Assured Guaranty Ltd. — Q3 2012 Form 10-Q
Period: Quarter and nine months ended September 30, 2012. Unaudited consolidated results include the Company’s financial guaranty variable interest entities (VIEs). Assured Guaranty provides credit protection for public finance and structured finance obligations.
Financial results and position
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenue | $342 million | $1,345 million | $744 million | $1,740 million |
| Net earned premiums | $222 million | $211 million | $635 million | $695 million |
| Net investment income | $102 million | $95 million | $301 million | $295 million |
| Loss and loss-adjustment expense | $90 million | $215 million | $459 million | $313 million |
| Net income | $142 million | $761 million | $36 million | $857 million |
| Diluted EPS | $0.73 | $4.13 | $0.19 | $4.60 |
| Non-GAAP operating income | $166 million | $38 million | $351 million | $429 million |
| Present value of new business production (PVP) | $35 million | $51 million | $141 million | $155 million |
At September 30, 2012, total assets were $17.6 billion, total liabilities $12.6 billion and shareholders’ equity $5.0 billion. The investment portfolio was $11.1 billion; cash was $133 million. Long-term debt had a carrying value of $840 million and principal of $1.146 billion, down from a $1.038 billion carrying value and $1.350 billion principal at year-end 2011. No standard operating margin measure is provided; the company’s results are materially affected by insurance loss estimates and fair-value movements.
Operating cash flow was negative $223 million for the first nine months, compared with positive $601 million in 2011; cash declined to $133 million from $215 million at year-end. Investing cash flow was positive $802 million and financing cash flow was negative $662 million. Management said the operating cash flow decline principally reflected higher claim payments, including on Greek bonds, and the prior-year receipt of Bank of America settlement proceeds; 2012 commutation receipts partly offset the outflow.
Material changes versus comparable periods
- Q3 net income fell to $142 million from $761 million, principally because the prior-year quarter included $1.156 billion of unrealized credit-derivative gains; Q3 2012 recorded a $38 million unrealized loss on credit derivatives. These fair-value changes are volatile and are not necessarily indicative of ultimate claims or economic losses.
- Nine-month net income fell to $36 million from $857 million, reflecting a $466 million net credit-derivative fair-value loss in 2012 versus an $855 million gain in 2011, alongside lower earned premiums and higher reported loss expense.
- Q3 premiums increased, aided by $73 million of accelerated premium recognition from refundings and terminations, versus $27 million a year earlier. Nine-month premiums declined as the structured-finance portfolio ran off.
- Non-GAAP operating income rose in Q3, but fell for the nine-month period. PVP also declined year over year for both periods, reflecting lower new-business production amid low interest rates and rating uncertainty.
- Net insured par outstanding declined to $536.4 billion from $558.0 billion at year-end 2011. Below-investment-grade (BIG) net par fell to $24.4 billion, or 4.5% of total net par, from $26.8 billion, or 4.8%. Portfolio classifications reflect the company’s internal ratings and a new treatment for certain collateralized reimbursement agreements.
Outlook, management commentary, risks and unusual items
- Outlook: The filing gives no quantified earnings guidance. Management expected scheduled premium revenue to decline over time absent new business or reassumed business. It anticipated that structured-finance and international infrastructure opportunities could recover as markets improve, but said timing and demand were uncertain. The company reported it remained the most active financial guaranty provider, while acknowledging weak industry demand and pressure on municipal insurance penetration.
- Ratings and liquidity sensitivity: Moody’s had placed the company and rated subsidiaries under review for possible downgrade; on October 30, 2012, it said it expected to resolve the review in the first half of November. A downgrade could reduce new business, trigger collateral or claims, and affect access to liquidity. At September 30, a specified AGM downgrade could prompt withdrawal of $358 million of GIC funds and collateral posting on $2.9 billion of GIC balances, estimated at $3.1 billion at a 105% margin. Credit-derivative collateral pledged was $687 million; downgrade-related termination or collateral requirements could materially affect liquidity. Management stated it believed holding-company and insurance-subsidiary liquidity needs for the next 12 months could be met from available resources and operating cash flows.
- Credit and estimation risks: Management’s net expected loss to be paid across the insured portfolio was $753 million at September 30, including financial-guaranty insurance, VIEs and credit derivatives; this is an estimate, not the GAAP loss reserve, and depends on uncertain assumptions about defaults, recoveries, discount rates and timing. Total BIG net par was $24.4 billion. U.S. RMBS remained a significant risk area, including Alt-A, Option ARM, subprime and HELOC exposures. The filing notes that modeled mortgage losses assume eventual housing-market improvement and that actual losses could differ materially.
- Recovery assumptions and settlements: The company estimated a $1.1 billion benefit from mortgage representation-and-warranty recoveries in its insurance loss estimates. It reported approximately $2.8 billion paid or committed by providers, including the $166 million Deutsche Bank cash settlement and future loss-sharing arrangements. Future recoveries remain uncertain and dependent on counterparties, transaction losses and litigation outcomes.
- Public finance and Europe: Troubled U.S. municipal credits included Jefferson County, Alabama, with $708 million net exposure, and Stockton, California, with $160 million net exposure; Stockton had generated $8 million in net claims paid. The company estimated $10 million of total expected net losses on troubled U.S. public-finance credits. It had no direct Greek sovereign exposure at quarter-end after paying $289 million in net claims. Net exposure to selected European countries was $4.5 billion, including $980 million to Spain; Spanish regional exposures were downgraded internally and expected loss increased by $31 million in Q3 to $34 million.
- Other events: The company acquired MIAC for $91 million in cash in May 2012. It reassumed or reinsured $19.1 billion of par through Radian- and Tokio-related transactions and recorded $84 million in nine-month commutation gains. The June settlement of equity units resulted in issuance of 13.4 million common shares; the company also repurchased 2.1 million shares for $24 million and paid $51 million of dividends. Hurricane Sandy occurred after quarter-end; management said it did not expect significant insured losses at that time.
- Legal and regulatory matters: Recovery litigation over RMBS representations and warranties, municipal-finance disputes, and legacy municipal guaranteed-investment-contract investigations remained outstanding. The company said it could not reasonably estimate potential losses in several matters. It also stated that Dodd-Frank implementation could impose additional derivatives registration, compliance or capital requirements; it believed it was likely to be required to register as a major swap participant, subject to final rules.
Most important facts for investors to verify
- How much of reported earnings and equity reflects fair-value estimates—especially Level 3 credit derivatives and VIEs—rather than recurring premiums, investment income and realized cash flows.
- Whether mortgage-loss assumptions and the estimated $1.1 billion representation-and-warranty recovery benefit are supported by realized recoveries and enforceable agreements.
- How rating-agency actions could affect GIC withdrawals, collateral posting, CDS termination rights, reinsurance recapture and future business production.
- Whether claim payments, municipal and European exposures, and counterparty/reinsurer credit quality remain consistent with management’s loss and liquidity estimates.
- How the negative nine-month operating cash flow, available holding-company liquidity, debt maturities and restrictions on subsidiary dividends affect capital flexibility.