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Business Overview of Primary Bond Insurers and
    Report on Involvement in U.S. Residential Mortgage-Backed
           Se...
Table of Contents




               ● Business Overview of Primary Bond Insurers

               ● Bond Insurer Involveme...
Business Overview




AFGI1107.ppt                       3
Business Overview
 Executive Summary

               ● Financial guaranty is a pure credit business
                  - Un...
Business Overview
 Monoline Financial Guaranty Insurance Industry Business Model

         ●     Industry established in 1...
Business Overview
 Financial Guaranty Benefits


         ● Benefits to Issuers:
               -   Allows credit rating o...
Business Overview
 Types of Bonds Insured




  ● All insured bonds are rated by rating agencies (“shadow rating”)        ...
Business Overview
 Monoline Financial Guaranty Industry - Total Claims-Paying Resources*


                               ...
Bond Insurer Involvement in U.S. Residential
             Mortgage-Backed Securities (RMBS) and
          Collateralized D...
Bond Insurer Involvement in U.S. RMBS and CDOs of ABS
  Current Issues Related to Market Dislocation


               Prim...
Bond Insurer Involvement in U.S. RMBS and CDOs of ABS
  Industry Net Par Outstanding by Sector and Ratings Distribution


...
Bond Insurer Involvement in U.S. RMBS and CDOs of ABS
  First Lien Subprime RMBS Performance Expectations



             ...
Bond Insurer Involvement in U.S. RMBS and CDOs of ABS
  Allocation of Subprime Mortgage Risks in CDOs



● Subprime mortga...
Bond Insurer Involvement in U.S. RMBS and CDOs of ABS
  Unrealized Mark-to-Market Losses for Insured Derivative Portfolios...
Monoline Implications




AFGI1107.ppt                           15
Monoline Implications



        ● The monoline financial guaranty business model is designed to withstand the test of tim...
Monoline Implications (Cont’d)




         ● If required to raise capital, monolines should have the capability and time ...
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AGFI Bonds with Mortgage Backed Securities and Collateralized Debt

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AGFI Bonds with Mortgage Backed Securities and Collateralized Debt

  1. 1. Business Overview of Primary Bond Insurers and Report on Involvement in U.S. Residential Mortgage-Backed Securities and Collateralized Debt Obligations of Asset-Backed Securities November 2007 AFGI is a trade association of the 12 insurers and reinsurers of municipal bonds and asset-backed securities. AFGI1107.ppt 1
  2. 2. Table of Contents ● Business Overview of Primary Bond Insurers ● Bond Insurer Involvement in U.S. Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations of Asset- Backed Securities (CDO of ABS) Sector ● Monoline Implications AFGI1107.ppt 2
  3. 3. Business Overview AFGI1107.ppt 3
  4. 4. Business Overview Executive Summary ● Financial guaranty is a pure credit business - Unconditional and irrevocable guaranty to pay scheduled principal and interest on U.S. municipal, public infrastructure and asset-backed securities; no acceleration - Product provides efficiency in capital markets - The closest equivalent to financial guaranty is an irrevocable long-term bank letter of credit ● Financial guaranty companies are generally rated AAA ● Policy forms also include surety bonds as well as credit derivatives, whose terms mirror a financial guaranty - No liquidity risk - No collateral posting - Pay-as-you-go settlement terms ● Financial guaranty companies take long-term credit risk - Cannot trade out of risk; hold to maturity, but may mitigate risk through reinsurance - Control of remedies and remediation is critical to loss mitigation ● Credit is principal driver of long-term profitability - Underwrite investment-grade risks only ● Industry is heavily regulated and transparent - New York State Insurance Department (or other state insurance departments) - Financial Services Authority in the U.K. - Rating agencies require ongoing information from the financial guarantors AFGI1107.ppt 4
  5. 5. Business Overview Monoline Financial Guaranty Insurance Industry Business Model ● Industry established in 1971 to serve U.S. municipal bond sector; today serves both public infrastructure and asset-backed global markets ● Monolines are specialized insurance companies – participants must operate solely as a separately structured and capitalized entity, providing guarantees of financial obligations only. No other insurance can be written. - Monolines do not originate securities or mortgages. ● Regulated by government agencies and rating agencies: - Insurance company operating under Article 69 of the New York State Insurance law - Three principal agencies: Moody’s, Standard & Poor’s and Fitch Ratings ● Investment-grade underwriting practice has resulted in low industry loss experience - Low probability/low severity/highly diverse credit portfolios - Withstand highly strenuous scenarios - Decidedly not a banking model - Since inception, industry has incurred only 3 bps in losses on net debt service. (Banks had weighted average annual charge-offs on principal of 60 bps from 1992 to 2006.) ● Total industry insured net par outstanding is approximately $2.3 trillion, and approximately 50% of all U.S. municipal bonds are insured. The largest primary providers: AMBAC, FGIC, FSA & MBIA have nearly $2.0 trillion in insured net par outstanding. ● From 2001-2006, monolines have insured: - More than $1 trillion of U.S. municipal bonds to fund schools, highways, airports, transit systems, hospitals, environmental systems and other projects. - Almost $82 billion of bonds to fund essential public projects outside of the U.S. - More than $1 trillion of asset-backed bonds to provide cost efficient funding to corporates and financial institutions throughout the world. AFGI1107.ppt 5
  6. 6. Business Overview Financial Guaranty Benefits ● Benefits to Issuers: - Allows credit rating of the guarantor to be applied to the bonds - Reduced cost of funds - since inception, the financial guarantors have saved municipalities over $40 billion. - Increased economic leverage through efficient structuring - Broader funding sources - Streamlined execution - In case of small municipal issuers, access to capital markets only possible through a financial guaranty. ● Benefits to Investors: - Default protection - Bond guarantor waives all defenses including fraud and non-payment of premiums - Enhanced liquidity - Reduced secondary-market price volatility, particularly if underlying issue is downgraded - Consolidated analysis, diligence and surveillance; exercise of remedies when necessary - Unlike a trustee, bond guarantor has capital at risk, therefore its interest aligns with those of bondholders. AFGI1107.ppt 6
  7. 7. Business Overview Types of Bonds Insured ● All insured bonds are rated by rating agencies (“shadow rating”) Net Par Outstanding - Needs to be rated investment grade by at least one rating As of December 31, 2006 agency International 14% ● Public finance bonds: - Backed by tax and other municipal authority revenues - Essential infrastructure (transportation, healthcare) - Municipal and investor-owned utilities U.S. Structured Finance U.S. Public ● Structured finance bonds Finance 26% - Mortgage-backed (MBS and home equity) 60% - Asset-backed (consumer, franchise, future flows) - Pooled debt obligations (CDO, CLO, CBO) $2.2 trillion - Structured credit AFGI1107.ppt 7
  8. 8. Business Overview Monoline Financial Guaranty Industry - Total Claims-Paying Resources* 48.8 $ Bn 46.7 41.1 38.7 35.8 26.7 23.5 20.2 18.9 16.7 14.8 12.3 10.9 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1H07 At 6/30/07 Source: S&P and company operating supplements and financial reports of MBIA, AMBAC, FSA, FGIC, XLCA (SCA), CIFG, Radian, Assured & ACA. Reported financials for Radian, CIFG and XCLA (SCA) combine financial guaranty insurance and reinsurance. *Includes Statutory Capital, Unearned Premium Reserves, Installment Premiums, Soft Capital Facilities, and Loss and Loss Adjustment Expense (LAE) Reserves. AFGI1107.ppt 8
  9. 9. Bond Insurer Involvement in U.S. Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations of Asset-Backed Securities (CDO of ABS) Sector AFGI1107.ppt 9
  10. 10. Bond Insurer Involvement in U.S. RMBS and CDOs of ABS Current Issues Related to Market Dislocation Primary Mortgage Market ● Unprecedented credit deterioration in mortgage market exceeded the most conservative historical loss expectations – Since the Depression there has been no year-over-year decline in home prices for the entire U.S. (only regional declines). ● Increased activity by financial intermediaries and mortgage originators to introduce affordability products, which facilitated greater home ownership, increased credit risk. ● Mortgage deterioration was faster than projected. CDO Market ● High-grade and mezzanine CDOs of ABS ultimately contain a high percentage of subprime mortgage loans. Some observations about expected credit performance: – Potential for collateral losses are higher than the original assigned credit rating – Diversity and correlation assumptions may be low – Embedded leverage magnifies the effects of poor collateral performance. ● Attachment at Triple-A or higher levels will be able to withstand greater collateral losses. AFGI1107.ppt 10
  11. 11. Bond Insurer Involvement in U.S. RMBS and CDOs of ABS Industry Net Par Outstanding by Sector and Ratings Distribution Sector Distribution Underlying Ratings Distribution ABS/CDO High Grade Super AAA 31% 28% Subprime BIG 13% ABS/CDO 1% Mezzanine 8% AAA 38% BBB 22% CMBS/CDO HELOC 22% 26% A AA 7% 4% $249 Billion Net Par Outstanding AFGI1107.ppt 11
  12. 12. Bond Insurer Involvement in U.S. RMBS and CDOs of ABS First Lien Subprime RMBS Performance Expectations Subprime First Lien Pool 2006 Nov. 2007 Rating Agency 4.5%-6.0% 11.0%-15.0% Expected Losses Monoline Attachment 23.0%-28.0% 34.0%-42.0% Point at AAA Monoline Attachment 8.0%-10.0% 14.0%-18.0% Point at BBB Based on rating agency information. AFGI1107.ppt 12
  13. 13. Bond Insurer Involvement in U.S. RMBS and CDOs of ABS Allocation of Subprime Mortgage Risks in CDOs ● Subprime mortgage loans can be first mortgages, with a first lien on the property serving as collateral to the loan, or second mortgages (generally closed-end loans where the borrower receives a specified amount at closing) that are subordinated to the first mortgage. ● The loans are generally packaged by type into pools of collateral, forming the basis of RMBS. ● Different tranches, created with varying levels of priority on cash flows generated by the underlying pool, are then sold to third parties. The Aaa-rated tranche has first priority, followed by the Aa-rated tranche, etc. ● ABS CDOs, in turn, may invest in tranches of RMBS transactions, as well as in other ABS. - Classified as “high-grade”- Aa or higher tranches - Classified as “mezzanine”- Baa or higher tranches ● Both types typically have a small allocation within the collateral pool that may be invested in lower-rated collateral. Source: Moody’s, September 2007 AFGI1107.ppt 13
  14. 14. Bond Insurer Involvement in U.S. RMBS and CDOs of ABS Unrealized Mark-to-Market Losses for Insured Derivative Portfolios ● Under U.S. GAAP, insurance policies issued in credit default swaps form typically must be marked to market through the company’s income statement. ● Absent any claims under the guaranty, any decreases or increases to income due to marks will sum to zero by the time of each contract’s maturity. ● The industry and rating agencies view the large, negative unrealized mark-to-market adjustments taken in the third quarter of 2007 as accounting requirements. Capital adequacy is concerned with fundamental credit analysis and not mark-to-market losses. ● Perception problem: the accounting effect has created a misperception regarding the industry’s financial performance as spread widening due to liquidity and credit deterioration have become rolled into one ball of confusion. AFGI1107.ppt 14
  15. 15. Monoline Implications AFGI1107.ppt 15
  16. 16. Monoline Implications ● The monoline financial guaranty business model is designed to withstand the test of time. ● Our industry is facing unprecedented stress from a variety of sources: - Deteriorating asset performance in the residential mortgage sector - Declining confidence in the rating agencies and Triple-A ratings - Rating agencies recalibrating standards to maintain Triple-A ratings - Aggressive and vocal short-selling community ● It is imperative for financial guarantors to maintain the Triple-A-rated capital levels. - Insured portfolios were underwritten and structured to a remote loss standard and to provide portfolio granularity to mitigate correlation risk, avoid liquidity risk, and generally insulate financial guaranty companies from event risk. - New business production will continue to be underwritten at high attachment points to minimize losses, preserve capital and maintain franchises. ● Rating agency downgrades on existing transactions will require increased capital; one or more industry participants may be required to raise additional capital to maintain: - Triple-A ratings - Investor confidence AFGI1107.ppt 16
  17. 17. Monoline Implications (Cont’d) ● If required to raise capital, monolines should have the capability and time to meet rating agency Triple-A capital requirements. Capital can be raised through a variety of activities and sources: - Reinsure well-performing, capital-intensive insured financings - Issue equity, debt, and/or hybrid securities - Insure higher rated, less capital-intensive deals to limit incremental capital requirements - Run-off from existing portfolio - Earnings generate significant incremental capital annually - As exposure amortizes, capital is released ● Losses in the financial guaranty insurance industry are expected to be manageable. ● These turbulent market conditions present financial guarantors with a significant opportunity to increase profitable business production as a result of: - Increased perception of risk, versus real risk, in certain markets - Wider/widening credit spreads - More leverage to increase pricing and further strengthen structure AFGI1107.ppt 17

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