Assured Guaranty Ltd. — Q2 2011 Form 10-Q
Reporting period: Three and six months ended June 30, 2011; balance-sheet comparisons are with December 31, 2010. Assured Guaranty provides financial guaranty insurance and related credit protection, primarily for public finance and structured finance obligations. Amounts below are U.S. dollars.
Key financial results
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Total revenue | $102.0 million | $447.7 million | $356.1 million | $1,115.0 million |
| Net earned premiums | $230.0 million | $292.1 million | $484.0 million | $611.7 million |
| Net investment income | $100.8 million | $90.9 million | $197.2 million | $175.2 million |
| Loss and LAE expense | $132.9 million | $71.2 million | $105.9 million | $201.7 million |
| Net income (loss) | $(57.7) million | $203.5 million | $67.7 million | $525.5 million |
| Diluted EPS | $(0.31) | $1.08 | $0.36 | $2.77 |
| Non-GAAP operating income | $136.3 million | $172.0 million | $385.2 million | $284.6 million |
Q2 GAAP results included a $59.4 million loss from credit derivatives and a $193.7 million loss from financial guaranty variable interest entities (VIEs). These fair-value items materially affected reported revenue and net income. Management’s non-GAAP operating income excludes specified market-value and VIE effects; it fell 20.8% year over year in Q2, but increased 35.3% for the six-month period, mainly reflecting higher representation-and-warranty recoveries.
- Cash flow: Six-month operating cash flow was $614.4 million, compared with cash used of $249.6 million a year earlier. The company attributed the improvement mainly to Bank of America settlement proceeds. Investing cash flow was $57.2 million and financing cash flow was $(622.8) million, including $593.3 million of VIE liability paydowns. Cash ended the period at $159.2 million.
- Balance sheet and debt: Total assets were $19.24 billion, total liabilities $15.29 billion and shareholders’ equity $3.95 billion. The investment portfolio was $11.19 billion. Long-term debt had a $1.05 billion carrying value and $1.36 billion principal amount; the principal/carrying-value difference largely reflects acquisition-related accounting adjustments on AGMH debt.
- Liquidity: The $300 million revolving credit facility had no borrowings outstanding; $2.9 million of letters of credit remained outstanding. Management said holding-company liquidity should be sufficient for the next 12 months, including common-share dividends, while noting dependence on subsidiary dividends and the possibility that future external financing may be needed. Insurance-subsidiary liquidity is supported by cash, short-term investments, operating cash flow and portfolio maturities, subject to regulatory and rating-agency constraints.
- Portfolio and capital: Net par outstanding was $587.2 billion at June 30, down from $617.1 billion at year-end. Below-investment-grade exposure was $27.8 billion, or 4.7% of net par. Net debt-service outstanding was $886.8 billion. These are insured exposures, not balance-sheet debt.
Material changes and significant developments
- Net earned premiums fell 21% in Q2 and 21% for the first half, mainly as the structured-finance insured book ran off. Management said premiums are expected to decline unless replaced by new business; $5.6 billion of deferred premium revenue remained to be earned.
- New-business production weakened: present value of new business production was $51.9 million in Q2, down 42.3%, and $104.4 million for six months, down 38.1%. U.S. municipal issuance was $115.0 billion in the first half, down 44% year over year. Management cited lower issuance and uncertainty over proposed rating criteria.
- On April 14, 2011, Bank of America agreed to pay $1.1 billion relating to 29 insured RMBS transactions. Assured Guaranty received $928.1 million for second-lien transactions and expected the remaining $171.9 million by March 2012, in exchange for releasing related repurchase claims. For 21 first-lien transactions, Bank of America agreed to reimburse 80% of claims, subject to a $6.6 billion collateral-loss threshold, and had placed $1.0 billion of eligible assets in trust. Management estimated $126.8 million of expected losses after those first-lien recoveries, compared with $630.9 million before them. The settlement and related assumptions materially supported first-half results.
- Loss estimates remain sensitive to mortgage performance, recovery timing and discount rates. Management reported $70.9 million of economic loss development in Q2, including $55.4 million for U.S. RMBS; lower risk-free discount rates were a significant contributor. First-lien mortgage severities remained elevated, and the company extended stress assumptions for second-lien loans.
- Eight additional VIEs were consolidated during Q2, bringing the total to 35. The consolidation produced a $95.3 million pretax loss; fair-value changes in these entities can create substantial reported earnings volatility.
- Standard & Poor’s was reviewing proposed bond-insurance rating criteria that could lower insurer ratings unless companies raise capital or reduce risk. Final criteria and updated ratings were expected by September 30, 2011. As of August 9, after the quarter, AGM and AGC were rated Aa3 with negative outlook by Moody’s and AA+ with negative outlook by S&P; S&P’s outlook revision followed its U.S. sovereign downgrade.
Outlook, risks and contingencies
The filing provides no numerical earnings or revenue guidance. Management’s stated priorities included improving rating-agency capital, mitigating losses and developing new business. The company had stopped underwriting new U.S. RMBS and new CDS protection, and was selectively underwriting structured finance. It expected AGM’s structured-finance portfolio to run off substantially over time.
- Rating downgrades could reduce demand for new insurance, trigger collateral posting or CDS termination payments, increase claims or accelerate payments, and permit reinsurers to recapture business. The company disclosed $2.7 billion of CDS par subject to rating-based termination provisions and approximately $768.6 million of collateral agreed to be posted under certain CDS contracts, with potential for additional posting.
- Mortgage loss and recovery estimates are inherently uncertain. The company’s estimated benefit from RMBS representations-and-warranties recoveries was $1.5 billion before consolidation effects; actual recoveries may differ materially. The filing describes ongoing claims and litigation against other providers.
- AGM had a court ruling adverse to its recovery priority in an RMBS transaction: it was ordered to repay approximately $7.2 million and estimated up to $144 million of possible unreimbursed claims over the transaction’s life if the ruling is not modified. AGM intended to appeal.
- Other disclosed exposures include possible liquidity claims of approximately $1.1 billion on 45 leveraged-lease transactions under existing rating triggers, plus $1.0 billion on 26 additional transactions if AGM were downgraded further to specified thresholds. No such lease-default claims had occurred as of the filing.
- The filing discusses litigation and investigations, including municipal-bond-insurance and former municipal derivatives matters. Management said it could not reasonably estimate possible losses for several proceedings; it believed litigation against the company was not expected to materially harm financial position or liquidity, though a particular period’s results could be affected.
Important facts for investors to verify
- Whether Bank of America paid the remaining $171.9 million by March 2012 and how first-lien recoveries and collateral-loss estimates developed.
- Final S&P criteria, subsequent ratings actions, and resulting impacts on demand, capital requirements, collateral calls and claims.
- Changes in RMBS delinquencies, severities, loss assumptions, expected recoveries and the $27.8 billion below-investment-grade exposure.
- Whether operating cash flow and subsidiary dividends remain sufficient for holding-company obligations, and whether restricted or pledged assets limit usable liquidity.
- Developments in the RMBS recovery litigation, the MARM reimbursement ruling and leveraged-lease exposures.