | Net premiums written | | $ | 404,744 | | $ | 390,538 | |
| | |
| |
| |
| | Net premiums earned | | $ | 336,674 | | $ | 310,073 | |
| | Net investment income | | | 174,681 | | | 159,501 | |
| | Net realized gains (losses) | | | (3,128 | ) | | (4,836 | ) |
| | Interest income from financial products segment | | | 102,119 | | | 101,834 | |
| | Net realized and unrealized gains (losses) on derivative instruments | | | (364,395 | ) | | 73,405 | |
| | Income from assets acquired in refinancing transactions | | | 16,498 | | | 18,664 | |
| | Net realized gains (losses) from assets acquired in refinancing transactions | | | 1,439 | | | 12,795 | |
| | Other income | | | 12,782 | | | 9,433 | |
| | |
| |
| |
| TOTAL REVENUES | | | 276,670 | | | 680,869 | |
| | |
| |
| |
EXPENSES |
|
|
|
|
|
|
|
| | Losses and loss adjustment expenses | | | 19,128 | | | 16,343 | |
| | Interest expense on related party debt | | | 16,101 | | | 19,600 | |
| | Amortization of deferred acquisition costs | | | 47,589 | | | 44,734 | |
| | Foreign exchange (gains) losses from financial products segment | | | 32,733 | | | 82,562 | |
| | Net interest expense from financial products segment | | | 107,366 | | | 108,416 | |
| | Other operating expenses | | | 77,601 | | | 61,635 | |
| | |
| |
| |
| TOTAL EXPENSES | | | 300,518 | | | 333,290 | |
| | |
| |
| |
| INCOME (LOSS) BEFORE INCOME TAXES AND MINORITY INTEREST | | | (23,848 | ) | | 347,579 | |
| | |
| |
| |
| | Total provision (benefit) for income taxes | | | (32,378 | ) | | 96,836 | |
| | |
| |
| |
| NET INCOME BEFORE MINORITY INTEREST | | | 8,530 | | | 250,743 | |
| | Less: Minority interest | | | (52,711 | ) | | (43,157 | ) |
| | |
| |
| |
| NET INCOME | | | 61,241 | | | 293,900 | |
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX |
|
|
|
|
|
|
|
| Unrealized gains (losses) arising during period, net of deferred income tax provision (benefit) of $(10,554) and $7,045 | | | (19,600 | ) | | 13,083 | |
| Less: Reclassification adjustment for gains (losses) included in net income, net of deferred income tax provision (benefit) of $2,231 and $3,315 | | | 4,143 | | | 6,157 | |
| | |
| |
| |
| Other comprehensive income (loss) | | | (23,743 | ) | | 6,926 | |
| | |
| |
| |
| COMPREHENSIVE INCOME | | $ | 37,498 | | $ | 300,826 | |
| | |
| |
| |
The accompanying Notes are an integral part of the Consolidated Financial Statements (unaudited).
2
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands)
| | Nine Months Ended
September 30,
| |
|---|
| | 2007
| | 2006
| |
|---|
| Cash flows from operating activities: | | | | | | | |
| | Premiums received, net | | $ | 371,535 | | $ | 397,054 | |
| | Operating expenses paid, net | | | (138,324 | ) | | (151,405 | ) |
| | Salvage and subrogation received | | | 292 | | | 1,300 | |
| | Losses and loss adjustment expenses paid, net | | | (3,786 | ) | | (1,180 | ) |
| | Net investment income received in general investment portfolio | | | 171,956 | | | 154,981 | |
| | Investment income received in financial products segment | | | 29,494 | | | 28,119 | |
| | Federal income taxes (paid) recovered | | | (81,349 | ) | | (58,964 | ) |
| | Interest paid on financial products segment debt | | | (6,297 | ) | | (4,283 | ) |
| | Net derivative payments in financial products segment | | | (23,906 | ) | | (18,384 | ) |
| | Interest paid on surplus notes and notes payable to affiliate | | | (16,017 | ) | | (19,246 | ) |
| | Income received from refinanced assets | | | 14,679 | | | 33,876 | |
| | Other | | | 4,343 | | | 4,777 | |
| | |
| |
| |
| | | Net cash provided by (used for) operating activities | | | 322,620 | | | 366,645 | |
| | |
| |
| |
| Cash flows from investing activities: | | | | | | | |
| | Proceeds from sales of bonds in general investment portfolio | | | 2,621,282 | | | 1,062,967 | |
| | Proceeds from maturities of bonds in general investment portfolio | | | 138,073 | | | 126,451 | |
| | Purchases of bonds in general investment portfolio | | | (2,941,826 | ) | | (1,407,211 | ) |
| | Net (increase) decrease in short-term investments in general investment portfolio | | | (20,927 | ) | | 16,630 | |
| | Proceeds from maturities of bonds in financial products segment | | | 179,400 | | | 103,662 | |
| | Net (increase) decrease in short-term investments in financial products segment | | | 17,289 | | | (21,555 | ) |
| | Paydowns of assets acquired in refinancing transactions | | | 73,468 | | | 63,144 | |
| | Proceeds from sales of assets acquired in refinancing transactions | | | 4,339 | | | 17,854 | |
| | Purchases of property, plant and equipment | | | (1,072 | ) | | (2,144 | ) |
| | Other investments | | | 11,860 | | | 24,079 | |
| | |
| |
| |
| | | Net cash provided by (used for) investing activities | | | 81,886 | | | (16,123 | ) |
| | |
| |
| |
| Cash flows from financing activities: | | | | | | | |
| | Dividends paid | | | — | | | (120,000 | ) |
| | Repayment of notes payable to affiliate | | | (74,815 | ) | | (120,703 | ) |
| | Capital issuance costs | | | (764 | ) | | (711 | ) |
| | Repurchase of shares | | | (125,000 | ) | | — | |
| | Repayment of financial products segment debt | | | (190,900 | ) | | (82,500 | ) |
| | |
| |
| |
| | | Net cash provided by (used for) financing activities | | | (391,479 | ) | | (323,914 | ) |
| | |
| |
| |
| Effect of changes in foreign exchange rates on cash balances | | | 785 | | | (176 | ) |
| | |
| |
| |
| | Net increase (decrease) in cash | | | 13,812 | | | 26,432 | |
| Cash at beginning of period | | | 29,660 | | | 39,506 | |
| | |
| |
| |
| Cash at end of period | | $ | 43,472 | | $ | 65,938 | |
| | |
| |
| |
The accompanying Notes are an integral part of the Consolidated Financial Statements (unaudited).
3
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
1. ORGANIZATION AND OWNERSHIP
Financial Security Assurance Inc. (the "Company"), a wholly owned subsidiary of Financial Security Assurance Holdings Ltd. (the "Parent"), is an insurance company domiciled in the State of New York. The Company operates in two business segments: a Financial Guaranty Segment and a Financial Products ("FP") Segment.
The Financial Guaranty Segment is the principal segment, providing financial guaranty insurance on public finance and asset-backed obligations. The Company's underwriting policy is to insure public finance and asset-backed obligations that it determines would be investment-grade quality without the benefit of the Company's insurance. Public finance obligations insured by the Company consist primarily of general obligation bonds supported by the issuers' taxing powers and special revenue bonds and other special obligations of states and local governments supported by the issuers' abilities to impose and collect fees and charges for public services or specific projects. Public finance obligations include obligations backed by the cash flow from leases or other revenues from projects serving substantial public purposes, including government office buildings, toll roads, health care facilities and utilities. Asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets, such as residential mortgage loans, consumer receivables, securities or other assets having an ascertainable cash flow or market value. The Company also insures synthetic asset-backed obligations that generally take the form of credit default swap ("CDS") obligations or credit-linked notes that reference specific asset-backed securities or pools of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. In addition, the Company insures guaranteed investment contracts ("GICs") issued by FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the "GIC Affiliates"), affiliates of the Company.
The Company has refinanced certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are consolidated. The Company's management believes that the assets held by the refinancing vehicles are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. Refinanced transactions are included in the Financial Guaranty Segment.
The Company's FP Segment includes its funding operations conducted through variable interest entities ("VIEs"). Generally, FP Segment debt is issued at or converted into LIBOR-based floating-rate obligations and the proceeds are invested in or converted into LIBOR-based floating-rate investments intended to result in profits from a higher investment rate than borrowing rate.
The VIEs include FSA Global Funding Limited ("FSA Global") and Premier International Funding Co. ("Premier"). FSA Global issues FSA-insured medium term notes and generally invests the proceeds from the sale of its notes in FSA-insured GICs or other FSA-insured obligations with a view to realizing the yield difference between the notes issued and the obligations purchased with the proceeds. Substantially all the assets of FSA Global are pledged to secure the repayment, on a pro rata basis, of FSA Global's notes and its other obligations. Premier is principally engaged in debt defeasance for lease transactions. The Company's management believes that the assets held by the consolidated VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership.
4
2. BASIS OF PRESENTATION
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial statements and, in the opinion of management, reflect all adjustments necessary for a fair statement of the financial position, results of operations and cash flows for all periods presented. These Consolidated Financial Statements should be read in conjunction with the Company's Consolidated Financial Statements and notes thereto included as an exhibit to the Parent's Annual Report on Form 10-K for the year ended December 31, 2006. The accompanying Consolidated Financial Statements have not been audited by an independent registered public accounting firm in accordance with the standards of the Public Company Accounting Oversight Board (United States). The December 31, 2006 consolidated balance sheet was derived from audited financial statements. The results of operations for the periods ended September 30, 2007 and 2006 are not necessarily indicative of the results of operations for the full year. Certain prior-year balances have been reclassified to conform to the 2007 presentation.
Revisions
The statement of cash flows for the period ended September 30, 2007 appropriately segregates the effect of changes in foreign exchange rates on cash balances into a separate line item. The effect of foreign exchange rates on cash balances has historically been included in cash flows from operations. The statements of cash flows for the period ended September 30, 2006 has been revised to conform to the 2007 presentation. The 2006 statement of cash flows also reflects the reclassification of certain accounts. The amount of the revision at September 30, 2006 from cash to short-term investments was $19.3 million.
3. LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company establishes loss liabilities based on its estimate of specific and non-specific losses. The Company also establishes liabilities for loss adjustment expenses ("LAE"), consisting of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process.
The Company calculates a loss and LAE liability based upon identified risks inherent in its insured portfolio. If an individual policy risk has a reasonably estimable and probable loss as of the balance sheet date, a case reserve is established. For the remaining policy risks in the portfolio, a non-specific reserve is established to account for the inherent credit losses that can be statistically estimated.
The following table presents the activity in non-specific and case reserves for the nine months ended September 30, 2007. Adjustments to reserves represent management's estimate of the amount required to cover the present value of the net cost of claims, based on statistical provisions for new originations. Transfers between non-specific and case reserves represent a reallocation of existing loss reserves and have no impact on earnings.
Reconciliation of Net Losses and Loss Adjustment Expense Reserve
| | Non-
Specific
| | Case
| | Total
| |
|---|
| | (in millions)
| |
|---|
| December 31, 2006 | | $ | 137.8 | | $ | 53.0 | | $ | 190.8 | |
| Incurred | | | 19.1 | | | — | | | 19.1 | |
| Transfers | | | (3.8 | ) | | 3.8 | | | — | |
| Payments | | | — | | | (3.3 | ) | | (3.3 | ) |
| | |
| |
| |
| |
| September 30, 2007 balance | | $ | 153.1 | | $ | 53.5 | | $ | 206.6 | |
| | |
| |
| |
| |
5
Management of the Company periodically evaluates its estimates for losses and LAE and establishes reserves that management believes are adequate to cover the present value of the ultimate net cost of claims. However, because of the uncertainty involved in developing these estimates, the ultimate liability may differ from current estimates.
The gross and net par amounts outstanding on transactions with case reserves were $252.3 million and $188.5 million, respectively, at September 30, 2007. The net case reserves consisted primarily of four collateralized debt obligation ("CDO") risks and two municipal risks, which collectively accounted for approximately 95.4% of total net case reserves. The remaining three exposures were in non-municipal sectors.
Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms, such as, but not limited to, "unallocated losses," "active credit reserves" and "portfolio reserves," or may use different statistical techniques from those used by the Company to determine loss at a given point in time.
4. FINANCIAL PRODUCTS SEGMENT DEBT
At September 30, 2007, the interest rates on FP Segment debt were between 1.98% and 6.20% per annum. FP Segment debt is comprised of VIE debt. Payments due under the FP Segment debt (including $1,028.4 million of future interest accretion and excluding fair value adjustments of $69.8 million) in the remainder of 2007 and each of the next four years ending December 31 and thereafter, are as follows:
| | Principal
Amount
|
|---|
| | (in millions)
|
|---|
| Remainder of 2007 | | $ | 241.2 |
| 2008 | | | 88.2 |
| 2009 | | | 362.0 |
| 2010 | | | 94.5 |
| 2011 | | | 16.2 |
| Thereafter | | | 2,834.0 |
| | |
|
| | Total | | $ | 3,636.1 |
| | |
|
Certain FSA Global debt issuances contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its funding requirements in such transactions, it entered into several liquidity facilities with Dexia and other counterparties for amounts totaling $760.9 million.
5. OUTSTANDING EXPOSURE
The Company's policies insure the scheduled payments of principal and interest on public finance and asset-backed obligations (including FSA-insured derivatives). The gross amount of financial guarantees in force (principal and interest) was $827.7 billion at September 30, 2007 and $764.8 billion at December 31, 2006. The net amount of financial guarantees in force was $602.3 billion at September 30, 2007 and $552.3 billion at December 31, 2006. The Company limits its exposure to losses from writing financial guaranties by underwriting investment-grade obligations, satisfying both rating agency and its own credit standards, diversifying its portfolio by product type and geography and through reinsurance.
6
The net and ceded par outstanding of insured obligations in the public finance insured portfolio were comprised as set forth below:
| | Net Par Outstanding
| | Ceded Par Outstanding
|
|---|
| | September 30,
2007
| | December 31,
2006
| | September 30,
2007
| | December 31,
2006
|
|---|
| | (in millions)
|
|---|
| Domestic obligations | | | | | | | | | | | | |
| | General obligation | | $ | 111,809 | | $ | 103,112 | | $ | 31,014 | | $ | 28,143 |
| | Tax-supported | | | 47,749 | | | 46,479 | | | 18,783 | | | 18,733 |
| | Municipal utility revenue | | | 42,808 | | | 40,495 | | | 13,594 | | | 13,367 |
| | Health care revenue | | | 14,080 | | | 13,155 | | | 11,471 | | | 10,144 |
| | Housing revenue | | | 7,622 | | | 7,576 | | | 2,146 | | | 2,039 |
| | Transportation revenue | | | 17,057 | | | 16,164 | | | 11,002 | | | 10,337 |
| | Education | | | 4,863 | | | 4,378 | | | 1,622 | | | 1,027 |
| | Other domestic public finance | | | 2,356 | | | 1,628 | | | 977 | | | 509 |
| International | | | 23,370 | | | 18,306 | | | 19,241 | | | 14,554 |
| | |
| |
| |
| |
|
| | | Total public finance obligations | | $ | 271,714 | | $ | 251,293 | | $ | 109,850 | | $ | 98,853 |
| | |
| |
| |
| |
|
The net and ceded par outstanding of insured obligations in the asset-backed insured portfolio (including FSA-insured derivatives) included the following amounts:
| | Net Par Outstanding
| | Ceded Par Outstanding
|
|---|
| | September 30,
2007
| | December 31,
2006
| | September 30,
2007
| | December 31,
2006
|
|---|
| | (in millions)
|
|---|
| Domestic obligations | | | | | | | | | | | | |
| | Residential mortgages | | $ | 18,772 | | $ | 15,666 | | $ | 2,830 | | $ | 2,555 |
| | Consumer receivables(1) | | | 11,915 | | | 10,599 | | | 935 | | | 664 |
| | Pooled corporate obligations | | | 55,000 | | | 45,914 | | | 7,998 | | | 8,729 |
| | Other domestic asset-backed obligations(1) | | | 26,584 | | | 23,351 | | | 3,564 | | | 2,952 |
| International obligations | | | 29,929 | | | 29,295 | | | 6,512 | | | 8,077 |
| | |
| |
| |
| |
|
| | Total asset-backed obligations | | $ | 142,200 | | $ | 124,825 | | $ | 21,839 | | $ | 22,977 |
| | |
| |
| |
| |
|
- (1)
- Includes net par outstanding of $19,007 million as of September 30, 2007 and $16,558 million as of December 31, 2006, respectively, relating to FSA-insured GICs issued by the GIC Affiliates and other related party insurance.
As of September 30, 2007, the Company did not have a case reserve recorded for any home equity line of credit ("HELOC") transactions; however, as of November 14, 2007, the Company had net claims during the fourth quarter of 2007 of approximately $29.5 million on insured HELOCs, which together with the $2.0 million in net claims paid in the third quarter of 2007 brings the aggregate net claims through November 14, 2007 to approximately $31.5 million. The five HELOC transactions for which claims were made had an aggregate net par outstanding at October 31, 2007 of $3.1 billion. Credit support for the HELOC transactions is primarily provided by excess spread (usually targeted at
7
400 basis points of par outstanding). Generally, once the over-collateralization is exhausted, the Company will pay a claim if losses in a period exceed excess spread for the period, and to the extent excess spread exceeds losses, the Company is reimbursed for any losses paid to date. In mortgage transactions, loss rates are typically higher early in the life of a transaction and thereafter decline. Based on the latest information available to the Company, various loss scenarios were developed with a wide range of possible outcomes. The Company currently believes it will recover all claim payments and has therefore established no case reserve for these transactions. The Company will continue to monitor the performance of these transactions and recalculate loss scenarios for any changes in market conditions or changes in the performance of the specific transactions.
6. TAXES
The Company adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No.109" ("FIN 48") as of January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes in an entity's financial statements pursuant to FASB Statement No. 109, "Accounting for Income Taxes" and provides thresholds for recognizing and measuring benefits of a tax position taken or expected to be taken in a tax return. Consequently, the Company recognizes tax benefits only on tax positions where it is "more likely than not" to prevail. There was no effect on the Company's statements of operations and comprehensive income from adopting FIN 48.
The total amount of unrecognized tax benefits at January 1, 2007 and September 30, 2007 were $20.2 million and $22.3 million, respectively. If recognized, the entire amount would favorably affect the effective tax rate. Further, the Company recognizes interest and penalties related to unrecognized tax benefits as part of income taxes. For the period ended September 30, 2007, the Company accrued $0.3 million of expenses related to interest and penalties. Cumulative interest and penalties of $2.2 million had been accrued on the Company's balance sheet at September 30, 2007.
The Company files consolidated income tax returns in the United States as well as separate tax returns for certain of its subsidiaries or branches in various state and local and foreign jurisdictions, including the United Kingdom, Japan and Australia. With limited exceptions, the Company is no longer subject to income tax examinations for its 2003 and prior tax years for U.S. federal, state and local, or non-U.S. jurisdictions.
Within the next 12 months, it is reasonably possible that unrecognized tax benefits for tax positions taken on previously filed tax returns will become recognized as a result of the expiration of the statute of limitations for the 2004 tax year, which, absent any extension, will close in September 2008.
In the third quarter of 2007, the Company recognized a tax benefit of $3.0 million, which includes the benefit of $0.5 million of interest from the expiration of the statute of limitations for the 2003 tax year.
8
The 2007 and 2006 effective tax rates differ from the statutory rate of 35% primarily due to tax-exempt interest income. The current year effective tax rate reflects the higher ratio of tax-exempt interest income to year-to-date pre-tax losses due to significant fair value adjustments discussed in Note 7. A reconciliation of the effective tax rate with the federal statutory rate follows:
| | Nine Months
Ended
September 30,
| |
|---|
| | 2007
| | 2006
| |
|---|
| Tax (benefit) at statutory rate | | (35.0 | )% | 35.0 | % |
| Tax-exempt investments | | (167.2 | ) | (10.7 | ) |
| Minority interest and equity in unconsolidated subsidiaries | | 77.4 | | 4.3 | |
| Tax contingencies | | (13.6 | ) | (0.9 | ) |
| Other | | 2.6 | | 0.2 | |
| | |
| |
| |
| | Total | | (135.8 | )% | 27.9 | % |
| | |
| |
| |
7. DERIVATIVE INSTRUMENTS
The components of net realized and unrealized gains (losses) on derivative instruments are shown in the table below:
| | Nine Months
Ended
September 30,
|
|---|
| | 2007
| | 2006
|
|---|
| | (in millions)
|
|---|
| Insured derivatives | | $ | (352.5 | ) | $ | 24.5 |
| FP Segment derivatives | | | (12.2 | ) | | 48.5 |
| Other | | | 0.3 | | | 0.4 |
| | |
| |
|
| | Net realized and unrealized gains (losses) on derivative instruments | | $ | (364.4 | ) | $ | 73.4 |
| | |
| |
|
Insured Derivatives
Included in the Company's insured portfolio are certain contracts that qualify as derivatives under Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") or SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS 155"). Changes in the fair-value of these contracts are recorded through the statements of operations and comprehensive income. These contracts include FSA-insured CDS, insured interest rate swaps ("IR swaps") entered into in connection with the issuance of certain public finance obligations and insured net interest margin ("NIM") securitizations issued in connection with certain mortgage-backed security ("MBS") financings. The Company considers all such agreements to be a normal extension of its financial guaranty insurance business but, for accounting purposes, these contracts are deemed to be derivative instruments.
The table below shows the changes in the fair value of insured derivatives recorded in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and
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comprehensive income. Management expects that these transactions will not be subject to a market value termination for which the Company would be liable. Management does not expect that changes in fair value of these highly rated swap guarantees are an indication of any material deterioration in the underlying credit quality of the Company's insured CDS portfolio or of any potential claims under the Company's financial guarantees.
| | Nine Months
Ended
September 30,
|
|---|
| | 2007
| | 2006
|
|---|
| | (in millions)
|
|---|
| Insured Derivatives: | | | | | | |
| Insured CDS | | $ | (348.2 | ) | $ | 24.4 |
| Other(1)(2) | | | (4.3 | ) | | 0.1 |
| | |
| |
|
| | Total | | $ | (352.5 | ) | $ | 24.5 |
| | |
| |
|
- (1)
- Includes NIM securitization and insured IR swaps.
- (2)
- As of January 1, 2007, the Company implemented SFAS 155, which resulted in a mark-to-market loss of $2.9 million related to insured NIM securitizations for the nine months ended September 30, 2007. The change in fair value was primarily a function of the market's adverse perception of mortgage-backed products.
The Company recorded net earned premium under these agreements of $72.4 million for the nine months ended September 30, 2007 and $68.7 million for the nine months ended September 30, 2006.
The Company's net par outstanding of $80.2 billion and $74.7 billion relating to insured CDS and NIM securitizations at September 30, 2007 and December 31, 2006, respectively, are included in the asset-backed balances in Note 5. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to record earned premiums over the installment period and to record changes in fair value as incurred.
Fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is the case with most of the Company's insured CDS contracts because these contracts are not traded, then the determination of fair value is based on internally developed estimates that employ credit-spread algorithms. These algorithms are unique to each insured CDS category and utilize various publicly available indices, depending on the types of assets referenced by the insured CDS contract and the contract's tenor. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal credit assessments or rating agency-based shadow ratings, and, for its insured obligations, the level at which the deductible has been set. Estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions.
The average remaining life of these contracts was 3.6 years and 3.1 years as of September 30, 2007 and December 31, 2006, respectively. The inception-to-date gain (loss) for all insured derivatives is recorded in other assets or other liabilities, as appropriate.
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VIE Derivatives
The Company enters into derivative contracts to manage interest rate and foreign currency exposure in its FP Segment debt and investment portfolio, which is comprised of VIE debt and investments. All gains and losses from changes in the fair value of derivatives are recognized immediately in the consolidated statements of operations and comprehensive income. These derivatives generally include interest rate and currency swap agreements, which are primarily utilized to convert fixed-rate debt and investments into U.S. dollar floating-rate debt and investments. The inception-to-date net unrealized gain on the outstanding derivatives held by the FP Segment of $430.8 million and $516.8 million at September 30, 2007 and December 31, 2006, respectively, was recorded in other assets.
8. NOTES PAYABLE TO AFFILIATE
The Company has recorded $246.6 million of notes payable to an affiliate at September 30, 2007. These notes were issued by special purpose entities consolidated by the Company and formed to facilitate the refinancing transactions. Principal payments due under these refinanced notes for the remainder of 2007 and each of the next four years ending December 31 and thereafter, are as follows:
| | Principal
Amount
|
|---|
| | (in thousands)
|
|---|
| Remainder of 2007 | | $ | 7,959 |
| 2008 | | | 11,141 |
| 2009 | | | 16,660 |
| 2010 | | | 28,625 |
| 2011 | | | 34,798 |
| Thereafter | | | 147,373 |
| | |
|
| | Total | | $ | 246,556 |
| | |
|
9. OTHER ASSETS
The detailed balances that comprise other assets at September 30, 2007 and December 31, 2006 are as follows:
| | September 30,
2007
| | December 31,
2006
|
|---|
| | (in thousands)
|
|---|
| Unrealized gain on FP Segment derivatives | | $ | 430,836 | | $ | 516,762 |
| Fair-value adjustments on insured derivatives | | | — | | | 89,195 |
| VIE other invested assets | | | 269,233 | | | 418,677 |
| Tax and loss bonds | | | 149,911 | | | 127,150 |
| Accrued interest on FP Segment | | | 158,905 | | | 136,975 |
| Accrued interest income on general investment portfolio | | | 62,348 | | | 60,500 |
| Other assets | | | 176,773 | | | 146,911 |
| | |
| |
|
| | Total other assets | | $ | 1,248,006 | | $ | 1,496,170 |
| | |
| |
|
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10. SEGMENT REPORTING
The Company operates in two business segments: financial guaranty and financial products. The Financial Guaranty Segment is primarily in the business of providing financial guaranty insurance on public finance and asset-backed obligations in exchange for a premium. Reflecting the manner in which the VIEs' operations are managed, the results of the VIEs are included in the FP Segment beginning in the fourth quarter of 2006. Prior period disclosures have been reclassified to conform to the 2007 presentation.
The following tables summarize the financial information by segment as of and for the nine months ended September 30, 2007 and 2006. The exclusions from pretax operating earnings are the fair value adjustments on insured derivatives and economic hedges.
| | Nine Months Ended September 30, 2007
| |
|---|
| | Financial
Guaranty
| | Financial
Products
| | Intersegment
Eliminations
| | Total
| |
|---|
| | (in thousands)
| |
|---|
| Revenues: | | | | | | | | | | | | | |
| | External | | $ | 186,703 | | $ | 89,967 | | $ | — | | $ | 276,670 | |
| | Intersegment | | | 2,512 | | | — | | | (2,512 | ) | | — | |
| Expenses: | | | | | | | | | | | | | |
| | External | | | (160,353 | ) | | (140,165 | ) | | — | | | (300,518 | ) |
| | Intersegment | | | — | | | (2,512 | ) | | 2,512 | | | — | |
| Less: | | | | | | | | | | | | | |
| | SFAS 133 fair-value adjustments for insured derivatives and economic hedges | | | (352,510 | ) | | (53,340 | ) | | — | | | (405,850 | ) |
| | |
| |
| |
| |
| |
| Pre-tax segment operating earnings | | $ | 381,372 | | $ | 630 | | $ | — | | $ | 382,002 | |
| | |
| |
| |
| |
| |
| Segment assets | | $ | 7,129,343 | | $ | 2,803,924 | | $ | — | | $ | 9,933,267 | |
| | Nine Months Ended September 30, 2006
| |
|---|
| | Financial
Guaranty
| | Financial
Products
| | Intersegment
Eliminations
| | Total
| |
|---|
| | (in thousands)
| |
|---|
| Revenues: | | | | | | | | | | | | | |
| | External | | $ | 529,069 | | $ | 151,800 | | $ | — | | $ | 680,869 | |
| | Intersegment | | | 2,712 | | | — | | | (2,712 | ) | | — | |
| Expenses: | | | | | | | | | | | | | |
| | External | | | (140,788 | ) | | (192,502 | ) | | — | | | (333,290 | ) |
| | Intersegment | | | — | | | (2,712 | ) | | 2,712 | | | — | |
| Less: | | | | | | | | | | | | | |
| | SFAS 133 fair-value adjustments for insured derivatives and economic hedges | | | 24,540 | | | (43,461 | ) | | — | | | (18,921 | ) |
| | |
| |
| |
| |
| |
| Pre-tax segment operating earnings | | $ | 366,453 | | $ | 47 | | $ | — | | $ | 366,500 | |
| | |
| |
| |
| |
| |
| Segment assets | | $ | 6,824,675 | | $ | 3,008,305 | | $ | — | | $ | 9,832,980 | |
12
The following tables present reconciliations of the segments' pre-tax operating earnings to net income.
| | Nine Months Ended September 30, 2007
| |
|---|
| | Financial
Guaranty
| | Financial
Products
| | Intersegment
Eliminations
| | Total
| |
|---|
| | (in thousands)
| |
|---|
| Pretax operating earnings | | $ | 381,372 | | $ | 630 | | $ | — | | $ | 382,002 | |
| SFAS 133 fair-value adjustments for insured derivatives and economic hedges | | | (352,510 | ) | | (53,340 | ) | | — | | | (405,850 | ) |
| Taxes | | | | | | | | | | | | 32,378 | |
| Minority interest | | | | | | | | | | | | 52,711 | |
| | | | | | | | | | | |
| |
| Net income | | | | | | | | | | | $ | 61,241 | |
| | | | | | | | | | | |
| |
| | Nine Months Ended September 30, 2006
| |
|---|
| | Financial
Guaranty
| | Financial
Products
| | Intersegment
Eliminations
| | Total
| |
|---|
| | (in thousands)
| |
|---|
| Pretax operating earnings | | $ | 366,453 | | $ | 47 | | $ | — | | $ | 366,500 | |
| SFAS 133 fair-value adjustments for insured derivatives and economic hedges | | | 24,540 | | | (43,461 | ) | | — | | | (18,921 | ) |
| Taxes | | | | | | | | | | | | (96,836 | ) |
| Minority interest | | | | | | | | | | | | 43,157 | |
| | | | | | | | | | | |
| |
| Net income | | | | | | | | | | | $ | 293,900 | |
| | | | | | | | | | | |
| |
The intersegment revenues and expenses relate to premiums paid by FSA Global on FSA-insured notes.
The amount of SFAS 133 fair-value adjustments for insured derivatives are a reconciling item between pre-tax segment operating earnings and net income. In addition, management subtracts the impact of economic hedges when analyzing the segments. Marking the derivatives to fair value but not marking the hedged assets or liabilities causes one-sided accounting. By removing its effect, in the view of management, the measure more closely reflects the underlying economic performance of segment operations.
11. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company and certain Subsidiaries are parties to litigation. The Company is not a party to any material pending litigation.
On November 15, 2006, the Parent received a subpoena from the Antitrust Division of the U.S. Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs. On November 16, 2006, FSA received a subpoena from the SEC related to an ongoing industry-wide civil investigation of brokers of municipal GICs. The Parent issues municipal GICs through the FP Segment, but does not serve as a GIC broker. The subpoenas request that the Parent furnish to the DOJ and SEC records and other information with respect to the Company's municipal GIC business. The Parent is cooperating with the investigations by the DOJ and the SEC.
13
12. RECENTLY ISSUED ACCOUNTING STANDARDS
On September 15, 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 157, "Fair Value Measurements" ("SFAS 157"), which addresses how companies should measure fair value when required to use fair value measures for recognition or disclosure purposes under GAAP. SFAS 157 adopted an "exit price" approach to determining fair value and set forth a three-level fair value hierarchy to prioritize the inputs used in valuation techniques. Level 1 is the highest priority and is defined as observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 is defined as inputs other than quoted prices included in Level 1 that are observable for the asset or liability through corroboration with observable market data. Level 3 is the lowest priority and is defined as a valuation based on unobservable inputs such as a company's own data. Prioritization of inputs, as well as other considerations, determine the level of disclosure required. SFAS 157 is applicable to financial statements issued for fiscal years beginning after November 15, 2007 and for interim periods within those fiscal years. The Company is in the process of evaluating the impact of SFAS 157 on its financial statements.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"), which permits reporting entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. The fair value option may be applied instrument by instrument, is applied only to entire instruments and not to portions of instruments and the election is irrevocable. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating SFAS 159 and the implications for the Company's financial statements.
In April 2007, the FASB issued FSP No. FIN 39-1, "Amendment of FASB Interpretation No. 39" ("FSP 39-1"). FSP 39-1 amends FIN No. 39, "Offsetting of Amounts Related to Certain Contracts" ("FIN 39"), to permit 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 accordance with FIN 39. FSP 39-1 also amends FIN 39 for certain terminology modifications. FSP 39-1 is effective for fiscal years beginning after November 15, 2007, with early application permitted, and is applied retrospectively as a change in accounting principle for all financial statements presented. Upon adoption of FSP 39-1, the Company is permitted to change its accounting policy to offset or not offset fair value amounts recognized for derivative instruments under master netting arrangements. The Company is currently evaluating FSP 39-1 and has not yet determined the effect the adoption of FSP 39-1 will have on the consolidated financial statements.
On April 18, 2007, the FASB issued an Exposure Draft entitled "Accounting for Financial Guarantee Insurance Contracts," an interpretation of SFAS 60, "Accounting and Reporting by Insurance Enterprises" (the "Exposure Draft"). The Exposure Draft addresses premium revenue and claim liabilities recognition, as well as related disclosures. Under the Exposure Draft, the Company would be required to recognize premium revenue only in proportion to contractual payments (principal and interest) made by the issuer of the insured financial obligation. The proposed recognition approach for a claim liability would require the Company to recognize a claim liability when there is an expectation that a claim loss will exceed the unearned premium revenue (liability) on a policy basis based on the present value of expected cash flows. Additionally, the Exposure Draft would require the Company to provide expanded disclosures relating to factors affecting the recognition and measurement of financial guarantee contracts.
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In September 2007, the FASB held a discussion forum with interested parties and it is management's understanding that the FASB plans to begin redeliberations of the Exposure Draft in the fourth quarter of 2007. The final statement is expected to be issued in the first quarter of 2008. Until final guidance is issued by the FASB the Company will continue to apply its existing policies with respect to the establishment of both case basis and non-specific loss reserves and the recognition of premium revenue.
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FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS (unaudited) September 30, 2007FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS (unaudited) September 30, 2007INDEXFINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (unaudited) (in thousands, except share data)FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (in thousands)FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands)FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
