Significant Mark-To-Market Losses On Credit Derivatives Not Expected To Affect Bond Insurer Ratings

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1 October 31, 2007 Significant Mark-To-Market Losses On Credit Derivatives Not Expected To Affect Bond Insurer Ratings Primary Credit Analyst: Dick P Smith, New York (1) ; dick_smith@standardandpoors.com Secondary Credit Analyst: Ron Joas, New York (1) ; ron_joas@standardandpoors.com Table Of Contents Commentary Analytic Considerations Required GAAP Accounting Analytical Significance Summary 1 Standard & Poor's. All rights reserved. No reprint or dissemination without S&Ps permission. See Terms of Use/Disclaimer on the last page

2 Significant Mark-To-Market Losses On Credit Derivatives Not Expected To Affect Bond Insurer Ratings Commentary With many bond insurers reporting significant mark-to-market losses on credit derivatives in their third-quarter 2007 GAAP earnings reports, accounting issues have once again come to the forefront in shaping investors' perceptions of insurers. Standard & Poor's Ratings Services has previously commented on this topic, explaining that we do not view mark-to-market losses or gains on credit derivatives as having a fundamental economic effect (in that they are not predictive of future claims) for the purposes of our capital adequacy and profitability analyses. As a result, this volatility--to the extent that it is not reflective of credit deterioration in the underlying issues--will not likely precipitate any rating or outlook changes. Nevertheless, in light of the significant decline in earnings that some companies experienced this quarter, we believe it is appropriate to reaffirm our position on this topic. Mark-to-market accounting can have a meaningful effect on two elements of our analysis. First, if a company's ability to generate new business is impaired because potential customers grow concerned over significant reported negative marks, they may question the company's vibrancy and vitality, and ultimately, its viability. Secondly, lower GAAP net worth, driven by significant negative marks, may trigger covenant violations in debt instruments, leading to the possibility that the company may be required to pay off certain borrowings or lose access to bank lines that support liquidity. Analytic Considerations When assessing the capital adequacy of a bond insurer, Standard & Poor's uses a capital adequacy model based on statutory accounting principles required by the various state insurance regulators. Although statutory accounting principles are inherently more conservative because they focus on solvency, they do not require that credit derivatives be marked to market, so there is no need for us to adjust reported results for our analysis. Statutory accounting requires the establishment of loss reserves upon the event of default, instead of losses based on a negative change in fair value. In addition, financial guarantors are required to establish contingency reserves (aside from the unearned premium reserves) ranging as high as 2.5% of the premiums written despite losses typically being far less than the established reserves. In the unusual event that statutory capital is impaired by a mark-to-market adjustment, such as to the net worth of a subsidiary company (reflected as an investment in the statutory accounts), we would adjust statutory capital to eliminate that impairment, although the potential regulatory capital requirements might be nominally affected. Our capital model is sensitive to the current credit quality of the insured portfolio. Changes in credit quality will result in changes to capital charges, which will drive changes in our assessment of capital adequacy. We base changes in credit quality on our assessment of the credit quality of the insured transaction, not on changes in the market's view of the risk as reflected in mark-to-market gains or losses. Standard & Poor s RatingsDirect October 31,

3 Significant Mark-To-Market Losses On Credit Derivatives Not Expected To Affect Bond Insurer Ratings When measuring a bond insurance holding company's return on equity, Standard & Poor's calculates the ratio in two ways: by using reported GAAP results that incorporate the mark-to-market adjustments, or by using operating income, which excludes mark-to-market adjustments. This second ratio gives us a better view of the company's sustainable earnings power. The different metrics reflect our analytical perspective of rating through a cycle, as well as our conservative analytical approach to assessing capital, which ensures greater stability in our ratings for the bond insurance industry. None of the bond insurers have net worth maintenance covenants in their outstanding debt that require repayment of the debt if a breach of covenant occurs. Certain liquidity lines may require an insurer to maintain its net worth at a specified level. One insurer, ACA Financial Guaranty Corp. ('A' Financial Strength and Financial Enhancement Ratings), lost its ability to draw on a liquidity facility due to a significant decline in net worth that was partly caused by negative marks. Typically, these levels are set well below the current net worth at the time the facility is established so that some deterioration in net worth is possible without access to the facility coming into question. Insurers maintain liquidity facilities as a portion of their overall liquidity management. Required GAAP Accounting Under FASB statement 133, "Accounting for Derivative Instruments and Hedging Activities," bond insurers are required to mark their credit derivative exposures to market. The credit derivative exposures are, in effect, financial guarantees written in swap form, typically on CDOs but also on other asset-backed obligations. At the end of each reporting period, the insurers must revalue these exposures to current market value and reflect the effects of these marks (positive and negative) in their income statements. The severe repricing of risk in the mortgage-backed and corporate debt markets is the source of the significant negative marks to market in the third quarter. In the wake of heightened fears regarding the potential losses that could materialize on mortgage-backed securities, particularly subprime, the securities have become extremely difficult to value. In addition, the trading in the market for these assets is often sporadic and at prices that seemingly assume a worst-case scenario for recovery. Investors have also grown concerned about prospects for speculative-grade corporate bonds and loans, driving prices down on these as well. With this significant price uncertainty and erosion, any credit derivative obligation linked to these securities will suffer a negative mark. Analytical Significance Mark-to-market accounting for credit derivatives introduces inconsistent treatment within insurers' financial statements (relative to the similar risk encompassed in a traditional guarantee arrangement) based solely on the form of the risk assumption agreement and not on the substance of the risk assumed. Moreover, it substitutes market judgment for management's judgment in setting loss reserves and results in income statement volatility that may have little to do with the actual risk of loss. For these reasons, while Standard & Poor's assesses the marks for actual credit deterioration, in the absence of it we do not ascribe any analytical significance to these negative marks as relating to our assessments of capital adequacy or profitability. We discuss each of these reasons below in more detail: 3

4 Significant Mark-To-Market Losses On Credit Derivatives Not Expected To Affect Bond Insurer Ratings Not Predictive Of Loss Because the overwhelming majority of the credit default swaps have 'AAA' quality underlying risks at origination, a very high percentage of the swaps will likely mature without any claims on the bond insurer. Therefore, for these performing transactions, the negative (or positive) marks to market will zero out at the maturity of the contracts. Interim changes in the value of the swap contract reflect changes in the market's judgment about the underlying risk. Actual credit deterioration or a change in risk perception may be the basis for these changes. In the third quarter of 2007, some credit deterioration occurred; however, had these contracts been accounted for in a manner consistent with insurance contracts, the deterioration would not have been significant enough to result in a need to post increased loss reserves. This was the case, for example, with Ambac ('AAA' Financial Strength and Financial Enhancement Ratings); except for the required mark-to-market accounting treatment, it would not have taken any reserves on its credit derivative block of business in the third quarter. Mark-to-market accounting may not be predictive of actual losses and can introduce inconsistencies in our profitability and capital analyses, as illustrated by the following example: If an insurer wrote a credit default swap on a 'AAA'-rated state-issued bond and the state was subsequently downgraded to 'AA+', the next mark to market on that swap would show a loss, all else being equal. However, if the swap was written as a financial guarantee policy, that same change in risk would not have generated a loss reserve since the underlying quality of a 'AA+'-rated state is indicative of an extremely low probability of default. In all likelihood, the negative mark would zero out over time, with the swap written on that state expiring without a claim payment. The earnings volatility caused by the original negative mark and the subsequent positive marks would not have been reflective of the fundamental risk of loss that we would otherwise take into account in our capital analysis. Moreover, information on the change in the market value of swap contracts commingles real credit information with changes in spreads. In the example of the 'AA+' state used above, assume that investors had taken a decidedly negative view on state credits because of certain court rulings which would not otherwise translate into a fundamental deterioration in credit quality; as a result, all states would trade in the market as if they were rated one designation lower ('AA+' versus 'AAA', etc.) than before the court ruling. The negative mark on the downgraded state would now reflect both the actual downgrade and the wider spreads, but all swaps on states that Standard & Poor's did not downgrade would have negative marks due to the spread changes. Fast-forward one quarter and assume the courts clarified their rulings, eliminating concern over state credits and returning spreads to pre-ruling levels. In that quarter, a bond insurer with state swaps would have a mark-to-market gain. The negative marks of the previous quarter and the positive marks of the current quarter would have introduced volatility into the insurer's income statements unreflective of its actual economic results and earning power, given that no states were in jeopardy of defaulting. No Liquidity Risk Negative mark-to-market information is not indicative of any liquidity risk to 'AAA' rated insurers relating to a requirement to post collateral as marks change. Unlike the typical swap contract between non-bond insurance counterparties that requires them to post collateral when the cumulative mark to market exceeds a threshold value, 'AAA' rated bond insurers for the past several years have only engaged in swap contracts where they were not required to post collateral. This policy is consistent with the bond insurers' overall business model, which seeks to minimize liquidity risks. Some insurers may have a small number of legacy transactions that require the posting of collateral in certain scenarios, but the exposure is minimal and is declining over time as the contracts mature. ACA Financial Guaranty Corp. is the one insurer that is required to post collateral in certain scenarios; these scenarios Standard & Poor s RatingsDirect October 31,

5 Significant Mark-To-Market Losses On Credit Derivatives Not Expected To Affect Bond Insurer Ratings vary from transaction to transaction and are generally related to the downgrade of the company below 'A-' but also include instances where actual losses exceed a significant threshold. Swap Not Cancelable Bond insurer credit default swaps are non-cancelable, potentially making interim mark-to-market values of the contract less valuable in that the intention of the marks is to convey information regarding termination or replacement costs. Some proponents of mark-to-market accounting contend that current values of swaps are relevant because the market can view changes to the current value of the contract as the incremental cost to an insurer to cancel the contract or to purchase an offsetting position. However, bond insurers write the contracts to be non-cancelable and the insurers are at risk for the life of the contract regardless of the volatility that occurs in the interim. The bond insurance business model is that of a risk accumulator employing sound risk management techniques; it is not a risk originator and syndicator, instead focusing on fee generation and minimization of risk accumulation. Although it may be possible to purchase offsetting positions, bond insurers have not historically sought to purchase third-party protection on deteriorated credits. Moreover, such activity would be limited under Standard & Poor's criteria that define the maximum amount of all third-party capital support (including the offsetting positions discussed here) that is allowable. Summary Standard & Poor's strongly prefers the accounting model used on financial guarantee policies where the counterparties post reserves when the possibility of loss has become significant. Posting reserves when the possibility of losses remains remote, which is what essentially occurs with derivative contract accounting for bond insurers, tends to obscure the actual potential for losses. The mark-to-market changes that result in increases in the derivative liabilities due to widening credit spreads have this effect in spite of the fact that current accounting standards for financial guarantee insurance contracts would not require these loss reserves. Mark-to-market accounting further compounds the 'reserving' problem by relying on market, rather than management, judgment. This problem is most acute at times of extreme uncertainty or stress, when markets can cease to function in a rational manner, leading to highly volatile and less-than-credible pricing information. As a result, we rely on capital models that do not incorporate mark-to-market accounting and measure returns on equity using operating earnings that exclude mark-to-market gains or losses. For all of the above reasons, we do not expect the negative marks to market that are a feature of the bond insurers' third-quarter earnings reports to precipitate any ratings or outlook changes at any of the insurers. 5

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