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Financial Guaranty Insurance Contracts
 6 Months Ended
Jun. 30, 2012
Insurance [Abstract]  
Financial Guaranty Insurance Contracts
Financial Guaranty Insurance Contracts
 
Change in accounting for deferred acquisition costs
 
In October 2010, the Financial Accounting Standards Board adopted Accounting Standards Update (“Update”) No. 2010-26. This guidance was effective January 1, 2012, with retrospective application. The Update specifies that certain costs incurred in the successful acquisition of new and renewal insurance contracts should be capitalized. These costs include direct costs of contract acquisition that result directly from and are essential to the contract transaction. These costs include expenses such as ceding commissions and the cost of underwriting personnel. Management uses its judgment in determining the type and amount of cost to be deferred. The Company conducts an annual study to determine which operating costs vary with, and are directly related to, the acquisition of new business, and therefore qualify for deferral. Ceding commission income on business ceded to third party reinsurers reduces policy acquisition costs and is deferred. Costs incurred by the insurer for soliciting potential customers, market research, training, administration, unsuccessful acquisition efforts, and product development as well as all overhead type costs are charged to expense as incurred.
 
Expected losses, loss adjustment expenses (“LAE”) and the remaining costs of servicing the insured or reinsured business are considered in determining the recoverability of deferred acquisition costs. When an insured issue is retired early, the remaining related deferred acquisition cost is expensed at that time. Ceding commission expense and income associated with future installment premiums on assumed and ceded business, respectively, are calculated at their contractually defined rates and recorded in deferred acquisition costs on the consolidated balance sheets with a corresponding offset to net premium receivable or reinsurance balances payable.
 
As of January 1, 2011, the effect of retrospective application of the new guidance was a reduction to deferred acquisition costs of $94.4 million and a reduction to retained earnings of $64.0 million.
 
Effect of Retrospective Application of New Deferred Acquisition Cost Guidance
On Consolidated Statements of Operations
 
 
As Reported
Second Quarter 2011
 
Retroactive Application Adjustment
 
As Revised Second Quarter 2011
 
(in millions except per share amounts)
Amortization of deferred acquisition costs
$
9.5

 
$
(3.7
)
 
$
5.8

Other operating expenses
48.5

 
4.7

 
53.2

Net income (loss)
(42.6
)
 
(0.5
)
 
(43.1
)
Earnings per share:
 

 
 
 
 

Basic
$
(0.23
)
 
$
—

 
$
(0.23
)
Diluted
(0.23
)
 
—

 
(0.23
)
 
 
As Reported
Six Months 2011
 
Retroactive Application Adjustment
 
As Revised Six Months 2011
 
(in millions except per share amounts)
Amortization of deferred acquisition costs
$
16.9

 
$
(7.4
)
 
$
9.5

Other operating expenses
105.3

 
10.7

 
116.0

Net income (loss)
98.0

 
(1.8
)
 
96.2

Earnings per share:
 

 
 
 
 

Basic
0.53

 
(0.01
)
 
0.52

Diluted
0.52

 
(0.01
)
 
0.51



The portfolio of outstanding exposures discussed in Note 3, Outstanding Exposure, includes financial guaranty contracts that meet the definition of insurance contracts as well as those that meet the definition of derivative contracts. Amounts presented in this note relate to financial guaranty insurance contracts. Tables presented herein also present reconciliations to financial statement line items for other less significant types of insurance.
 
Net Earned Premiums
 
 
Second Quarter
 
Six Months
 
2012
 
2011
 
2012
 
2011
 
(in millions)
Scheduled net earned premiums
$
144.7

 
$
202.7

 
$
296.7

 
$
417.6

Acceleration of premium earnings
68.2

 
21.0

 
104.8

 
50.6

Accretion of discount on net premiums receivable
6.3

 
5.8

 
11.0

 
14.8

Total financial guaranty
219.2

 
229.5

 
412.5

 
483.0

Other
0.1

 
0.5

 
0.5

 
1.0

Total net earned premiums(1)
$
219.3

 
$
230.0

 
$
413.0

 
$
484.0

 ___________________
(1)                                  Excludes $15.5 million and $18.3 million in Second Quarter 2012 and 2011, respectively, and $32.5 million and $37.4 million for the Six Months 2012 and 2011, respectively, related to consolidated FG VIEs.
 
Gross Premium Receivable, Net of Ceding Commissions Roll Forward
 
 
Six Months
 
2012
 
2011
 
(in millions)
Balance beginning of period
$
1,002.9

 
$
1,167.6

Premium written, net
102.7

 
102.9

Premium payments received, net
(166.5
)
 
(151.7
)
Adjustments to the premium receivable:
 
 
 
Changes in the expected term of financial guaranty insurance contracts
18.8

 
(91.1
)
Accretion of discount
13.4

 
16.4

Foreign exchange translation
(0.5
)
 
22.8

Consolidation of FG VIEs
(5.4
)
 
(9.9
)
Other adjustments
(1.3
)
 
2.5

Balance, end of period (1)
$
964.1

 
$
1,059.5

____________________
(1)                                  Excludes $31.7 million and $31.7 million as of June 30, 2012 and 2011, respectively, related to consolidated FG VIEs.
 
Gains or losses due to foreign exchange rate changes relate to installment premium receivables denominated in currencies other than the U.S. dollar. Approximately 49%, 47% and 51% of installment premiums at June 30, 2012, December 31, 2011 and June 30, 2011, respectively, are denominated in currencies other than the U.S. dollar, primarily in euro and British Pound Sterling.
 
Actual collections may differ from expected collections in the tables below due to factors such as foreign exchange rate fluctuations, counterparty collectability issues, accelerations, commutations and changes in expected lives.
 
Expected Collections of Gross Premiums Receivable,
Net of Ceding Commissions (Undiscounted)
 
 
June 30, 2012
 
(in millions)
2012 (July 1 – September 30)
$
48.4

2012 (October 1 – December 31)
50.0

2013
106.6

2014
93.3

2015
83.3

2016
77.3

2017-2021
305.6

2022-2026
206.6

2027-2031
152.2

After 2031
187.6

Total(1)
$
1,310.9

 ____________________
(1)                                  Excludes expected cash collections on FG VIEs of $37.8 million.
 
Components of Unearned Premium Reserve
 
 
As of June 30, 2012
 
As of December 31, 2011
 
Gross
 
Ceded
 
Net(1)
 
Gross
 
Ceded
 
Net(1)
 
(in millions)
Deferred premium revenue
$
5,698.6

 
$
610.6

 
$
5,088.0

 
$
6,046.3

 
$
727.4

 
$
5,318.9

Contra-paid
(123.1
)
 
(19.8
)
 
(103.3
)
 
(92.2
)
 
(18.8
)
 
(73.4
)
Total financial guaranty
5,575.5

 
590.8

 
4,984.7

 
5,954.1

 
708.6

 
5,245.5

Other
7.9

 
0.0

 
7.9

 
8.7

 
0.3

 
8.4

Total
$
5,583.4

 
$
590.8

 
$
4,992.6

 
$
5,962.8

 
$
708.9

 
$
5,253.9

 ____________________
(1)                              Total net unearned premium reserve excludes $255.5 million and $274.2 million related to FG VIEs as of June 30, 2012 and December 31, 2011, respectively.
 
The following table provides a schedule of the expected timing of the income statement recognition of pre-tax financial guaranty insurance net deferred premium revenue and the present value of net expected losses to be expensed. The amount and timing of actual premium earnings and loss and LAE may differ from the estimates shown below due to factors such as refundings, accelerations, commutations, changes in expected lives and updates to loss estimates. A loss and LAE reserve is only recorded for the amount by which net expected loss to be expensed exceeds deferred premium revenue determined on a contract-by-contract basis. This table excludes amounts related to consolidated FG VIEs.
 
Expected Timing of Premium and Loss Recognition
 
 
As of June 30, 2012
 
Scheduled
Net Earned
Premium
 
Net Expected
Loss to be
Expensed
 
Net
 
(in millions)
2012 (July 1–September 30)
$
137.9

 
$
16.2

 
$
121.7

2012 (October 1–December 31)
131.0

 
14.9

 
116.1

Subtotal 2012
268.9

 
31.1

 
237.8

2013
472.9

 
61.0

 
411.9

2014
434.7

 
48.6

 
386.1

2015
384.6

 
38.0

 
346.6

2016
349.1

 
33.7

 
315.4

2017 - 2021
1,325.7

 
142.1

 
1,183.6

2022 - 2026
834.5

 
78.5

 
756.0

2027 - 2031
505.6

 
39.5

 
466.1

After 2031
512.0

 
30.7

 
481.3

Total present value basis(1)(2)
5,088.0

 
503.2

 
4,584.8

Discount
279.6

 
275.6

 
4.0

Total future value
$
5,367.6

 
$
778.8

 
$
4,588.8

 ____________________
(1)                                  Balances represent discounted amounts.
 
(2)                                  Consolidation of FG VIEs resulted in reductions of $381.4 million in future scheduled net earned premium and $196.8 million in net expected loss to be expensed.
 
Selected Information for Policies Paid in Installments
 
 
As of
June 30, 2012
 
As of December 31, 2011
 
(dollars in millions)
Premiums receivable, net of ceding commission payable
$
964.1

 
$
1,002.9

Gross deferred premium revenue
2,013.1

 
2,192.6

Weighted-average risk-free rate used to discount premiums
3.6
%
 
3.4
%
Weighted-average period of premiums receivable (in years)
10.0

 
9.8


 
Loss Estimation Process
 
The Company’s loss reserve committees estimate expected loss to be paid. Surveillance personnel present analyses related to potential losses to the Company’s loss reserve committees for consideration in estimating the expected loss to be paid. Such analyses include the consideration of various scenarios with potential probabilities assigned to them. Depending upon the nature of the risk, the Company’s view of the potential size of any loss and the information available to the Company, that analysis may be based upon individually developed cash flow models, internal credit rating assessments and sector-driven loss severity assumptions or judgmental assessments. In the case of its assumed business, the Company may conduct its own analysis as just described or, depending on the Company’s view of the potential size of any loss and the information available to the Company, the Company may use loss estimates provided by ceding insurers. The Company’s loss reserve committees review and refresh the estimate of expected loss to be paid each quarter. The Company’s estimate of ultimate loss on a policy is subject to significant uncertainty over the life of the insured transaction due to the potential for significant variability in credit performance as a result of economic, fiscal and financial market variability over the long duration of most contracts. The determination of expected loss to be paid is an inherently subjective process involving numerous estimates, assumptions and judgments by management.
 
The following table presents a roll forward of the present value of net expected loss to be paid for financial guaranty insurance contracts by sector. Net expected loss to be paid is the estimate of the present value of future claim payments, net of reinsurance and net of salvage and subrogation, which includes the present value benefit of estimated recoveries for breaches of representations and warranties (“R&W”). The Company used weighted average risk-free rates for U.S. dollar denominated obligations, which ranged from 0.0% to 3.04% as of June 30, 2012 and 0.0% to 3.27% as of December 31, 2011.
 

Present Value of Net Expected Loss to be Paid
Roll Forward by Sector(1)
 
Net Expected
Loss to be
Paid as of
March 31, 2012
 
Economic Loss
Development(2)
 
(Paid)
Recovered
Losses(3)
 
Net Expected
Loss to be
Paid as of
June 30, 2012(4)
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
2.2

 
$
0.7

 
$
—

 
$
2.9

Alt-A first lien
116.9

 
22.8

 
52.4

 
192.1

Option ARM
75.3

 
0.7

 
(112.3
)
 
(36.3
)
Subprime
150.4

 
10.6

 
(1.6
)
 
159.4

Total first lien
344.8

 
34.8

 
(61.5
)
 
318.1

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(89.7
)
 
(2.6
)
 
75.9

 
(16.4
)
HELOCs
(42.5
)
 
14.8

 
(36.0
)
 
(63.7
)
Total second lien
(132.2
)
 
12.2

 
39.9

 
(80.1
)
Total U.S. RMBS
212.6

 
47.0

 
(21.6
)
 
238.0

TruPS
8.5

 
(1.8
)
 
(0.2
)
 
6.5

Other structured finance
196.8

 
30.9

 
(6.6
)
 
221.1

U.S. public finance
32.7

 
35.5

 
(9.8
)
 
58.4

Non-U.S. public finance
301.8

 
(15.0
)
 
15.7

 
302.5

Total financial guaranty
752.4

 
96.6

 
(22.5
)
 
826.5

Other
1.9

 
(6.0
)
 
—

 
(4.1
)
            Total
$
754.3

 
$
90.6

 
$
(22.5
)
 
$
822.4


 
Net Expected
Loss to be
Paid as of
March 31, 2011
 
Economic Loss
Development(2)
 
(Paid)
Recovered
Losses(3)
 
Net Expected
Loss to be
Paid as of
June 30, 2011
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
1.5

 
$
1.7

 
$
—

 
$
3.2

Alt-A first lien
171.4

 
15.3

 
(19.1
)
 
167.6

Option ARM
322.1

 
26.3

 
(81.5
)
 
266.9

Subprime
167.5

 
(5.4
)
 
(0.6
)
 
161.5

Total first lien
662.5

 
37.9

 
(101.2
)
 
599.2

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(76.9
)
 
(3.2
)
 
(14.6
)
 
(94.7
)
HELOCs
(792.7
)
 
27.1

 
727.3

 
(38.3
)
Total second lien
(869.6
)
 
23.9

 
712.7

 
(133.0
)
Total U.S. RMBS
(207.1
)
 
61.8

 
611.5

 
466.2

TruPS
(0.9
)
 
7.0

 
(1.4
)
 
4.7

Other structured finance
173.9

 
1.2

 
0.8

 
175.9

U.S. public finance
55.9

 
3.7

 
(0.2
)
 
59.4

Non-U.S. public finance
10.4

 
(3.6
)
 
—

 
6.8

Total financial guaranty
32.2

 
70.1

 
610.7

 
713.0

Other
2.1

 
—

 
—

 
2.1

            Total
$
34.3

 
$
70.1

 
$
610.7

 
$
715.1


 
 
Net Expected
Loss to be
Paid as of
December 31, 2011(4)
 
Economic Loss
Development(2)
 
(Paid)
Recovered
Losses(3)
 
Net Expected
Loss to be
Paid as of
June 30, 2012(4)
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
1.8

 
$
1.1

 
$
—

 
$
2.9

Alt-A first lien
134.9

 
14.2

 
43.0

 
192.1

Option ARM
152.9

 
(1.0
)
 
(188.2
)
 
(36.3
)
Subprime
140.3

 
21.9

 
(2.8
)
 
159.4

Total first lien
429.9

 
36.2

 
(148.0
)
 
318.1

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(79.6
)
 
(3.7
)
 
66.9

 
(16.4
)
HELOCs
(31.1
)
 
22.4

 
(55.0
)
 
(63.7
)
Total second lien
(110.7
)
 
18.7

 
11.9

 
(80.1
)
Total U.S. RMBS
319.2

 
54.9

 
(136.1
)
 
238.0

TruPS
13.2

 
(6.3
)
 
(0.4
)
 
6.5

Other structured finance
239.6

 
11.6

 
(30.1
)
 
221.1

U.S. public finance
15.8

 
58.3

 
(15.7
)
 
58.4

Non-U.S public finance
50.2

 
182.9

 
69.4

 
302.5

Total financial guaranty
638.0

 
301.4

 
(112.9
)
 
826.5

Other
1.9

 
(6.0
)
 
—

 
(4.1
)
            Total
$
639.9

 
$
295.4

 
$
(112.9
)
 
$
822.4


 
Net Expected
Loss to be
Paid as of
December 31, 2010
 
Economic Loss
Development(2)
 
(Paid)
Recovered
Losses(3)
 
Expected
Loss to be
Paid as of
June 30, 2011
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
1.4

 
$
1.8

 
$
—

 
$
3.2

Alt-A first lien
184.4

 
21.8

 
(38.6
)
 
167.6

Option ARM
523.7

 
(88.4
)
 
(168.4
)
 
266.9

Subprime
200.4

 
(23.2
)
 
(15.7
)
 
161.5

Total first lien
909.9

 
(88.0
)
 
(222.7
)
 
599.2

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
56.6

 
(109.6
)
 
(41.7
)
 
(94.7
)
HELOCs
(805.7
)
 
104.7

 
662.7

 
(38.3
)
Total second lien
(749.1
)
 
(4.9
)
 
621.0

 
(133.0
)
Total U.S. RMBS
160.8

 
(92.9
)
 
398.3

 
466.2

TruPS
(0.6
)
 
7.0

 
(1.7
)
 
4.7

Other structured finance
159.7

 
17.5

 
(1.3
)
 
175.9

U.S. public finance
81.6

 
(13.0
)
 
(9.2
)
 
59.4

Non-U.S public finance
7.3

 
(0.5
)
 
—

 
6.8

Total financial guaranty
408.8

 
(81.9
)
 
386.1

 
713.0

Other
2.1

 
—

 
—

 
2.1

            Total
$
410.9

 
$
(81.9
)
 
$
386.1

 
$
715.1

 ____________________
    
(1)    Amounts include all expected payments whether or not the insured VIE is consolidated.

(2) Economic loss development includes the effects of changes in assumptions based on observed market trends, changes in discount rates, accretion of discount and the economic effects of loss mitigation efforts.

(3)
Net of ceded paid losses, whether or not such amounts have been settled with reinsurers. Ceded paid losses are typically settled 45 days after the end of the reporting period. Such amounts are recorded in reinsurance recoverable on paid losses included in other assets.

(4)
Includes expected LAE to be paid for mitigating claim liabilities of $31.1 million as of June 30, 2012 and $35.5 million as of December 31, 2011.


The table below provides a reconciliation of expected loss to be paid to expected loss to be expensed. Expected loss to be paid differs from expected loss to be expensed due to: (1) the contra-paid which represent the payments that have been made but have not yet been expensed, (2) for transactions with a net expected recovery, the addition of claim payments that have been made (and therefore are not included in expected loss to be paid) that are expected to be recovered in the future (and therefore have also reduced expected loss to be paid), and (3) loss reserves that have already been established (and therefore expensed but not yet paid).
 
Reconciliation of Financial Guaranty Insurance Present Value of Net Expected Loss to be Paid
and Net Present Value of Net Expected Loss to be Expensed
 
 
As of
June 30, 2012
 
(in millions)
Net expected loss to be paid
$
826.5

Less: net expected loss to be paid for FG VIEs
(65.7
)
Total
892.2

Contra-paid, net
103.3

Salvage and subrogation recoverable
370.8

Ceded salvage and subrogation recoverable(1)
(40.3
)
Loss and LAE reserve
(992.0
)
Reinsurance recoverable on unpaid losses
169.2

Net expected loss to be expensed(2)
$
503.2

 ____________________
(1)                            Recorded in reinsurance balances payable on the consolidated balance sheet.
 
(2)                            Excludes $196.8 million related to consolidated FG VIEs.
 
The Company’s Approach to Projecting Losses in U.S. RMBS
 
The Company projects losses on its insured U.S. RMBS on a transaction-by-transaction basis by projecting the performance of the underlying pool of mortgages over time and then applying the structural features (i.e., payment priorities and tranching) of the RMBS to the projected performance of the collateral over time. The resulting projected claim payments or reimbursements are then discounted using risk-free rates. For transactions where the Company projects it will receive recoveries from providers of R&W, it projects the amount of recoveries and either establishes a recovery for claims already paid or reduces its projected claim payments accordingly.
 
The further behind a mortgage borrower falls in making payments, the more likely it is that he or she will default. The rate at which borrowers from a particular delinquency category (number of monthly payments behind) eventually default is referred to as the “liquidation rate.” Liquidation rates may be derived from observed roll rates, which are the rates at which loans progress from one delinquency category to the next and eventually to default and liquidation. The Company applies liquidation rates to the mortgage loan collateral in each delinquency category and makes certain timing assumptions to project near-term mortgage collateral defaults from loans that are currently delinquent.
 
Mortgage borrowers that are not more than one payment behind (generally considered performing borrowers) have demonstrated an ability and willingness to pay throughout the recession and mortgage crisis, and as a result are viewed as less likely to default than delinquent borrowers. Performing borrowers that eventually default will also need to progress through delinquency categories before any defaults occur. The Company projects how many of the currently performing loans will default and when they will default, by first converting the projected near term defaults of delinquent borrowers derived from liquidation rates into a vector of conditional default rates "CDR", then projecting how the conditional default rates will develop over time. Loans that are defaulted pursuant to the conditional default rate after the liquidation of currently delinquent loans represent defaults of currently performing loans. A conditional default rate is the outstanding principal amount of defaulted loans liquidated in the current month divided by the remaining outstanding amount of the whole pool of loans (or “collateral pool balance”). The collateral pool balance decreases over time as a result of scheduled principal payments, partial and whole principal prepayments, and defaults.
 
In order to derive collateral pool losses from the collateral pool defaults it has projected, the Company applies a loss severity. The loss severity is the amount of loss the transaction experiences on a defaulted loan after the application of net proceeds from the disposal of the underlying property. The Company projects loss severities by sector based on its experience to date. Further detail regarding the assumptions and variables the Company used to project collateral losses in its U.S. RMBS portfolio may be found below in the sections “U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien” and “U.S. First Lien RMBS Loss Projections: Alt-A First Lien, Option ARM, Subprime and Prime.”
 
The Company is in the process of enforcing claims for breaches of R&W regarding the characteristics of the loans included in the collateral pools. The Company calculates a credit from the RMBS issuer for such recoveries where the R&W were provided by an entity the Company believes to be financially viable and where the Company already has access or
believes it will attain access to the underlying mortgage loan files. Where the Company has an agreement with an R&W provider (e.g., the the Bank of America Agreement or the Deutsche Bank Agreement) or where it is in advanced discussions on a potential agreement, that credit is based on the agreement or potential agreement. In second lien RMBS transactions where there is no agreement or advanced discussions, this credit is based on a percentage of actual repurchase rates achieved across those transactions where material repurchases have been made. In first lien RMBS transactions where there is no agreement or advanced discussions, this credit is estimated by reducing collateral losses projected by the Company to reflect a percentage of the recoveries the Company believes it will achieve, based on a percentage of actual repurchase rates achieved or based on the amounts the Company was able to negotiate under the Bank of America Agreement and Deutsche Bank Agreement. The first lien approach is different from the second lien approach because the Company’s first lien transactions have multiple tranches and a more complicated method is required to correctly allocate credit to each tranche. In each case, the credit is a function of the projected lifetime collateral losses in the collateral pool, so an increase in projected collateral losses generally increases the R&W credit calculated by the Company for the RMBS issuer. Further detail regarding how the Company calculates these credits may be found under “Breaches of Representations and Warranties” below.
 
The Company projects the overall future cash flow from a collateral pool by adjusting the payment stream from the principal and interest contractually due on the underlying mortgages for (a) the collateral losses it projects as described above, (b) assumed voluntary prepayments and (c) recoveries for breaches of R&W as described above. The Company then applies an individual model of the structure of the transaction to the projected future cash flow from that transaction’s collateral pool to project the Company’s future claims and claim reimbursements for that individual transaction. Finally, the projected claims and reimbursements are discounted using risk-free rates. As noted above, the Company runs several sets of assumptions regarding mortgage collateral performance, or scenarios, and probability weights them.
 
Second Quarter-End 2012 U.S. RMBS Loss Projections
 
The Company retained the same general approach and methodology to projecting RMBS performance at June 30, 2012 as it did at March 31, 2012 and December 31, 2011. The approach combines using each transaction's observed data with the Company's estimate of how the transaction will ultimately perform based on the Company's view of the magnitude and timing of a recovery in the mortgage market. During the quarter the Company observed both positive and negative developments in the market. These developments were reflected by moderately lowering the initial CDR's which are a function of the observed delinquency data, and by adjusting the scenarios used to project the amount of time until the RMBS market stabilizes.

The scenarios the Company used to project first and second lien RMBS collateral losses at June 30, 2012 were essentially the same as those it used at March 31, 2012 and December 31, 2011, except that (i) based on its observation of the continued elevated levels of early stage delinquencies, the Company updated its projections to reflect a slower recovery in its base cases and (ii) the Company reduced the time until the market stabilizes in its most optimistic case by three months, so it assumed that the recovery projected last quarter was occurring at the expected pace and (iii) the Company adjusted its most pessimistic case, where it assumed the recovery would happen six months more slowly than what was assumed last quarter.
 
The Company also used generally the same methodology and assumptions to project the credit received for recoveries in R&W at June 30, 2012 as March 31, 2012 and December 31, 2011. The primary differences relate to a change in assumption regarding the likelihood and amount of recovery from certain R&W providers.
 
U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien
 
The Company insures two types of second lien RMBS: those secured by HELOCs and those secured by closed end second lien mortgages. HELOCs are revolving lines of credit generally secured by a second lien on a one to four family home. A mortgage for a fixed amount secured by a second lien on a one to four family home is generally referred to as a closed end second lien. Second lien RMBS sometimes include a portion of loan collateral with a different priority than the majority of the collateral. The Company has material exposure to second lien mortgage loans originated and serviced by a number of parties, but the Company’s most significant second lien exposure is to HELOCs originated and serviced by Countrywide, a subsidiary of Bank of America. See “—Breaches of Representations and Warranties.”
 
The delinquency performance of HELOC and closed end second lien exposures included in transactions insured by the Company began to deteriorate in 2007, and such transactions, continue to perform below the Company’s original underwriting expectations. While insured securities benefit from structural protections within the transactions designed to absorb collateral losses in excess of previous historically high levels, in many second lien RMBS projected losses now exceed those structural protections.
 
The Company believes the primary variables affecting its expected losses in second lien RMBS transactions are the amount and timing of future losses in the collateral pool supporting the transactions and the amount of loans repurchased for breaches of R&W (or agreements with R&W providers related to such obligations). Expected losses are also a function of the structure of the transaction; the voluntary prepayment rate (typically also referred to as conditional prepayment rate "CPR" of the collateral); the interest rate environment; and assumptions about the draw rate and loss severity. These variables are interrelated, difficult to predict and subject to considerable volatility. If actual experience differs from the Company’s assumptions, the losses incurred could be materially different from the estimate. The Company continues to update its evaluation of these exposures as new information becomes available.
 
The following table shows the key assumptions used in the calculation of estimated expected loss to be paid for direct vintage 2004 - 2008 second lien U.S. RMBS.
 
Key Assumptions in Base Case Expected Loss Estimates
Second Lien RMBS(1)
 
HELOC key assumptions
 
As of
June 30, 2012
 
As of
March 31, 2012
 
As of December 31, 2011
Plateau CDR
 
2.9
%
–
20.9%
 
3.3
%
–
26.3%
 
4.0
%
–
27.4%
Final CDR trended down to
 
0.4
%
–
3.2%
 
0.4
%
–
3.2%
 
0.4
%
–
3.2%
Expected period until final CDR
 
36 months
 
36 months
 
36 months
Initial CPR
 
2.7
%
–
16.4%
 
2.6
%
–
15.1%
 
1.4
%
–
25.8%
Final CPR
 
10%
 
10%
 
10%
Loss severity
 
98%
 
98%
 
98%
Initial draw rate
 
0.0
%
–
4.1%
 
0.0
%
–
7.8%
 
0.0
%
–
15.3%
 
Closed-end second lien key assumptions
 
As of
June 30, 2012
 
As of
March 31, 2012
 
As of
December 31, 2011
Plateau CDR
 
4.3
%
–
20.7%
 
5.4
%
– 
24.9%
 
6.9
%
–
24.8%
Final CDR trended down to
 
3.3
%
–
9.1%
 
3.3
%
–
9.2%
 
3.5
%
–
9.2%
Expected period until final CDR
 
36 months
 
36 months
 
36 months
Initial CPR
 
1.1
%
–
11.0%
 
1.2
%
–
8.6%
 
0.9
%
–
14.7%
Final CPR
 
10%
 
10%
 
10%
Loss severity
 
98%
 
98%
 
98%
 ____________________
(1)                                  Represents variables for most heavily weighted scenario (the “base case”).
 
In second lien transactions the projection of near-term defaults from currently delinquent loans is relatively straightforward because loans in second lien transactions are generally “charged off” (treated as defaulted) by the securitization’s servicer once the loan is 180 days past due. Most second lien transactions report the amount of loans in five monthly delinquency categories (i.e., 30-59 days past due, 60-89 days past due, 90-119 days past due, 120-149 days past due and 150-179 days past due). The Company estimates the amount of loans that will default over the next five months by calculating current representative liquidation rates (the percent of loans in a given delinquency status that are assumed to ultimately default) from selected representative transactions and then applying an average of the preceding twelve months’ liquidation rates to the amount of loans in the delinquency categories. The amount of loans projected to default in the first through fifth months is expressed as a CDR. The first four months’ CDR is calculated by applying the liquidation rates to the current period past due balances (i.e., the 150-179 day balance is liquidated in the first projected month, the 120-149 day balance is liquidated in the second projected month, the 90-119 day balance is liquidated in the third projected month and the 60-89 day balance is liquidated in the fourth projected month). For the fifth month the CDR is calculated using the average 30-59 day past due balances for the prior three months. An average of the third, fourth and fifth month CDR is then used as the basis for the plateau period that follows the embedded five months of losses.
 
As of June 30, 2012, for the base case scenario, the CDR (the “plateau CDR”) was held constant for one month. Once the plateau period has ended, the CDR is assumed to gradually trend down in uniform increments to its final long-term steady state CDR. In the base case scenario, the time over which the CDR trends down to its final CDR is 30 months. Therefore, the total stress period for second lien transactions is 36 months, comprising five months of delinquent data, a one month plateau period and 30 months of decrease to the steady state CDR. This is the same as March 31, 2012 and December 31, 2011. The long-term steady state CDR are calculated as the constant CDR that would have yielded the amount of losses originally expected at underwriting. When a second lien loan defaults, there is generally a very low recovery. Based on current expectations of future performance, the Company assumes that it will only recover 2% of the collateral, the same as March 31, 2012 and December 31, 2011.
 
The rate at which the principal amount of loans is prepaid may impact both the amount of losses projected (which is a function of the CDR and the loan balance over time) as well as the amount of excess spread (which is the excess of the interest paid by the borrowers on the underlying loan over the amount of interest and expenses owed on the insured obligations). In the base case, the current CPR is assumed to continue until the end of the plateau before gradually increasing to the final CPR over the same period the CDR decreases. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant. The final CPR is assumed to be 10% for both HELOC and closed-end second lien transactions. This level is much higher than current rates for most transactions, but lower than the historical average, which reflects the Company’s continued uncertainty about the projected performance of the borrowers in these transactions. This pattern is consistent with how the Company modeled the CPR at March 31, 2012 and December 31, 2011. To the extent that prepayments differ from projected levels it could materially change the Company’s projected excess spread and losses.
 
The Company uses a number of other variables in its second lien loss projections, including the spread between relevant interest rate indices, and HELOC draw rates (the amount of new advances provided on existing HELOCs expressed as a percentage of current outstanding advances). For HELOC transactions, the draw rate is assumed to decline from the current level to a final draw rate over a period of three months. The final draw rates were assumed to range from 0.0% to 2.1%.
 
In estimating expected losses, the Company modeled and probability weighted three possible CDR curves applicable to the period preceding the return to the long-term steady state CDR. The Company believes that the level of the elevated CDR and the length of time it will persist is the primary driver behind the likely amount of losses the collateral will suffer (before considering the effects of repurchases of ineligible loans). The Company continues to evaluate the assumptions affecting its modeling results.
 
At June 30, 2012, the Company’s base case assumed a one month CDR plateau and a 30 month ramp-down (for a total stress period of 36 months), the same as March 31, 2012 and December 31, 2011. The Company also modeled a scenario with a longer period of elevated defaults and another with a shorter period of elevated defaults and weighted them the same as of March 31, 2012 and December 31, 2011, but in each case changed the length of the ramp-downs by three months (and so the length of elevated defaults) in order to reflect both positive and negative developments observed by the Company in the market. Increasing the CDR plateau to four months and increasing the ramp-down by three months to 33-months (rather than 30 months at March 31, 2012 and December 31, 2011, for a total stress period of 42 months rather than 39 months as at March 31, 2012 and December 31, 2011) would increase the expected loss by approximately $64.9 million for HELOC transactions and $3.9 million for closed-end second lien transactions. On the other hand, keeping the CDR plateau at one month but decreasing the length of the CDR ramp-down to a 21 months (rather than 24 months as at March 31, 2012 and December 31, 2011, for a total stress period of 33 months rather than 30 months as at March 31, 2012 and December 31, 2011) would decrease the expected loss by approximately $65.3 million for HELOC transactions and $2.9 million for closed-end second lien transactions.
 
U.S. First Lien RMBS Loss Projections: Alt-A First Lien, Option ARM, Subprime and Prime
 
First lien RMBS are generally categorized in accordance with the characteristics of the first lien mortgage loans on one-to-four family homes supporting the transactions. The collateral supporting “subprime RMBS” transactions consists of first-lien residential mortgage loans made to subprime borrowers. A “subprime borrower” is one considered to be a higher risk credit based on credit scores or other risk characteristics. Another type of RMBS transaction is generally referred to as “Alt-A first lien.” The collateral supporting such transactions consists of first-lien residential mortgage loans made to “prime” quality borrowers who lack certain ancillary characteristics that would make them prime. When more than 66% of the loans originally included in the pool are mortgage loans with an option to make a minimum payment that has the potential to amortize the loan negatively (i.e., increase the amount of principal owed), the transaction is referred to as an “Option ARM.” Finally, transactions may be composed primarily of loans made to prime borrowers. First lien RMBS sometimes include a portion of loan collateral that differs in priority from the majority of the collateral.
 
The performance of the Company’s first lien RMBS exposures began to deteriorate in 2007 and such transactions, continue to perform below the Company’s original underwriting expectations. The Company currently projects first lien collateral losses many times those expected at the time of underwriting. While insured securities benefited from structural protections within the transactions designed to absorb some of the collateral losses, in many first lien RMBS transactions, projected losses exceed those structural protections.
 
The majority of projected losses in first lien RMBS transactions are expected to come from non-performing mortgage loans (those that are delinquent or in foreclosure or where the loan has been foreclosed and the RMBS issuer owns the underlying real estate). Changes in the amount of non-performing loans from the amount projected in the previous period is one of the primary drivers of loss development in this portfolio. In order to determine the number of defaults resulting from these delinquent and foreclosed loans, the Company applies a liquidation rate assumption to loans in each of various delinquency categories. The Company arrived at its liquidation rates based on data purchased from a third party, and assumptions about how delays in the foreclosure process may ultimately affect the rate at which loans are liquidated. The liquidation rate is a standard industry measure that is used to estimate the number of loans in a given aging category that will default within a specified time period. The Company projects these liquidations to occur over two years. The Company used the same liquidation rates for June 30, 2012 as it did for March 31, 2012 and December 31, 2011. The following table shows liquidation assumptions for various delinquency categories.
 
First Lien Liquidation Rates
as of June 30, 2012
 
30 – 59 Days Delinquent
 
Alt A and Prime
35%
Option ARM
50
Subprime
30
60 – 89 Days Delinquent
 
Alt A and Prime
55
Option ARM
65
Subprime
45
90+ Days Delinquent
 
Alt A and Prime
65
Option ARM
75
Subprime
60
Bankruptcy
 
Alt A and Prime
55
Option ARM
70
Subprime
50
Foreclosure
 
Alt A and Prime
85
Option ARM
85
Subprime
80
Real Estate Owned ("REO")
 
All
100

 
While the Company uses liquidation rates as described above to project defaults of non-performing loans, it projects defaults on presently current loans by applying a CDR trend. The start of that CDR trend is based on the defaults the Company projects will emerge from currently nonperforming loans. The total amount of expected defaults from the non-performing loans is translated into a constant CDR (i.e., the CDR plateau), which, if applied for each of the next 24 months, would be sufficient to produce approximately the amount of defaults that were calculated to emerge from the various delinquency categories. The CDR thus calculated individually on the delinquent collateral pool for each RMBS is then used as the starting point for the CDR curve used to project defaults of the presently performing loans.
 
In the base case, each transaction’s CDR is projected to improve over 12 months to an intermediate CDR (calculated as 20% of its CDR plateau); that intermediate CDR is held constant for 36 months and then trails off in steps to a final CDR of 5% of the CDR plateau. Under the Company’s methodology, defaults projected to occur in the first 24 months represent defaults that can be attributed to loans that are currently delinquent or in foreclosure, while the defaults projected to occur using the projected CDR trend after the first 24 month period represent defaults attributable to borrowers that are currently performing.
 
Another important driver of loss projections is loss severity, which is the amount of loss the transaction incurs on a loan after the application of net proceeds from the disposal of the underlying property. Loss severities experienced in first lien transactions have reached historic high levels, and the Company is assuming that these high levels generally will continue for another year (in the case of subprime loans, the Company assumes the unprecedented 90% loss severity rate will continue for six months then drop to 80% for six months before following the ramp described below). The Company determines its initial loss severity based on actual recent experience. The Company’s loss severity assumptions for June 30, 2012 were the same as it used for March 31, 2012 and December 31, 2011. The Company then assumes that loss severities begin returning to levels consistent with underwriting assumptions beginning in June 2013, and in the base case scenario, decline over two years to 40%.
 
The following table shows the key assumptions used in the calculation of expected loss to be paid for direct vintage 2004 - 2008 first lien U.S. RMBS.
 
Key Assumptions in Base Case Expected Loss Estimates
First Lien RMBS
 
 
As of
June 30, 2012
 
As of
March 31, 2012
 
As of
December 31, 2011
Alt-A First Lien
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
3.3
%
–
23.0%
 
2.7
%
–
33.9%
 
2.8
%
–
41.3%
Intermediate CDR
0.7
%
–
4.6%
 
0.5
%
–
6.8%
 
0.6
%
–
8.3%
Final CDR
0.2
%
–
1.2%
 
0.1
%
–
1.7%
 
0.1
%
–
2.1%
Initial loss severity
65%
 
65%
 
65%
Initial CPR
0.0
%
–
27.1%
 
0.0
%
–
34.1%
 
0.0
%
–
24.4%
Final CPR
15%
 
15%
 
15%
Option ARM
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
9.3
%
–
30.2%
 
9.7
%
–
32.2%
 
11.7
%
–
31.5%
Intermediate CDR
1.9
%
–
6.0%
 
1.9
%
–
6.4%
 
2.3
%
–
6.3%
Final CDR
0.5
%
–
1.5%
 
0.5
%
–
1.6%
 
0.6
%
–
1.6%
Initial loss severity
65%
 
65%
 
65%
Initial CPR
0.6
%
–
4.9%
 
0.1
%
–
5.3%
 
0.3
%
–
10.8%
Final CPR
15%
 
15%
 
15%
Subprime
 
 
 
 
 
 
 
 
 
 
 
Plateau conditional default rate
7.2
%
–
29.2%
 
8.3
%
–
30.0%
 
8.6
%
–
29.9%
Intermediate conditional default rate
1.4
%
–
5.8%
 
1.7
%
–
6.0%
 
1.7
%
–
6.0%
Final conditional default rate
0.4
%
–
1.5%
 
0.4
%
–
1.5%
 
0.4
%
–
1.5%
Initial loss severity
90%
 
90%
 
90%
Initial CPR
0.0
%
–
8.8%
 
0.0
%
–
8.8%
 
0.0
%
–
16.3%
Final CPR
15%
 
15%
 
15%

 
The rate at which the principal amount of loans is prepaid may impact both the amount of losses projected (since that amount is a function of the conditional default rate, the loss severity and the loan balance over time) as well as the amount of excess spread (the amount by which the interest paid by the borrowers on the underlying loan exceeds the amount of interest owed on the insured obligations). The assumption for the CPR follows a similar pattern to that of the conditional default rate. The current level of voluntary prepayments is assumed to continue for the plateau period before gradually increasing over 12 months to the final CPR, which is assumed to be either 10% or 15% depending on the scenario run. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant.
 
The ultimate performance of the Company’s first lien RMBS transactions remains highly uncertain and may be subject to considerable volatility due to the influence of many factors, including the level and timing of loan defaults, changes in housing prices and other variables. The Company will continue to monitor the performance of its RMBS exposures and will adjust the loss projections for those transactions based on actual performance and management’s estimates of future performance.
 
In estimating expected losses, the Company modeled and probability weighted sensitivities for first lien transactions by varying its assumptions of how fast a recovery is expected to occur. One of the variables used to model sensitivities was how quickly the conditional default rate returned to its modeled equilibrium, which was defined as 5% of the current conditional default rate. The Company also stressed CPR and the speed of recovery of loss severity rates. The Company probability weighted a total of five scenarios (including its base case) at June 30, 2012, the same number of scenarios as March 31, 2012 and December 31, 2011. For June 30, 2012 the Company assumed in the most stressful scenario that the recovery would occur three months more slowly and in the most optimistic scenario that it would occur three months more quickly than it had for March 31, 2012 and December 31, 2011, but otherwise used the same scenarios and weightings for June 30, 2012 as March 31, 2012 and December 31, 2011. In a somewhat more stressful environment than that of the base case, where the conditional default rate plateau was extended three months (to be 27 months long) before the same more gradual conditional default rate recovery and loss severities were assumed to recover over four rather than two years (and subprime loss severities were assumed to recover only to 60%), expected loss to be paid would increase from current projections by approximately $26.9 million for Alt-A first liens, $25.6 million for Option ARM, $112.2 million for subprime and $1.2 million for prime transactions. In an even more stressful scenario where loss severities were assumed to rise and then recover over eight years and the initial ramp-down of the conditional default rate was assumed to occur over 15 months (rather than 12 months as at March 31, 2012 and December 31, 2011) and other assumptions were the same as the other stress scenario, expected loss to be paid would increase from current projections by approximately $75.4 million for Alt-A first liens, $63.3 million for Option ARM, $174.5 million for subprime and $3.5 million for prime transactions. The Company also considered two scenarios where the recovery was faster than in its base case. In a scenario with a somewhat less stressful environment than the base case, where conditional default rate recovery was somewhat less gradual and the initial subprime loss severity rate was assumed to be 80% for 12 months and was assumed to recover to 40% over two years, expected loss to be paid would decrease from current projections by approximately $5.1 million for Alt-A first lien, $30.3 million for Option ARM, $26.8 million for subprime and $0.1 million for prime transactions. In an even less stressful scenario where the conditional default rate plateau was three months shorter (21 months, effectively assuming that liquidation rates would improve) and the conditional default rate recovery was more pronounced, (including an initial ramp-down of the conditional default rate over nine months rather than 12 months as at March 31, 2012 and December 31, 2011), expected loss to be paid would decrease from current projections by approximately $31.1 million for Alt-A first lien, $73.7 million for Option ARM, $54.0 million for subprime and $0.9 million for prime transactions.
 
Breaches of Representations and Warranties
 
The Company is pursuing reimbursements for breaches of R&W regarding loan characteristics. Performance of the collateral underlying certain first and second lien securitizations has substantially differed from the Company’s original expectations. The Company has employed several loan file diligence firms and law firms as well as devoted internal resources to review the mortgage files surrounding many of the defaulted loans. The Company’s success in these efforts has resulted in three negotiated agreements in respect of the Company’s R&W claims, including one on April 14, 2011 with Bank of America and one on May 8, 2012 with Deutsche Bank AG as described under “Deutsche Bank Agreement” in Note 2, Business Changes, Uncertainties and Accounting Developments.

The Company has included in its net expected loss estimates as of June 30, 2012 an estimated benefit from loan repurchases related to breaches of R&W of $1.2 billion, which includes $546.7 million from Bank of America and Deutsche Bank AG under their respective agreements and $666.2 million in transactions where the Company does not yet have such an agreement. Proceeds projected to be reimbursed to the Company on transactions where the Company has already paid claims are viewed as a recovery on paid losses. For transactions where the Company has not already paid claims, projected recoveries reduce projected loss estimates. In either case, projected recoveries have no effect on the amount of the Company's exposure. These amounts reflect payments made pursuant to the negotiated transaction agreements and not payments made pursuant to legal settlements. See “-Recovery Litigation” below for a description of the related legal proceedings the Company has commenced.

The Company's success in pursuing breaches of R&W is based upon a detailed review of loan files. The company reviewed approximately 34,200 second lien and 6,800 first lien loan files (representing approximately $2,593 million and $2,357 million, respectively, of loans) in financial guaranty transactions as to which it eventually reached agreements, including the agreements with Bank of America and Deutsche Bank. For the RMBS transactions as to which the Company had not settled its claims for breaches of R&W as of June 30, 2012, the Company had performed a detailed review of approximately 11,000 second lien and 20,300 first lien loan files, representing approximately $812 million in second lien and $6,293 million in first lien outstanding par of loans underlying insured transactions. In the majority of its loan file reviews, the Company identified breaches of one or more R&W regarding the characteristics of the loans, such as misrepresentation of income or employment of the borrower, occupancy, undisclosed debt and non-compliance with underwriting guidelines at loan origination.

Through June 30, 2012 the Company has caused entities providing R&Ws to pay or agree to pay approximately $2.6 billion in respect of their R&W liabilities for transactions in which the Company has provided a financial guaranty. Of this, $2.0 billion are payments made or to be made directly to the Company pursuant to agreements with R&W providers (e.g. the Bank of America Agreement and Deutsche Bank Agreement) and approximately $602 million are amounts paid (or committed to be paid) into the relevant RMBS financial guaranty transactions pursuant to the transaction documents.

The $2.0 billion of payments made or to be made directly to the Company by R&W providers under agreements with the Company includes $1,473 million that has already been received by the Company, as well as $568 million (gross of reinsurance) the Company projects receiving in the future pursuant to such currently existing agreements. Because most of that $568 million is projected to be received through loss-sharing arrangements, the exact amount the Company will receive will depend on actual losses experienced by the covered transactions. This amount is included in the Company's calculated credit for R&W recoveries, described below.

The $602 million paid, or committed to be paid, by R&W providers into the relevant RMBS transactions pursuant to the transaction documents flow through the transaction “waterfalls.” Because the Company may insure only a portion of the capital structure of a transaction, such payments will not necessarily directly benefit the Company dollar-for-dollar, especially in first lien transactions. However, such payments do reduce collateral pool losses and so usually reduce the Company's expected losses.
 
The Company did not incorporate any gain contingencies or damages paid from potential litigation in its estimated repurchases. The amount the Company will ultimately recover related to contractual R&W is uncertain and subject to a number of factors including the counterparty’s ability to pay, the number and loss amount of loans determined to have breached R&W and, potentially, negotiated settlements or litigation recoveries. As such, the Company’s estimate of recoveries is uncertain and actual amounts realized may differ significantly from these estimates. In arriving at the expected recovery from breaches of R&W, the Company considered the creditworthiness of the provider of the R&W, the number of breaches found on defaulted loans, the success rate in resolving these breaches across those transactions where material repurchases have been made and the potential amount of time until the recovery is realized.
 
The calculation of expected recovery from breaches of R&W involved a variety of scenarios which ranged from the Company recovering substantially all of the losses it incurred due to violations of R&W to the Company realizing limited recoveries. The Company did not include any recoveries related to breaches of R&W in amounts greater than the losses it paid or expected to pay under any given cash flow scenario. These scenarios were probability weighted in order to determine the recovery incorporated into the Company’s estimate of expected losses. This approach was used for both loans that had already defaulted and those assumed to default in the future.
 
Balance Sheet Classification of R&W Benefit, Net of Reinsurance
 
 
As of June 30, 2012
 
As of December 31, 2011
 
For all
Financial
Guaranty
Insurance
Contracts
 
Effect of
Consolidating
FG VIEs
 
Reported on
Balance Sheet(1)
 
For all
Financial
Guaranty
Insurance
Contracts
 
Effect of
Consolidating
FG VIEs
 
Reported on
Balance Sheet(1)
 
(in millions)
Salvage and subrogation recoverable
$
313.1

 
$
(124.5
)
 
$
188.6

 
$
401.8

 
$
(197.3
)
 
$
204.5

Loss and LAE reserve
740.7

 
(39.8
)
 
700.9

 
857.5

 
(74.6
)
 
782.9

____________________
(1)       The remaining benefit for R&W is not recorded on the balance sheet until the expected loss, net of R&W, exceeds unearned premium reserve.
 
The following table represents the Company’s total estimated R&W recoveries netted in expected loss to be paid, from defective mortgage loans included in certain first and second lien U.S. RMBS loan securitizations that it insures.
 
Roll Forward of Estimated Benefit from
Recoveries from Representation and Warranty Breaches, Net of Reinsurance
 
 
Future Net
R&W Benefit as of
December 31, 2011
 
R&W Development
and Accretion of
Discount
During Six Months 2012
 
R&W Recovered
During Six Months
2012(1)
 
Future Net
R&W Benefit as of
June 30, 2012
 
(in millions)
Prime first lien
$
3.0

 
$
1.0

 
$
—

 
$
4.0

Alt-A first lien
202.7

 
21.0

 
(64.2
)
 
159.5

Option ARM
713.9

 
59.0

 
(75.8
)
 
697.1

Subprime
101.5

 
(8.1
)
 
(0.1
)
 
93.3

Closed end second lien
223.8

 
(2.0
)
 
(84.9
)
 
136.9

HELOC
189.9

 
(0.2
)
 
(67.6
)
 
122.1

Total
$
1,434.8

 
$
70.7

 
$
(292.6
)
 
$
1,212.9

 
 
Future Net
R&W Benefit as of
December 31, 2010
 
R&W Development
and Accretion of
Discount
During Six Months 2011
 
R&W Recovered
During Six Months
2011(1)
 
Future Net
R&W Benefit as of
June 30, 2011
 
(in millions)
Prime first lien
$
1.1

 
$
1.8

 
$
—

 
$
2.9

Alt-A first lien
81.0

 
46.6

 
—

 
127.6

Option ARM
309.3

 
449.2

 
(47.3
)
 
711.2

Subprime
26.8

 
54.7

 
—

 
81.5

Closed end second lien
178.2

 
61.5

 
—

 
239.7

HELOC
1,004.1

 
157.1

 
(850.8
)
 
310.4

Total
$
1,600.5

 
$
770.9

 
$
(898.1
)
 
$
1,473.3

____________________
(1)           Gross amounts recovered were $311.4 million and $1,015.0 million in Six Months 2012 and 2011, respectively.
 

 
Financial Guaranty Insurance U.S. RMBS Risks with R&W Benefit
 
 
Number of Risks (1) as of
 
Debt Service as of
 
June 30, 2012
 
December 31,
2011
 
June 30,
2012
 
December 31,
2011
 
(dollars in millions)
Prime first lien
1

 
1

 
$
39.3

 
$
41.9

Alt-A first lien
19

 
22

 
1,492.9

 
1,732.6

Option ARM
10

 
12

 
1,129.4

 
1,459.7

Subprime
5

 
5

 
842.0

 
905.8

Closed-end second lien
4

 
4

 
245.3

 
361.4

HELOC (2)
6

 
15

 
543.6

 
2,978.5

Total
45

 
59

 
$
4,292.5

 
$
7,479.9

____________________
(1)                                 A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making debt service payments.
 
(2)                                 The decline in number of HELOC risks and debt service relates to the final payment from Bank of America for covered HELOC transactions.
 
The following table provides a breakdown of the development and accretion amount in the roll forward of estimated recoveries associated with alleged breaches of R&W.
 
 
Second Quarter
 
Six Months
 
2012
 
2011
 
2012
 
2011
 
(in millions)
Inclusion or removal of deals with breaches of R&W during period
$
(5.0
)
 
$
—

 
$
(5.0
)
 
$
107.1

Change in recovery assumptions as the result of additional file review and recovery success
(10.0
)
 
—

 
69.7

 
198.4

Estimated increase (decrease) in defaults that will result in additional (lower) breaches
50.9

 
(5.8
)
 
(0.4
)
 
34.0

Results of settlements
—

 
95.6

 
—

 
429.7

Accretion of discount on balance
2.4

 
1.1

 
6.4

 
1.7

Total
$
38.3

 
$
90.9

 
$
70.7

 
$
770.9


 
The R&W development during Second Quarter 2012 resulted primarily from the change in projected future defaults offset by an adjustment to the projected recovery from one counterparty. The Company also eliminated the credit in two instances where the Company has become less confident that it will obtain the loan files.
 
The Company assumes that recoveries on transactions backed by HELOC and closed-end second lien loans that were not subject to the Bank of America Agreement or Deutsche Bank Agreement will occur in two to four years from the balance sheet date depending on the scenarios, and that recoveries on transactions backed by Alt-A first lien, Option ARM and Subprime loans will occur as claims are paid over the life of the transactions. Recoveries on second lien transactions subject to the Bank of America Agreement were paid in full by March 31, 2012.
 
As of June 30, 2012, cumulative collateral losses on the first lien RMBS transactions subject to a comprehensive agreement with Bank of America Corporation and its subsidiaries, including Countrywide Financial Corporation and its subsidiaries (collectively, “Bank of America”), 20 of which were transactions as to which the Company issued financial guaranty insurance contracts and one of which was a transaction on which the Company sold protection through a CDS (the “Bank of America Agreement”), were approximately $2.5 billion and $0.09 billion, respectively. The Company estimates that cumulative projected collateral losses for the 20 financial guaranty insurance transactions and one CDS transaction will be $5.0 billion and $0.2 billion, respectively. The Bank of America Agreement covers cumulative collateral losses up to $6.6 billion for all these transactions. Bank of America had placed approximately $1.0 billion of eligible assets in trust in order to collateralize the reimbursement obligation relating to these and one covered first lien CDS transaction. The amount of assets required to be posted may increase or decrease from time to time as determined by rating agency requirements.

On May 8, 2012, Assured Guaranty reached a settlement with Deutsche Bank AG and certain of its affiliates (collectively, “Deutsche Bank”), resolving claims related to certain RMBS transactions issued, underwritten or sponsored by Deutsche Bank that were insured by Assured Guaranty under financial guaranty insurance policies and to certain RMBS exposures in re-securitization transactions as to which Assured Guaranty provides credit protection through CDS. See Note 2, Business Changes, Risks, Uncertainties and Accounting Developments for more information.
 
Student Loan Transactions
 
The Company has insured or reinsured $2.7 billion net par of student loan securitizations, of which $1.4 billion was issued by private issuers and classified as asset-backed and $1.3 billion was issued by public authorities and classified as public finance. Of these amounts, $170.1 million and $447.4 million, respectively, are rated BIG. The Company is projecting approximately $62.7 million of net expected loss to be paid in these portfolios. In general, the losses are due to: (i) the poor credit performance of private student loan collateral and high loss severities; (ii) high interest rates on auction rate securities with respect to which the auctions have failed or (iii) lower risk-free rates used for discounting, which result in higher present value losses on transactions where losses are payable at final maturity. The largest of these losses was approximately $27.4 million and related to a transaction backed by a pool of private student loans ceded to AG Re by another monoline insurer. The guaranteed bonds were issued as auction rate securities that now bear a high rate of interest due to the downgrade of the primary insurer’s financial strength rating. Further, the underlying loan collateral has performed below expectations. Additionally, on another public student loan transaction reinsured from Ambac Assurance Corporation ("Ambac"), Ambac commuted its entire exposure during Second Quarter 2012. The Company's portion of the commutation payment was approximately $7 million, which was lower than expected. The overall decrease of approximately $2.7 million in net expected loss during Second Quarter 2012 is primarily due to the decrease in risk-free rates used to discount losses as well as an increase in the projected loss severities of certain transactions.
 
Trust Preferred Securities Collateralized Debt Obligations
 
The Company has insured or reinsured $1.7 billion of net par of collateralized debt obligations (“CDOs”) backed by TruPS and similar debt instruments, or “TruPS CDOs.” Of that amount, $745.1 million is rated BIG. The underlying collateral in the TruPS CDOs consists of subordinated debt instruments such as TruPS issued by bank holding companies and similar instruments issued by insurance companies, real estate investment trusts (“REITs”) and other real estate related issuers.
 
The Company projects losses for TruPS CDOs by projecting the performance of the asset pools across several scenarios (which it weights) and applying the CDO structures to the resulting cash flows. At June 30, 2012, the Company has projected expected losses to be paid for TruPS CDOs that are accounted for as financial guaranty insurance of $6.5 million. The decrease of approximately $2.0 million in net expected loss during Second Quarter 2012 was driven primarily by a modest improvement in performance, which was partially offset by lower risk-free rates used to discount losses.
 
“XXX” Life Insurance Transactions
 
The Company’s $2.3 billion net par of XXX life insurance transactions as of June 30, 2012 include $882.5 million rated BIG. The BIG “XXX” life insurance reserve securitizations are based on discrete blocks of individual life insurance business. In each such transaction the monies raised by the sale of the bonds insured by the Company were used to capitalize a special purpose vehicle that provides reinsurance to a life insurer or reinsurer. The monies are invested at inception in accounts managed by third-party investment managers.
 
The BIG “XXX” life insurance transactions consist of two transactions: Ballantyne Re p.l.c and Orkney Re II p.l.c. These transactions had material amounts of their assets invested in U.S. RMBS transactions. Based on its analysis of the information currently available, including estimates of future investment performance, and projected credit impairments on the invested assets and performance of the blocks of life insurance business at June 30, 2012, the Company’s projected net expected loss to be paid is $135.3 million. The increase of $12.6 million during Second Quarter 2012 is due primarily to decreases in the risk-free rate used to discount losses and mild deterioration in the assets held by the trust, which was partially offset by the purchase of additional insured bonds for one of the transactions.

U.S. Public Finance Transactions

U.S. municipalities and related entities have been under increasing pressure over the last few quarters, and a few have filed for protection under the U.S. Bankruptcy Code, entered into state processes designed to help municipalities in fiscal distress or otherwise indicated they may consider not meeting their obligations to make timely payments on their debts. The Company expects that bondholder rights will be enforced. However, due to the early stage of these developments, and the circumstances surrounding each instance, the ultimate outcome cannot be certain. The Company will continue to analyze developments in each of these matters closely.

The Company has net exposure to Jefferson County, Alabama of $708.7 million. On November 9, 2011, Jefferson County filed for bankruptcy under Chapter 9 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the Northern District of Alabama (Southern Division).

Most of the Company's net exposure relates to $478.5 million in Jefferson County sewer revenue exposure, of which $205.4 million is direct and $273.1 million is assumed reinsurance exposure. The sewer revenue warrants are secured by a pledge of the net revenues of the sewer system. The bankruptcy court has affirmed that the net revenues constitute a “special revenue” under Chapter 9. Therefore, the net revenues of the sewer system are not subject to an automatic stay during the pendency of Jefferson County's bankruptcy case. BNY Mellon, as trustee, had brought a lawsuit regarding the amount of net revenues to which it is entitled. Since its bankruptcy filing, Jefferson County had been withholding estimated bankruptcy-related legal expenses and an amount representing a monthly reserve for future expenditures and depreciation and amortization from the monthly payments it had been making to the trustee from sewer revenues for debt service. On June 29, 2012 the Bankruptcy Court ruled that “Operating Expenses” as determined under the bond indenture do not include (1) a reserve for depreciation, amortization, or future expenditures, or (2) an estimate for professional fees and expenses, such that, after payment of Operating Expenses (as defined in the indenture), monies remaining in the Revenue Account created under the bond indenture must be distributed in accordance with the waterfall set forth in the indenture without withholding any monies for depreciation, amortization, reserves, or estimated expenditures that are the subject of this litigation. The court did not rule on whether actual incurred legal and professional fees constituted Operating Expenses that could be paid prior to debt service and Jefferson County filed a motion in July 2012 to clarify this point. Whether sufficient net revenues will be available for the payment of regularly scheduled debt service ultimately depends on the bankruptcy court's valuation of the sewer revenue stream.

The Company also has assumed exposure of $31.9 million to warrants that are payable from Jefferson County's general fund. During the past quarter Jefferson County chose not to make payment under its General Obligation bonds, so the Company has established a projected loss for these warrants as well. The Company's remaining net exposure of $198.3 million to Jefferson County relates to obligations that are secured by, or payable from, certain taxes that may have the benefit of a statutory lien or a lien on “special revenues” or other collateral.

On June 26, 2012, the City of Stockton filed for bankruptcy under Chapter 9 of the U.S. Bankruptcy Code due to drains on the general fund and projected deficits. The Company's net exposure to Stockton's general fund is $161.4 million, consisting of pension obligation and lease revenue bonds. As of June 30, 2012, the Company has paid $0.4 million in net claims.

The Company has $155.2 million of net par exposure to The City of Harrisburg, Pennsylvania, of which $94.9 million is BIG. The Company has paid $8.6 million in net claims to date, and expects a full recovery.

The Company projects that its total expected net loss from troubled U.S. public finance credits will be $58.4 million as of June 30, 2012, up from $32.7 million as of March 31, 2012. This increase was due primarily to changes in the interest and discount rates the Company uses to project cash flow related to the Jefferson County sewer revenue bonds and the establishment of expected losses related to the decision by Jefferson County not to make payments on its General Obligation bonds and the City of Stockton's filing for protection under Chapter 9 of the U.S. Bankruptcy Code.
 
Other Notable Transactions
 
The Company projects losses on, or is monitoring particularly closely, a number of other individual structured finance and international transactions, the most significant of which are described in the following paragraphs.
 
As of June 30, 2012 the Company had exposure to sovereign debt of Greece through financial guarantees of €200.0 million of debt (€165.1 million on a net basis) due in 2037 with a 4.5% fixed coupon and €114.3 million of inflation-linked debt (€52.7 million on a net basis) due in 2057 with a 2.085% coupon. On February 24, 2012, Greece announced the terms of exchange offers and consent solicitations that requested the voluntary participation by holders of certain Greek bonds, including the insured 2037 and 2057 bonds, in an exchange that resulted in the cancellation of such bonds in exchange for a package of replacement securities with lower principal amounts, and requested the consent of holders to amendments of the bonds that could be used to impose the same terms on holders that do not voluntarily participate in the exchange. In March 2012, the exchange was imposed through collective action clauses on the Company’s exposure to the 2037 bonds. In April 2012, the Company consented to the exchange with respect to its exposure on the 2057 bonds. The exchanges have caused the Company to recognize inception to date economic loss development of $311.7 million gross of reinsurance and $216.2 million, net of reinsurance and net of salvage received in the form of such exchanged securities, as of June 30, 2012. The Company recorded $15.6 million in gains due to changes in foreign exchange rates on its Greece reserve, which was recorded in other income. The Company accelerated claims under its financial guaranty on the July payment date with respect to the 2057 bonds and intends to accelerate claims on or after the September payment date with respect to the 2037 bonds.
 
The Company insures a total of $316.2 million net par of securities backed by manufactured housing loans, a total of $214.9 million rated BIG. The Company has expected loss to be paid of $21.4 million as of June 30, 2012 compared to $18.4 million as of December 31, 2011 on two direct transactions from 2000-2001 with an aggregate net par of $137.1 million and one assumed transaction from 2001 with an aggregate net par of $4.8 million.
 
Recovery Litigation
 
RMBS Transactions
 
As of August 1, 2012, AGM and AGC have lawsuits pending on the following U.S. RMBS transactions insured by them. In the lawsuits, AGM and AGC have alleged breaches of R&W both in respect of the underlying loans in the transactions and the accuracy of the information provided to AGM and AGC, and failure to cure or repurchase defective loans identified by AGM and AGC to such persons:
 
·                              ACE Securities Corp. Home Equity Loan Trust, Series 2006-GP1 (a second lien transaction in which AGM has sued Deutsche Bank AG affiliates DB Structured Products, Inc. and ACE Securities Corp.);

·                              Flagstar Home Equity Loan Trust, Series 2005-1 and Series 2006-2 (both second lien transactions in which AGM has sued Flagstar Bank, FSB, Flagstar Capital Markets Corporation and Flagstar ABS, LLC);
 
·                              SACO I Trust 2005-GP1 (a second lien transaction in which AGC has sued JPMorgan Chase & Co.’s affiliate EMC Mortgage LLC (formerly known as EMC Mortgage Corporation), J.P. Morgan Securities Inc. (formerly known as Bear, Stearns & Co. Inc.) and JPMorgan Chase Bank, N.A.);
 
·                              Bear Stearns Asset Backed Securities I Trust 2005-AC5 and Bear Stearns Asset Backed Securities I Trust 2005-AC6 (both first lien transactions in which AGC has sued EMC Mortgage LLC); and

·     
GMAC RFC Home Equity Loan-Backed Notes, Series 2006-HSA3 and GMAC Home Equity Loan-Backed Notes, Series 2004-HE3 (both second lien transactions in which AGM has sued GMAC Mortgage, LLC (formerly GMAC Mortgage Corporation; Residential Asset Mortgage Products, Inc.; Ally Bank (formerly GMAC Bank); Residential Funding Company, LLC (formerly Residential Funding Corporation); Residential Capital, LLC (formerly Residential Capital Corporation); Ally Financial (formerly GMAC, LLC); and Residential Funding Mortgage Securities II, Inc. On May 14, 2012, Residential Capital, LLC (“ResCap”) and several of its affiliates (the “Debtors”) filed for Chapter 11 protection with the U.S. Bankruptcy Court.  The automatic stay of Bankruptcy Code Section 362 (a) stays lawsuits (such as the suit brought by AGM) against the Debtors.  On May 25, 2012, ResCap filed an adversary proceeding in the United States Bankruptcy Court in the Southern District of New York against 42 defendants (including AGM) who are plaintiffs in 27 lawsuits arising from the Debtors' issuance or sale of mortgage backed securities (the “MBS Actions”) that have asserted claims against non-debtor affiliates of ResCap. ResCap's adversary proceeding seeks declaratory relief or injunctive relief to extend the automatic stay to stay or enjoin the continuation of actions against the non-debtor affiliates based on the MBS Actions.
 
In these lawsuits, AGM and AGC seek damages, including indemnity or reimbursement for losses.
 
AGM also has a lawsuit pending in the Superior court of the State of California, County of Los Angeles, against UBS Securities LLC, as underwriter, as well as several named and unnamed control persons of IndyMac Bank, FSB and related IndyMac entities, that it filed in September 2010 on the IndyMac IMSC Mortgage Loan Trust, Series 2007-HOA-1a first lien transaction that it had insured, seeking damages for alleged violations of state securities laws and breach of contract, among other claims.

In October 2011, AGM and AGC brought an action in the Supreme Court of the State of New York against DLJ Mortgage Capital, Inc. (“DLJ”) and Credit Suisse Securities (USA) LLC (“Credit Suisse”) with regard to six first lien U.S. RMBS transactions insured by them:
 
·                              CSAB Mortgage-Backed Pass Through Certificates, Series 2006-2 (AGM insured);
·                              CSAB Mortgage-Backed Pass Through Certificates, Series 2006-3 (AGM insured);
·                              CSAB Mortgage-Backed Pass Through Certificates, Series 2006-4 (AGM insured);
·                              CMSC Mortgage-Backed Pass Through Certificates, Series 2007-3 (AGM insured);
·                              CSAB Mortgage-Backed Pass Through Certificates, Series 2007-1 (AGC insured); and
·                              TBW Mortgage-Backed Pass Through Certificates, Series 2007-2 (AGC insured).
 
The complaint alleges breaches of R&W by DLJ in respect of the underlying loans in the transactions, breaches of contract by DLJ and Credit Suisse in procuring falsely inflated shadow ratings (a condition to the issuance by AGC and AGM of its policies) by providing false and misleading information to the rating agencies, and failure by DLJ to cure or repurchase defective loans identified by AGM and AGC.
 
In February 2012, AGM filed a complaint in the Supreme Court of the State of New York against UBS Real Estate Securities Inc. with respect to three first lien U.S. RMBS transactions it had insured:
 
·                              MASTR Adjustable Rate Mortgages Trust 2006-OA2;
·                              MASTR Adjustable Rate Mortgages Trust 2007-1; and
·                              MASTR Adjustable Rate Mortgages Trust 2007-3.
 
The complaint alleges breaches of R&W by UBS Real Estate in respect of the underlying loans in the transactions, breaches of UBS Real Estate’s repurchase obligations with respect to the defective loans identified by AGM, and breaches of contract by UBS Real Estate in procuring falsely inflated shadow ratings (a condition to the issuance by AGM of its policies) by providing false and misleading information to the rating agencies concerning the underlying loans in the transactions.
 
“XXX” Life Insurance Transactions
 
In December 2008, Assured Guaranty (UK) Ltd. (“AGUK”) filed an action against J.P. Morgan Investment Management Inc. (“JPMIM”), the investment manager in the Orkney Re II transaction, in the Supreme Court of the State of New York alleging that JPMIM engaged in breaches of fiduciary duty, gross negligence and breaches of contract based upon its handling of the investments of Orkney Re II. After AGUK’s claims were dismissed with prejudice in January 2010, AGUK was successful in its subsequent motions and appeals and, as of December 2011, all of AGUK’s claims for breaches of fiduciary duty, gross negligence and contract were reinstated in full. Separately, at the trial court level, discovery is ongoing.
 
Public Finance Transactions
 
In June 2010, AGM sued JPMorgan Chase Bank, N.A. and JPMorgan Securities, Inc. (together, “JPMorgan”), the underwriter of debt issued by Jefferson County, in the Supreme Court of the State of New York alleging that JPMorgan induced AGM to issue its insurance policies in respect of such debt through material and fraudulent misrepresentations and omissions, including concealing that it had secured its position as underwriter and swap provider through bribes to Jefferson County commissioners and others. In December 2010, the court denied JPMorgan’s motion to dismiss. AGM has filed a motion with the Jefferson County bankruptcy court to confirm that continued prosecution of the lawsuit against JPMorgan will not violate the automatic stay applicable to Jefferson County notwithstanding JPMorgan’s interpleading of Jefferson County into the lawsuit. AGM is continuing its risk remediation efforts for this exposure.
 
In September 2010, AGM, together with TD Bank, National Association and Manufacturers and Traders Trust Company, as trustees, filed a complaint in the Court of Common Pleas of Dauphin County, Pennsylvania against The Harrisburg Authority, The City of Harrisburg, Pennsylvania, and the Treasurer of the City in connection with certain Resource Recovery Facility bonds and notes issued by The Harrisburg Authority, alleging, among other claims, breach of contract by both The Harrisburg Authority and The City of Harrisburg, and seeking remedies including an order of mandamus compelling the City to satisfy its obligations on the defaulted bonds and notes and the appointment of a receiver for The Harrisburg Authority. Acting on its own, the City Council of Harrisburg filed a purported bankruptcy petition for the City in October 2011, which petition and a subsequent appeal were dismissed by the bankruptcy judge in November 2011. The City Council has appealed the dismissal of the appeal. As a result of the dismissal, the actions brought by AGM and the trustees against The City of Harrisburg and The Harrisburg Authority are no longer stayed. A receiver for The City of Harrisburg (the “City Receiver”) was appointed by the Commonwealth Court of Pennsylvania in December 2011. The City Receiver filed a motion to intervene in the mandamus action and action for the appointment of a receiver for the resource recovery facility. In March 2012, the Court of Common Pleas of Dauphin County, Pennsylvania issued an order granting the motion for the appointment of a receiver for the resource recovery facility, which order has been appealed by The Harrisburg Authority.
 
Net Loss Summary
 
The following table provides information on loss and LAE reserves net of reinsurance and salvage and subrogation recoverable on the consolidated balance sheets.
 
Loss and LAE Reserve (Recovery)
Net of Reinsurance and Salvage and Subrogation Recoverable
 
 
As of June 30, 2012
 
As of December 31, 2011
 
Loss and
LAE
Reserve
 
Salvage and
Subrogation
Recoverable 
 
Net
 
Loss and
LAE
Reserve 
 
Salvage and
Subrogation
Recoverable
 
Net
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

 
 

 
 

Prime first lien
$
2.1

 
$
—

 
$
2.1

 
$
1.2

 
$
—

 
$
1.2

Alt-A first lien
84.4

 
—

 
84.4

 
69.8

 
55.4

 
14.4

Option ARM
85.8

 
189.8

 
(104.0
)
 
141.7

 
140.3

 
1.4

Subprime
71.8

 
0.3

 
71.5

 
51.4

 
0.3

 
51.1

Total first lien
244.1

 
190.1

 
54.0

 
264.1

 
196.0

 
68.1

Second lien:
 

 
 

 
 

 
 

 
 

 
 

Closed-end second lien
13.9

 
67.1

 
(53.2
)
 
11.2

 
136.2

 
(125.0
)
HELOC
45.4

 
194.3

 
(148.9
)
 
61.1

 
177.2

 
(116.1
)
Total second lien
59.3

 
261.4

 
(202.1
)
 
72.3

 
313.4

 
(241.1
)
Total U.S. RMBS
303.4

 
451.5

 
(148.1
)
 
336.4

 
509.4

 
(173.0
)
TruPS
4.6

 
—

 
4.6

 
11.1

 
—

 
11.1

Other structured finance
192.4

 
6.6

 
185.8

 
221.9

 
5.9

 
216.0

U.S. public finance
108.2

 
75.2

 
33.0

 
62.2

 
69.9

 
(7.7
)
Non-U.S. public finance
280.3

 
—

 
280.3

 
37.8

 
—

 
37.8

Total financial guaranty
888.9

 
533.3

 
355.6

 
669.4

 
585.2

 
84.2

Other
1.9

 
6.0

 
(4.1
)
 
1.9

 
—

 
1.9

Subtotal
890.8

 
539.3

 
351.5

 
671.3

 
585.2

 
86.1

Effect of consolidating FG VIEs
(66.1
)
 
(202.8
)
 
136.7

 
(61.6
)
 
(258.1
)
 
196.5

Total (1)
$
824.7

 
$
336.5

 
$
488.2

 
$
609.7

 
$
327.1

 
$
282.6

 _______________
 (1)                                 See “Components of Net Reserves (Salvage)” table for loss and LAE reserve and salvage and subrogation recoverable components.
 
The following table reconciles the loss and LAE reserve and salvage and subrogation components on the consolidated balance sheet to the financial guaranty net reserves (salvage) in the financial guaranty BIG transaction loss summary tables.
 
Components of Net Reserves (Salvage)
 
 
As of
 June 30, 2012
 
As of
 December 31, 2011
 
(in millions)
Loss and LAE reserve
$
995.2

 
$
679.0

Reinsurance recoverable on unpaid losses
(170.5
)
 
(69.3
)
Subtotal
824.7

 
609.7

Salvage and subrogation recoverable
(376.8
)
 
(367.7
)
Salvage and subrogation payable(1)
40.3

 
40.6

Subtotal
(336.5
)
 
(327.1
)
Total
488.2

 
282.6

Less: other
(4.1
)
 
1.9

Financial guaranty net reserves (salvage)
$
492.3

 
$
280.7

 ___________________
(1)                                  Recorded as a component of reinsurance balances payable.
 
The following table presents the loss and LAE recorded in the consolidated statements of operations by sector for financial guaranty insurance contracts. Amounts presented are net of reinsurance and net of the benefit for recoveries from breaches of R&W.

Loss and LAE Reported
on the Consolidated Statements of Operations
 
 
Second Quarter
 
Six Months
 
2012
 
2011
 
2012
 
2011
 
(in millions)
Financial Guaranty:
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
$
0.5

 
$
1.2

 
$
0.9

 
$
1.1

Alt-A first lien
29.0

 
19.2

 
27.7

 
27.4

Option ARM
16.9

 
70.4

 
69.4

 
41.3

Subprime
16.7

 
4.3

 
24.5

 
(5.1
)
Total first lien
63.1

 
95.1

 
122.5

 
64.7

Second lien:
 
 
 
 
 
 
 
Closed end second lien
2.4

 
(5.7
)
 
1.6

 
(15.6
)
HELOC
4.1

 
36.2

 
19.2

 
97.2

Total second lien
6.5

 
30.5

 
20.8

 
81.6

Total U.S. RMBS
69.6

 
125.6

 
143.3

 
146.3

TruPS
(1.8
)
 
3.7

 
(6.1
)
 
3.7

Other structured finance
29.3

 
7.4

 
1.2

 
27.7

U.S. public finance
25.3

 
3.4

 
44.5

 
(12.4
)
Non-U.S. public finance
5.6

 
0.7

 
195.1

 
0.7

Total financial guaranty
128.0

 
140.8

 
378.0

 
166.0

Other
(6.0
)
 
—

 
(6.0
)
 
—

Subtotal
122.0

 
140.8

 
372.0

 
166.0

Effect of consolidating FG VIEs
0.5

 
(16.9
)
 
(2.7
)
 
(67.6
)
Total loss and LAE
$
122.5

 
$
123.9

 
369.3

 
98.4



 
The following table provides information on financial guaranty contracts categorized as BIG.
 
Financial Guaranty Insurance BIG Transaction Loss Summary
June 30, 2012
 
 
BIG Categories
 
BIG 1
 
BIG 2
 
BIG 3
 
Total
BIG, Net
 
Effect of
Consolidating
FG VIEs
 
Total
 
Gross
 
Ceded
 
Gross
 
Ceded
 
Gross
 
Ceded
 
 
 
 
(dollars in millions)
Number of risks(1)
164

 
(60
)
 
79

 
(25
)
 
132

 
(50
)
 
375

 
—

 
375

Remaining weighted-average contract period (in years)
10.4

 
9.2

 
14.4

 
26.1

 
9.1

 
6.6

 
10.7

 
—

 
10.7

Outstanding exposure:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Principal
$
8,959.2

 
$
(1,492.5
)
 
$
3,622.2

 
$
(268.6
)
 
$
7,462.1

 
$
(568.0
)
 
$
17,714.4

 
$
—

 
$
17,714.4

Interest
4,207.6

 
(563.4
)
 
3,042.4

 
(504.0
)
 
2,328.4

 
(157.0
)
 
8,354.0

 
—

 
8,354.0

Total(2)
$
13,166.8

 
$
(2,055.9
)
 
$
6,664.6

 
$
(772.6
)
 
$
9,790.5

 
$
(725.0
)
 
$
26,068.4

 
$
—

 
$
26,068.4

Expected cash outflows (inflows)
$
1,594.1

 
$
(673.3
)
 
$
1,738.1

 
$
(225.7
)
 
$
2,940.2

 
$
(144.8
)
 
$
5,228.6

 
$
(767.2
)
 
$
4,461.4

Potential recoveries(3)
(1,712.4
)
 
696.1

 
(653.2
)
 
20.3

 
(2,571.8
)
 
122.0

 
(4,099.0
)
 
805.4

 
(3,293.6
)
Subtotal
(118.3
)
 
22.8

 
1,084.9

 
(205.4
)
 
368.4

 
(22.8
)
 
1,129.6

 
38.2

 
1,167.8

Discount
18.6

 
(6.3
)
 
(247.4
)
 
29.4

 
(94.1
)
 
(3.3
)
 
(303.1
)
 
27.5

 
(275.6
)
Present value of expected cash flows
$
(99.7
)
 
$
16.5

 
$
837.5

 
$
(176.0
)
 
$
274.3

 
$
(26.1
)
 
$
826.5

 
$
65.7

 
$
892.2

Deferred premium revenue
$
122.1

 
$
(15.8
)
 
$
310.4

 
$
(32.0
)
 
$
863.3

 
$
(102.9
)
 
$
1,145.1

 
$
(331.3
)
 
$
813.8

Reserves (salvage)(4)
$
(132.5
)
 
$
23.2

 
$
617.4

 
$
(158.1
)
 
$
(0.4
)
 
$
6.0

 
$
355.6

 
$
136.7

 
$
492.3

 
Financial Guaranty Insurance BIG Transaction Loss Summary
December 31, 2011
 
 
BIG Categories
 
BIG 1
 
BIG 2
 
BIG 3
 
Total
BIG, Net
 
Effect of
Consolidating
FG VIEs
 
Total
 
Gross
 
Ceded
 
Gross
 
Ceded
 
Gross
 
Ceded
 
 
(dollars in millions)
Number of risks(1)
171

 
(68
)
 
71

 
(26
)
 
126

 
(48
)
 
368

 
—

 
368

Remaining weighted-average contract period (in years)
10.0

 
9.2

 
13.7

 
20.5

 
9.2

 
6.4

 
10.4

 
—

 
10.4

Outstanding exposure:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Principal
$
9,675.8

 
$
(1,378.0
)
 
$
3,731.6

 
$
(274.0
)
 
$
7,830.8

 
$
(627.7
)
 
$
18,958.5

 
$
—

 
$
18,958.5

Interest
4,307.9

 
(485.6
)
 
2,889.4

 
(404.8
)
 
2,486.4

 
(170.0
)
 
8,623.3

 
—

 
8,623.3

Total(2)
$
13,983.7

 
$
(1,863.6
)
 
$
6,621.0

 
$
(678.8
)
 
$
10,317.2

 
$
(797.7
)
 
$
27,581.8

 
$
—

 
$
27,581.8

Expected cash outflows (inflows)
$
1,730.6

 
$
(658.8
)
 
$
1,833.3

 
$
(120.3
)
 
$
2,423.0

 
$
(133.4
)
 
$
5,074.4

 
$
(998.4
)
 
$
4,076.0

Potential recoveries(3)
(1,798.0
)
 
664.0

 
(1,079.3
)
 
38.5

 
(2,040.5
)
 
100.3

 
(4,115.0
)
 
1,059.8

 
(3,055.2
)
Subtotal
(67.4
)
 
5.2

 
754.0

 
(81.8
)
 
382.5

 
(33.1
)
 
959.4

 
61.4

 
1,020.8

Discount
15.7

 
(4.6
)
 
(240.6
)
 
31.6

 
(125.1
)
 
1.6

 
(321.4
)
 
45.3

 
(276.1
)
Present value of expected cash flows
$
(51.7
)
 
$
0.6

 
$
513.4

 
$
(50.2
)
 
$
257.4

 
$
(31.5
)
 
$
638.0

 
$
106.7

 
$
744.7

Deferred premium revenue
$
260.8

 
$
(69.1
)
 
$
280.9

 
$
(12.3
)
 
$
991.8

 
$
(126.6
)
 
$
1,325.5

 
$
(390.7
)
 
$
934.8

Reserves (salvage)(4)
$
(96.6
)
 
$
6.9

 
$
319.5

 
$
(41.9
)
 
$
(110.2
)
 
$
6.5

 
$
84.2

 
$
196.5

 
$
280.7

 ____________________
(1)
A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making debt service payments. The ceded number of risks represents the number of risks for which the Company ceded a portion of its exposure.

(2)
Includes BIG amounts related to FG VIEs which are not eliminated.

(3)
Includes estimated future recoveries for breaches of R&W as well as excess spread, and draws on HELOCs.
 
(4)
See table “Components of net reserves (salvage).”

The Company also has outstanding exposures to certain infrastructure transactions in its insured portfolio that may expose it to refinancing risk. These transactions generally involve long-term infrastructure projects that are financed by bonds that mature prior to the expiration of the project concession. While the cash flows from these projects were expected to be sufficient to repay all of the debt over the life of the project concession, in order to pay the principal on the early maturing debt, the Company expected it to be refinanced in the market at or prior to its maturity. Due to market dislocation and increased credit spreads, the Company may have to pay a claim at the maturity of the securities, and then recover its payment from cash flows produced by the project in the future. The Company generally projects that in most scenarios it will be fully reimbursed for such payments. The projected inflows and outflows are included in the Company's “Financial Guaranty Insurance BIG Transaction Loss Summary” table in this Note.

Ratings Impact on Financial Guaranty Business
 
A downgrade of one of the Company’s insurance subsidiaries may result in increased claims under financial guaranties issued by the Company, if the insured obligors were unable to pay.
 
For example, AGM has issued financial guaranty insurance policies in respect of the obligations of municipal obligors under interest rate swaps. Under the swaps, AGM insures periodic payments owed by the municipal obligors to the bank counterparties. Under certain of the swaps, AGM also insures termination payments that may be owed by the municipal obligors to the bank counterparties. If (i) AGM has been downgraded below the rating trigger set forth in a swap under which it has insured the termination payment, which rating trigger varies on a transaction by transaction basis; (ii) the municipal obligor has the right to cure by, but has failed in, posting collateral, replacing AGM or otherwise curing the downgrade of AGM; (iii) the transaction documents include as a condition that an event of default or termination event with respect to the municipal obligor has occurred, such as the rating of the municipal obligor being downgraded past a specified level, and such condition has been met; (iv) the bank counterparty has elected to terminate the swap; (v) a termination payment is payable by the municipal obligor; and (vi) the municipal obligor has failed to make the termination payment payable by it, then AGM would be required to pay the termination payment due by the municipal obligor, in an amount not to exceed the policy limit set forth in the financial guaranty insurance policy. The claim payments would be subject to recovery from the municipal obligor. As of June 30, 2012, taking into consideration whether the rating of the municipal obligor was below any applicable specified trigger as of such date, if the financial strength rating of AGM were downgraded below "A" by S&P or below "A2" by Moody's, and the conditions giving rise to the obligation of AGM to make a payment under the swap policies were all satisfied, then AGM could pay claims in an amount not exceeding $370.1 million in respect of such termination payments.
     

As another example, with respect to variable rate demand obligations ("VRDOs") for which a bank has agreed to provide a liquidity facility, a downgrade of AGM or AGC may provide the bank with the right to give notice to bondholders that the bank will terminate the liquidity facility, causing the bondholders to tender their bonds to the bank. Bonds held by the bank accrue interest at a “bank bond rate” that is higher than the rate otherwise borne by the bond (typically the prime rate plus 2.00% — 3.00%, and capped at the lesser of 25% and the maximum legal limit). In the event the bank holds such bonds for longer than a specified period of time, usually 90-180 days, the bank has the right to demand accelerated repayment of bond principal, usually through payment of equal installments over a period of not less than five years. In the event that a municipal obligor is unable to pay interest accruing at the bank bond rate or to pay principal during the shortened amortization period, a claim could be submitted to AGM or AGC under its financial guaranty policy. As of June 30, 2012, AGM and AGC has insured approximately $0.7 billion of par of VRDOs issued by municipal obligors rated BBB- or lower pursuant to the Company’s internal rating. For a number of such obligations, a downgrade of AGM or AGC below “A+” by S&P or below “A1” by Moody’s triggers the ability of the bank to notify bondholders of the termination of the liquidity facility and to demand accelerated repayment of bond principal over a period of 5 to 10 years. The specific terms relating to the rating levels that trigger the bank’s termination right, and whether it is triggered by a downgrade by one rating agency or a downgrade by all rating agencies then rating the insurer, vary depending on the transaction.