10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 1-11356

 

 

RADIAN GROUP INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   23-2691170

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

1601 Market Street, Philadelphia, PA   19103
(Address of principal executive offices)   (Zip Code)

(215) 231-1000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, $.001 par value per share   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    YES  x    NO  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    YES  ¨    NO  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

 

Large accelerated filer  x   Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨
    (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. As of June 30, 2007, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $4,341,264,984 based on the closing sale price as reported on the New York Stock Exchange. Excluded from this amount is the value of all shares beneficially owned by executive officers and directors of the registrant. These exclusions should not be deemed to constitute a representation or acknowledgement that any such individual is, in fact, an affiliate of the registrant or that there are not other persons or entities who may be deemed to be affiliates of the registrant.

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 80,460,406 shares of common stock, $.001 par value per share, outstanding on March 6, 2008.

DOCUMENTS INCORPORATED BY REFERENCE

List hereunder the following documents if incorporated by reference and the Part of the Form 10-K (e.g., Part I, Part II, etc.) into which the document is incorporated: (1) Any annual report to security holders; (2) Any proxy or information statement; and (3) Any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act of 1933. The listed documents should be clearly described for identification purposes (e.g., annual report to security holders for fiscal year ended December 24, 1980).

 

     

Form 10-K Reference Document

Definitive Proxy Statement for the Registrant’s 2008 Annual Meeting of Stockholders   

Part III

(Items 10 through 14)

 

 

 


Table of Contents

TABLE OF CONTENTS

 

               Page
Number
     

Forward Looking Statements—Safe Harbor Provisions

   3

PART I

        
   Item 1   

Business

   6
     

General

   6
     

Mortgage Insurance Business

   7
     

Financial Guaranty Business

   12
     

Financial Services Business

   19
     

Risk in Force/Net Par Outstanding

   20
     

Defaults and Claims

   32
     

Loss Management

   35
     

Risk Management

   38
     

Customers

   42
     

Sales and Marketing

   43
     

Competition

   45
     

Ratings

   47
     

Investment Policy and Portfolio

   50
     

Regulation

   53
     

Employees

   62
   Item 1A   

Risk Factors

   63
   Item 1B   

Unresolved Staff Comments

   85
   Item 2   

Properties

   86
   Item 3   

Legal Proceedings

   87
   Item 4   

Submission of Matters to a Vote of Security Holders

   87

PART II

        
   Item 5   

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   87
   Item 6   

Selected Financial Data

   89
   Item 7   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   90
   Item 7A   

Quantitative and Qualitative Disclosures About Market Risk

   151
   Item 8   

Financial Statements and Supplementary Data

   153
   Item 9   

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   227
   Item 9A   

Controls and Procedures

   228
   Item 9B   

Other Information

   230

PART III

        
   Item 10   

Directors, Executive Officers and Corporate Governance

   231
   Item 11   

Executive Compensation

   231
   Item 12   

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   231
   Item 13   

Certain Relationships and Related Transactions, and Director Independence

   231
   Item 14   

Principal Accounting Fees and Services

   231

PART IV

        
   Item 15   

Exhibits and Financial Statement Schedules

   232

SIGNATURES

   233

INDEX TO FINANCIAL STATEMENT SCHEDULES

   234

INDEX TO EXHIBITS

   241

 

2


Table of Contents

Forward Looking Statements—Safe Harbor Provisions

All statements in this report that address events, developments or results that we expect or anticipate may occur in the future are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the U.S. Private Securities Litigation Reform Act of 1995. In most cases, forward-looking statements may be identified by words such as “may,” “should,” “expect,” “intend,” “plan,” “goal,” “contemplate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue” or the negative or other variations on these words and other similar expressions. These statements, which include, without limitation, projections regarding our future performance and financial condition are made on the basis of management’s current views and assumptions with respect to future events. Any forward-looking statement is not a guarantee of future performance and actual results could differ materially from those contained in the forward looking information. The forward-looking statements, as well as our prospects as a whole, are subject to risks and uncertainties, including the following:

 

   

actual or perceived changes in general financial and political conditions, such as extended national or regional economic recessions, changes in housing demand or mortgage originations, changes in housing values (in particular, further deterioration in the housing, mortgage and related credit markets, which would harm our future consolidated results of operations and, if more severe than our current predictions, could cause losses for our mortgage insurance business to be worse than expected), changes in the liquidity in the capital markets and the further contraction of credit markets, population trends and changes in household formation patterns, changes in unemployment rates, changes or volatility in interest rates or consumer confidence, changes in credit spreads, changes in the way investors perceive the strength of private mortgage insurers or financial guaranty providers, investor concern over the credit quality and specific risks faced by the particular businesses, municipalities or pools of assets covered by our insurance;

 

   

actual or perceived economic changes or catastrophic events in geographic regions (both domestic and international) where our mortgage insurance or financial guaranty insurance in force is more concentrated;

 

   

our ability to successfully acquire additional capital in the event that capital is required to support our long-term liquidity needs and to protect our credit and financial strength ratings;

 

   

a decrease in the volume of home mortgage originations due to reduced liquidity in the lending market, tighter underwriting standards and a deterioration in housing markets throughout the U.S.;

 

   

a decrease in the volume of the municipal bonds, and other public finance and structured finance transactions that we insure, or a decrease in the volume of such transactions for which issuers or investors seek or demand financial guaranty insurance;

 

   

the loss of a customer for whom we write a significant amount of mortgage insurance or financial guaranty insurance or the influence of large customers;

 

   

reduction in the volume of reinsurance business available to us from one or more of our primary financial guaranty insurer customers due to adverse changes in their ability to generate new profitable direct financial guaranty insurance or their need for us to reinsure their risk;

 

   

disruption in the servicing of mortgages covered by our insurance policies;

 

   

the aging of our mortgage insurance portfolio and changes in severity or frequency of losses associated with certain of our products that are riskier than traditional mortgage insurance or financial guaranty insurance policies;

 

   

the performance of our insured portfolio of higher risk loans, such as Alternative-A (“Alt-A”) and subprime loans, and adjustable rate products, such as adjustable rate mortgages and interest-only mortgages, which have resulted in increased losses in 2007 and may result in further losses;

 

3


Table of Contents
   

reduced opportunities for loss mitigation in markets where housing values fail to appreciate or begin to decline;

 

   

changes in persistency rates of our mortgage insurance policies caused by changes in refinancing activity, in the rate of appreciation or depreciation of home values and changes in the mortgage insurance cancellation requirements of mortgage lenders and investors;

 

   

downgrades or threatened downgrades of, or other ratings actions with respect to, our credit ratings or the insurance financial strength ratings assigned by the major rating agencies to any of our rated insurance subsidiaries at any time (in particular, our credit rating and the financial strength ratings of our mortgage insurance subsidiaries that are currently under review for possible downgrade), which risk is discussed in more detail under Item 1A of Part I of this report;

 

   

heightened competition for our mortgage insurance business from others such as the Federal Housing Administration and the Veterans’ Administration or other private mortgage insurers, from alternative products such as “80-10-10” loans or other forms of simultaneous second loan structures used by mortgage lenders, from investors using forms of credit enhancement other than mortgage insurance as a partial or complete substitution for private mortgage insurance and from mortgage lenders that demand increased participation in revenue sharing arrangements such as captive reinsurance arrangements;

 

   

changes in the charters or business practices of Federal National Mortgage Association and Freddie Mac, the largest purchasers of mortgage loans that we insure;

 

   

heightened competition for financial guaranty business from other financial guaranty insurers, including those recently downgraded to ratings equal to or lower than our ratings, from other forms of credit enhancement such as letters of credit, guaranties and credit default swaps provided by foreign and domestic banks and other financial institutions and from alternative structures that may permit insurers to securitize assets more cost-effectively without the need for the types of credit enhancement we offer, or result in our having to reduce the premium we charge for our products;

 

   

the application of existing federal or state consumer, lending, insurance, securities and other applicable laws and regulations, or changes in these laws and regulations or the way they are interpreted; including, without limitation: (i) the possibility of private lawsuits or investigations by state insurance departments and state attorneys general alleging that services offered by the mortgage insurance industry, such as captive reinsurance, pool insurance and contract underwriting, are violative of the Real Estate Settlement Procedures Act and/or similar state regulations, (ii) legislative and regulatory changes affecting demand for private mortgage insurance or financial guaranty insurance, or (iii) legislation and regulatory changes limiting or restricting our use of (or requirements for) additional capital, the products we may offer, the form in which we may execute the credit protection we provide or the aggregate notional amount of any product we may offer for any one transaction or in the aggregate;

 

   

the possibility that we may fail to estimate accurately the likelihood, magnitude and timing of losses in connection with establishing loss reserves for our mortgage insurance or financial guaranty businesses, or the premium deficiency for our second-lien mortgage insurance business, or to estimate accurately the fair value amounts of derivative contracts in our mortgage insurance and financial guaranty businesses in determining gains and losses on these contracts;

 

   

changes in accounting guidance from the Securities and Exchange Commission (“SEC”) or the Financial Accounting Standards Board (in particular changes regarding income recognition and the treatment of loss reserves in the financial guaranty industry);

 

   

our ability to profitably grow our insurance businesses in international markets, which depends on a number of factors such as foreign governments’ monetary policies and regulatory requirements, foreign currency exchange rate fluctuations, and our ability to develop and market products appropriate to foreign markets;

 

4


Table of Contents
   

legal and other limitations on the amount of dividends we may receive from our subsidiaries; and

 

   

vulnerability to the performance of our strategic investments, including in particular, our investment in Sherman Financial Group LLC.

For more information regarding these risks and uncertainties as well as certain additional risks that we face, you should refer to the Risk Factors detailed in Part I, Item 1A of this report. We caution you not to place undue reliance on these forward-looking statements, which are current only as of the date on which we filed this report. We do not intend to, and we disclaim any duty or obligation to, update or revise any forward-looking statements made in this report to reflect new information or future events or for any other reason.

 

5


Table of Contents

Part I

 

Item 1. Business.

I. General

We are a credit enhancement company. Our strategic objective is to prudently grow our core mortgage credit enhancement business while providing value to our clients in the acquisition, management and distribution of credit risk, primarily in domestic and also in selected international markets. We develop and deliver credit enhancement products by applying our credit risk expertise and structured finance capabilities to the credit enhancement needs of our counterparties.

Based on this foundation of credit risk evaluation and expertise, we offer products and services through three business segments—mortgage insurance, financial guaranty and financial services:

 

   

Our mortgage insurance business provides credit protection for mortgage lenders and other financial services companies on residential mortgage assets through traditional mortgage insurance as well as other mortgage-backed structured products.

 

   

Our financial guaranty business insures and reinsures municipal bonds and other credit-based risks, and provides synthetic credit protection on various asset classes through credit default swaps.

 

   

Our financial services business consists mainly of our ownership interests in Sherman Financial Group LLC (“Sherman”)—a consumer asset and servicing firm specializing in credit card and bankruptcy-plan consumer assets and Credit-Based Asset Servicing and Securitization LLC (“C-BASS”)—a mortgage investment firm that specialized in credit-sensitive, residential mortgage assets and residential mortgage-backed securities.

The following shows the allocation of our equity to our three business segments at December 31, 2007:

 

     Equity  

Mortgage Insurance

   58 %

Financial Guaranty

   37 %

Financial Services

   5 %

A summary of financial information for each of our business segments and a discussion of net premiums earned attributable to our domestic and international operations for each of the last three fiscal years is included in “Segment Reporting” in Note 20 of Notes to Consolidated Financial Statements.

Background. We began conducting business as CMAC Investment Corporation, a Delaware corporation, following our spin-off from Commonwealth Land Title Insurance Company through an initial public offering on November 6, 1992. On June 9, 1999, we merged with Amerin Corporation, an Illinois based mortgage insurance company, and were renamed Radian Group Inc. (“Radian”). On February 28, 2001, we entered the financial guaranty insurance business through our acquisition of Enhance Financial Services Group Inc. (“EFSG”), a New York-based insurance holding company that owns our principal financial guaranty subsidiaries, Radian Asset Assurance Inc. (“Radian Asset Assurance”) and Radian Asset Assurance Limited (“RAAL”). Our principal executive offices are located at 1601 Market Street, Philadelphia, Pennsylvania 19103, and our telephone number is (215) 231-1000.

Terminated Merger with MGIC Investment Corporation (“MGIC”). On February 6, 2007, we and MGIC, the largest private mortgage insurer in the industry, entered into an Agreement and Plan of Merger pursuant to which we agreed, subject to the terms and conditions of the merger agreement, to merge with and into MGIC, with the combined company to be renamed MGIC Radian Financial Group Inc.

On September 4, 2007, facing market conditions that had made combining the companies significantly more challenging, we and MGIC entered into a Termination and Release Agreement relating to the Agreement and

 

6


Table of Contents

Plan of Merger. As a result of this agreement, we and MGIC terminated the Agreement and Plan of Merger, abandoned the merger contemplated by the merger agreement and released each other from related claims. Neither party made a payment to the other in connection with the termination.

Additional Information. We maintain a website with the address www.radian.biz. We are not including or incorporating by reference the information contained on our website into this report. We make available on our website, free of charge and as soon as reasonably practicable after we file with, or furnish to, the SEC, copies of our most recently filed Annual Report on Form 10-K, all Quarterly Reports on Form 10-Q and all Current Reports on Form 8-K, including all amendments to those reports. In addition, copies of our guidelines of corporate governance, code of business conduct and ethics (which includes the code of ethics applicable to our chief executive officer, principal financial officer and principal accounting officer) and the governing charters for each committee of our board of directors are available free of charge on our website, as well as in print to any stockholder upon request.

A. Mortgage Insurance Business (General)

Our mortgage insurance business provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions located throughout the U.S. and in limited, select countries outside the U.S. We provide these products and services mainly through our wholly-owned subsidiaries, Radian Guaranty Inc. (“Radian Guaranty”), Radian Insurance Inc. (“Radian Insurance”) and Amerin Guaranty Corporation (“Amerin Guaranty”).

Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made mostly to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to Freddie Mac and the Federal National Mortgage Association (“Fannie Mae”). We sometimes refer to Freddie Mac and Fannie Mae together as “Government Sponsored Enterprises” or “GSEs.”

Our mortgage insurance segment, through Radian Guaranty, offers private mortgage insurance coverage on residential first-lien mortgages. We have used Radian Insurance to provide credit enhancement for mortgage-related capital market transactions and to write credit insurance on mortgage-related assets such as international insurance transactions and credit default swaps. We also insured net interest margin securities (“NIMS”) and second-lien mortgages through Radian Insurance and second-lien mortgages in Amerin Guaranty, although we have discontinued writing new insurance for these products and other capital markets transactions. We refer to the risk associated with products other than residential first-lien mortgages as “other risk in force”. At December 31, 2007, our other risk in force was 23.3% of our total mortgage insurance risk in force. 78% of this other risk in force was contained in two large international transactions.

 

7


Table of Contents

Premiums written and earned by our mortgage insurance segment for the last three fiscal years were as follows:

 

     2007    2006    2005

Net premiums written (in thousands)

        

Primary and Pool Insurance

   $ 835,961    $ 723,213    $ 752,194

Seconds

     27,236      57,935      56,092

International

     35,306      20,375      25,612
                    

Net premiums written—insurance

     898,503      801,523      833,898

Net premiums written—credit derivatives

     56,610      47,588      43,734
                    

Net premiums written

   $ 955,113    $ 849,111    $ 877,632
                    

Net premiums earned (in thousands)

        

Primary and Pool Insurance

   $ 730,966    $ 715,136    $ 712,538

Seconds

     32,744      52,588      50,043

International

     15,549      7,028      1,584
                    

Net premiums earned—insurance

     779,259      774,752      764,165

Net premiums earned—credit derivatives

     64,263      37,263      42,732
                    

Net premiums earned

   $ 843,522    $ 812,015    $ 806,897
                    

1. Traditional Types of Coverage (General—Mortgage Insurance)

Primary Mortgage Insurance. Primary mortgage insurance provides protection against mortgage default on prime and non-prime mortgages (discussed below under “Risk in Force/Net Par Outstanding—Mortgage Insurance—Lender and Mortgage Characteristics”) at a specified coverage percentage. When there is a claim, the coverage percentage is applied to the claim amount—which consists of the unpaid loan principal, plus past due interest and certain expenses associated with the default—to determine our maximum liability. We provide primary mortgage insurance on both a flow basis (which is loan-by-loan) and a structured basis (in which we insure a group of individual loans). Our structured business can be written in a “second to pay” or “second-loss” position, meaning that we are not required to make a payment until a certain amount of losses have already been recognized. See “Types of Transactions” below.

In 2007, we wrote $57.1 billion of primary mortgage insurance, of which 70.6% was originated on a flow basis and 29.4% was originated on a structured basis, compared to $40.1 billion of primary mortgage insurance written in 2006 of which 63.2% was originated on a flow basis and 36.8% was originated on a structured basis. Primary insurance on first-lien mortgages made up 91% of our total first-lien mortgage insurance risk in force at December 31, 2007.

Pool Insurance. We offer pool insurance on a limited basis. Pool insurance differs from primary insurance in that our maximum liability is not limited to a specific coverage percentage on each individual mortgage. Instead, an aggregate exposure limit, or “stop loss,” generally between 1% and 10%, is applied to the initial aggregate loan balance on a group or “pool” of mortgages. In addition to a stop loss, many pool policies are written in a second-loss position. We believe the deductible and stop loss features are important in limiting our exposure on a specified pool.

Premium rates for our pool insurance business are generally lower than primary mortgage insurance rates due to the aggregate stop loss. As a result of these lower premium rates, the lack of exposure limits on individual loans, and the greater concentration of risk in force associated with much of our pool insurance, the rating agency capital requirements per dollar of risk for this product are generally more restrictive than for primary insurance. In 2007, we wrote $261 million of pool insurance risk, compared to $359 million of pool insurance risk written in 2006. Pool insurance on first-lien mortgages made up approximately 9% of our total first-lien mortgage insurance risk in force at December 31, 2007.

 

8


Table of Contents

We write most of our pool insurance in the form of credit enhancement on residential mortgage loans underlying residential mortgage-backed securities, whole loan sales and other structured transactions. An insured pool of mortgages may contain mortgages that are already covered by primary mortgage insurance, and the pool insurance is secondary to any primary mortgage insurance that exists on mortgages within the pool. Generally, the mortgages we insure with pool insurance are similar to primary insured mortgages.

Modified Pool Insurance. We also write modified pool insurance, which differs from standard pool insurance in that it includes an exposure limit on each individual loan as well as a stop loss feature for the entire pool of loans. Modified pool insurance and the related risk in force is included in our primary mortgage statistics.

2. Types of Transactions (General—Mortgage Insurance)

Our mortgage insurance business provides credit enhancement mainly through two forms of transactions. We write mortgage insurance on an individual loan basis, which is commonly referred to as “flow” business, and we insure multiple mortgages in a single transaction, which is commonly referred to as “structured” business. In flow transactions, mortgages typically are insured as they are originated, while in structured deals, we typically provide insurance on mortgages after they have been originated and closed. For 2007, our mortgage insurance business wrote $40.3 billion of flow business and $16.8 billion in structured transactions, compared to $25.4 billion of flow business and $14.7 billion in structured transactions for 2006.

In structured mortgage insurance transactions, we typically insure the individual mortgages included in the structured portfolio up to specified levels of coverage. Most structured mortgage insurance transactions that we have insured involved non-traditional mortgages, such as non-prime mortgages or mortgages with higher than average balances. A single structured mortgage insurance transaction may include primary insurance or pool insurance, and an increasing number of structured transactions have both primary and pool components. We are not currently writing such business on non-prime mortgages.

We also have insured mortgage-related assets, such as mortgage-backed securities in structured transactions. In these transactions, similar to our financial guaranty insurance business, we insured the timely payment of principal and interest to the holders of debt securities, the payment for which is backed by a pool of residential mortgages. Unlike our traditional flow and structured transactions, in our residential mortgage-backed securities transactions, we do not insure the payment of the individual loans in the pool, but rather that there will be aggregate payments on the pool of loans sufficient to meet the principal and interest payment obligations to the holders of the debt securities. Some structured transactions include a risk-sharing component under which the insured or a third-party assumes a first-loss position or shares in losses in some other manner. Given market conditions, we are not currently writing such business.

Opportunities for structured transactions depend on a number of macroeconomic factors, and thus, the volume of structured transactions we enter into can vary significantly from year to year. In 2007, we wrote $16.8 billion of primary mortgage insurance in structured transactions, consisting of approximately 20.5% prime loans and 79.5% non-prime loans, compared to $14.7 billion of primary new insurance written in structured transactions in 2006, of which 27.1% was prime loans and 72.9% was non-prime loans. Also in 2007, we wrote $258.9 million of pool mortgage insurance risk in structured transactions, compared to $324.3 million in 2006. For 2008, we expect to write less business in structured transactions, and these transactions will primarily contain higher credit quality mortgage loans.

3. Non-Traditional Forms of Credit Enhancement (General—Mortgage Insurance)

In addition to traditional mortgage insurance, we provide other forms of credit enhancement on residential mortgage assets. Until recently, these products were a growing part of our total mortgage insurance business. However, in light of the current housing and credit market turmoil, characterized by declining home prices in certain markets, deteriorating credit performance of mortgage assets—particularly subprime—and reduced

 

9


Table of Contents

liquidity for many participants in the mortgage industry, we have significantly reduced or eliminated the amount of non-traditional business we have been writing. With respect to both second-lien mortgages and NIMS, which have resulted in significant losses in our mortgage insurance business during 2007, we do not expect to insure these products again in the future.

Second-Lien Mortgages. In addition to insuring first-lien mortgages, to a lesser extent, we also provided primary or modified pool insurance on second-lien mortgages. Beginning in 2004, we began limiting our participation in these transactions to situations (1) where there was a loss deductible or other first-loss protection that preceded our loss exposure or (2) where a lender otherwise was required to share in a significant portion of any losses. Despite these measures, our second-lien business was largely susceptible to the disruption in the housing market and the subprime mortgage market during 2007. We significantly reduced the amount of new second-lien business we had been writing in a first-loss position during the first quarter of 2007. We wrote $30 million of second-lien mortgage insurance risk in 2007, with no risk written in the fourth quarter, compared to $280 million of risk written in 2006 and $668 million written in 2005. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview of Business Results—Mortgage Insurance—Second-Lien Mortgages” below for information regarding our recent loss experience and total loss expectations with respect to second-lien mortgages.

Credit Enhancement on Net Interest Margin Securities. We provided credit enhancement on NIMS bonds. A NIMS bond represents the securitization of a portion of the excess cash flow and prepayment penalties from a mortgage-backed security comprised mostly of subprime mortgages. The majority of this excess cash flow consists of the spread between the interest rate on the mortgage-backed security and the interest generated from the underlying mortgage collateral. Historically, issuers of mortgage-backed securities would have earned this excess interest over time as the collateral aged, but market efficiencies enabled these issuers to sell a portion of their residual interests to investors in the form of NIMS bonds. Typically, the issuer retained a significant portion of the residual interests, which was subordinated to the NIMS bond in a first-loss position, so that the issuer would suffer losses associated with any shortfalls in residual cash flows before the NIMS bond experienced any losses.

On the NIMS bonds for which we have provided credit protection, our policy covers any principal and interest shortfalls on the insured bonds. For certain deals, we only insured a portion of the NIMS bond that was issued. The NIMS transactions that we have insured were typically rated BBB or BB at inception based on the amount of subordination and other factors. The $604 million of risk in force associated with NIMS at December 31, 2007, representing 1.3% of our total risk in force, comprised 37 deals with an average notional balance of $16 million ($59 million at origination) and a total notional balance of $704 million. The average expiration of our existing NIMS transactions is approximately two years. At December 31, 2007, our risk in force related to NIMS had decreased by approximately $108 million from September 30, 2007, primarily reflecting the normal, rapid paydown of the insured securities. In addition, in the fourth quarter of 2007, as a risk mitigation initiative, we purchased, at a discount to par, some of our insured NIMS bonds, thereby contributing to the reduction in our overall risk on NIMS.

Approximately 39% or $234 million of our total risk in force on NIMS as of December 31, 2007 was written in the first half of 2007. Almost all of our 2007 NIMS business was with large national lenders, reflecting our decision to diversify away from doing NIMS with monoline subprime lenders. In addition, the 2007 NIMS bonds and the mortgage securitizations underlying the NIMS bonds, have been structured with more over-collateralization to meet adjustments to the ratings methodologies employed by the major ratings agencies.

NIMS are a relatively unproven product with volatile performance history, particularly in the current declining housing market. Like second-liens, NIMS bonds have largely been susceptible to the disruption in the housing market and the subprime mortgage market during 2007. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview of Business Results—Mortgage Insurance—NIMS” below for information regarding our total loss expectations with respect to NIMS.

 

10


Table of Contents

Domestic Credit Default Swaps. In our mortgage insurance business, we sold protection on residential mortgage-backed securities through credit default swaps. A credit default swap is an agreement to pay our counterparty should an underlying security or the issuer of such security suffer a specified credit event, such as nonpayment, downgrade or a reduction of the principal of the security as a result of defaults in the underlying collateral. A credit default swap operates much like a financial guaranty insurance policy in that our obligation to pay is absolute. Unlike with most of our mortgage insurance and financial guaranty products, however, our ability to engage in loss mitigation is generally limited. Further, in a credit default swap structure, there is no requirement that our counterparty hold the security for which credit protection is provided. This has the effect of greatly increasing the volume and liquidity in the market. In 2007, our mortgage insurance segment did not write any new credit protection on residential mortgage-backed securities in credit default swap form, compared to $32 million in notional value written in 2006. We are not currently writing any such business. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview of Business Results—Mortgage Insurance—Credit Default Swap” below for information regarding our total loss expectations with respect to credit default swaps.

International Mortgage Insurance Operations. Our International Mortgage Group carefully reviews and assesses international markets for opportunities to expand our mortgage insurance operations in areas where we believe our business would produce acceptable risk adjusted returns. In 2007, we wrote $197 million of mortgage insurance risk related to our international business compared to $86 million in 2006.

International mortgage insurance transactions can take the form of primary or pool mortgage insurance, reinsurance or credit default swaps. In the fourth quarter of 2005, we wrote $7.3 billion in notional value of credit protection in credit default swap form on two large AAA tranches of mortgage-backed securities, one in Germany and one in Denmark. Due to foreign currency changes since we underwrote such risk, the current U.S. dollar-denominated risk has increased to $8.2 billion, representing 18.2% of our total risk in force. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview of Business Results—Mortgage Insurance—Credit Default Swaps” below.

We currently have several reinsurance arrangements in place in Australia. We recently cancelled the authorization of Radian Europe Limited (“Radian Europe”) to engage in the business of insurance in the United Kingdom and other European Union member states. No business had been written by Radian Europe. Approximately $62 million, which represents Radian Europe’s capital, was distributed back to Radian Guaranty in the fourth quarter of 2007.

We have written our international mortgage insurance business through Radian Insurance. As discussed below under “Ratings—S&P”, S&P recently downgraded Radian Insurance from AA- to A-, triggering termination rights under five of our international transactions. We believe the S&P downgrade will make it difficult for us to continue to write international mortgage insurance business through Radian Insurance, and we are in the process of exploring other alternatives for writing such business.

4. Premium Rates (General—Mortgage Insurance)

We cannot change our premium rates after we issue coverage. Accordingly, we determine premium rates in our mortgage insurance business on a risk-adjusted basis that includes borrower, loan and property characteristics. We use proprietary default and prepayment models to project the premiums we should charge, the losses and expenses we should expect to incur and the capital we need to hold in support of our risk. We establish pricing in an amount that we expect will allow a reasonable return on allocated capital.

Premiums for our mortgage insurance may be paid by the lender, which will in turn charge a higher interest rate to the borrower, or directly by the borrower. We price our borrower-paid flow business based on rates that we have filed with the various state insurance departments. We generally price our structured business and some

 

11


Table of Contents

lender-paid business based on the specific characteristics of the insured portfolio, which can vary significantly from portfolio to portfolio depending on a variety of factors, including the quality of the underlying loans, the credit history of the borrowers, the amount of coverage required and the amount, if any, of credit protection or subordination in front of our risk exposure.

5. Underwriting (General—Mortgage Insurance)

Delegated Underwriting. We have a delegated underwriting program with a number of our customers. Our delegated underwriting program enables us to meet lenders’ demands for immediate insurance coverage by having us commit to insure loans that meet agreed-upon underwriting guidelines. Our delegated underwriting program currently involves only lenders that are approved by our risk management group, and we routinely audit loans submitted under this program. Once we accept a lender into our delegated underwriting program, however, we generally insure all loans submitted to us by that lender even if the lender has, without our knowledge, not followed our specified underwriting guidelines. A lender could commit us to insure a number of loans with unacceptable risk profiles before we discover the problem and terminate that lender’s delegated underwriting authority. We mitigate this risk through periodic, on-site reviews of selected delegated lenders. As of December 31, 2007, approximately 43% of our total first-lien mortgage insurance in force was originated on a delegated basis, compared to 36% as of December 31, 2006.

Contract Underwriting. Our mortgage insurance business also utilizes its underwriting skills to provide an outsourced underwriting service to its customers known as contract underwriting. For a fee, we underwrite our customers’ loan files for secondary market compliance (i.e., for sale to GSEs), while concurrently assessing the file for mortgage insurance, if applicable. Contract underwriting continues to be a popular service to our mortgage insurance customers. During 2007, loans underwritten via contract underwriting accounted for 12.3% of applications, 11.5% of commitments for insurance and 10.1% of insurance certificates issued for flow business.

We give recourse to our customers on loans that we underwrite for compliance. Typically, we agree that if we make a material error in underwriting a loan, we will provide a remedy to the customer by repurchasing or placing additional mortgage insurance on the loan, or by indemnifying the customer against loss. Providing these remedies means we assume some credit risk and interest-rate risk if an error is found during the limited remedy period, which may be up to seven years, but typically is only two years. Rising mortgage interest rates or an economic downturn may expose the mortgage insurance business to an increase in such costs. During 2007, we processed requests for remedies on less than 1% of the loans underwritten and sold a number of loans previously acquired as part of the remedy process. We expect this may increase in 2008 due to the increases in delinquencies and foreclosures throughout the mortgage industry. We closely monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis. We also routinely audit the performance of our contract underwriters to ensure that customers receive quality underwriting services.

B. Financial Guaranty Business (General)

Our financial guaranty business mainly insures and reinsures credit-based risks through our wholly-owned subsidiary, Radian Asset Assurance and through its wholly-owned subsidiary, RAAL, located in the United Kingdom.

Financial guaranty insurance typically provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due. Financial guaranty insurance may be issued at inception of an insured obligation or may be issued for the benefit of a holder of an obligation in the secondary market, to institutional holders. Financial guaranty insurance generally lowers an issuer’s cost of borrowing when the insurance premium is less than the value of the spread (commonly referred to as the “credit spread”) between the market yield required to be paid on the insured obligation (carrying the credit rating of the insurer) and the market yield required to be paid on the obligation if sold on the basis of its uninsured credit

 

12


Table of Contents

rating. Financial guaranty insurance also can increase the marketability of obligations issued by infrequent or unknown issuers or obligations with complex structures. Investors generally benefit from financial guaranty insurance through increased liquidity in the secondary market, reduced exposure to price volatility caused by changes in the credit quality of the underlying insured issue, and added protection against loss in the event of the obligor’s default on its obligation.

Our financial guaranty business offers the following products:

 

   

Public Finance—Insurance of public finance obligations, including tax-exempt and taxable indebtedness of states, counties, cities, special service districts, other political subdivisions and tribal finance and for enterprises such as airports, public and private higher education and health care facilities, project finance and private finance initiative assets in sectors such as schools, healthcare and infrastructure projects. The issuers of public finance obligations we insure are typically rated investment grade without the benefit of our insurance;

 

   

Structured Finance—Insurance of structured finance obligations, including collateralized debt obligations (“CDOs”) and asset-backed securities (“ABS”), consisting of funded and non-funded “synthetic” executions that are payable from or tied to the performance of a specific pool of assets. Examples of the pools of assets that underlie structured finance obligations include corporate loans and bonds, residential and commercial mortgages, a variety of consumer loans, equipment receivables and real and personal property leases. The structured finance obligations we insure are generally rated investment-grade at the time we issue our insurance policy, without the benefit of our insurance;

 

   

Financial Solutions—Financial solutions products (which we include as part of our structured finance business), including guaranties of securities exchange clearinghouses, excess-Securities Investor Protection Corporation (“SIPC”) insurance for brokerage firms and excess-Federal Deposit Insurance Corporation (“FDIC”) insurance for banks; and

 

   

Reinsurance—Reinsurance of domestic and international public finance obligations, including those issued by sovereign and sub-sovereign entities, as well as reinsurance of structured finance and financial solutions obligations.

In October 2005, we exited the trade credit reinsurance line of business. Accordingly, this line of business has been placed into run-off and we have ceased initiating new trade credit reinsurance contracts.

 

13


Table of Contents

The following table summarizes the net premiums written and earned by our financial guaranty business’s various products for the last three fiscal years:

 

     Year Ended December 31  
     2007    2006    2005  
     (In thousands)  

Net premiums written:

        

Public finance direct

   $ 60,117    $ 79,655    $ 73,049  

Public finance reinsurance

     86,821      81,065      77,797  

Structured finance direct

     16,594      18,772      21,023  

Structured finance reinsurance

     21,933      18,676      20,422  

Trade credit reinsurance

     1,264      4,599      35,023  
                      
     186,729      202,767      227,314  

Impact of recapture (1)

     —        —        (54,742 )
                      

Net premiums written—insurance

     186,729      202,767      172,572  

Net premiums written—credit derivatives

     43,043      60,107      50,483  
                      

Total net premiums written

   $ 229,772    $ 262,874    $ 223,055  
                      

Net premiums earned:

        

Public finance direct

   $ 45,770    $ 32,517    $ 32,519  

Public finance reinsurance

     44,667      37,765      34,413  

Structured finance direct

     17,325      19,446      21,002  

Structured finance reinsurance

     22,957      21,086      20,174  

Trade credit reinsurance

     2,303      21,476      49,309  
                      
     133,022      132,290      157,417  

Impact of recapture (1)

     —        —        (4,539 )
                      

Net premiums earned—insurance

     133,022      132,290      152,878  

Net premiums earned—credit derivatives

     62,066      71,541      58,895  
                      

Total net premiums earned

   $ 195,088    $ 203,831    $ 211,773  
                      

 

(1) Amount represents the immediate impact of reinsurance business recaptured by one customer in 2005 (referred to herein as the “2005 recapture”). See Note 2 of Notes to Consolidated Financial Statements for more information regarding this recapture.

In our financial guaranty business, the issuer of an insured obligation generally pays the premiums for our insurance either, in the case of most public finance transactions, in full at the inception of the policy or, in the case of most structured finance transactions, in regular monthly, quarterly, semi-annual or annual installments from the cash flow of the related collateral. Premiums for synthetic credit protection are generally paid in monthly, quarterly, or in semi-annual or annual installments, but occasionally all or a portion of the premium is paid upfront at the inception of the protection. Unlike our funded structured finance transactions, in synthetic credit protection transactions, payment is due directly from our counterparty and is generally not restricted to the cash flows from the underlying obligation or collateral supporting the obligation. Since we depend on the corporate creditworthiness of our counterparty rather than the cash flows from the insured collateral for payment, we generally have a right to terminate synthetic credit protection without penalty to us if our counterparty fails, or is financially unable to make timely payments to us under the terms of the synthetic credit transaction.

For public finance transactions, premium rates typically are stated as a percentage of debt service, which includes total principal and interest. For structured finance obligations, premium rates are typically stated as a percentage of the total principal. Premiums are generally non-refundable. Premiums paid in full at inception are initially recorded as unearned premiums and “earned” over the life of the insured obligation (or the coverage period for such obligation, if shorter). Premiums paid in installments are generally recorded as revenue in the

 

14


Table of Contents

accounting period in which coverage is provided. The long and relatively predictable premium earnings pattern from our public finance and structured products transactions provides us with a relatively predictable source of future “earned” revenues.

The establishment of a premium rate for a transaction reflects some or all of the following factors:

 

   

issuer-related factors, such as the issuer’s credit strength and sources of income;

 

   

servicer-related factors, such as the ability of our counterparty or third-party servicer to manage the underlying collateral and the servicer’s credit strength and sources of income;

 

   

obligation-related factors, such as the type of issue, the type and amount of collateral pledged, the revenue sources and amounts, the existence of structural features designed to provide additional credit enhancement should collateral performance not meet original expectations, the nature of any restrictive covenants, the length of time until the obligation’s stated maturity, and our ability to mitigate potential losses; and

 

   

insurer and market-related factors, such as rating agency capital charges, competition, if any, from other insurers and the credit spreads in the market available to pay premiums.

1. Public Finance (General—Financial Guaranty)

Financial guaranty of public finance obligations provides credit enhancement of bonds, notes and other evidences of indebtedness issued by states and their political subdivisions (for example, counties, cities or towns), school districts, utility districts, public and private non-profit universities and hospitals, public housing and transportation authorities, tribal governments and authorities and other public and quasi-public entities such as airports, public and private higher education and healthcare facilities. Public finance transactions may also include project finance and public finance initiatives. Municipal bonds can be categorized generally into tax-backed bonds and revenue bonds. Tax-backed bonds, which include general obligation bonds, are backed by the taxing power of the governmental agency that issues them, while revenue bonds are backed by the revenues generated by a specific project such as bridge or highway tolls, or by rents or hospital fees. Insurance provided to the public finance market has been and continues to be a significant source of revenue for our financial guaranty business. Public finance direct business represented 26.8% of financial guaranty net insurance premiums written, including credit derivatives, in 2007, compared to 30.5% in 2006. Our public finance business is subject to seasonality. We generally experience an increase in public finance business written during the second and fourth quarters of each fiscal year commensurate with the higher municipal volume of originations occurring during these periods in the sectors in which we participate.

2. Structured Finance (General—Financial Guaranty)

The structured finance market includes the market for both synthetic and funded CDOs, which generally consist of multiple pools of corporate obligations and asset-backed securities as well as asset-backed or mortgage-backed obligations. Each asset in the pool is typically of a different credit quality or possesses different characteristics with respect to interest rates, amortization and level of subordination. At December 31, 2007, we had $47.9 billion of notional exposure related to credit protection of direct structured finance transactions, compared to $45.0 billion at December 31, 2006. Structured finance direct business represented 25.3% of financial guaranty net premiums written, including credit derivatives in 2007, compared to 29.7% in 2006. Although Radian Asset Assurance has been an active participant in the structured finance market, especially the synthetic corporate CDO market, we believe that this market will shrink dramatically in 2008 and will likely represent a very small part of our financial guaranty new business written.

Funded asset-backed obligations usually take the form of a secured interest in a pool of assets, often of uniform credit quality, such as credit card or auto loan receivables or commercial or residential mortgages. Funded asset-backed securities also may be secured by a few specific assets such as utility mortgage bonds and

 

15


Table of Contents

multi-family housing bonds. In low interest rate environments and when credit spreads are tight, our ability to participate in the funded asset-backed market is limited.

Synthetic transactions are tied to the performance of pools of assets, but are not secured by those assets. Most of the synthetic transactions we insure are CDOs, where we typically assume credit risk on defined portfolios of referenced corporate credits, asset-backed securities, residential and commercial mortgage-backed securities and/or a combination of these asset types. A portion of these CDOs consist of synthetic commercial or residential mortgage-backed securities or other synthetic consumer asset-backed securities. See “Risk in Force/Net Par Outstanding—Financial Guaranty—Exposure to Residential and Commercial Mortgage-Backed Securities”. The transfer of this type of credit risk typically is done through synthetic credit default swaps.

With respect to CDOs that we insure, we generally are required to make payments to our counterparty upon the occurrence of (1) certain specified credit-related events related to the borrowings or bankruptcy of obligors contained within pools of investment grade corporate obligations or (2) in the case of pools of mortgage or other asset-backed obligations, upon the occurrence of certain specified credit-related events related to the specific obligations in the pool. The corporate CDO pools we insure can range in size from 80 to 249 or more obligors or obligations, most of which are investment grade at the time we begin providing credit protection.

Typically, we provide protection up to a specified exposure amount that tends to range from $20.0 million to $40.0 million per obligor or obligation (but may be as low as $10.0 million per obligor or obligation or up to $60.0 million per obligor or obligation in specific transactions), with an aggregate exposure of $20.0 million to $600.0 million per transaction. Our exposure varies significantly from transaction to transaction. To manage the amount of risk we incur on these transactions, we have set internal limits as to the aggregate risk per obligor, industry sector and tranche size that we are willing to insure, and we comply with applicable insurance regulations limiting the size and composition of the pools we insure. We also have developed a methodology for aggregating risk across insured pools. See “Risk Management—Financial Guaranty” below for additional information regarding our risk management of our CDO portfolio.

With respect to synthetic credit default swaps covering a specific obligation rather than a pool of debt obligations or referenced entities, our payment obligations to our counterparties are generally the same as those we have when insuring the underlying obligations. We agree to pay our counterparty should an underlying security or the issuer of such security suffer a specified credit event, such as nonpayment of scheduled interest or principal, or a reduction of the principal of the security as a result of defaults in the underlying collateral. For example, when providing synthetic credit protection for one or more specified obligations, if an event occurred resulting in the acceleration of principal and interest on an underlying obligation, we generally would be responsible for paying these amounts to our counterparty on their regularly scheduled dates, despite the counterparty’s not holding the obligation or directly suffering a loss for such amount.

In addition, with respect to corporate CDOs, CDOs of asset-backed securities (including residential and commercial mortgage-backed securities) and other secondary market transactions for which we provide synthetic credit protection, we generally do not have recourse or other rights and remedies against the issuer and/or any related collateral for amounts we may be obligated to pay under these transactions. Even when we have recourse or rights and remedies in a synthetic credit protection transaction, they are generally much more limited than the recourse, rights and remedies we generally have in our more traditional financial guaranty transactions.

The same corporate obligor may exist in a number of our structured finance obligations. The five largest corporate obligors, measured by gross nominal (nondiscounted) exposures, in our direct written book as of December 31, 2007 represented approximately $10.6 billion of our total nominal exposure, compared to $9.9 billion for 2006. Because each transaction has a distinct subordination requirement, prior credit events would typically have to occur with respect to several obligors in the pool before we would have an obligation to pay in respect of any particular obligor, meaning that our risk adjusted exposure to each corporate obligor in a CDO pool is significantly less than our nominal exposure. In the unlikely event that each one of our five largest

 

16


Table of Contents

corporate obligors were to have defaulted at December 31, 2007, absent any other defaults in the CDOs in which these obligors were included, we would not have incurred any losses due to the significant subordination remaining in each transaction in which they were included in the pool.

We monitor not only the nominal exposure for each obligor for which we provide protection, but also risk-adjusted measures, taking into account, among other factors, our assessment of the relative risk that would be represented by direct exposure to the particular obligor and the remaining subordination in the transactions in which we are exposed to a particular obligor. On occasion, we may have some limited exposure to our affiliates, C-BASS and Sherman, under our structured finance transactions, although this exposure generally constitutes a small part of any such transaction and is insignificant in the aggregate. Initial subordination before we are obligated to pay a claim generally ranges from 12.5% to 25.0% of the initial total pool size.

The following table shows the gross par amounts (net present value) of structured finance obligations originated in each of the years presented:

 

Type

   2007    2006    2005
     (In millions)

Collateralized debt obligations

   $ 13,470    $ 22,362    $ 11,152

Asset-backed obligations

     2,025      1,305      2,534

Other structured

     198      1,436      1,197
                    

Total structured finance

   $ 15,693    $ 25,103    $ 14,883
                    

The following table shows the gross par outstanding on structured finance obligations at the end of each of the years presented:

 

Type

   2007    2006    2005
     (In millions)

Collateralized debt obligations

   $ 46,961    $ 43,989    $ 22,736

Asset-backed obligations

     5,275      4,514      6,024

Other structured

     2,656      2,721      1,810
                    

Total structured finance

   $ 54,892    $ 51,224    $ 30,570
                    

The net par originated and outstanding on our structured finance obligations is not materially different from the gross par originated and outstanding for each period because we do not cede a material amount of business to reinsurers.

Financial solutions products include guarantees for securities exchange clearinghouses, excess SIPC insurance for U.S. brokerage firms, and excess FDIC insurance for U.S. banks. In our guarantees of securities exchange clearinghouses, we provide credit protection for losses that may be incurred by a clearinghouse as a consequence of a default by a clearing member financial institution. Potential losses arising from a clearing member default are those amounts unpaid by a defaulting clearing member in excess of margin collateral posted by such clearing member and required by the clearinghouse to cover potential clearing losses. In addition, we only pay those amounts that are in excess of an aggregate deductible for the clearinghouse. The deductibles we require are structured such that the underlying risks we insure on these guarantees are typically rated significantly above investment grade without the benefit of our insurance. In our excess-SIPC and excess-FDIC coverage, we provide excess of loss protection for customers of brokerage firms or federally insured banks in the event of losses upon the liquidation of such brokerage firms or banks. Such protection covers only high-quality brokerage firms or banks eligible for insurance protection by SIPC or the FDIC.

 

17


Table of Contents

3. Reinsurance (General—Financial Guaranty)

We provide reinsurance on direct financial guaranties written by other primary insurers or “ceding companies.” Reinsurance allows a ceding company to write larger single risks and larger aggregate risks while remaining in compliance with the risk limits and capital requirements of applicable state insurance laws and rating agency guidelines. State insurance regulators allow ceding companies to reduce the liabilities appearing on their balance sheets to the extent of reinsurance coverage obtained from licensed reinsurers or from unlicensed reinsurers meeting certain solvency and other financial criteria. Similarly, the rating agencies permit a reduction in both exposures and liabilities ceded under reinsurance agreements, with the amount of credit permitted dependent on the financial strength rating of the reinsurer. Because of the recent significant disruptions in the financial guaranty industry, the future of our reinsurance business is somewhat uncertain, although the current demand for our reinsurance seems to be strong.

We have reinsurance agreements with several of the financial guaranty insurers. These reinsurance agreements generally are subject to termination: (1) upon written notice by either party (ranging from 90 to 120 days) before the specified deadline for renewal; (2) at the option of the ceding company if we fail to maintain applicable ratings or certain financial, regulatory and rating agency criteria; or (3) upon certain changes of control. Upon termination under the conditions set forth in (2) and (3) above, we may be required (under some of the reinsurance agreements) to return to the ceding company all unearned premiums, less ceding commissions, attributable to reinsurance ceded pursuant to these agreements. Upon the occurrence of the conditions set forth in (2) above, regardless of whether or not an agreement is terminated, we may be required to obtain a letter of credit or alternative form of security to collateralize our obligation to perform under that agreement, or we may be obligated to increase the level of ceding commissions paid. These and other matters associated with a downgrade in our subsidiaries’ ratings are discussed in “Risk Factors—Risks Affecting Our Company—A downgrade or potential downgrade of our credit ratings or the insurance financial strength ratings assigned to any of our operating subsidiaries is possible and could weaken our competitive position and affect our financial condition”.

Treaty and Facultative Arrangements. The principal forms of reinsurance agreements are treaty and facultative. Under a treaty arrangement, the ceding company is obligated to cede to us, and we are obligated to assume, a specified portion of all risks, within ranges, of transactions deemed eligible for reinsurance by the terms of a negotiated treaty. Limitations on transactions deemed eligible for reinsurance typically focus on size, security and ratings of the insured obligation. Each treaty is entered into for a defined term, generally one year, with renewals upon mutual consent and rights to early termination (subject to the existing reinsurance risk thereafter extending for the life of the respective underlying obligations) under certain circumstances. The termination rights described above under “Reinsurance” also are typical provisions for the termination of treaty reinsurance arrangements.

In treaty reinsurance, there is a risk that the ceding company may select weaker credits or proportionally larger amounts to cede to us. We mitigate this risk by requiring the ceding company to retain a sizable minimum portion of each ceded risk, and we include limitations on individual transactions and on aggregate amounts within each type of transaction. Under a facultative agreement, the ceding company has the option to offer to us, and we have the option to accept, a portion of specific risks, usually in connection with particular obligations. Unlike under a treaty agreement, where we generally rely on the ceding company’s credit analysis, under a facultative agreement, we often perform our own underwriting and credit analysis to determine whether to accept the particular risk. The majority of our financial guaranty reinsurance is provided under treaty arrangements.

Proportional or Non-Proportional Reinsurance. We typically accept reinsurance risk on either a proportional or non-proportional basis. Proportional relationships are those in which we and the ceding company share a proportionate amount of the premiums and the losses of the risk subject to reinsurance. In addition, we generally pay the ceding company a commission, which typically is related to the ceding company’s underwriting and other expenses in connection with obtaining the business being reinsured. Non-proportional relationships are those in which the losses, and consequently, the premiums paid are not shared by the ceding company and us on a proportional basis. Non-proportional reinsurance can be based on an excess-of-loss or first-loss basis. Under excess-of-loss reinsurance agreements, we provide coverage to a ceding company up to a

 

18


Table of Contents

specified dollar limit for losses, if any, incurred by the ceding company in excess of a specified threshold amount. A first-loss reinsurance agreement is a form of structural credit enhancement that provides coverage to the ceding company on the first dollar of loss up to a specified dollar limit for losses. Generally, we do not pay a commission for non-proportional reinsurance. However, the same factors that affect the payment of a ceding commission in proportional arrangements also may be taken into account with respect to non-proportional reinsurance to determine the proportion of the aggregate premium paid to us. The majority of our financial guaranty reinsurance business is originated on a proportional basis.

4. European Operations (General—Financial Guaranty)

Through RAAL, we have additional opportunities to write financial guaranty insurance in the United Kingdom and, subject to compliance with the European passporting rules, in other countries in the European Union. RAAL primarily insures synthetic credit default swaps which are substantially reinsured (at least 90% of the risk) by Radian Asset Assurance. RAAL accounted for $14.4 million of direct premiums written in 2007 (or 12.0% of financial guaranty’s 2007 direct premiums written), which is a $5.2 million increase from the $9.2 million or 5.8% of direct premiums written in 2006.

C. Financial Services Business (General)

Our financial services segment includes the credit-based businesses conducted through our affiliates, C-BASS and Sherman. We currently hold a 46% equity interest in C-BASS and a 21.8% equity interest in Sherman.

1. C-BASS (General—Financial Services)

C-BASS is an unconsolidated, less than 50%-owned investment that is not controlled by us. We and MGIC each own 46% of C-BASS, with the remaining interests owned by management of C-BASS. Historically, C-BASS has been principally engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages. As a result of the disruption in the subprime mortgage market during 2007, C-BASS ceased purchasing mortgages and mortgage securities and its securitization activities in the third quarter of 2007 and sold its loan-servicing platform in the fourth quarter of 2007. On July 29, 2007, we concluded that there were indicators that a material charge for impairment of our investment in C-BASS was required under accounting principles generally accepted in the United States of America (“GAAP”). In November 2007, we received financial statements from C-BASS as of September 30, 2007, at which point we made a final determination with respect to impairment. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Summary—Financial Services—C-BASS,” for more information regarding the events leading to the impairment of our interest in C-BASS as well as the sale of C-BASS’s servicing platform. The orderly run-off of C-BASS’s business is dictated by an override agreement under which we, MGIC and all of C-BASS’s creditors are parties. The agreement provides the basis for the collection and distribution of cash generated from C-BASS’s whole loans and securities portfolio, as well as the sale of certain assets, including the servicing platform.

2. Sherman (General—Financial Services)

Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets, which are generally unsecured, that Sherman typically purchases at deep discounts from national financial institutions and major retail corporations and subsequently seeks to collect. In addition, Sherman originates subprime credit card receivables through its subsidiary CreditOne and has a variety of other similar ventures related to consumer assets. On September 19, 2007, we sold to an entity owned by Sherman’s management approximately 43.4% of our equity interest in Sherman. Concurrent with this sale, we also granted to another entity owned by Sherman’s management the right to purchase our remaining equity interest in Sherman at any time during the one year period following September 19, 2007. See “Management’s Discussion and Analysis of

 

19


Table of Contents

Financial Condition and Results of Operations—Business Summary—Financial Services—Sherman” for more information regarding the sale of a portion of our equity interest in Sherman and the option granted to Sherman’s management.

II. Risk in Force/Net Par Outstanding

Our business involves taking credit risk in various forms across various asset classes, products and geographies. Credit risk is measured in our mortgage insurance business as risk in force, which represents the maximum exposure that we have at any point in time, and as net par outstanding in our financial guaranty business, which represents our proportionate share of the aggregate outstanding principal on insured obligations. We are also responsible for the timely payment of interest on insured financial guaranty obligations. Our total mortgage insurance risk in force and financial guaranty net par outstanding was $161.2 billion as of December 31, 2007, compared to $142.6 billion as of December 31, 2006. Of the $161.2 billion of total risk in force/net par outstanding as of December 31, 2007, approximately 72% consists of financial guaranty risk and 28% of mortgage insurance risk.

A. Mortgage Insurance (Risk in Force/Net Par Outstanding)

Our primary mortgage insurance risk in force was $31.6 billion as of December 31, 2007, compared to $25.3 billion as of December 31, 2006. We analyze our portfolio in a number of ways to identify any concentrations or imbalances in risk dispersion. We believe the performance of our mortgage insurance portfolio is affected significantly by:

 

   

the age of the loans insured;

 

   

the geographic dispersion of the properties securing the insured loans;

 

   

the quality of loan originations; and

 

   

the characteristics of the loans insured (including loan-to-value (“LTV”), purpose of the loan, type of loan instrument and type of underlying property securing the loan).

Persistency rates, defined as the percentage of insurance in force that remains on our books after any 12-month period, are a key indicator for the primary mortgage insurance industry. Because most of our insurance premiums are earned over time, higher persistency rates enable us to recover our policy acquisition costs. Therefore, higher persistency rates generally increase the profitability of a mortgage insurer. At December 31, 2007, the persistency rate of our primary mortgage insurance was 75.4%, compared to 67.3% at December 31, 2006.

1. Primary Risk in Force by Policy Year (Risk in Force/Net Par Outstanding—Mortgage Insurance)

The following table shows the percentage of our primary mortgage insurance risk in force by policy origination year as of December 31, 2007:

 

2002 and prior

   8.1 %

2003

   9.4  

2004

   10.6  

2005

   16.2  

2006

   19.0  

2007

   36.7  
      

Total

   100.0 %
      

 

20


Table of Contents

2. Geographic Dispersion (Risk in Force/Net Par Outstanding—Mortgage Insurance)

The following tables show the percentage of direct primary mortgage insurance risk in force by location of property for the top 10 states and top 15 metropolitan statistical areas (“MSAs”) in the U.S. as of December 31, 2007 and 2006:

 

     December 31  

Top Ten States

   2007     2006  

Florida

   9.0 %   9.2 %

California

   8.8     7.8  

Texas

   6.5     6.5  

Georgia

   4.8     4.8  

Ohio

   4.7     4.9  

New York

   4.4     5.1  

Illinois

   4.4     4.4  

Michigan

   3.6     3.8  

New Jersey

   3.4     3.4  

Pennsylvania

   3.3     3.5  
            

Total

   52.9 %   53.4 %
            

 

     December 31  

Top Fifteen MSAs

   2007     2006  

Atlanta, GA

   3.4 %   3.5 %

Chicago, IL

   3.3     3.2  

Phoenix/Mesa, AZ

   2.3     2.1  

New York, NY

   2.2     2.5  

Houston, TX

   2.0     2.0  

Washington, DC—MD—VA

   1.6     1.3  

Riverside—San Bernardino, CA

   1.6     1.5  

Minneapolis-St. Paul, MN—WI

   1.6     1.6  

Los Angeles—Long Beach, CA

   1.5     1.4  

Tampa—St. Petersburg—Clearwater, FL

   1.4     1.4  

Dallas, TX

   1.4     1.3  

Las Vegas, NV

   1.3     1.2  

Philadelphia, PA

   1.2     1.3  

Denver, CO

   1.2     1.2  

Miami—Hialeah, FL

   1.2     1.3  
            

Total

   27.2 %   26.8 %
            

The following table shows the percentage of our international mortgage insurance risk in force by location of property as of December 31, 2007 and 2006:

 

     December 31  

International

   2007     2006  

Denmark

   47.9 %   45.9 %

Germany

   44.1     47.9  

Hong Kong

   5.3     4.0  

Netherlands

   1.5     1.4  

Australia

   1.2     0.6  

United Kingdom

   —       0.2  
            

Total

   100.0 %   100.0 %
            

 

21


Table of Contents

3. Lender and Mortgage Characteristics (Risk in Force/Net Par Outstanding—Mortgage Insurance)

Although geographic dispersion is an important component of our overall risk diversification—our strategy has been to limit our exposure in the top 10 states and top 15 MSAs—the quality of the risk in force should be considered in conjunction with other elements of risk diversification such as product distribution and our risk management and underwriting practices. In recent years, we have faced increased competition for traditional prime mortgage credit enhancement. As a result, non-prime mortgages and products such as adjustable rate mortgages (“ARMs”), negative amortizing loans and interest-only loans have grown to represent a greater percentage of our total risk profile. Given current market conditions in which traditional prime mortgages are the predominant mortgage product being originated, we expect that non-prime and other non-traditional products will decrease as a percentage of our overall mortgage insurance risk in force in 2008.

In response to current market conditions, we implemented changes to our underwriting criteria in the fourth quarter of 2007, and we are in the process of adjusting our pricing to reflect our view of the markets for the foreseeable future. The most important change to our underwriting criteria is the adoption of a declining market policy in which we reduce the maximum LTV that we will insure by 5% in any region of the U.S. that experiences a decline in value based on the most recent data produced by the Office of Federal Housing Enterprise Oversight. Based on this process, approximately 60% of the U.S. is experiencing declines and we are correspondingly reducing risk by reducing our maximum LTVs in these areas. In addition, in the third quarter of 2007, we made significant changes to our Alternative A (“Alt-A”) guidelines by restricting our exposure to various combinations of reduced documentation and high-LTV loans. We believe these changes are necessary to improve our risk profile, and we began to see improvement in our fourth quarter 2007 mix of business as a result of these changes, our corporate-wide focus on prime business and the industry-wide shift to higher quality credit.

Loan to Value. One of the most important indicators of claim incidence is the relative amount of a borrower’s equity or down payment that exists in a home. Generally, loans with higher LTVs are more likely to result in a claim than lower LTV loans. For example, claim incidence on mortgages with LTVs between 90.01% and 95% (“95s”) is significantly higher than the expected claim incidence on mortgages with LTVs between 85.01% and 90% (“90s”). We, along with the rest of the industry, have been insuring loans with LTVs between 95.01% and 97% (“97s”) since 1995 and loans with an LTV of between 97.01% and 100% (“100s”) since 2000. These loans are expected to have a higher claim incidence than 95s. We also insure an insignificant amount of loans having an LTV over 100%. We charge a premium for higher LTV loans commensurate with the additional risk and the higher expected frequency and severity of claims. We expect the concentration of loans with LTVs above 97.01% to fall due to a tightening of underwriting guidelines implemented during the fourth quarter of 2007.

Loan Grade. The risk of claim on non-prime loans is significantly higher than that on prime loans. We generally define prime loans as loans where the borrower’s Fair Isaac and Company (“FICO”) score is 620 or higher and the loan file meets “fully documented” standards of our credit guidelines and/or the GSE’s guidelines for fully documented loans. Prime loans made up 58.2% of our primary new insurance written in 2007, compared to 56.3% of primary new insurance written in 2006. As discussed above, we expect that prime loans will constitute a greater percentage of primary new insurance written in 2008 as a result of tighter underwriting standards in the mortgage market as well as our own more restrictive underwriting guidelines.

Within our non-prime mortgage insurance program, we have three defined categories of loans that we insure: Alt-A, A minus and B/C loans. Non-prime lending programs have represented an area of significant growth in the mortgage industry during the last several years, although we believe this trend will likely reverse in 2008 as a result of the tighter underwriting standards in the mortgage market. During 2007, non-prime business accounted for 41.8% of our primary new insurance written in our mortgage insurance business (81.0% of which was Alt-A), compared to 43.7% in 2006 (80.2% of which was Alt-A).

We define Alt-A loans as loans where the borrower’s FICO score is 620 or higher and where the loan documentation has been reduced or eliminated. Because of the reduced documentation, we consider Alt-A business to be more risky than prime business, particularly Alt-A loans to borrowers with FICO scores below

 

22


Table of Contents

660. We insure Alt-A loans with FICO scores ranging from 620 to 660, but we have measures in place to limit this exposure, and we charge a significantly higher premium for the increased default risk associated with these loans. Alt-A loans tend to have higher balances than other loans that we insure because they are often more heavily concentrated in high-cost areas. Alt-A loans made up 33.9% of our primary new insurance written in 2007, compared to 35.0% of primary new insurance written in 2006.

We generally define A minus loans as loans where the borrower’s FICO score ranges from 575 to 619. This product has come to us both through structured transactions in which the insurance typically is lender-paid and through flow business in which the borrower pays the insurance premium. We also classify loans with certain characteristics originated within the GSE’s automated underwriting system as A minus loans, regardless of the FICO score. Our pricing of A minus loans is tiered into levels based on the FICO score, with increased premiums at each descending tier of FICO score. We receive a significantly higher premium for insuring this product commensurate with the increased default risk. A minus loans made up 7.8% of our primary new insurance written in 2007, compared to 7.4% of primary new insurance written in 2006. Less than 1% of our total primary mortgage risk in force consists of Alt-A loans with FICO scores below 620, which we classify within our A minus portfolio.

We define B/C loans as loans where the borrower’s FICO score is below 575. Certain structured transactions that we insure contain a small percentage of B/C loans. We price these structured transactions to reflect a higher premium on B/C loans due to the increased default risk associated with these types of loans. B/C loans made up approximately 0.1% of total primary new insurance written during 2007, compared to 1.3% of total primary new insurance written in 2006.

We use our own proprietary statistical models to price our mortgage insurance business to produce what we believe are appropriate risk-adjusted rates of return. We have limited our participation in these non-prime markets to mostly Alt-A and A minus loans rather than B/C loans, and we have targeted the business we insure to specific lenders that we believe have proven results and servicing experience in this area.

Adjustable-Rate Mortgages (“ARMs”). Our claim frequency on insured ARMs has been higher than on fixed-rate loans due to monthly payment increases that occur when interest rates rise. We consider a loan an ARM if the interest rate for that loan will reset at any point during the life of the loan. It has been our experience that loans subject to reset five years or later from origination are less likely to result in a claim than shorter term ARMs, and our premium rates for these longer term reset loans are lower to reflect the lower risk.

We also insure Option ARMs, a product that, until recently, was popular in the mortgage market. Option ARMs offer a number of different monthly payment options to the borrower. One of these options is a minimum payment that is below the full amortizing payment, which results in principal being added to the loan balance and the loan balance continually increasing. This process is referred to as negative amortization. Additional premiums are charged for these Option ARMs as a result. As of December 31, 2007, Option ARMs represented approximately 4.9% of our primary mortgage insurance risk in force. As of December 31, 2007, approximately 2.4% of the adjustable rate mortgages we insure are scheduled to reset during 2008, with most of the Option ARMs and interest-only loans that we insure having first time resets in 2009 or later.

Interest-Only Mortgages. We insure interest-only mortgages, where the borrower pays only the interest charge on a mortgage for a specified period of time, usually five to ten years, after which the loan payment increases to include principal payments. These loans may have a heightened propensity to default because of possible “payment shocks” after the initial low-payment period expires and because the borrower does not automatically build equity as payments are made. As of December 31, 2007, interest-only mortgages represented approximately 10.5% of our primary mortgage insurance risk in force.

Loan Size. The average size of loans that we insure has been increasing as a result of our insuring a larger percentage of non-prime loans, in particular Alt-A loans, which tend to have larger loan balances relative to our

 

23


Table of Contents

other loans, and as a result of a general increase in the size of borrowings during the recent past. The increase in average loan size has resulted in a corresponding increase in the average size of loans in default, primarily and most significantly, with respect to Alt-A loans. At December 31, 2007, the average size of loans subject to our primary mortgage insurance was $159,844, compared to $144,910 at December 31, 2006.

Amortization Periods. We believe that 15-year mortgages are less risky than 30-year mortgages, mainly as a result of the faster amortization and the more rapid accumulation of borrower equity in the property. Premium rates for 15-year mortgages are lower to reflect the lower risk. Mortgages with amortization periods beyond 30 years recently have grown in the mortgage market. Our current exposure to these loans is minimal.

Property Type. The risk of claim also is affected by the type of property securing the insured loan. Loans on single-family detached housing are less likely to result in a claim than loans on other types of properties. Conversely, we generally consider loans on attached housing types, particularly condominiums and cooperatives, to be a higher risk due to the higher density of these properties. Our more stringent underwriting guidelines on condominiums and cooperatives reflect this higher expected risk.

We believe that loans on non-owner-occupied homes purchased for investment purposes are more likely to result in a claim and are subject to greater value declines than loans on either primary or second homes. Accordingly, we underwrite loans on non-owner-occupied investment homes more stringently, and we charge a significantly higher premium rate than the rate charged for insuring loans on owner-occupied homes.

It has been our experience that higher-priced properties experience wider fluctuations in value than moderately priced residences and that the high incomes of many people who buy higher-priced homes are less stable than those of people with moderate incomes. Underwriting guidelines for these higher-priced properties reflect these factors.

 

24


Table of Contents

The following table shows the percentage of our direct primary mortgage insurance risk in force (as determined on the basis of information available on the date of mortgage origination) by the categories indicated as of December 31, 2007 and 2006:

 

     December 31  
     2007     2006  

Product Type:

    

Primary

     91.3 %     89.4 %

Pool

     8.7       10.6  
                

Total

     100.0 %     100.0 %
                

Direct Primary Risk in Force (dollars in millions)

   $ 31,622     $ 25,311  

Lender Concentration:

    

Top 10 lenders (by original applicant)

     47.9 %     45.6 %

Top 20 lenders (by original applicant)

     61.9       59.6  

LTV:

    

95.01% and above

     23.8 %     17.6 %

90.01% to 95.00%

     30.6       31.6  

85.01% to 90.00%

     33.5       35.8  

85.00% and below

     12.1       15.0  
                

Total

     100.0 %     100.0 %
                

Loan Grade:

    

Prime

     71.9 %     71.9 %

Alt-A

     18.3       16.7  

A minus and below

     9.8       11.4  
                

Total

     100.0 %     100.0 %
                

Loan Type:

    

Fixed

     78.4 %     72.5 %

ARM (fully indexed) (1)

    

Less than 5 years

     7.6       14.5  

5 years and longer

     9.2       8.8  

ARM (potential negative amortization) (2)

    

Less than 5 years

     4.3       4.1  

5 years and longer

     0.5       0.1  
                

Total

     100.0 %     100.0 %
                

FICO Score:

    

<=619

     8.1 %     10.6 %

620-679

     30.2       31.6  

680-739

     35.6       34.2  

>=740

     26.1       23.6  
                

Total

     100.0 %     100.0 %
                

Mortgage Term:

    

15 years and under

     1.4 %     3.2 %

Over 15 years

     98.6       96.8  
                

Total

     100.0 %     100.0 %
                

Property Type:

    

Non-condominium (principally single-family detached)

     91.8 %     92.7 %

Condominium or cooperative

     8.2       7.3  
                

Total

     100.0 %     100.0 %
                

 

25


Table of Contents
     December 31  
     2007     2006  

Occupancy Status:

    

Primary residence

   92.6 %   92.4 %

Second home

   3.7     3.5  

Non-owner-occupied

   3.7     4.1  
            

Total

   100.0 %   100.0 %
            

Mortgage Amount:

    

Less than $400,000

   92.1 %   94.7 %

$400,000 and over

   7.9     5.3  
            

Total

   100.0 %   100.0 %
            

Loan Purpose:

    

Purchase

   68.9 %   66.7 %

Rate and term refinance

   14.9     15.4  

Cash-out refinance

   16.2     17.9  
            

Total

   100.0 %   100.0 %
            

 

(1) “Fully Indexed” refers to loans where payment adjustments are the same as mortgage interest-rate adjustments.
(2) Loans with potential negative amortization will not have increasing principal balances unless interest rates increase as contrasted with scheduled negative amortization where an increase in loan balance will occur even if interest rates do not change.

B. Financial Guaranty (Risk in Force/Net Par Outstanding)

Our financial guaranty net par outstanding was $116.0 billion as of December 31, 2007, compared to $104.0 billion as of December 31, 2006. The following table shows the distribution of our financial guaranty net par outstanding by type of issue and as a percentage of total financial guaranty net par outstanding as of December 31, 2007 and 2006:

 

     Net Par Outstanding (1)  

Type of Obligation

   2007     2006  
     Amount    Percent     Amount    Percent  
     ($ in billions)  

Public finance:

          

General obligation and other tax-supported

   $ 25.6    22.1 %   $ 22.0    21.1 %

Healthcare and long-term care

     12.4    10.7       11.7    11.2  

Water/sewer/electric/gas and other investor-owned utilities

     10.5    9.0       8.6    8.3  

Airports/transportation

     6.9    5.9       5.4    5.2  

Education

     4.2    3.6       4.1    3.9  

Housing revenue

     0.6    0.5       0.8    0.8  

Other municipal (2)

     1.8    1.6       1.2    1.2  
                          

Total public finance

     62.0    53.4       53.8    51.7  
                          

Structured finance:

          

Collateralized debt obligations

     47.0    40.5       44.0    42.3  

Asset-backed obligations

     4.3    3.8       3.5    3.4  

Other structured

     2.7    2.3       2.7    2.6  
                          

Total structured finance

     54.0    46.6       50.2    48.3  
                          

Total

   $ 116.0    100.0 %   $ 104.0    100.0 %
                          

 

26


Table of Contents

 

(1) Represents our proportionate share of the aggregate outstanding principal on insured obligations.
(2) Represents other types of municipal obligations, none of which individually constitutes a material amount of our financial guaranty net par outstanding.

1. Distribution of Structured Finance Risk (Risk in Force/Net Par Outstanding—Financial Guaranty)

The following table shows the distribution of our $47.0 billion of CDO net par outstanding by type of exposure, by percentage of our total CDO net par outstanding and by percentage of financial guaranty’s total net par outstanding as of December 31, 2007:

 

Type of CDO

   Amount    Percentage of
CDO Net Par
Outstanding
    Percentage of Total
Net Par
Outstanding
 
     (in billions)             

Synthetic Corporate

   $ 38.8    82.7 %   33.4 %

Trust Preferred

     2.5    5.2     2.1  

Assumed

     1.8    3.9     1.5  

CDO of Commercial Mortgage-Backed Securities (“CMBS”) (1)

     1.8    3.9     1.6  

Collateralized Loan Obligation (“CLO”) (including Second to Pay)

     0.8    1.7     0.7  

CDO of ABS (1)

     0.8    1.6     0.7  

Multi-Sector

     0.3    0.6     0.3  

Second to Pay (Corporate CDO)

     0.2    0.4     0.2  
                   

Total CDOs

   $ 47.0    100.0 %   40.5 %
                   

 

(1) For more information regarding this exposure, see “Exposure to Residential and Commercial Mortgage-Backed Securities” below.

The following table shows the distribution of our $4.3 billion of net par outstanding on ABS obligations by type of exposure, by percentage of our total ABS obligation net par outstanding and by percentage of financial guaranty’s total net par outstanding as of December 31, 2007:

 

Type of Asset-Backed Security

   Amount    Percentage of
CDO Net Par
Outstanding
    Percentage of Total
Net Par
Outstanding
 
     (in billions)             

Consumer Assets

   $ 1.7    39.5 %   1.6 %

Commercial and other

     1.4    32.6     1.2  

Residential Mortgage-Backed Securities (“RMBS”) (1)

     1.2    27.9     1.0  
                   

Total ABS

   $ 4.3    100.0 %   3.8 %
                   

 

(1) For more information regarding this exposure, see “Exposure to Residential and Commercial Mortgage-Backed Securities” below.

 

27


Table of Contents

2. Largest Single Insured Risks (Risk in Force/Net Par Outstanding—Financial Guaranty)

The following table represents our 10 largest public finance single risks by net par outstanding as of December 31, 2007, along with the credit rating assigned as of that date (in the absence of financial guaranty insurance) to each issuer:

 

Credit

   Credit
Rating (1)
   Obligation Type    Aggregate
Net Par Outstanding
as of

December 31, 2007 (1)
               (In millions)

New York, NY

   AA    General Obligation    $ 827

California

   A+    General Obligation      745

Port Authority of New York & New Jersey

   AA-    Transportation      723

Chicago, IL

   AA    General Obligation      572

New Jersey Transportation Trust Fund Authority

   AA-    General Obligation      541

Washington, G.O

   AA+    General Obligation      467

Los Angeles Unified School District, CA

   AA-    General Obligation      424

Massachusetts, G.O

   AA    General Obligation      414

Metropolitan Transportation Authority, NY

   A    Transportation      402

Massachusetts School Building Authority

   AA+    Tax-Backed      359

 

(1) Indicated ratings as of December 31, 2007 reflect the highest rating assigned to the underlying obligation from the three major rating agencies (Standard & Poor’s Ratings Service (“S&P”), Moody’s Investor Service (“Moody’s”) and Fitch Ratings (“Fitch”)), or, if no such rating has been assigned, our rating estimate of the obligation utilizing rating agency models and methodologies to the extent available. Our rating estimates are subject to revision at any time and may differ from the credit ratings ultimately assigned by the three rating agencies.

The following list of transactions represents our largest structured finance exposures as of December 31, 2007:

 

   

Seven $600 million transactions representing non-managed, fixed portfolio or “static” synthetic corporate CDOs.

 

   

One $599 million transaction representing a static, synthetic CDO of commercial mortgage-backed securities.

 

   

One $563 million transaction representing a static, synthetic corporate CDO.

 

   

One $502 million transaction representing a managed CDO portfolio of asset-backed securities.

 

   

28 transactions ($450 million each) representing static, synthetic corporate CDOs.

 

   

One $450 million transaction representing a CDO in which we are in a second to pay position, meaning that our obligation to pay is conditioned on both a collateral default and another monoline financial guarantor’s failing to pay interest and principal when due.

 

   

One $450 million transaction representing a static, synthetic CDO of commercial mortgage-backed securities.

The above transactions represent $19.4 billion of net par outstanding, or 16.7% of financial guaranty’s net par outstanding as of December 31, 2007. Each of these transactions is currently rated AAA by S&P. The $502 million transaction referenced above has been placed on negative watch by S&P and is currently rated A- under our internal ratings. See “Exposure to Residential and Commercial Mortgage-Backed Securities” below for more information regarding this transaction.

 

28


Table of Contents

3. Credit Quality of Insured Risks (Risk in Force/Net Par Outstanding—Financial Guaranty)

The following table identifies our net par outstanding as of December 31, 2007 and 2006 by credit ratings:

 

     As of December 31  
     2007     2006  

Credit Rating (1)

   Net Par
Outstanding
   Percent     Net Par
Outstanding
   Percent  
     ($ in billions)  

AAA

   $ 50.2    43.3 %   $ 43.2    41.5 %

AA

     20.4    17.6       19.4    18.7  

A

     22.3    19.2       20.2    19.4  

BBB

     20.5    17.7       18.3    17.6  

BIG (2)

     1.8    1.5       1.4    1.4  

Not rated

     0.8    0.7       1.5    1.4  
                          

Total

   $ 116.0    100.0 %   $ 104.0    100.0 %
                          

 

(1) Indicated ratings reflect the highest rating assigned to the underlying obligation from the three major rating agencies (S&P, Moody’s and Fitch), or, if no such rating has been assigned, our rating estimate of the obligation utilizing rating agency models and methodologies to the extent available. Our rating estimates are subject to revision at any time and may differ from the credit ratings ultimately assigned by the three rating agencies.
(2) Below investment grade.

4. Geographic Distribution of Insured Risk (Risk in Force/Net Par Outstanding—Financial Guaranty)

The following table shows the geographic distribution of our financial guaranty net par outstanding as of December 31, 2007 and 2006:

 

     December 31  

State

   2007     2006  

Domestic Public Finance by State:

    

California

   6.2 %   5.9 %

New York

   5.1     4.9  

Texas

   3.8     4.0  

Florida

   3.0     3.1  

Pennsylvania

   2.8     2.8  

Illinois

   2.7     2.8  

New Jersey

   2.3     2.2  

Massachusetts

   2.1     2.2  

Washington

   1.8     1.7  

Colorado

   1.6     1.3  

Other domestic public finance

   17.3     17.9  
            

Total Domestic Public Finance

   48.7 %   48.8 %

Domestic Structured Finance

   31.9     35.8  

International Public and Structured Finance

   19.4     15.4  
            

Total Public and Structured Finance

   100.0 %   100.0 %
            

For each of the years ended December 31, 2007, 2006 and 2005, financial guaranty premiums written attributable to foreign countries were approximately 1.9%, 2.1%, and 4.2% of total premiums written and 9.8%, 9.0% and 20.6% (16.5% excluding the 2005 recapture) of total financial guaranty premiums written. The decrease from 2005 largely reflects our decision to exit the trade credit reinsurance line of business.

 

29


Table of Contents

5. Exposure to Residential and Commercial Mortgage-Backed Securities (Risk in Force/Net Par Outstanding—Financial Guaranty)

Our financial guaranty business has exposure to RMBS and CMBS. We retain this exposure through our insurance of CDOs that include asset classes of RMBS or CMBS (referred to as “CDO RMBS” and “CDO CMBS”) and through our insurance of asset-backed securities of RMBS outside of CDOs (referred to as “Non-CDO RMBS”). We do not have any exposure to CMBS outside of CDOs that we insure. Our exposure to RMBS and CMBS is both through our direct insurance and through our reinsurance of business assumed from other financial guarantors.

Non-CDO RMBS Exposure. At December 31, 2007, our insured financial guaranty portfolio included approximately $1.2 billion of net par outstanding related to Non-CDO RMBS. Our exposure to Non-CDO RMBS is spread among 295 transactions and represents 1.0% of financial guaranty’s total net par outstanding as of December 31, 2007.

Included in our Non-CDO RMBS exposure is subprime RMBS exposure, which is spread among 149 transactions with the largest individual exposure being $47.2 million. 65.4% of our financial guaranty Non-CDO subprime RMBS exposure has been assumed as reinsurance, while 34.6% has been insured directly, with no new Non-CDO subprime RMBS having been written directly since 2004. The following table provides additional information regarding our Non-CDO RMBS exposure as of December 31, 2007:

Financial Guaranty Non-CDO RMBS Exposure

($ in millions)

 

     
    Total
Net Par
Outstanding
  Net Par Outstanding   % of
Non-CDO
RMBS
Portfolio
  2006/2007
    Vintage %    
    % of Net Par Outstanding by Rating
      Direct     Assumed (1)       AAA *    AA *    A *     BBB *    BIG(2)*

Subprime

  $ 423   $ 147       $276   36.3   10.7/31.6     19.6    0.2    25.8     11.7    42.7

Prime

    270     124       146   23.2   7.9/26.2     66.6    9.4    4.2     18.7    1.1

Alt-A

    428     78       350    36.7   25.8/32.4     74.3    3.5    3.2     14.0    5.0

Second to Pay

    44     0       44    3.8   0.0/85.8     100.0    0.0    0.0     0.0    0.0
                                      

Total Non-CDO RMBS

  $ 1,165   $ 349      $ 816   100.0   15.2/32.6     53.6    3.6    11.5     13.7    17.6
                                      

 

* Ratings are based on our rating estimate of the collateral using rating agency models and methodologies to the extent available.
(1) As of December 31, 2007, we had approximately $169 million of exposure to home equity lines of credit (including $25 million to subprime and $79 million to Alt-A), all of which was assumed from our primary financial guaranty reinsurance customers.
(2) Below investment grade.

We have no direct financial guaranty exposure to Non-CDO RMBS tranches that were downgraded or placed on negative watch by Moody’s or S&P during their rating actions on RMBS transactions between July 2007 and January 2008.

CDO Subprime RMBS Exposure. We have subprime RMBS exposure through three directly-insured CDOs of ABS with an aggregate net par outstanding of $752.1 million (or 0.7% of financial guaranty’s total net par outstanding as of December 31, 2007). Two of these transactions, with net par outstanding of $502.1 million and $150 million, respectively, are currently rated AAA by S&P, with ratings of A- and AAA, respectively, under our internal ratings. The $502.1 million transaction was placed on negative watch by S&P on January 30, 2008.

 

30


Table of Contents

The third transaction, representing the remaining $100 million of CDO of ABS net par outstanding, is rated BBB by S&P. At December 31, 2007, we had established a $100 million reserve for this transaction, representing our entire exposure. We began paying claims on this transaction in January 2008, and have paid claims totaling our entire $100 million exposure. For more information regarding this credit see “Management’s Discussion and Analysis of Financial Condition and Result of Operations—Financial Guaranty—Year Ended December 31, 2007 Compared to Year Ended December 31, 2006—Provision for Losses.”

Moody’s and S&P took multiple rating actions that affected RMBS and CDOs of asset backed securities between July 2007 and January 2008. As of December 31, 2007, 18 RMBS credits and four CDOs of ABS credits representing $114.3 million (or 18.3%) of the $625.9 million collateral pool underlying our $502.1 million CDO of ABS transaction had been downgraded. The total subordination in this transaction equals $126.8 million. No collateral has been downgraded or is on negative watch or review for possible downgrade in the transaction with $150 million exposure. The following table provides additional information regarding these two transactions:

 

     Collateral Pool    Subordination     

Net Par
Outstanding

   RMBS (1)    CMBS    CDO of
ABS
   CDO of
CDO
   Other     Total    Amount    % of
Collateral

(Attachment
Point)
   % of
Collateral
(Detachment
Point)
($ in millions)                                   ($ in millions)          

$ 502.1

   65.5%    13.5%    12.6%    3.6%    4.8%     100.0%    $ 126.8    20.0%    100.0%

$ 150.0

   64.8%    0.0%    0.0%    0.0%    35.2% (2)   100.0%    $ 78.0    13.0%    38.0%

 

(1) Of the RMBS collateral included in the $502.1 million and $150.0 million transactions, approximately 42.5% and 15.8% of this collateral, respectively, represents subprime RMBS.
(2) Includes 25.2% other ABS collateral.

CDO CMBS Exposure. We have approximately $1.8 billion in exposure to CMBS through four synthetic insured CDOs. These four CDOs, each of which is currently rated AAA by both Moody’s and S&P, contain 127 triple-A rated CMBS tranches (the “CMBS Obligations”) that were issued as part of 88 securitizations (the “CMBS Securitizations”). The following table provides additional information regarding our CMBS exposure as of December 31, 2007:

Financial Guaranty CDO CMBS Exposure

 

Outstanding Exposure

  

Number of

Obligations

  

Average Size of
Obligation

  

Average
Subordination of
Obligation

  Total Delinquencies
(Average of
Securitizations)

$ 353 million

   30    $50 million    14%   0.37%

$ 430 million

   40    $25 million    13%   0.37%

$ 599 million

   30    $80 million    20%   0.35%

$ 450 million

   27    $72 million    31%   0.35%

The loan collateral pool supporting the CMBS Obligations consists of 15,000 loans with a balance of approximately $200 billion. The underlying loan collateral is well diversified both geographically and by property type.

 

31


Table of Contents

III. Defaults and Claims

We establish reserves to provide for losses and the estimated costs of settling claims in both our mortgage insurance and financial guaranty businesses. Setting loss reserves in both businesses involves significant use of estimates with regard to the likelihood, magnitude and timing of a loss. We have determined that the establishment of loss reserves in our businesses constitutes a critical accounting policy. Accordingly, a detailed description of our policies is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Reserve for Losses” included in Item 7 below and in Notes 2 and 6 of Notes to Consolidated Financial Statements.

A. Mortgage Insurance (Defaults and Claims)

The default and claim cycle in our mortgage insurance business begins with our receipt of a default notice from the insured lender. A “default” is defined under our master policy as a borrower’s failure to make a payment equal to or greater than one monthly regular payment under a loan. Generally, our master policy of insurance requires the insured to notify us of a default within 15 days of (1) the loan’s having been in default for three months or (2) the occurrence of an early default in which the borrower fails to make any one of the initial twelve monthly payments under a loan so that an amount equal to two monthly payments has not been paid. For reporting and internal tracking purposes, we do not consider a loan to be in default until the loan has been in default for 60 days.

Defaults can occur due to a variety of factors, including death or illness, unemployment, inability to manage credit or other events reducing the borrower’s income, such as divorce or other marital problems. Depending on the type of loan, defaults also may be caused by rising interest rates.

The following table shows the number of primary and pool loans that we have insured, related loans in default and the percentage of loans in default as of the dates indicated:

 

     December 31  
     2007     2006     2005  

Primary Insurance:

      

Prime

      

Number of insured loans in force

   630,352     563,144     567,574  

Number of loans in default (1)

   25,339     18,441     20,685  

Percentage of loans in default

   4.0 %   3.3 %   3.6 %

Alt-A

      

Number of insured loans in force

   172,085     133,633     118,336  

Number of loans in default (1)

   16,763     7,995     7,510  

Percentage of loans in default

   9.7 %   6.0 %   6.3 %

A Minus and below

      

Number of insured loans in force

   92,600     89,037     101,414  

Number of loans in default (1)

   18,746     16,264     16,015  

Percentage of loans in default

   20.2 %   18.3 %   15.8 %

Total Primary Insurance

      

Number of insured loans in force

   895,037     785,814     787,324  

Number of loans in default (1)

   60,848     42,700     44,210  

Percentage of loans in default

   6.8 %   5.4 %   5.6 %

Pool Insurance:

      

Number of loans in default (1)

   26,526 (2)   18,681 (2)   10,194 (2)

 

(1) Loans in default exclude loans that are 60 or fewer days past due, in each case as of December 31 of each year.

 

32


Table of Contents
(2) Includes 20,193, 13,309 and 3,699 defaults at December 31, 2007, 2006 and 2005, respectively, where reserves have not been established because no claim payment is currently anticipated on such loans.

The default rate in our mortgage insurance business is subject to seasonality. Historically, our mortgage insurance business experiences a fourth quarter seasonal increase in defaults as a result of higher defaults reported towards the end of the year.

Regions of the U.S. may experience different default rates due to varying economic conditions. The following table shows the primary mortgage insurance default rates by our defined regions as of the dates indicated, including prime and non-prime loans:

 

     December 31  
     2007     2006     2005  

East North Central

   8.50 %   7.72 %   7.32 %

New England

   8.16     6.65     5.12  

South Atlantic

   7.44     5.11     5.45  

Mid-Atlantic

   6.80     5.75     5.72  

East South Central

   6.37     5.82     7.11  

West North Central

   6.29     5.53     5.25  

Pacific

   5.95     2.81     2.37  

West South Central

   5.58     5.68     7.96  

Mountain

   4.79     3.27     3.34  

As of December 31, 2007, the two states with the highest primary mortgage insurance default rates were Michigan and Massachusetts, at 11.4% and 10.3%, respectively. We believe that the higher default rates in Massachusetts are attributable to declining home values in the Boston area and that the higher rates in Michigan are related to ongoing problems with the domestic auto industry.

Mortgage insurance claim volume is influenced by the circumstances surrounding the default. The rate at which defaults cure, and therefore do not go to claim, depends in large part on a borrower’s financial resources and circumstances, local housing prices and housing supply (i.e., whether borrowers may cure defaults by selling the property in full satisfaction of all amounts due under the mortgage), interest rates and regional economic conditions. In our first-lien mortgage insurance business, the insured lender is required to complete foreclosure proceedings and obtain title to the property before submitting a claim. It can take anywhere from three months to five years for a lender to acquire title to a property through foreclosure, depending on the state. On average, we do not receive a request for claim payment until 12 to 18 months following a default on a first-lien mortgage. In our second-lien business, we typically are required to pay a claim much earlier, within approximately 150 days of a borrower’s missed payment.

Claim volume in our mortgage insurance business is not evenly spread throughout the coverage period of our insurance in force. Historically, most claims under mortgage insurance policies on prime loans occurred during the third through fifth year after issuance of the policies, and on non-prime loans during the second through fourth year after issuance of the policies. After those peak years, the number of claims that we receive historically has declined at a gradual rate, although the rate of decline can be affected by macroeconomic factors. Approximately 67.2% of our primary risk in force, including most of our risk in force on non-traditional products, and approximately 37.1% of our pool risk in force at December 31, 2007 had not yet reached its historical highest claim frequency years. The 2007 and 2006 business has experienced claim activity much sooner than has been the case for prior years. Because it is difficult to predict both the timing of originating new business and the run-off rate of existing business, it also is difficult to predict, at any given time, the percentage of risk in force that will reach its highest claim frequency years on any future date.

 

33


Table of Contents

The following table shows cumulative claims paid by us on our primary insured book of business at the end of each successive year after the year of original policy issuance, referred to as a “year of origination,” expressed as a percentage of the cumulative premiums written by us in each year of origination:

Claims Paid vs. Premiums Written—Primary Insurance

 

Year of Origination

   End of
1st year
    End of
2nd year
    End of
3rd year
    End of
4th year
    End of
5th year
    End of
6th year
    End of
7th year
 

2001

   0.4 %   10.7 %   29.5 %   46.9 %   54.2 %   57.8 %   60.0 %

2002

   0.5 %   8.5 %   23.4 %   32.3 %   37.0 %   40.7 %  

2003

   0.4 %   7.3 %   17.1 %   23.0 %   28.0 %    

2004

   0.6 %   6.6 %   15.8 %   28.0 %      

2005

   0.3 %   6.0 %   24.7 %        

2006

   0.9 %   13.1 %          

2007

   0.5 %            

Policy year 2001 was negatively impacted by poor credit performance on our structured business, primarily related to one subprime mortgage lending customer. Policy years 2003 and 2004 have developed better than anticipated due to significant home price appreciation and a liquid refinance market during the years following issuance of these policies. Business written in the latter half of 2005 contains a significant amount of poorly underwritten business generated by subprime and Alt-A customers due to the strong demand for mortgage product to populate mortgage-backed securities. The 2006 and 2007 business continued that trend, as well as containing higher LTV loans. Although early in their lives, the 2005 through 2007 policy years are expected to contain substantially higher ultimate loss ratios than in previous policy years.

In addition to claim volume, another significant factor affecting losses is claim severity. The severity of a claim is determined by dividing the claim paid by the original loan amount. The main determinants of the severity of a claim are the size of the loan, the amount of mortgage insurance coverage placed on the loan, and the impact of our loss management activities with respect to the loan. Pre-foreclosure sales, acquisitions and other early workout efforts help to reduce overall claim severity. The average claim severity for loans covered by our primary insurance was 27.5% for 2007, compared to 26.4% in 2006 and 25.2% in 2005.

The following table shows claims paid information for primary mortgage insurance for the periods indicated:

 

     Year Ended December 31
     2007    2006
     (In thousands)

Direct claims paid:

     

Prime

   $ 164,155    $ 117,471

Alt-A

     105,858      64,018

A minus and below

     150,098      93,662

Seconds

     89,269      38,204
             

Total

   $ 509,380    $ 313,355
             

States with highest claims paid:

     

Michigan

   $ 49,806    $ 29,567

Ohio

     40,689      30,147

Texas

     34,269      30,130

Georgia

     30,364      26,032

Colorado

     23,545      18,382

Average claim paid:

     

Prime

   $ 31.2    $ 26.1

Alt-A

     44.6      35.6

A minus and below

     33.2      28.3

Seconds

     31.9      26.8

Total

   $ 34.1    $ 28.4

 

34


Table of Contents

We believe that claims in the Midwest and Southeast have been rising (and will continue to rise) due to the weak industrial sector of the economy in those areas. A much higher level of claims exist in the auto states of Ohio and Michigan, as problems with the domestic auto industry and related industries have depressed economic growth, employment and housing prices in these states. In Colorado, increased claims are a result of a significant decline in property values in Denver and the areas north of Denver.

B. Financial Guaranty (Defaults and Claims)

In the event of default, payments under a typical financial guaranty insurance policy that we provide or reinsure may not be accelerated without our or the primary insurer’s approval, and without such approval, the policyholder is entitled to receive payments of principal and interest on their regularly scheduled dates as if no default had occurred. The insurer often has remedies against other parties to the transaction, which may be exercised both before and after making payment, if any payment is necessary.

In our direct financial guaranty business, and with respect to some of the mortgage-backed securities insured by our mortgage insurance business, we typically are obligated to pay claims in an amount equal to defaulted payments on insured obligations on their respective due dates. In certain transactions in which we insure mortgage-backed securities, we also are obligated to pay principal when and if due, but only to the extent the outstanding principal balance of the insured obligation exceeds the value of the collateral insuring the bonds at the end of a reporting period (either monthly or quarterly).

In our synthetic corporate CDO transactions, we typically are obligated to pay claims in an amount equal to the decrease in value of a senior unsecured corporate bond selected by our counterparty upon the occurrence of a specified credit event (i.e., typically bankruptcy, a failure to pay or certain restructuring of debt) with respect to a covered corporate entity or money borrowed by such defaulting entity, but only to the extent that the aggregate of such amounts exceeds a specified amount of subordination.

In our financial guaranty reinsurance line of business, net claim payments due to the ceding companies are typically deducted from premium amounts due to us. For public finance, asset-backed and other structured products insured by our financial guaranty business, we underwrite to a remote-expected loss standard, which means that under historical economic and operating environments, the assets providing the cash flow to pay the obligations insured by us should perform within the range anticipated at origination and should mature without our having to pay any claims. However, in a stressed or unexpectedly negative economic and operating environment, losses may occur. Accordingly, the patterns of claim payments tend to fluctuate and may be low in frequency and high in severity.

IV. Loss Management

A. Mortgage Insurance (Loss Management)

In 2007, we added significant resources to our mortgage insurance loss management department in order to better manage losses in the uncertain housing market. Our loss management function consists of approximately 63 full-time employees dedicated to avoiding or minimizing losses, representing a 15% increase in the number of full time loss management employees from 2006. Loss management pursues opportunities to mitigate losses both before and after claims are received.

In our traditional mortgage insurance business, upon receipt of a valid claim, we generally have the following three settlement options:

 

  (1) Pay the maximum liability—determined by multiplying the claim amount by the applicable coverage percentage—and allow the insured lender to keep title to the property;

 

  (2) Pay the amount of the claim required to make the lender whole, commonly referred to as the “deficiency amount” (not to exceed our maximum liability) following an approved sale; or

 

  (3) Pay the full claim amount and acquire title to the property.

 

35


Table of Contents

In general, we base our selection of a settlement option on the value of the property. In 2007, we settled 86% of claims by paying the maximum liability (compared to 82% of claims in 2006), 13% by paying the deficiency amount following an approved sale (compared to 17% of claims in 2006) and less than 1% by paying the full claim amount and acquiring title to the property (also less than 1% in 2006). Flat or declining property values in some regions of the U.S. during 2007 have made our loss management efforts more challenging. If property values continue to remain flat or further decline, our ability to mitigate losses would be adversely affected, which could have an adverse effect on our business, financial condition and operating results.

For pre-claim default situations, our loss management specialists focus on the following activities to reduce losses:

 

   

Communication with the insured or the insured’s servicer to ensure the timely and accurate reporting of default information;

 

   

Prompt and appropriate responses to all loss mitigation opportunities presented by the mortgage servicer; and

 

   

Proactive communication with the borrower, realtor or other individuals involved in the loss mitigation process to maximize results and to increase the likelihood of a completed loss mitigation transaction.

After a claim is received and/or paid our loss management specialists focus on:

 

   

A review to ensure that program compliance and our master policy requirements have been met;

 

   

Analysis and prompt processing to ensure that valid claims are paid in an accurate and timely manner;

 

   

Responses to real estate owned (“REO”) loss mitigation opportunities presented by the insured;

 

   

Aggressive management and disposal of acquired real estate; and

 

   

Post-claim payment activities to maximize recoveries on various products including, when appropriate, the pursuit of deficiencies through subrogation and/or acquired rights.

Recently, we have begun placing personnel on-site with our servicing partners to improve communication and workflow, allowing us to act more quickly to reduce loss exposure. In addition, we have launched a strategy where we advance to the servicer 15% of a claim amount, up to $15,000, to use, as necessary, in order to cure a defaulted loan.

Other units within our loss management department contribute additional risk management services. One unit is in charge of identifying and investigating insured loans involving non-compliance with the terms of our master policy of insurance (or commitment letter for structured transactions) to ensure that claims are ultimately paid, as agreed, upon valid and insurable risks. Much of our effort involves the identification, investigation and reporting of mortgage fraud schemes that impact our losses. We coordinate our activities with legal counsel, law enforcement and fraud prevention organizations, and work to promote mortgage fraud awareness, detection and prevention among our personnel and client lenders. A second unit manages counterparty risk by examining operational risk, completing underwriting reviews, and performing ongoing surveillance of our lender clients.

B. Financial Guaranty (Loss Management)

In our financial guaranty business, our surveillance risk management department is responsible for monitoring credit quality as well as changes in the economic or political environment that they expect could affect the timely payment of debt service on an insured transaction and mitigating losses should they occur. Our surveillance procedures include periodic review of all exposures, focusing principally on those exposures with which we have concerns. The specific procedures vary depending on whether the risk is public finance or structured finance, funded or synthetic, or direct or reinsurance, but the general procedures we follow for surveillance of risks include:

 

   

defining the scope and depth of review necessary for an individual transaction based on the credit profile of the transaction, its size and the specific transaction characteristics;

 

36


Table of Contents
   

review of any changes to the ratings for those transactions that have been assigned a public rating by any of the major rating agencies;

 

   

regular review of available news and other information, including subscription services and public sources, regarding the issuer, the specific insured transaction and the related industry;

 

   

periodic internal meetings between risk management and personnel from the relevant business line to discuss potential issues related to the applicable risks;

 

   

review of financial and other information, including periodic audited financial statements, that we require the relevant issuer to supply, and such other information that becomes publicly or otherwise available regarding the issuer or the specific insured transaction;

 

   

the preparation of written reports that provide an internal credit scoring and a report on transaction performance against expectations. We also review compliance with transaction-specific covenants;

 

   

classification of credits as “intensified surveillance credits” when we determine that continued performance is questionable and, in the absence of a positive change, may result in a claim. A summary of our exposures to credits classified as “intensified surveillance credits” at December 31, 2007, 2006 and 2005 is included below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Financial Guaranty—Year Ended December 31, 2007 Compared to Year Ended December 31, 2006—Provision for Losses;” and

 

   

additional scrutiny of transactions over a specified amount or for which a covenant or compliance breach has occurred, including consideration of additional monitoring, consultations with industry experts, investment bankers, and others, and discussions with management and/or site visits.

In our financial guaranty reinsurance business, the primary obligation for assessing and mitigating claims rests with the primary insurer. We and the rating agencies conduct extensive reviews of the ceding companies and their procedures for determining and mitigating losses. Moreover, to help align the ceding company’s interests with our interests, the ceding company typically is required to retain at least 25% of the exposure on any single risk that we reinsure. As a part of our surveillance for reinsurance transactions, we periodically re-evaluate the risk underwriting and management of treaty customers and monitor the performance of our reinsured portfolio generated by these customers.

As soon as our risk management department detects a problem, it works with the appropriate parties in an attempt to avoid a default. Loss mitigation can consist of:

 

   

restructuring the obligation;

 

   

enforcing available security arrangements;

 

   

working with the issuer to solve management or potential political problems; and

 

   

when appropriate, exercising applicable rights to replace problem parties.

Issuers typically are under no obligation to restructure insured transactions to prevent losses, but often will cooperate to avoid being associated with an obligation that experiences losses. When appropriate, we discuss potential settlement options, either at our request or that of our counterparties, regarding particular obligations with appropriate parties. On occasion, loss mitigation may include an early termination of our obligations, which could result in payments to or from us. To determine the appropriate loss mitigation approach, we generally consider various factors relevant to such insured transaction, which may include:

 

   

the current and projected performance of the underlying obligation (both on an expected case basis and stressed for more adverse performance and/or market circumstances that we expect);

 

   

the likelihood that we will pay a claim in light of credit deterioration and reductions in available payment reserves and existing subordination;

 

37


Table of Contents
   

our total exposure to the obligation;

 

   

expected future premium payments from the credit; and

 

   

the cost to us of pursuing mitigation remedies.

V. Risk Management

We consider effective risk management to be critical to our long-term financial stability. As such, we are continuously seeking to enhance the risk management function across our business lines. In 2005, we created the executive position of Chief Risk Officer to enhance our corporate-wide credit processes, to further integrate our credit culture and to establish a single credit risk platform for analysis and valuation. The Chief Risk Officer is responsible for formulating corporate-wide credit policy, maintaining the economic capital methodology, assessing risk analytics and model integrity, maintaining underwriting standards, establishing and monitoring risk limits, and ensuring adequate supporting technological and human resources are in place. The respective heads of risk management in our mortgage insurance and financial guaranty businesses report directly to the Chief Risk Officer. In addition, we created the role of Deputy Chief Risk Officer. This individual manages risk analytics, model integrity and economic capital methodologies and also focuses on enterprise risk management.

We have implemented a credit committee structure applicable to both our mortgage insurance and financial guaranty businesses. Overseeing this credit committee structure is the Enterprise Risk Committee (the “ERC”), consisting of members of company-wide senior management. The ERC oversees individual credit committees organized by product line. These product-line committees include representatives from the product line, along with members of our credit policy, finance and legal departments. We believe that this credit committee structure enables us to more fully and consistently utilize the intelligence, knowledge, experience and skills available throughout our company to evaluate the risk associated with our insurance in force and in proposed transactions. The credit committee structure also ensures that each transaction is approved by an appropriate group of individuals throughout the company and that no one individual or group of individuals from a single business line or department may commit the company to insure material or extraordinary items.

A committee of independent directors assists our full board of directors to execute its oversight responsibilities as it relates to our credit risk management policies and procedures, including heightening board-level awareness of the impact of developing risk trends on our portfolio and plans. The Chief Risk Officer provides the committee with a quarterly review of all aspects of our credit risk, including notable transactions and a quarterly assessment of the state of our risk management function.

In order to evaluate and review credit risk across the company, we have developed an internal economic capital methodology which allows us to attribute economic capital to each individual credit exposure within our portfolio. Economic capital provides us with a uniform risk measure for analyzing and valuing risk that is consistent across the mortgage insurance and financial guaranty businesses. The ability to measure risk in the same units allows us to set company-wide position limits for our portfolio that take into account both differences in loss probabilities for each credit and also for the correlation in loss probabilities across a portfolio of credit exposures. Economic capital is also the basis for calculating risk-adjusted returns on our capital (“RAROC”), which allows us to establish criteria for weighing the credit risk relative to the premium received.

Our economic capital methodology relies heavily on our ability to quantify the underlying risks of default and prepayment. We have established a Model Review and Advisory Committee to address the performance of our models. This company-wide committee is made up of representatives of our quantitative modeling groups in each business line and is chaired by the Deputy Chief Risk Officer. The results of the committee’s model reviews are reported to and approved by the ERC.

In addition to credit risk, we evaluate our risk by reviewing market risk, currency risk, interest-rate risk, operational risk and legal risk across all of our businesses on a regular basis.

 

38


Table of Contents

A. Mortgage Insurance (Risk Management)

Our mortgage insurance business has a comprehensive risk management function which includes a Risk Origination group that consists of individual risk managers aligned with our lender customers as well as three distinct functions—Portfolio Management, Credit Analytics and Risk Analytics—that operate across the mortgage insurance business. The mortgage insurance risk management group is focused on mortgage collateral and is responsible for overall credit policy creation and monitoring of compliance, portfolio management, limit setting and reporting, quantitative model creation and maintenance, comprehensive analytics and communication of credit related issues to management and our board of directors. This group reports directly to the Chief Risk Officer.

1. Risk Origination (Risk Management—Mortgage Insurance)

Understanding our business partners and customers is a key component of managing risk. Individual risk managers are assigned to specific lender accounts and perform ongoing business-level due diligence to understand a lender’s strengths and weaknesses in originating mortgage credit risk. This information allows the individual risk managers to customize credit policy to address lender-specific performance issues.

2. Portfolio Management (Risk Management—Mortgage Insurance)

Portfolio Management oversees the allocation of economic capital within our mortgage insurance business. This group establishes the portfolio limits for product type, loan attributes, geographic concentration and counterparties and also is responsible for distribution of risk using risk transfer mechanisms such as captive reinsurance or the Smart Home arrangements discussed below under “Reinsurance—Ceded.”

Portfolio Management—SurveillanceThe Surveillance function is responsible for monitoring the performance of various risks in our mortgage portfolio. The analysis performed by Surveillance is used by the Credit Analytics and Risk Analytics functions where it is incorporated into the development of credit policy and the development of our proprietary default and prepayment models.

Portfolio Management—Reporting and Analysis. The Reporting and Analysis function is responsible for reporting on the risks in our mortgage portfolio and performing a data and systems management function for the mortgage insurance business. Portfolio analysis involves analyzing risks to the portfolio from the market (e.g., the effects of changes in housing prices and interest rate movements) and analyzing risks from particular lenders, products, and geographic locales.

3. Credit Analytics (Risk Management—Mortgage Insurance)

Credit Analytics is responsible for establishing and maintaining all mortgage related credit risk policy around risk acceptance, counterparty, portfolio, operational and structured risks secured by or involving mortgage collateral. Credit Analytics also is responsible for establishing insurable risk guidelines for product types and loan attributes.

4. Risk Analytics (Risk Management—Mortgage Insurance)

Risk Analytics is responsible for all modeling functions in the mortgage insurance business. Risk Analytics estimates, implements and controls our proprietary Prophet Models® used in pricing our flow rate cards and structured transactions. Our proprietary Prophet Models® jointly estimate default and prepayment risk on all of our major product lines. Risk Analytics also reviews and approves all third party models used to approve loans for delegated mortgage insurance. Risk Analytics is also responsible for the economic capital model and RAROC pricing tools, builds and updates the reserve model for the mortgage insurance portfolio and oversees economic research.

 

39


Table of Contents

5. Reinsurance—Ceded (Risk Management—Mortgage Insurance)

We use reinsurance in our mortgage insurance business as a capital and risk management tool.

Smart Home. In 2004, we developed an approach, referred to as “Smart Home,” for reinsuring risk associated with non-prime mortgages and riskier products. These arrangements effectively transfer risk from our portfolio to investors in the capital markets.

Each transaction begins with the formation of an unaffiliated, offshore reinsurance company. We then enter into an agreement with the Smart Home reinsurer to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of loans, consisting mostly of non-prime residential mortgages, insured by us. The Smart Home reinsurer is funded in the capital markets through the issuance to investors of a series of separate classes of credit-linked notes. Each class relates to the loss coverage levels on the reinsured portfolio and is assigned a rating by one or more of the three major rating agencies.

We typically retain the risk associated with the first-loss coverage levels, and we may retain or sell, in a separate risk transfer agreement, the risk associated with the AAA-rated or most remote coverage level. Holders of the Smart Home credit-linked notes bear the risk of loss from losses that would be paid to us under the reinsurance agreement. The Smart Home reinsurer invests the proceeds of the notes in high-quality short-term investments approved by the rating agencies. Income earned on those investments and a portion of the reinsurance premiums that we pay are applied to pay interest on the notes as well as certain of the Smart Home reinsurer’s expenses. The rate of principal amortization of the credit-linked notes is intended to approximate the rate of principal amortization of the underlying mortgages.

Since August 2004, we have completed four Smart Home arrangements, with the last of these transactions closing in May 2006. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2007 are as follows:

 

     Initial   

As of

December 31, 2007

Pool of mortgages (par value)

   $ 14.7   billion    $ 6.6   billion

Risk in force (par value)

   $ 3.9   billion    $ 1.7   billion

Notes sold to investors/risk ceded (principal amount)

   $ 718.6   million    $ 605.2   million

At December 31, 2007, approximately 5.3% of our primary risk in force was included in Smart Home arrangements, compared to approximately 10.1% at December 31, 2006. In these transactions, we reinsured the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions. Ceded premiums written and earned related to Smart Home for 2007 were $11.0 million and $11.4 million, respectively, compared to $12.0 million and $12.3 million, respectively, for 2006. Ceded losses related to Smart Home in 2007 were $9.8 million. There were no ceded losses in 2006 or 2005. Ceded losses related to Smart Home are expected to increase in 2008. Most actual cash recoveries are not expected until 2009 and later.

Captive Reinsurance. We and other companies in the mortgage insurance industry participate in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically establishes a reinsurance company that assumes part of the risk associated with the portfolio of that lender’s mortgages insured by us on a flow basis (as compared to mortgages insured in structured transactions, which typically are not eligible for captive reinsurance arrangements). In return for the reinsurance company’s assumption of a portion of the risk, we cede a portion of the mortgage insurance premiums paid to us to the reinsurance company. In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development. Until recently, losses under most captive reinsurance treaties have not approached a

 

40


Table of Contents

level requiring payment to us. However, in the current credit environment in which losses have increased significantly, it is likely that many captive reinsurance treaties relating to the 2005 through 2007 insured mortgage portfolios will attach and require payment to us from the captive reinsurer. We began to book losses recoverable in the fourth quarter of 2007, and expect that these losses recoverable will accelerate throughout 2008. Most actual cash recoveries are not expected until 2009 and later. We also offer, on a limited basis, “quota share” captive reinsurance agreements under which the captive reinsurance company assumes a pro rata share of all losses in return for a pro rata share of the premiums collected.

Because of many factors, including the incentives for mortgage lenders to funnel relatively higher-quality loans through their captive reinsurers due to the risk-sharing feature, we continue to evaluate the level of revenue sharing to risk sharing on a customer-by-customer basis as part of our customer profitability analysis. We believe that all of our captive reinsurance arrangements transfer risk to the captive reinsurer at a premium level that is commensurate with the risk. We also believe that captive reinsurance agreements are important in aligning our interests with those of the lenders by providing lenders with an ongoing stake in the outcome of the lending decision. In February 2008, Freddie Mac and Fannie Mae announced that they will be limiting the percentage of premiums that mortgage insurers may cede to captives to 25%, effective May 31, 2008. As a result, it is expected that the terms of all of our captive arrangements that cede an amount greater than 25% will be amended to comply with these limitations.

We and other mortgage insurers have faced private lawsuits alleging, among other things, that our captive reinsurance arrangements constitute unlawful payments to mortgage lenders under the anti-referral fee provisions of the Real Estate Settlement Practices Act of 1974 (“RESPA”). We also have been subject to inquiries from the New York insurance department relating to our captive reinsurance arrangements. For more information, see “Regulation—Federal Regulation—RESPA” below.

At December 31, 2007 and 2006 we had 53 active captive reinsurance agreements. Premiums ceded to captive reinsurance companies in 2007 were $121.6 million, representing 14.1% of total mortgage insurance premiums earned, as compared to $96.7 million, or 11.7% in 2006. Primary new insurance written in 2007 that had captive reinsurance associated with it was $23.3 billion or 40.8% of our total primary new insurance written, as compared to $13.2 billion, or 32.8% of total primary new insurance written in 2006. These percentages can be volatile as a result of increases or decreases in the volume of structured transactions, which are not typically eligible for captive reinsurance arrangements. Ceded losses related to captives in 2007 were $3.9 million. Ceded losses related to captives in 2006 were not significant.

GSE Arrangements. We also have entered into risk/revenue-sharing arrangements with the GSEs whereby the primary insurance coverage amount on certain loans is recast into primary and pool insurance and our overall exposure is reduced in return for a payment made to the GSEs. Ceded premiums written and earned for the year ended December 31, 2007 were $6.4 million under these programs.

Other Reinsurance. Certain states limit the amount of risk a mortgage insurer may retain on a single loan to 25% of the indebtedness to the insured. Radian Guaranty currently uses reinsurance from affiliated companies to remain in compliance with these insurance regulations.

B. Financial Guaranty (Risk Management)

We employ a comprehensive risk system in our financial guaranty business. This system incorporates the integration of company-wide risk management policies and processes as well as best practices of the financial guaranty industry. All transactions are subject to a thorough underwriting analysis, a comprehensive risk committee decision process, and if a transaction is booked, ongoing surveillance.

Transaction underwriting includes the analysis of all credit and legal aspects as well as any specific risks that may be inherent in the transaction. Further, we utilize our proprietary internal economic capital model for

 

41


Table of Contents

risk analysis, valuation and as the basis for calculating RAROC on our financial guaranty business. All transactions are subject to a credit committee decision process embedded in the financial guaranty business and governed by the ERC. Following documented protocols and voting rules, a transaction must be approved in order to qualify for financial guaranty insurance. For transactions that are approved and booked, responsibility transfers to the surveillance department for monitoring, review, feedback to underwriting and risk mitigation.

1. Underwriting (Risk Management—Financial Guaranty)

Our financial guaranty underwriting discipline incorporates a multi-discipline underwriting process for both direct transactions and reinsurance transactions.

Direct Transactions. Direct transactions are sourced and screened by our financial guaranty business based upon established criteria and profitability requirements. Transactions that qualify for further analysis are subject to an underwriting process to determine the creditworthiness of the obligor. The underwriting analysis is performed at a transactional level, examining the fundamental ability and willingness of the obligor and/or issuer to meet the specified obligation. This analysis includes all aspects of the obligation ranging from the fundamental financial strength of the obligor to the structure of the transaction, which may dictate the payment structure. All transaction analyses are subject to legal review.

Reinsurance Transactions. The same disciplined approach and risk requirements applied to direct transactions are also applied to our reinsurance transactions. The primary insurance company is subject to a review by us that involves an examination of its operating, underwriting and surveillance procedures, personnel, organization and existing book of business. Additionally, our long-standing relationships with these select companies provide for experience-based analysis and information.

2. Surveillance (Risk Management—Financial Guaranty)

Financial guaranty also has a surveillance risk management department that is dedicated to the surveillance of our book of business. See “Loss Management—Financial Guaranty” above for information regarding this department.

VI. Customers

A. Mortgage Insurance (Customers)

The principal customers of our mortgage insurance business are mortgage originators such as mortgage bankers, mortgage brokers, commercial banks and savings institutions. This is the case even though individual mortgage borrowers generally incur the cost of primary mortgage insurance coverage. We also offer lender-paid mortgage insurance, in which the mortgage lender or loan servicer pays the mortgage insurance premiums. The cost of the mortgage insurance is then generally passed through to the borrower in the form of higher interest rates. In 2007, approximately 57% of our mortgage insurance was originated on a lender-paid basis, compared to approximately 63% in 2006, much of which resulted from structured transactions. This lender-paid business is highly concentrated among a few large mortgage-lending customers.

To obtain primary mortgage insurance from us, a mortgage lender must first apply for and receive a master policy. Our approval of a lender as a master policyholder is based, among other factors, on our evaluation of the lender’s financial position and demonstrated adherence to sound loan origination practices.

The number of individual primary mortgage insurance policies in force at December 31, 2007, was 895,037, compared to 785,814 at December 31, 2006 and 787,324 at December 31, 2005.

Our mortgage insurance business depends to a significant degree on a small number of lending customers. Our top 10 mortgage insurance customers, measured by primary new insurance written, were responsible for

 

42


Table of Contents

64.0% of our primary new insurance written in 2007, compared to 64.7% in 2006 and 57.3% in 2005. The largest single mortgage insurance customer (including branches and affiliates), measured by primary new insurance written, accounted for 19.4% of new insurance written during 2007, compared to 18.6% in 2006 and 10.6% in 2005. The top three mortgage insurance customers measured by pool new insurance written were responsible for 98.4% of our pool new insurance written for 2007, compared to 78.3% in 2006 and 87.0% in 2005. The largest single mortgage insurance customer (including branches and affiliates) measured by pool new insurance written accounted for 50.5% of pool new insurance written during 2007, compared to 45.0% in 2006 and 42.6% in 2005.

Challenging market conditions during 2007 have adversely affected, and may continue to adversely affect, the financial condition of a number of our largest lending customers. These customers may become subject to serious liquidity constraints that could jeopardize the viability of their business plans or their access to additional capital, forcing them to consider alternatives such as bankruptcy or, as has occurred recently, consolidation with others in the industry. See “Risk Factors—Risks Particular to Our Mortgage Insurance Business—Because our mortgage insurance business is concentrated among a few significant customers, our revenues could decline if we lose any significant customer” for more information.

B. Financial Guaranty (Customers)

Our direct financial guaranty insurance customers consist of many of the major global financial institutions that structure, underwrite or trade securities issued in public finance and structured finance obligations. These institutions typically are large commercial or investment banks that focus on high-quality deals in the public finance and structured finance markets.

As a reinsurer of financial guaranty obligations, our financial guaranty business has maintained close and long-standing relationships with most of the primary financial guaranty insurers. We believe that these long-term relationships provide us with a comprehensive understanding of the market and of the financial guaranty insurers’ underwriting guidelines and reinsurance needs. Our financial guaranty reinsurance customers consist mainly of the largest primary insurance companies licensed to write financial guaranty insurance and their foreign-based affiliates, including Ambac Assurance Corporation (“Ambac”), Financial Security Assurance Inc. (“FSAI”) and Financial Guaranty Insurance Company (“FGIC”). In 2007, these three primary insurers accounted for $90.6 million or 39.3% of the financial guaranty segment’s gross written premiums. Two of these primary insurers accounted for $73.9 million or 32.1% of the financial guaranty segment’s gross written premiums in 2007. These three primary insurers accounted for $91.3 million or 34.7% of the financial guaranty segment’s gross written premiums in 2006. No other primary insurer accounted for more than 10% of the financial guaranty segment’s gross written premiums in 2007 or 2006. The largest single customer of our financial guaranty business, measured by gross premiums written, accounted for 20.8% of gross premiums written during 2007, compared to 13.8% in 2006 and 19.3% in 2005 (15.5% excluding the 2005 recapture).

Several of our financial guaranty reinsurance customers and potential customers have recently been downgraded (or threatened by a potential downgrade) by one or more rating agencies. While these ratings actions have not affected the legal terms of our current reinsurance arrangements with these customers, these ratings actions may adversely affect these customers’ and potential customers’ ability to enter into the volume of transactions eligible for reinsurance to us under our treaty arrangements or otherwise as they have done in the past and may reduce the need or ability for them to cede insurance to us on a facultative basis.

VII. Sales and Marketing

A. Mortgage Insurance (Sales and Marketing)

In 2007, following the termination of our merger with MGIC in early September, we reorganized our sales and marketing efforts to combine our two distinct domestic mortgage insurance channels—Lender Solutions, which focused mainly on customers with traditional mortgage insurance needs, and Capital Markets, which focused on customers that required our non-traditional product offerings and risk based solutions—into one functional sales unit. This was done in an effort to more appropriately align our mortgage insurance business to

 

43


Table of Contents

meet the needs of a changing business environment, resulting from the lack of demand for non-conforming mortgage products and a sharp increase in more “traditional” GSE conforming mortgage insurance products. Our international mortgage insurance operations continue to be conducted through a separate business channel—the International Mortgage Group.

Moving to a more functionally aligned organizational structure allows us to have a clear focus and priority on the primary opportunities available to our domestic mortgage insurance business. As the lending environment has recently moved to a primarily GSE conforming market, mortgage insurance market penetration rates increased significantly relative to the previous three to four years. As a single, combined sales force, we hope to take advantage of these opportunities, while remaining focused on meeting the needs of all of our lending partners with specific customer segmentation product offerings that best fit their needs. Additionally, as an organization, we continue to focus on high quality top-line revenue as well as an ongoing pursuit of achieving efficiencies through cost reductions and increased productivity.

1. Domestic Mortgage Insurance (Sales and Marketing—Mortgage Insurance)

We employ six national account managers, who focus on the largest mortgage lenders, as well as a mortgage insurance field sales force of approximately 54 persons, organized into four divisions, that provides local sales representation throughout the U.S. Each of the four regions is supervised by a divisional sales manager who is directly responsible for several regional sales managers. The divisional sales managers are responsible for managing the profitability of business in their regions, including premiums, losses and expenses. The regional sales managers are responsible for managing a sales force in different areas within the region. In addition, there are several account managers that manage specific accounts within a region that are not national accounts, but that need more targeted oversight and attention. We plan to add additional account managers across the U.S. based on the mortgage insurance opportunities in any given region.

Mortgage insurance sales personnel are compensated by salary, credit quality, commissions on new insurance written and an incentive component based on the achievement of various goals.

2. International Mortgage Insurance (Sales and Marketing—Mortgage Insurance)

The International Mortgage Group is responsible for the development of mortgage opportunities outside the U.S. With personnel located in Hong Kong, Philadelphia and Australia, the International Mortgage Group develops and underwrites both mortgage insurance and financial guaranty type products.

The International Mortgage Group comprises a small group of professionals who work with mortgage lenders and originators, investment banks and other market intermediaries to identify market opportunities and credit risk management solutions.

B. Financial Guaranty (Sales and Marketing)

Our financial guaranty business develops its public finance business mainly through relationships with investment banks, commercial banks and financial advisors that provide financial and debt management services to, and intermediate transactions with, public finance borrowers. We, along with many of the financial entities underwriting this business, market directly to these intermediaries. We do not pay or otherwise reimburse these intermediaries for their services. We also have direct relationships with some issuers.

Our financial guaranty business originates its structured finance transaction flow principally by developing and maintaining strong relationships with the financial institutions, both in the U.S. and abroad, that are actively involved in the structured finance market. Our financial guaranty business develops its structured finance business through three primary business development units—asset-backed securities, CDOs and financial solutions. We have a dedicated structured finance business development team which reports directly to the head

 

44


Table of Contents

of our financial guaranty business’s structured products group, for the purpose of developing new clients. In addition, our financial guaranty business has a London-based team of structured finance professionals responsible for sales and marketing for European structured finance obligations that also reports to the head of financial guaranty structured products.

Our financial guaranty reinsurance business markets directly to primary financial guaranty insurers that write credit enhancement business. Our financial guaranty business’s goal is to meet the needs of the primary insurers, subject to our internal underwriting and risk management requirements.

VIII. Competition

A. Mortgage Insurance (Competition)

We compete directly with six other private mortgage insurers—Genworth Financial Inc., MGIC, PMI Mortgage Insurance Co., Republic Mortgage Insurance Company, Triad Guaranty Insurance Corporation and United Guaranty Corporation—some of which are subsidiaries of well-capitalized companies with stronger financial strength ratings and greater access to capital than we have. We also compete against various federal and state governmental and quasi-governmental agencies, principally the Federal Housing Administration (“FHA”), the Veterans’ Administration (“VA”) and state-sponsored mortgage insurance funds. Legislation has passed both Houses of the U.S. Congress to reform the FHA, which, if enacted, could provide the FHA with greater flexibility in establishing new products and increase the FHA’s competitive position against private mortgage insurers. The legislation includes increases to the maximum loan amount that the FHA can insure and establishes lower minimum downpayments. We do not know whether this proposed legislation, which has passed the House and Senate in different versions, will be enacted, and if enacted what final form the legislation will take.

Governmental and quasi-governmental entities typically do not have the same capital requirements that we and other mortgage insurance companies have, and therefore, may have greater financial flexibility in their pricing and capacity that could put us at a competitive disadvantage. In the event that a government-owned or sponsored entity in one of our markets determines to reduce prices significantly or alter the terms and conditions of its mortgage insurance or other credit enhancement products in furtherance of social or other goals rather than a profit motive, we may be unable to compete in that market effectively, which could have an adverse effect on our financial condition and results of operations.

We compete for flow business with other private mortgage insurance companies on the basis of both service and price. The service-based component includes risk management services, loss mitigation efforts and management and field service organization and expertise. We compete for structured transactions with other mortgage insurers and, in the past, have competed with capital market executions such as senior/subordinated security structures for this business. Competition for this business generally is based both on price and on the percentage of a given pool of loans that we are willing to insure.

We also provide contract underwriting services and participate in arrangements such as captive reinsurance and affordable housing programs. We cede a significant portion of our mortgage insurance business to captive reinsurance companies through captive reinsurance arrangements. Historically, these arrangements have reduced the profitability and return on capital in our mortgage insurance business.

In the past, we also have faced competition from a number of alternatives to traditional private mortgage insurance, including:

 

   

mortgage lenders structuring mortgage originations to avoid private mortgage insurance, mostly through “80-10-10 loans” or other forms of simultaneous second loans;

 

45


Table of Contents
   

investors using other forms of credit enhancement such as credit default swaps or securitizations as a partial or complete substitute for private mortgage insurance; and

 

   

mortgage lenders and other intermediaries that forego third-party insurance coverage and retain the full risk of loss on their high-LTV loans.

Recently, competition from these alternatives has significantly diminished as a result of the recent housing market decline and credit market turmoil. In particular, the recent poor performance of subprime loans, which made up a significant portion of capital market securitizations, has all but eliminated the secondary market for mortgage collateral.

B. Financial Guaranty (Competition)

We are subject to competition from companies that specialize in financial guaranty insurance or reinsurance, including MBIA Insurance Corporation, Ambac, FGIC, FSAI, Assured Guaranty Corp., CDC IXIS Financial Guaranty, XL Capital Assurance Inc., XL Financial Assurance Ltd. and RAM Reinsurance Company. In addition, in January 2008, a new monoline financial guarantor, Berkshire Hathaway Assurance Corporation (“BHAC”), owned by Berkshire Hathaway, began writing municipal bond insurance. Several multiline insurers have also increased their participation in financial guaranty reinsurance and have formed strategic alliances with some of the U.S. primary financial guaranty insurers. We expect to face limited competition from BHAC, which has publicly announced its plan to insure obligations only available to triple-A rated insurers.

Competition in the financial guaranty reinsurance business is based on many factors, including overall financial strength, financial strength ratings, perceived financial strength, the perceived value of financial guaranty insurance, credit spreads, pricing and service. The rating agencies provide credit to a ceding company’s capital requirements and single risk limits for reinsurance that is ceded. The amount of this credit is in part determined by the financial strength rating of the reinsurer. Some of our competitors have greater financial resources than we have and are better capitalized than we are and/or have been assigned higher ratings by one or more of the major rating agencies. In addition, the rating agencies could change the level of credit they will allow a ceding company to take for amounts ceded to us and/or similarly rated reinsurers.

The majority of insured public finance and structured finance obligations are guaranteed by triple-A rated financial guaranty insurers. As a AA/Aa3-rated company, our financial guaranty business mainly targets distinct niches in the capital markets. There is generally a greater interest cost savings to an issuer by using triple-A rated credit enhancement as compared to our AA/Aa3 rated credit enhancement, although these cost savings are also based on other factors, including credit spreads. However, financial guaranty insurance provided by a double-A provider also can provide significant value over uninsured executions in markets where the triple-A rated financial guaranty insurance is unavailable or uneconomical. In some markets, issuers and other counterparties receive no additional rating agency credit or regulatory relief from triple-A rated enhancement than they do with our AA/Aa3 enhancement, so our enhancement in these markets may be more economical. For example, under the Basel I and Basel II Capital Accords, there is no additional capital relief afforded to those using triple-A rated enhancement rather than our AA/Aa3 enhancement. See “Regulation—Basel II Capital Accord” below for more information regarding the Basel Accord. Recent downgrades of certain financial guaranty insurers from triple-A to AA/Aa3 or below may result in greater direct competition to us from similarly rated monoline financial guarantors for the business traditionally available to a double-A rated credit enhancer.

Our financial guaranty insurance and reinsurance businesses also compete with other forms of credit enhancement, including letters of credit, guaranties and credit default swaps provided, in most cases, by banks, derivative products companies, and other financial institutions or governmental agencies, some of which have greater financial resources than we do, may not be facing the same market perceptions regarding their stability that we are facing and/or have been assigned the highest credit ratings awarded by one or more of the major rating agencies. Most of these forms of credit enhancement, however, serve to provide ceding companies with

 

46


Table of Contents

increased insurance capacity only for rating agency purposes. Unlike financial guaranty reinsurance, most of these forms of credit do not qualify as capital for state regulatory purposes, nor do they constitute credit against specific liabilities that would allow the ceding company greater single risk capacity. However, the laws applicable to those ceding companies domiciled in New York were amended in 2004 to permit such ceding companies to use certain credit default swaps meeting applicable requirements as collateral to offset statutory single limits, aggregate risk limits, aggregate net liability calculations and contingency reserve requirements. This regulatory change, which makes credit default swaps an alternative to traditional financial guaranty insurance, could result in a reduced demand for traditional monoline financial guaranty reinsurance, although we have not experienced this effect to date.

We also face competition from alternate transaction structures that permit issuers to securitize assets more cost-effectively without the need for other credit enhancement and from cash-rich investors seeking additional yield on their investments by foregoing credit enhancement. Our financial guaranty business is highly dependent on credit spreads, both with respect to credit spreads available to pay premiums for the insurance we offer and spreads on our trading value (and perceived value of the insurance we offer). In a tight credit spread environment, our financial guaranty insurance is generally less attractive to issuers or other intermediaries that use alternative structures. As credit spreads widen, generally our insurance becomes more attractive to issuers and other intermediaries as the cost of our premium relative to the cost savings advantage to issuers and other intermediaries increases. However, when spreads on our trading value increase, as has occurred recently, the cost advantage of using our insurance decreases and other alternatives appear less costly relative to our insurance.

We also are seeing increased competition in our financial guaranty reinsurance business as a result of captive reinsurance arrangements involving our financial guaranty primary reinsurance customers.

IX. Ratings

S&P, Moody’s and Fitch each rate the financial strength of our insurance subsidiaries. The rating agencies mainly focus on the following factors: capital resources; financial strength; franchise value; commitment of management to, and alignment of stockholder interests with, the insurance business; demonstrated management expertise in our insurance business; credit analysis; systems development; risk management; marketing; earnings volatility; capital markets and investment operations, including the ability to raise additional capital, if necessary; and capital sufficient to meet projected growth and capital adequacy standards. As part of their rating process, S&P, Moody’s and Fitch test our insurance subsidiaries by subjecting them to a “stress level scenario” in which losses over a stress period are tested against our capital level. Determinations of ratings by the rating agencies also are affected by macroeconomic conditions and economic conditions affecting the mortgage insurance and financial guaranty industries in particular, changes in regulatory conditions, competition, underwriting and investment losses.

The financial strength rating assigned by the rating agencies to an insurance or reinsurance company is based on factors relevant to policyholders and is not intended to protect that company’s equity holders or creditors. A financial strength rating is neither a rating of securities nor a recommendation to buy, hold or sell any security. Financial strength ratings are an indication to an insurer’s customers of the insurer’s present financial strength and its capacity to honor its future claims payment obligations. Therefore, ratings generally are considered critical to an insurer’s ability to compete for new insurance business.

 

47


Table of Contents

The following table illustrates the current financial strength ratings assigned to our principal insurance subsidiaries:

 

     MOODY’S    MOODY’S
OUTLOOK
  S&P    S&P
OUTLOOK
  FITCH (1)    FITCH
OUTLOOK

Radian Guaranty

   Aa3    (2)   AA-    (3)   AA-    (4)

Radian Insurance

   Aa3    (2)   A-    (3)   AA-    (4)

Amerin Guaranty

   Aa3    (2)   AA-    (3)   AA-    (4)

Radian Asset Assurance

   Aa3    Stable   AA    Stable   A+    Evolving

Radian Asset Assurance Limited

   Aa3    Stable   AA    Stable   A+    Evolving

 

(1) Fitch continues to rate us and our subsidiaries despite our request to Fitch on September 5, 2007 that Fitch immediately withdraw all of its ratings for us and our subsidiaries. See “Fitch” below.
(2) Each Moody’s rating for our mortgage insurance subsidiaries is currently under review for possible downgrade.
(3) Each S&P rating for our mortgage insurance subsidiaries is currently on CreditWatch with negative implications.
(4) Each Fitch rating for our mortgage insurance subsidiaries is currently Ratings Watch Negative.

Radian Group currently has been assigned a senior debt rating of A- (CreditWatch with negative implications) by S&P, A2 (under review for possible downgrade) by Moody’s and A- (Rating Watch Negative) by Fitch. In addition, the trusts that have issued money market committed preferred custodial trust securities for the benefit of Radian Asset Assurance have been rated A by S&P and BBB+ (Ratings Watch Evolving Outlook) by Fitch. Our credit ratings generally impact the interest rates that we pay on money that we borrow. A downgrade in our credit ratings could increase our cost of borrowing, which could have an adverse affect on our liquidity, financial condition and operating results. In addition, we are required to maintain a certain level of credit ratings from S&P and Moody’s in order to avoid a default under our $400 million credit facility.

S&P

On February 26, 2008, S&P downgraded Radian Insurance to A- from AA-. Radian Insurance remains on CreditWatch with negative implications. The rating change was based on the fact that Radian Insurance is no longer considered by S&P to be a strategic entity to Radian mainly because of our decision in 2007 to discontinue writing insurance on NIMS and second-liens. Radian Insurance had eight active international transactions at the time of the S&P downgrade. Of these transactions, five have early termination clauses that were triggered as a result of the downgrade which allow our counterparties to terminate these transactions. On March 4, 2008, Standard Chartered Bank in Hong Kong informed us that they wished to terminate their contract with Radian Insurance, effective immediately. While we still are in the process of assessing the validity of the notice and the potential impact of termination, there is a possibility that Radian Insurance could be required to return to Standard Chartered Bank, or to transfer to another insurer, unearned premium related to this transaction. Unless extended, this transaction was expected to expire at the end of 2009. We are working closely with our counterparties under the remaining four transactions and cannot provide any assurance as to whether we will be successful in retaining this business. If these transactions also are terminated, we could be required to return, or transfer to another insurer, additional unearned premiums.

On February 13, 2008, S&P took mostly unfavorable ratings actions on several U.S. mortgage insurers. These ratings actions were the result of S&P’s reassessment of its expectations for the mortgage insurance sector in light of further deterioration in both the housing markets and the performance of all types of mortgages as well as S&P’s concerns that the 2008 vintage portfolio may be unprofitable. S&P downgraded its credit rating for Radian Group from A to A- and its financial strength ratings for our mortgage insurance subsidiaries from AA to AA-. S&P placed these ratings on CreditWatch with negative implications, citing concerns with our mortgage insurance operating performance and risk management. S&P further stated that its ratings for our mortgage insurance subsidiaries could be lowered multiple notches or affirmed with a negative outlook.

S&P’s recent ratings actions followed an affirmation by S&P on November 21, 2007 of its credit rating for Radian Group and its financial strength ratings for our mortgage insurance subsidiaries, in each case with a

 

48


Table of Contents

negative outlook. On November 21, 2007, S&P stated that it would lower its ratings for Radian Group and its mortgage insurance subsidiaries one notch if the results of our mortgage insurance business failed to meet S&P’s expectations that: (1) the loss ratio for our first-lien insured mortgage portfolio (a) will compare favorably with the industry mean in both 2008 and 2009, and (b) will be between 120% and 140% in 2008 and about 70% in 2009; and (2) we will maintain excellent capitalization. S&P further stated that a downgrade of one or more notches could occur if our mortgage insurance business fails to maintain its access to the flow channel of business on terms similar to its competitors.

On September 25, 2007, S&P stated that its ratings for Radian Group and its mortgage insurance entities were predicated on S&P’s expectations that we will (1) generate underwriting profits in 2009 in our traditional mortgage insurance business, (2) maintain excellent capitalization, (3) strengthen our Enterprise Risk Management (“ERM”) capabilities, (4) narrow the disparity in the operating performance of our traditional mortgage insurance business with that of others in the industry and (5) maintain a reasonable market share in the mortgage insurance industry.

S&P has continued to maintain the AA ratings on our financial guaranty subsidiaries with a stable outlook, stating that Radian Asset Assurance’s capital position and operating capabilities are largely independent of those of our mortgage insurance companies.

Moody’s

On January 31, 2008, Moody’s announced that the ratings of our mortgage insurance subsidiaries would remain on review for possible downgrade while it evaluated the capital adequacy of all mortgage insurers. This evaluation will be based on updated information incorporating revised expectations about performance across different loan types. In its analysis, Moody’s also will consider the changing risk and opportunities available to mortgage insurers as a result of shifting dynamics in the conforming mortgage market.

On September 5, 2007, following the termination of our merger with MGIC, Moody’s placed its ratings for Radian Group and our mortgage insurance subsidiaries under review for possible downgrade, citing the deterioration in the residential mortgage market as a growing concern for the mortgage industry as a whole and for us in particular due to our exposure to NIMS and second-lien transactions.

According to Moody’s, its review of our ratings will focus on the capital adequacy of our mortgage insurance franchise in light of (1) the higher losses we expect to incur on our insured portfolio, (2) the viability of our revised business strategy to focus on relationships with large lenders and traditional mortgage insurance products, (3) the extent of continued support from lenders and from the GSEs and (4) the cohesiveness and capability of our senior management team in navigating us through the current stress period. In addition, Moody’s also stated that it will also be evaluating our ability to improve the volume and credit quality of our insured portfolio with new business writings, which could serve to offset some of the earnings deterioration expected on our existing portfolio.

Moody’s has continued to maintain its Aa3 ratings, with a stable outlook, on our financial guaranty subsidiaries. According to Moody’s, the affirmation of its ratings for these entities reflects their stable earnings, limited exposure to residential mortgage risk, and the diversity of their direct financial guaranty and reinsurance portfolios.

Fitch

On February 25, 2008, Fitch affirmed the AA- financial strength ratings of Radian Guaranty and its operational affiliates and the A- long-term issuer ratings of Radian Group, but placed these ratings on Ratings Watch Negative as compared to the previous status of negative outlook. Fitch cited growing losses and a potential capital shortfall, which, if not addressed within the next several months, could result in a one notch downgrade.

 

49


Table of Contents

On September 5, 2007, following the termination of our merger with MGIC, Fitch downgraded the long-term debt rating of Radian Group to A- from A and the insurer financial strength ratings of all of our mortgage insurance subsidiaries to AA- from AA and revised its outlook for these entities to Negative. Additionally, Fitch downgraded the insurance financial strength ratings of our financial guaranty subsidiaries to A+ from AA and revised its outlook for these entities to Evolving. As a result of this downgrade, one reinsurance customer in our financial guaranty business had the right to recapture approximately $1.0 billion in net par outstanding insured by us. On September 25, 2007, this insurer waived its right to recapture this business, without additional cost to us.

We believe Fitch’s downgrade of Radian Asset Assurance is unwarranted, and on September 5, 2007, we formally requested that Fitch immediately withdraw all of its ratings for Radian Group and its subsidiaries. We also informed Fitch that we would no longer be providing information to Fitch in support of its ratings. On September 9, 2007, Fitch announced that it would not honor our request in light of the current high level of investor interest in both the mortgage insurance and financial guaranty industries, but that Fitch would instead monitor investor interest and make a decision with respect to our request at a future date based on market feedback. Fitch also acknowledged that it would withdraw our ratings regardless of investor interest if it believed that it no longer had enough access to adequate public and non-public information to credibly maintain its ratings.

In addition to these Radian specific ratings developments, the rating agencies have indicated that they are engaged in on-going monitoring of the mortgage insurance and financial guaranty industries and the mortgage-backed securities market to assess the adequacy of, and where necessary refine, their capital models. Changes to their capital model, or the assumptions used therein, could result in a downgrade of our credit ratings or the insurance financial strength ratings of our insurance subsidiaries or could require us to raise additional capital to maintain our current ratings. See “Risk Factors—Risks Affecting Our Company—A downgrade or potential downgrade of our credit ratings or the insurance financial strength ratings assigned to any of our operating subsidiaries could weaken our competitive position and affect our financial condition” for more information regarding the risks associated with a downgrade of our credit or insurance financial strength ratings.

X. Investment Policy and Portfolio

Our income from our investment portfolio is one of our primary sources of cash flow to support our operations and claim payments.

We follow an investment policy that, at a minimum, requires:

 

   

At least 95% of our investment portfolio to consist of cash and securities (including redeemable preferred stock) that, at the date of purchase, were rated investment grade by a nationally recognized rating agency (e.g., “BBB” or better by S&P); and

 

   

At least 50% of our investment portfolio, excluding cash and short-term investments, that, at the date of purchase, were rated the highest investment grade by a nationally recognized rating agency (e.g., AAA by S&P).

Under our investment policy, which is applied throughout our company on a consolidated risk and asset allocation basis, we are permitted to invest in equity securities (including convertible debt and convertible preferred stock), provided our equity component does not exceed 20% of our total investment portfolio and at least 95% of the portfolio is investment grade. We manage our investment portfolio to minimize exposure to interest rate volatility through active portfolio management and intensive monitoring of investments to ensure a proper mix of the types of securities held and to stagger the maturities of fixed-income securities. Our investment policy focuses on the generation of optimal after-tax returns, stable tax-efficient current returns, and the preservation and growth of capital.

Oversight responsibility of our investment portfolio rests with management—allocations are set by periodic asset allocation studies, calibrated by risk and return and after-tax considerations, and are approved by the Investment and Finance Committee (the “Investment Committee”) of our board of directors. Manager selection, monitoring, reporting and accounting (including valuation) of all assets are performed by management. We manage over 70% of the portfolio—the portion of the portfolio largely consisting of municipal bonds and short

 

50


Table of Contents

term investments—internally, with the remainder managed by eight external managers. External managers are selected by management based primarily upon the allocations approved by our Investment Committee as well as factors such as historical returns and stability of management. Management’s selections are presented to and approved by the Investment Committee.

We review our investment portfolio on at least a quarterly basis for declines in the fair value of securities below the amortized cost basis of such securities that are considered to be other-than-temporary, and we recognize declines in earnings if the security has not been sold. If the fair value of a security is below the cost basis, and it is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value through earnings as a realized loss and the fair value becomes the new basis. During 2007, we recorded approximately $9.4 million of charges related to declines in the fair value of securities (primarily small cap value stocks, convertible securities and $5.1 million related to an investment in a fund co-managed by C-BASS) considered to be other-than-temporary, compared to $10.6 million of charges related to declines in 2006. There were no such charges in 2005. At December 31, 2007 and 2006, there were no other investments held in the portfolio that were determined to be other-than-temporarily impaired.

At December 31, 2007, our investment portfolio had a cost basis of $6,223.4 million, a carrying value of $6,411.0 million and a market value of $6,412.8 million, including $697.3 million of short-term investments. Our investment portfolio did not include any real estate or mortgage loans. The portfolio included 42 privately placed, investment-grade securities with an aggregate carrying value of $17.9 million. At December 31, 2007, 95.0% of our investment portfolio (which includes fixed maturities, Hybrid securities, equity securities and a portion of our trading securities) consisted of cash and debt securities that were rated investment grade.

Our investment policies and strategies are subject to change depending on regulatory, economic and market conditions and our then-existing or anticipated financial condition and operating requirements, including our tax position. The investments held at our insurance subsidiaries are also subject to insurance regulatory requirements applicable to such insurance subsidiaries and are highly liquid.

A. Investment Portfolio Diversification (Investment Policy and Portfolio)

The diversification of our investment portfolio (other than short-term investments) at December 31, 2007, was as follows:

 

     December 31, 2007  
     Cost or
Amortized Cost
   Fair Value    Percent (1)  
     (In thousands)  

Fixed maturities held to maturity (2):

        

State and municipal obligations

   $ 53,310    $ 55,021    100.0 %
                    

Total

     53,310      55,021    100.0 %
                    

Fixed maturities available for sale:

        

U.S. government securities (3)

     89,658      93,130    2.0 %

U.S. government-sponsored enterprises

     24,231      24,941    0.5  

State and municipal obligations

     3,891,541      3,959,993    85.1  

Corporate obligations

     101,017      101,582    2.2  

Asset-backed securities (4)

     310,676      312,125    6.8  

Private placements

     17,552      17,871    0.4  

Foreign governments

     137,323      135,082    3.0  
                    

Total

     4,571,998      4,644,724    100.0 %
                    

Equity securities

     196,068      254,869   

Trading securities

     158,087      153,634   

Hybrid securities

     525,607      584,373   

Other invested assets

     21,087      22,868   
                

Total

   $ 5,526,157    $ 5,715,489   
                

 

51


Table of Contents

 

(1) Percentage of cost or amortized cost.
(2) All security types listed, other than U.S. government securities, consist mostly of investment-grade securities.
(3) Substantially all of these securities are backed by the full faith and credit of the U.S. government.
(4) Primarily comprised of securities issued by the government or government agencies and triple-A rated corporate obligations.

B. Investment Portfolio Scheduled Maturity (Investment Policy and Portfolio)

The weighted average duration of the assets in our investment portfolio as of December 31, 2007, was 5.57 years. The following table shows the scheduled maturities of the securities held in our investment portfolio at December 31, 2007:

 

     December 31, 2007  
     Carrying
Value
   Percent  
     (In thousands)  

Short-term investments

   $ 697,271    10.9 %

Less than one year (1)

     114,562    1.8  

One to five years (1)

     578,537    9.0  

Five to ten years (1)

     899,703    14.0  

Over ten years (1)

     3,694,394    57.6  

Other investments (2)

     426,582    6.7  
             

Total

   $ 6,411,049    100.0 %
             

 

(1) Actual maturities may differ as a result of calls before scheduled maturity.
(2) No stated maturity date.

C. Investment Portfolio by S&P Rating (Investment Policy and Portfolio)

The following table shows the ratings by S&P of our investment portfolio (other than short-term investments) as of December 31, 2007:

 

     December 31, 2007  
     Carrying
Value
   Percent  
     (In thousands)       

Rating (1)

     

U.S. government and agency securities

   $ 118,071    2.1 %

AAA

     3,007,267    52.6  

AA

     905,523    15.8  

A

     671,578    11.8  

BBB

     454,161    7.9  

BB and below and other (2)

     7,553    0.1  

Not rated (3)

     232,309    4.1  

Equity securities

     294,265    5.2  

Other invested assets

     23,051    0.4  
             

Total

   $ 5,713,778    100.0 %
             

 

(1) As assigned by S&P as of December 31, 2007.
(2) Securities in this category have been rated non-investment grade by S&P as of December 31, 2007.
(3) Securities in this category have not been rated by S&P as of December 31, 2007, but most have been rated investment grade as of December 31, 2007 by at least one other nationally recognized securities rating agency.

 

52


Table of Contents

D. Investment Risk Concentration—(Investment Policy and Portfolio)

The following table shows our top ten investment portfolio risk concentrations at December 31, 2007:

 

              Securities Classifications

(In thousands)

Issuer Description

  Market Value     U.S. Government Agency &
GSE Securities
  Municipal Securities    
  $   %     Short-Term   MBS   GSE Notes   Uninsured   Insured   Equity

State of California (1)

  $ 336,609   5.89 %   $ —     $ —     $ —     $ 238,353   $ 98,256   $ —  

Fidelity Institutional Government Portfolio (2)

    235,611   4.12       235,611     —       —       —       —       —  

Northern Institutional Government Portfolio (2)

    218,695   3.83       218,695     —       —       —       —       —  

State of New York (1)

    196,147   3.43       —       —       —       168,687     27,460     —  

Master Settlement Agreement (MSA) Securitizations (3)

    193,176   3.38       —       —       —       177,722     15,454     —  

Federal National Mortgage Association (Fannie Mae)

    172,708   3.02       —       158,891     13,817     —       —       —  

Vanguard Institutional Index Fund (4)

    147,005   2.57       —       —       —       —       —       147,005

Commonwealth of Massachusetts (1)

    115,598   2.02       —       —       —       75,358     40,240     —  

New York Metropolitan Transportation Authority

    103,053   1.80       —       —       —       58,225     44,828     —  

Federated Government Obligations Fund (2)

    101,806   1.78       101,806     —       —       —       —       —  
                                               

Top Investment Portfolio Risk Concentrations

  $ 1,820,408   31.85 %   $ 556,112   $ 158,891   $ 13,817   $ 718,345   $ 226,238   $ 147,005
                                               

 

(1) Includes securities with indirect and/or historical state funding support.
(2) Money Market Funds
(3) Aggregate investment in securities backed by MSA payments (the MSA obligated participating tobacco companies to compensate various states for health and other tobacco related expenses).
(4) Tracks performance of the S&P 500 Index.

XI. Regulation

A. State Regulation (Regulation)

We and our insurance subsidiaries are subject to comprehensive, detailed regulation principally designed for the protection of policyholders, rather than for the benefit of investors, by the insurance departments in the various states where our insurance subsidiaries are licensed to transact business. Insurance laws vary from state to state, but generally grant broad supervisory powers to agencies or officials to examine insurance companies and enforce rules or exercise discretion affecting almost every significant aspect of the insurance business.

Insurance regulations address, among other things, the licensing of companies to transact business, claims handling, reinsurance requirements, premium rates and policy forms offered to customers, financial statements, periodic reporting, permissible investments and adherence to financial standards relating to surplus, dividends and other criteria of solvency intended to assure the satisfaction of obligations to policyholders.

Our insurance subsidiaries’ premium rates and policy forms are generally subject to regulation in every state in which the insurers are licensed to transact business. These regulations are intended to protect policyholders against the adverse effects of excessive, inadequate or unfairly discriminatory rates and to encourage competition in the insurance marketplace. In most states, premium rates and policy forms must be filed and, in some states approved, before their use. Changes in premium rates may be subject to justification, generally on the basis of the insurer’s loss experience, expenses and future trend analysis. The general default experience in the mortgage insurance industry also may be considered with regard to mortgage insurers.

 

53


Table of Contents

Radian Guaranty is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of mortgage guaranty insurance pursuant to the provisions of the Pennsylvania insurance law and related rules and regulations governing property and casualty insurers. In addition to Pennsylvania, Radian Guaranty is authorized to write mortgage guaranty insurance (or in certain states where there is no specific authorization for mortgage guaranty insurance, the applicable line of insurance under which mortgage guaranty insurance is regulated) in each of the other states, the District of Columbia and Guam. Radian Guaranty must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on under specified but limited circumstances. Radian Guaranty and other mortgage insurers in the U.S. generally are restricted to writing residential mortgage guaranty insurance.

Radian Insurance is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance (the line of insurance business under which mortgage guaranty insurance is regulated in the state) pursuant to the provisions of the Pennsylvania insurance law and related rules and regulations governing property and casualty insurers. Radian Insurance must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on under specified but limited circumstances. Radian Insurance is also authorized in Hong Kong to carry on the business of credit insurance, suretyship and miscellaneous financial loss (including mortgage guaranty insurance) through a local branch office.

Amerin Guaranty is domiciled and licensed in Illinois as a mortgage guaranty insurer and is subject to the provisions of the Illinois insurance law and related rules and regulations governing property-casualty insurers. In addition to Illinois, Amerin Guaranty is authorized to write mortgage guaranty insurance (or in certain states where there is no specific authorization for mortgage guaranty insurance, the applicable line of insurance under which mortgage guaranty is regulated), in each of the other states except Rhode Island (Amerin operates under an industrial insured exemption in Rhode Island) and the District of Columbia. Amerin Guaranty must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on under specified but limited circumstances.

Radian Asset Assurance is domiciled and licensed in New York as a financial guaranty insurer and is subject to all other provisions of the New York insurance law and related rules and regulations governing property-casualty insurers to the extent these provisions are not inconsistent with the New York financial guaranty insurance statute. Radian Asset Assurance is also licensed under the New York insurance law to write surety insurance and credit insurance. In addition to New York, Radian Asset Assurance is authorized to write financial guaranty and surety insurance (or in one state where there is no specific authorization for financial guaranty insurance, credit insurance) in each of the other states, the District of Columbia, Guam and the U.S. Virgin Islands. Radian Asset Assurance must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on under specified but limited circumstances with approval of the Superintendent of the New York Insurance Department. Radian Asset Assurance and other financial guaranty insurers in the U.S. are generally restricted to writing financial guaranty insurance.

Each insurance subsidiary is required by its state of domicile and each other jurisdiction in which it is licensed to transact business to make various filings with those jurisdictions and with the National Association of Insurance Commissioners, including quarterly and annual financial statements prepared in accordance with statutory accounting practices. In addition, our insurance subsidiaries are subject to examination by the insurance departments of each of the states in which they are licensed to transact business.

 

54


Table of Contents

1. Insurance Holding Company Regulation (Regulation—State Regulation)

We are an insurance holding company and our insurance subsidiaries belong to an insurance holding company system. All states have enacted legislation regulating insurance companies in an insurance holding company system. These laws generally require the insurance holding company to register with the insurance regulatory authority of each state in which its insurance subsidiaries are domiciled as well as its state of domicile and to furnish to this regulator financial and other information concerning the holding company and its affiliated companies within the system that may materially affect the operations, management or financial condition of insurers within the system.

Because we are an insurance holding company, and because Radian Guaranty and Radian Insurance are Pennsylvania insurance companies, Amerin Guaranty is an Illinois insurance company, CMAC of Texas and Radian Mortgage Insurance Inc. (each an operating subsidiary used primarily for intra-company reinsurance) are Texas and Arizona insurance companies, respectively, and Radian Asset Assurance is a New York insurance company, the Pennsylvania, Texas, Arizona, Illinois and New York insurance laws regulate, among other things, certain transactions in our common stock and certain transactions between us, our insurance subsidiaries and other parties affiliated with us. Specifically, no person may, directly or indirectly, offer to acquire or acquire “control” of us or our insurance subsidiaries, unless that person files a statement and other documents with the Commissioner of Insurance of the state in which such target company is domiciled and obtains the Commissioner’s prior approval. The Commissioner may hold a public hearing on the matter. In addition, material transactions between us, our insurance subsidiaries and our affiliates are subject to certain conditions, including that they be “fair and reasonable.” These restrictions generally apply to all persons controlling or who are under common control with us or our insurance subsidiaries. Certain transactions between us, our insurance subsidiaries or our affiliates may not be entered into unless the applicable Commissioner of Insurance is given 30 days’ prior notification and does not disapprove the transaction during that 30-day period.

2. Dividends (Regulation—State Regulation)

Radian Guaranty’s and Radian Insurance’s ability to pay dividends on their common stock is restricted by certain provisions of the insurance laws of Pennsylvania. Under Pennsylvania’s insurance laws, dividends and other distributions may only be paid out of an insurer’s unassigned surplus unless the Pennsylvania Insurance Commissioner approves additional dividends. Radian Guaranty and Radian Insurance each had negative unassigned surplus at December 31, 2007 of $10.3 million and $26.1 million, respectively. In addition, without the prior approval of the Pennsylvania Insurance Commissioner, an insurer only may pay dividends during any 12-month period in an aggregate amount less than or equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus, or (ii) the preceding year’s statutory net income. In accordance with this test, no dividends could be paid from Radian Guaranty or Radian Insurance in 2008. Radian Insurance has not paid any dividends to Radian Guaranty, its immediate parent company. Radian Guaranty paid $150.9 million of dividends in 2007 and transferred its investment in Sherman of $104 million in 2007 to Radian Group.

Amerin Guaranty’s ability to pay dividends on its common stock is restricted by certain provisions of the insurance laws of Illinois. The insurance laws of Illinois establish a test limiting the maximum amount of dividends that may be paid from unassigned surplus by an insurer without prior approval by the Illinois Insurance Commissioner. Under this test, Amerin Guaranty may pay dividends during any 12-month period in an aggregate amount less than or equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus, or (ii) the preceding year’s statutory net income. In accordance with this test, Amerin Guaranty would not be able to pay a dividend in 2008 without prior regulatory approval.

Radian Asset Assurance’s ability to pay dividends is restricted by certain provisions of the insurance laws of New York. Under the New York insurance laws, Radian Asset Assurance may only declare or distribute dividends from earned surplus. Unless the company has prior approval from the New York Superintendent of Insurance, the company can only pay a dividend, which when totaled with all other dividends declared or

 

55


Table of Contents

distributed by it during the preceding twelve months, is the lesser of 10% of its surplus to policyholders as shown by its last statement on file with the Superintendent of Insurance, or 100% of adjusted net investment income. At December 31, 2007, Radian Asset Assurance had $113.7 million available for dividends that could be paid in 2008 without prior approval.

3. Risk-to-Capital (Regulation—State Regulation)

A number of states limit a private mortgage insurer’s risk in force to 25 times the total of the insurer’s policyholders’ surplus, plus the statutory contingency reserve. This is commonly known as the “risk-to-capital” requirement. As of December 31, 2007, the consolidated risk-to-capital ratio for our mortgage insurance business was 14.4 to 1 compared to 10.4 to 1 as of December 31, 2006. See “Risk Factors—Risks Affecting Our Company—A prolonged period of losses could increase our subsidiaries’ risk to capital or leverage ratios, preventing them from writing new insurance.”

4. Reserves (Regulation—State Regulation)

For statutory reporting, mortgage insurance companies are required annually to provide for additions to their contingency reserve in an amount equal to 50% of earned premiums. Such amounts cannot be withdrawn for a period of 10 years except under certain circumstances. The contingency reserve, designed to be a reserve against catastrophic losses, essentially restricts dividends and other distributions by mortgage insurance companies. We classify the contingency reserve as a statutory liability. At December 31, 2007, Radian Guaranty had statutory policyholders’ surplus of $184.4 million and a contingency reserve of $2.3 billion, Amerin Guaranty had negative statutory policyholders’ surplus of $11.4 million and Radian Insurance had statutory policyholders’ surplus of $509.9 million and a contingency reserve of $15.6 million. In March 2008, Radian Group contributed $15 million to Amerin Guaranty in order for them to be in compliance with minimum capital requirements under Illinois insurance regulations.

Our financial guaranty business is also required to establish contingency reserves. The contingency reserve on direct financial guaranty business written is established net of risk ceded (i.e., transferred) through reinsurance, in an amount equal to the greater of 50% of premiums written or a stated percentage (based on the type of obligation insured or reinsured) of the net amount of principal guaranteed, ratably over 15 to 20 years depending on the category of obligation insured. The contingency reserve on assumed reinsurance business is provided by the ceding company. At December 31, 2007, Radian Asset Assurance had statutory policyholders’ surplus of $1,137.4 million and a contingency reserve of $433.3 million.

5. Reinsurance (Regulation—State Regulation)

Restrictions apply under the laws of several states to any licensed company ceding business to an unlicensed reinsurer. Under those laws, if a reinsurer is not admitted, authorized or approved in such state, the company ceding business to the reinsurer cannot take credit in its statutory financial statements for the risk ceded to the reinsurer without compliance with certain reinsurance security requirements. Several states limit the amount of risk a mortgage insurer may retain with respect to coverage on an insured loan to 25% of the principal balance of the insured loan. Coverage in excess of 25% (i.e., deep coverage) must be reinsured.

6. Accreditation (Regulation—State Regulation)

The National Association of Insurance Commissioners instituted the Financial Regulatory Accreditation Standards Program, known as “FRASP,” in response to federal initiatives to regulate the business of insurance. FRASP provides standards intended to establish effective state regulation of the financial condition of insurance companies. FRASP requires states to adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce these items in order to become accredited. In accordance with the National Association of Insurance Commissioners’ Model Law on Examinations, accredited states are

 

56


Table of Contents

not permitted to accept certain financial examination reports of insurers prepared solely by the insurance regulatory agencies of non-accredited states. Although the State of New York is not accredited, no state where Radian Asset Assurance is licensed has refused to accept the New York Insurance Department’s Reports on Examination for Radian Asset Assurance. We cannot be certain that, if the New York Insurance Department remains unaccredited, other states that are accredited will continue to accept financial examination reports prepared solely by the New York Insurance Department. We do not believe that the refusal by an accredited state to continue accepting financial examination reports prepared by the New York Insurance Department would have a material adverse impact on our insurance businesses.

B. Federal Regulation (Regulation)

1. Mortgage Insurance Tax Deductibility (Regulation—Federal Regulation)

On December 20, 2006, federal legislation was enacted making mortgage insurance premiums tax deductible with regard to loans closing on or after January 1, 2007. Originally scheduled to expire at the end of 2007, the legislation was extended for three more years in December 2007 as part of the Mortgage Forgiveness Debt Relief Act of 2007. The legislation allows borrowers with adjusted gross incomes of $100,000 or less ($50,000 in the case of a married individual filing a separate return) to deduct the full amount of their mortgage insurance premiums paid in calendar years 2007 through 2010. Borrowers making between $100,000 and $110,000 will be eligible to write off a portion of the premiums paid in those years. As extended, the legislation applies to loans closing on or after January 1, 2007 through December 31, 2010, and to both purchase and refinance transactions. We believe this legislation will make our mortgage insurance products more competitive with “80-10-10 loans” and other forms of simultaneous second loans, which were often viewed by homebuyers and others as more favorable than loans with mortgage insurance because of the tax deductibility associated with mortgage payments related to these products.

2. Real Estate Settlement Practices Act—“RESPA” (Regulation—Federal Regulation)

The origination or refinance of a federally regulated mortgage loan is a settlement service, and therefore, subject to RESPA. In December 1992, regulations were issued stating that mortgage insurance also is a settlement service. As a result, mortgage insurers are subject to the anti-referral provisions of Section 8(a) of RESPA, which provide, in essence, that mortgage insurers are prohibited from paying anything of value to a mortgage lender in consideration of the lender’s referral of business to the mortgage insurer. Although many states prohibit mortgage insurers from giving rebates, RESPA has been interpreted to cover many non-fee services as well. The U.S. Department of Housing and Urban Development’s (“HUD”) interest in pursuing violations of RESPA has increased the awareness of both mortgage insurers and their customers of the possible sanctions resulting from a violation of RESPA. HUD, as well as the insurance commissioner or an attorney general of any state, may conduct investigations, levy fines and other sanctions or enjoin future violations of RESPA. We and other mortgage insurers have faced private lawsuits alleging, among other things, that our captive reinsurance arrangements, as well as pool insurance and contract underwriting services, constitute unlawful payments to mortgage lenders under RESPA. Although to date we have successfully defended against all such lawsuits on the basis that the plaintiffs lacked standing, we cannot be certain that we will have continued success defending against similar lawsuits.

The insurance law provisions of many states, including New York, also prohibit paying for the referral of insurance business and provide various mechanisms to enforce this provision. In February 1999, the New York Insurance Department issued Circular Letter No. 2 that discusses its position concerning various transactions between mortgage guaranty insurance companies licensed in New York and mortgage lenders. The letter confirms that captive reinsurance transactions are permissible if they “constitute a legitimate transfer of risk” and “are fair and equitable to the parties.” The letter also states that “supernotes/performance notes,” “dollar pool” insurance, and “un-captive captives” violate New York insurance law. In May 2005, we received a letter from the New York Insurance Department seeking information related to all of the captive mortgage reinsurance

 

57


Table of Contents

arrangements that we entered into since January 1, 2000, a list of the lenders associated with each captive along with each captive’s state of domicile and capital/surplus requirements. The letter also included a request for a description of any other arrangements through which we provide any payment or consideration to a lender in connection with mortgage insurance. We submitted our response and affirmed it as true under penalties of perjury to the New York insurance department on June 8, 2005. We are aware that other mortgage insurers received similar requests from the New York insurance department.

In February 2006, we and other mortgage insurers received a second letter from the New York insurance department seeking documentation and a description of the due diligence that we perform in selecting reinsurers for our mortgage insurance risk. The letter indicates that the New York insurance department is seeking evidence from us to rebut the assertion that the premiums we pay under our captive reinsurance arrangements constitute an inducement or compensation to lenders for doing business with us and to bolster a claim that it is difficult or impossible to obtain mortgage reinsurance from non-captive reinsurers. We submitted a response to the New York insurance department for Radian Guaranty in March 2006 and for Amerin Guaranty in May 2006, as requested. We have had no further inquiries from the insurance department about either company.

In addition to the New York inquiry, other mortgage insurers have received subpoenas from the Minnesota Insurance Commissioner relating to their captive reinsurer arrangements, and public reports have indicated that both the Colorado and North Carolina Insurance Commissioners were considering investigating or reviewing captive mortgage reinsurance arrangements. Insurance departments or other officials in other states may also conduct such investigations or reviews. Although we believe that all of our captive reinsurance arrangements transfer risk to the captive reinsurer at a premium rate that is commensurate with the risk, we cannot be certain that we will be able to successfully defend against any alleged violations of RESPA or other laws.

HUD proposed a rule under RESPA to create an exemption from Section 8(a) of RESPA. The proposed rule would have made the exemption available to lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all the settlement services associated with the loan, commonly referred to as “bundling.” In 2004, HUD indicated its intention to abandon the proposed rule and to submit a revised proposed rule to the U.S. Congress. HUD began looking at the reform process again in 2005 and there may be a new proposed rule in 2008. If bundling is exempted from RESPA, mortgage lenders may have increased leverage over us and the premiums we are able to charge for mortgage insurance could be negatively affected.

3. Home Mortgage Disclosure Act of 1975 (“HMDA”) (Regulation—Federal Regulation)

Most originators of mortgage loans are required to collect and report data relating to a mortgage loan applicant’s race, nationality, gender, marital status and census tract to HUD or the Federal Reserve under the HMDA. The purpose of the HMDA is to detect possible discrimination in home lending and, through disclosure, to discourage this discrimination. Mortgage insurers are not required pursuant to any law or regulation to report HMDA data, although under the laws of several states, mortgage insurers are currently prohibited from discriminating on the basis of certain classifications.

Several mortgage insurers, through their trade association, Mortgage Insurance Companies of America (“MICA”), entered into an agreement with the Federal Financial Institutions Examinations Council (“FFIEC”) to report the same data on loans submitted for insurance as is required for most mortgage lenders under HMDA. Reports of HMDA-type data for the mortgage insurance industry have been submitted by several mortgage insurers through MICA to the FFIEC since 1993. We are not aware of any pending or expected actions by governmental agencies in response to the reports submitted by MICA to the FFIEC. Since January 2004, we have been independently reporting HMDA data to the FFIEC, due to our withdrawal from MICA.

4. Mortgage Insurance Cancellation (Regulation—Federal Regulation)

The Homeowners Protection Act of 1998 (the “HPA”) was signed into law on July 29, 1998. The HPA imposes certain cancellation and termination requirements for borrower-paid private mortgage insurance and

 

58


Table of Contents

requires certain disclosures to borrowers regarding their rights under the law. The HPA also requires certain disclosures for loans covered by lender-paid private mortgage insurance. Specifically, the HPA provides that private mortgage insurance on most loans originated on or after July 29, 1999, may be canceled at the request of the borrower once the LTV reaches 80%, provided that certain conditions are satisfied. Private mortgage insurance must be canceled automatically once the LTV reaches 78% (or, if the loan is not current on that date, on the date that the loan becomes current). The HPA establishes special rules for the termination of private mortgage insurance in connection with loans that are “high risk.” The HPA does not define “high risk” loans but leaves that determination to Fannie Mae and Freddie Mac for loans up to the conforming loan limit and to the mortgagee for any other loan. For “high risk” loans above the conforming loan limit, private mortgage insurance must be terminated on the date that the LTV is first scheduled to reach 77%. In no case, however, may private mortgage insurance be required beyond the midpoint of the amortization period of the loan if the mortgagor is current on the payments required by the terms of the mortgage.

5. Freddie Mac and Fannie Mae (Regulation—Federal Regulation)

As the largest purchasers and sellers of conventional mortgage loans, and therefore beneficiaries of private mortgage insurance, Freddie Mac and Fannie Mae impose requirements on private mortgage insurers so that they may be eligible to insure loans sold to Freddie Mac and Fannie Mae. Freddie Mac’s current eligibility requirements impose limitations on the type of risk insured, standards for the geographic and customer diversification of risk, procedures for claims handling, standards for acceptable underwriting practices, standards for certain reinsurance cessions and financial requirements that generally mirror state insurance regulatory requirements. These requirements are subject to change from time to time. Both Freddie Mac’s and Fannie Mae’s eligibility requirements for “Type I” mortgage insurers currently require such insurers to maintain an insurer financial strength rating of AA- or Aa3 with the credit ratings agencies that customarily rate them. A downgrade below such levels could have an adverse impact on our ability to continue to do business with Freddie Mac and/or Fannie Mae. While we cannot predict if such eligibility requirements may be waived or altered by Freddie Mac or Fannie Mae in the event of such a downgrade, both Freddie Mac and Fannie Mae have indicated that loss of “Type I” mortgage insurer eligibility due to such a downgrade will no longer be automatic and will be subject to review if and when it occurs.

Freddie Mac and Fannie Mae have programs that allow for lower levels of required mortgage insurance coverage for certain low-down-payment 30-year fixed-rate loans approved through their automated underwriting systems. Under these programs the GSEs replace a portion of their standard mortgage insurance coverage with a reduced layer of coverage.

Freddie Mac and Fannie Mae require that we participate in “affordable housing” programs that they maintain to provide for loans to low- and moderate-income borrowers. These programs usually include 95s, 97s and 100s, and may require the liberalization of certain underwriting guidelines to achieve the programs’ objectives. Our default experience on loans that we insure through these programs has been worse than on non-“affordable housing” loans, but the risk in force attributable to our participation in these programs is immaterial.

6. Indirect Regulation (Regulation—Federal Regulation)

We also are indirectly, but significantly, impacted by regulations affecting originators and purchasers of mortgage loans, such as Freddie Mac and Fannie Mae, and regulations affecting governmental insurers such as the FHA and the VA. We and other private mortgage insurers may be significantly impacted by federal housing legislation and other laws and regulations that affect the demand for private mortgage insurance and the housing market generally. For example, legislation that increases the number of persons eligible for FHA or VA mortgages could have a material adverse effect on our ability to compete with the FHA or VA.

 

59


Table of Contents

As part of the Economic Stimulus Act of 2008, the U.S. Congress passed legislation that temporarily raises loan limits for FHA-insured loans as well as the limit on Fannie Mae and Freddie Mac conforming loans up to a maximum of $729,750. The increase in the GSEs’ conforming loan limits is intended to increase the size of the secondary market for purchasing and securitizing home loans and to encourage the GSEs to continue to provide liquidity to the residential mortgage market, particularly in higher-priced areas, at a time when many banks and similar institutions have seriously curtailed their activities due to the subprime lending crisis that developed and intensified during the latter half of 2007.

In October 2006, the federal banking regulators (Office of the Comptroller of the Currency, Treasury (“OCC”); Board of Governors of the Federal Reserve System (“Board”); Federal Deposit Insurance Corporation (“FDIC”); Office of Thrift Supervision, Treasury (“OTS”); and National Credit Union Administration (“NCUA”)) issued joint interagency guidance on non-traditional mortgage loans. The guidance was developed to address what the regulators identified as the risks associated with the growing use of mortgage products that allow borrowers to defer payment of principal and, sometimes, interest. While the guidance does not have a legally binding effect on lenders, the provisions are used by federal bank examiners to determine whether regulated institutions are in compliance with recommended underwriting and risk management practices. As a result, lenders often are influenced to adjust their business practices in order to conform to currently prevailing guidance. The guidance includes a focus on tightening underwriting and credit standards for non-traditional loans. Simultaneous second-lien loans (which typically are utilized in lieu of mortgage insurance) are among the factors cited in the guidance as a risk factor when used in conjunction with non-traditional loan features. The guidance cites the use of mortgage insurance as a mitigating factor for lenders to reduce risk in non-traditional loan products.

Concern about subprime lending has caused Congress to take an active interest in making changes to the mortgage origination process. The House of Representatives passed HR 3914 in 2007 which would establish national standards for mortgage origination including uniform licensing and new protections for high cost loans. The bill establishes assignee liability for the secondary market for assignees that fail to meet the standards in the bill. The Senate Banking Committee may take up its own version of legislation in 2008. While the final outcome of the legislative process is uncertain, the imposition of new liability in the secondary market could shift more lending to agency debt (Fannie Mae and Freddie Mac) and increase demand for mortgage insurance.

C. Foreign Regulation (Regulation)

We also are subject to certain regulation in various foreign countries, namely the United Kingdom, Hong Kong and Bermuda, as a result of our operations in those jurisdictions. In Australia, our transactions have consisted solely of off-shore reinsurance; consequently we are not subject to direct regulation by the relevant Australian authorities.

In the United Kingdom, we are subject to regulation by the Financial Services Authority (“FSA”). The FSA periodically performs a formal risk assessment of insurance companies or groups carrying on business in the United Kingdom. After each risk assessment, the FSA will inform the insurer of its views on the insurer’s risk profile. This will include details of any remedial action that the FSA requires. The FSA also supervises the management of insurance companies through the approved persons regime, by which any appointment of persons to perform certain specified “controlled functions” within a regulated entity, must be approved by the FSA.

In addition, the FSA supervises the sale of general insurance, including payment protection insurance and mortgage insurance. Under FSA rules, persons who are involved in the sale of general insurance (including insurers and distributors) are prohibited from offering or accepting any inducement in connection with the sale of general insurance that is likely to conflict materially with their duties to insureds. Although the rules do not generally require disclosure of broker compensation, the insurer or distributor must disclose broker compensation at the insured’s request.

 

60


Table of Contents

The FSA has extensive powers to intervene in the affairs of an insurance company or authorized person and has the power, among other things, to enforce, and take disciplinary measures in respect of, breaches of its rules. Under FSA rules, insurance companies must maintain a margin of solvency at all times, the calculation of which in any particular case depends on the type and amount of insurance business a company writes.

Our United Kingdom subsidiaries are prohibited from declaring a dividend to their shareholders unless they have “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses.

The acquisition of “control” of any United Kingdom insurance company will require FSA approval. For these purposes, a party that “controls” a United Kingdom insurance company includes any company or individual that (together with its or his associates) directly or indirectly acquires 10% or more of the shares in a United Kingdom authorized insurance company or its parent company, or is entitled to exercise or control the exercise of 10% or more of the voting power in such authorized insurance company or its parent company. In considering whether to approve an application for approval, the FSA must be satisfied that the acquirer is both a fit and proper person to have such “control” and that the interests of consumers would not be threatened by such acquisition of “control.” Failure to make the relevant prior application could result in action being taken against our United Kingdom subsidiaries by the FSA.

By reason of Radian Insurance’s authorization, in September 2006, to conduct insurance business through a branch in Hong Kong, we also are subject to regulation by the Hong Kong Insurance Authority (“HKIA”). The HKIA’s principal purpose is to supervise and regulate the insurance industry, primarily for the protection of policy holders and the stability of the industry. Hong Kong insurers are required by the Insurance Companies Ordinance to maintain minimum capital as well as an excess of assets over liabilities of not less than a required solvency margin, which is determined on the basis of a statutory formula. Foreign-owned insurers are also required to maintain assets in Hong Kong in an amount sufficient to ensure that assets will be available in Hong Kong to meet the claims of Hong Kong policy holders if the insurer should become insolvent. The HKIA also reviews the backgrounds and qualifications of insurance companies’ directors and key local management to ensure that these “controllers” are “fit and proper” to hold their positions, and has the authority to approve or disapprove key appointments.

In Bermuda, we are subject to regulation by the Bermuda Monetary Authority. The Insurance Department within the Monetary Authority is responsible for the supervision, regulation, licensing and inspection of Bermuda’s insurance companies, pursuant to the Insurance Act of 1978, as amended under the Insurance Amendment Act of 2002. The Insurance Department has full licensing and intervention powers, including the authority to obtain information and reports and to require the production of documents from licensed insurers.

We currently conduct reinsurance business as an off-shore reinsurer with Australian-licenced lenders’ mortgage insurers. Because we do not conduct an insurance business in Australia, we are not subject to regulation by the Australian Prudential Regulatory Authority (the “APRA”), the prudential regulator of insurance business in Australia, though our customers are themselves subject to APRA regulation.

D. Basel II Capital Accord (Regulation)

The Basel II Capital Accord represents a proposal by the Basel Committee on Banking Supervision (BCBS), consisting of bank supervisors and central bankers from 13 countries, to revise the international standards for measuring the adequacy of a bank’s capital. The implementation of the Basel II Capital Accord proposal will promote a more forward-looking approach to capital supervision and ensure greater consistency in the way banks and banking regulators approach risk management around the world. The implementation of the Basel II Capital Accord may affect the demand for and capital treatment provided to mortgage insurance and the capital available to large domestic and internationally active banking institutions for their mortgage origination and securitization activities.

 

61


Table of Contents

Our primary mortgage insurance business and opportunities may be significantly impacted by the implementation of the Basel II Capital Accord in the U.S., the European Union and Australia, due to adoption of jurisdiction specific prudential standards, that may lead to change in demand for and acceptance of mortgage insurance by large domestic and internationally active banking institutions. The implementation of the Basel II Capital Accord and adoption of standards is subject to the views and discretion of the local banking supervisors and its implementation is expected to vary across national jurisdictions. We are continuously assessing the impact of Basel II Capital Accord implementation in the countries where we have significant operations.

In Australia, where Basel II prudential standards took effect on January 1, 2008, the impact on the lenders’ mortgage insurance market is reasonably likely to increase lenders’ demand for coverage of residential loans with a relatively higher risk profile, due to increased regulatory capital charges to lenders for such assets. While increased demand could theoretically lead to upward price pressures for mortgage insurance, these may be offset by competitive pressures in an increasingly crowded market of mortgage insurance providers.

In Hong Kong, Basel II’s implementation in January 2007 had no material effect on the market for residential mortgage insurance. Most larger Hong Kong lenders have adopted the “internal ratings-based” or “IRB” approach to the Basel II capital rules, under which the risk weighting for their portfolios of residential mortgages was not affected. Smaller lenders who have adopted the “standard approach” do receive a relatively minor risk weight reduction (from 50% to 35%) for residential mortgages.

The European Union has begun to implement Basel II through the Capital Requirements Directive (“CRD”), which provides a revised framework for European Union member nation banking supervisors to implement new Basel II Capital Accord risk-based capital guidelines. The CRD prescribes standard criteria for credit risk mitigation instruments eligible to provide banks with risk relief and is subject to further clarification by the European Commission and incorporation into the regulatory framework of European Union member countries. Many European banks already report their capital adequacy ratios according to the new system, and by year end 2008, all banks regulated by European Union banking regulators must implement it.

Implementation of Basel II in the U.S. has been delayed, and while there is no official timeline for implementation, it is not expected to begin until 2009. In the U.S., Basel II applies to large, complex, internationally active financial institutions; however, all other banks have the option to apply it. Currently, U.S. banks (via U.S. regulators) apply Basel I – like rules. If the ratings based approach under Basel II benefits a particular, smaller bank, they might in fact take that option.

Under the Basel II Capital Accord, the regulatory capital relief provided to an affected bank is the same whether the provider of the relief is rated “triple-A” or “double-A” (such as Radian Asset Assurance). As a result, price should be a more significant factor in our bank customers’ making their selection of credit protection providers among the “triple-A” and “double-A” providers. Due to our lower cost of capital as a “double-A” insurer relative to “triple-A” providers, we believe we can compete effectively on price to provide this relief to our customers.

XII. Employees

At December 31, 2007, we had 832 employees, of which 129 work mainly for Radian Group Inc., while 543 and 160 are employed in our mortgage insurance and financial guaranty businesses, respectively. Approximately 169 of our employees are contract underwriters that are hired on an “as-needed” basis. The number of contract underwriters can vary substantially from period to period, mainly as a result of changes in the demand for these services. Our employees are not unionized and management considers employee relations to be good.

 

62


Table of Contents
Item 1A. Risk Factors.

Risks Affecting Our Company

We may require additional capital in light of our recent loss experience, which could worsen if general economic factors continue to deteriorate. Additional capital could dilute our existing stockholders and reduce our per-share earnings.

Our business is cyclical and tends to track general economic and market conditions. Our loss experience on the mortgage and financial guaranty insurance we write is subject to general and regional economic factors that are beyond our control, many of which we cannot anticipate, including extended national or regional economic recessions, interest-rate changes or volatility, home price depreciation or appreciation, business failures, the impact of terrorist attacks or acts of war or other conflicts.

Throughout 2007, we experienced increased delinquencies in our traditional mortgage insurance business, primarily driven by the poor performance of our late 2005 through 2007 vintage books of business, a lack of refinance capacity in the current mortgage market, which is forcing many borrowers into delinquency, and from home price depreciation in many parts of the U.S. If current housing market trends continue as is expected, we will experience increased credit losses in 2008 and possibly beyond. We may be required, even if only as a precaution, to seek additional capital in order to maintain our current credit and financial strength ratings in the face of such on-going losses.

Deterioration of general economic conditions, such as increasing unemployment rates, higher energy costs and inflation could further negatively affect the performance of our mortgage insurance business by increasing the likelihood that borrowers will not pay their mortgages. Throughout the recent turmoil in the housing, mortgage and related credit markets, the overall U.S. economy has remained resilient; however, recent economic indices have indicated that the turmoil in the housing and mortgage markets has begun to impact the broader U.S. economy. If a recession occurs that negatively impacts economic conditions in the U.S. as a whole or in specific regions of the U.S. where our mortgage insurance is concentrated, including by increasing unemployment rates, we would likely experience significantly increased delinquencies and credit losses in our mortgage insurance business. If this were to occur, we would likely require additional capital to support our long-term liquidity needs and to protect our credit and financial strength ratings. If capital were necessary, we cannot be certain that we would be able to access capital on terms that would be acceptable to us or in an amount that would be sufficient to cover losses we may incur. In addition, the influx of new capital could have a potential dilutive effect upon our existing stockholders, including by reducing our per-share earnings.

Our financial guaranty business also is impacted by adverse economic conditions due to the impact or perceived impact these conditions may have on the credit quality of municipalities, consumers and corporations. In particular, our financial guaranty business has been adversely affected by its, and the financial guaranty industry’s exposure to credit markets and residential mortgage-backed securities. See “Risks Particular to Our Financial Guaranty Business—Recent adverse developments in the mortgage and other asset-backed credit markets may continue to negatively affect our results of operations” below. An increase in our loss experience due to adverse economic factors could have a material adverse effect on our business, financial condition and operating results.

Deterioration in regional economic factors in areas where our business is concentrated increases our losses in these areas.

Our results of operations and financial condition are particularly affected by weakening economic conditions, such as depreciating home values and unemployment, in specific regions (including international markets) where our business is concentrated.

Approximately 53% of our primary mortgage insurance in force is concentrated in 10 states, with the highest percentages being in Florida, California and Texas. A large percentage of our second-lien mortgage

 

63


Table of Contents

insurance in force also is concentrated in California and Florida. During the second half of 2007, deteriorating markets in California and Florida, where non-prime and non-traditional mortgage products such as ARMs, including interest-only loans, are prevalent and where home price depreciation has been occurring, have had a significant negative impact on our mortgage insurance business results. Approximately 37% of our total increase in primary mortgage insurance loss reserves during 2007 was attributable to these states, which together represented approximately 18% of our primary mortgage insurance risk in force at December 31, 2007. During the prolonged period of home price appreciation that preceded the recent downturn in the U.S. housing market, very few mortgage delinquencies and claims were attributable to insured loans in California, despite the significant growth during this period of riskier, non-traditional mortgage products in California, such as ARM and non-prime products, including Alt-A mortgages. As a result, as mortgage credit performance in California and Florida has begun to deteriorate as is the current trend, given the size of these markets, our loss experience has been significantly affected and will continue to be negatively affected if conditions continue to deteriorate as is the current expectation.

In addition to California and Florida, approximately 10.5% of our primary mortgage insurance risk in force at December 31, 2007 was concentrated in the Midwestern states of Michigan, Indiana and Ohio. This region continued to experience higher default rates in 2007 as a result of the poor economic conditions in this region that are largely attributable to the difficult operating environment facing the domestic auto industry. We expect that this trend may continue and may become worse as other previously strong sectors of the U.S. economy begin to deteriorate and exert a negative influence on the already strained economies of the Midwestern states.

Our financial guaranty business also has a significant portion of its insurance in force concentrated in a small number of states, principally including California, New York, Texas, Florida and Pennsylvania, and could be affected by a weakening of economic conditions in these states.

In addition to the impact of regional housing and credit market deterioration, our results of operations and financial condition could be negatively impacted by natural disasters or other catastrophic events, acts of terrorism, conflicts, event specific economic depressions or other harmful events in the regions, including areas internationally, where our business is concentrated.

A downgrade or potential downgrade of our credit ratings or the insurance financial strength ratings assigned to any of our operating subsidiaries is possible and could weaken our competitive position and affect our financial condition.

The credit ratings of Radian Group Inc. and the insurance financial strength ratings assigned to our subsidiaries may be downgraded by one or more of S&P, Moody’s or Fitch if they believe that Radian Group Inc. or such subsidiary has experienced adverse developments in its business, financial condition or operating results. The rating agencies have indicated that they are engaged in on-going monitoring of the mortgage insurance and financial guaranty industries and the mortgage-backed securities market to assess the adequacy of, and where necessary refine, their capital models. The rating agencies could take action, including by downgrading or warning of the strong possibility of downgrade with respect to one or more companies in a specific industry, upon the conclusion of their respective reviews. Although we remain in frequent contact with the rating agencies and have prepared action plans to address any rating agency actions, we are generally not provided with much advance notice of an impending rating decision, which could come at any time.

Determinations of ratings by the rating agencies are affected by a variety of factors, including macroeconomic conditions, economic conditions affecting the mortgage insurance and financial guaranty industries, changes in regulatory conditions, competition, underwriting, risk management assessment, investment losses, earnings volatility, the perceived need for additional capital, if necessary, and the ability to raise capital and the perceived instability in the ongoing franchise value of participants in these industries.

Our ratings are critical to our ability to market our products and to maintain our competitive position and customer confidence in our products. A downgrade in these ratings, or the announcement of the potential for a

 

64


Table of Contents

downgrade or any other concern relating to the on-going financial strength of our insurance subsidiaries, could have a material adverse effect on our business, financial condition and operating results. In addition, we may be required to raise capital in the event of a downgrade or the likelihood of a downgrade, which we may not be able to do on terms acceptable to us or in an amount that would be sufficient to restore or stabilize our ratings. Additional capital could dilute our existing stockholders and reduce our per-share earnings.

Our principal operating subsidiaries had been assigned the following ratings as of the date of this report:

 

     MOODY’S    MOODY’S
OUTLOOK
  S&P    S&P
OUTLOOK
  FITCH (1)    FITCH
OUTLOOK

Radian Guaranty

   Aa3    (2)   AA-    (3)   AA-    (4)

Radian Insurance

   Aa3    (2)   A-    (3)   AA-    (4)

Amerin Guaranty

   Aa3    (2)   AA-    (3)   AA-    (4)

Radian Asset Assurance

   Aa3    Stable   AA    Stable   A+    Evolving

Radian Asset Assurance Limited

   Aa3    Stable   AA    Stable   A+    Evolving

 

(1) Fitch continues to rate us and our subsidiaries despite our request to Fitch on September 5, 2007 that Fitch immediately withdraw all of its ratings for us and our subsidiaries. See “Business—Ratings—Fitch” above.
(2) Each Moody’s rating for our mortgage insurance subsidiaries is currently under review for possible downgrade.
(3) Each S&P rating for our mortgage insurance subsidiaries is currently on CreditWatch with negative implications.
(4) Each Fitch rating for our mortgage insurance subsidiaries is currently Ratings Watch Negative

S&P

On February 26, 2008, S&P downgraded Radian Insurance to A- from AA-. Radian Insurance remains on CreditWatch with negative implications. The rating change was based on the fact that Radian Insurance is no longer considered by S&P to be a strategic entity to Radian because of our decision in 2007 to discontinue writing insurance on NIMS and second-liens, have been placed in run-off. Radian Insurance had eight active international transactions at the time of the S&P downgrade. Of these transactions, five have early termination clauses that were triggered as a result of the downgrade which allow our counterparties to terminate these transactions. On March 4, 2008, Standard Chartered Bank in Hong Kong informed us that they wished to terminate their contract with Radian Insurance, effective immediately. While we still are in the process of assessing the validity of the notice and the potential impact of termination, there is a possibility that Radian Insurance could be required to return to Standard Chartered Bank, or to transfer to another insurer, unearned premium related to this transaction. Unless extended, this transaction was expected to expire at the end of 2009. We are working closely with our counterparties under the remaining four transactions and cannot provide any assurance as to whether we will be successful in retaining this business. If these transactions also are terminated, we could be required to return, or transfer to another insurer, additional unearned premiums.

On February 13, 2008, S&P took mostly unfavorable ratings actions on several U.S. mortgage insurers. These ratings actions were the result of S&P’s reassessment of its expectations for the mortgage insurance sector in light of further deterioration in both the housing markets and the performance of all types of mortgages as well as S&P’s concerns that the 2008 vintage portfolio may be unprofitable. S&P downgraded its credit rating for Radian Group Inc. from A to A- and its financial strength ratings for our mortgage insurance subsidiaries from AA to AA-. S&P placed these ratings on CreditWatch with negative implications, citing concerns with our mortgage insurance operating performance and risk management. S&P further stated that its ratings for our mortgage insurance subsidiaries could be lowered multiple notches or affirmed with a negative outlook.

S&P’s recent ratings actions followed an affirmation by S&P on November 21, 2007 of its credit rating for Radian Group and its financial strength ratings for our mortgage insurance subsidiaries, in each case with a negative outlook. On November 21, 2007, S&P stated that it would lower its ratings for Radian Group Inc. and

 

65


Table of Contents

its mortgage insurance subsidiaries one notch if the results of our mortgage insurance business failed to meet S&P’s expectations that: (1) the loss ratio for our first-lien insured mortgage portfolio (a) will compare favorably with the industry mean in both 2008 and 2009, (b) will be between 120% and 140% in 2008 and about 70% in 2009 and (2) we will maintain excellent capitalization. S&P further stated that a downgrade of one or more notches could occur if our mortgage insurance business fails to maintain its access to the flow channel of business on terms similar to its competitors.

On September 25, 2007, S&P stated that its ratings for Radian Group Inc. and its mortgage insurance entities were predicated on S&P’s expectations that we will (1) generate underwriting profits in 2009 in our traditional mortgage insurance business, (2) maintain excellent capitalization, (3) strengthen our enterprise risk management capabilities, (4) narrow the disparity in the operating performance of our traditional mortgage insurance business with that of others in the industry and (5) maintain a reasonable market share in the mortgage insurance industry.

S&P has continued to maintain the AA ratings on our financial guaranty subsidiaries with a stable outlook, stating that Radian Asset Assurance’s capital position and operating capabilities are largely independent of those of our mortgage insurance companies.

Moody’s

On January 31, 2008, Moody’s announced that the ratings of our mortgage insurance subsidiaries would remain on review for possible downgrade while it evaluated the capital adequacy of all mortgage insurers. This evaluation will be based on updated information incorporating revised expectations about performance across different loan types. In its analysis, Moody’s also will consider the changing risk and opportunities available to mortgage insurers as a result of shifting dynamics in the conforming mortgage market.

On September 5, 2007, following the termination of our merger with MGIC, Moody’s placed its ratings for Radian Group Inc. and our mortgage insurance subsidiaries under review for possible downgrade, citing the deterioration in the residential mortgage market as a growing concern for the mortgage industry as a whole and for us in particular due to our exposure to NIMS and second-lien transactions.

According to Moody’s, its review of our ratings will focus on the capital adequacy of our mortgage insurance franchise in light of (1) the higher losses we expect to incur on our insured portfolio, (2) the viability of our revised business strategy to focus on relationships with large lenders and traditional mortgage insurance products, (3) the extent of continued support from lenders and from the GSEs and (4) the cohesiveness and capability of our senior management team in navigating us through the current stress period. In addition, Moody’s also stated that it will also be evaluating our ability to improve the volume and credit quality of our insured portfolio with new business writings, which could serve to offset some of the earnings deterioration expected on our existing portfolio.

Moody’s has continued to maintain its Aa3 ratings, with a stable outlook, on our financial guaranty subsidiaries. According to Moody’s, the affirmation of its ratings for these entities reflects their stable earnings, limited exposure to residential mortgage risk, and the diversity of their direct financial guaranty and reinsurance portfolios.

Fitch

On February 25, 2008, Fitch affirmed the AA- financial strength ratings of Radian Guaranty and its operational affiliates and the A- long-term issuer ratings of Radian Group, but placed these ratings on Ratings Watch Negative as compared to the previous status of negative outlook. Fitch cited growing losses and a potential capital shortfall, which, if not addressed within the next several months, could result in a one notch downgrade.

 

66


Table of Contents

On September 5, 2007, following the termination of our merger with MGIC, Fitch downgraded the long-term debt rating of Radian Group to A- from A and the insurer financial strength ratings of all of our mortgage insurance subsidiaries to AA- from AA and revised its outlook for these entities to Negative. Additionally, Fitch downgraded the insurance financial strength ratings of our financial guaranty subsidiaries to A+ from AA and revised its outlook for these entities to Evolving. As a result of this downgrade, one reinsurance customer in our financial guaranty business had the right to recapture approximately $1.0 billion in net par outstanding insured by us. On September 25, 2007, this insurer waived its right to recapture this business, without additional cost to us.

If the financial strength ratings assigned to any of our mortgage insurance subsidiaries were to fall below “Aa3” from Moody’s or the “AA-” level from S&P and Fitch, then national mortgage lenders and a large segment of the mortgage securitization market, including Freddie Mac and Fannie Mae, may decide not to purchase mortgages or mortgage-backed securities insured by that subsidiary. According to Fannie Mae, if such a downgrade were to occur, Fannie Mae would evaluate the downgraded insurance subsidiary, the current market environment and Fannie Mae’s alternative sources of credit enhancement. Based on that evaluation, Fannie Mae could restrict us from conducting certain types of business with Fannie Mae or take actions that may include not purchasing loans insured by us. Both Freddie Mac and Fannie Mae have indicated that any such downgrade would no longer result in an automatic loss of eligibility for an insurer, but that the insurer would be subject to review upon the happening of such event. Any such downgrade could also negatively affect Radian Group’s ratings or the ratings of our other insurance subsidiaries, including our financial guaranty subsidiaries. Any of these events would likely significantly harm the franchise value of our mortgage insurance business.

Any downgrade of the ratings assigned to our financial guaranty subsidiaries would limit the desirability of their respective direct insurance products and would reduce the value of Radian Asset Assurance’s reinsurance, even to the point where primary insurers may be unwilling to continue to cede insurance to Radian Asset Assurance at attractive rates. In addition, in the event of a downgrade, many of Radian Asset Assurance’s reinsurance agreements give the primary insurers the right to recapture business ceded to Radian Asset Assurance, and in some cases, in lieu of recapture, the right to increase commissions charged to Radian Asset Assurance if Radian Asset Assurance’s insurance financial strength rating is downgraded below specified levels. If Radian Asset Assurance was downgraded to A+ or below by S&P or A1 or below by Moody’s, up to $49.9 billion or 99.8% of our total net assumed par outstanding may be subject to recapture.

A downgrade of the ratings assigned to our financial guaranty subsidiaries below certain levels (both A- and below investment grade for S&P and below A3 for Moody’s) would allow counterparties in seven of our synthetic credit default swap transactions, representing an aggregate notional amount of approximately $1.1 billion, to terminate these transactions. Upon the termination of any such transaction following a downgrade trigger, the transaction would be settled on a mark-to-market basis, meaning that if there was a loss in fair value at the time of such termination, such loss would be realized and we would be required to pay such amount to our counterparty upon termination of the transaction. Based on the fair market value of such transactions at December 31, 2007, as discussed in Note 16 of Notes to Consolidated Financial Statements, we estimate that we would be required to pay the following amounts upon a termination of transactions following these specified downgrades: $2.7 million upon the termination of transactions following a downgrade by S&P below A- ; $2.9 million upon the termination of transactions following a downgrade by S&P below investment grade (BBB-); and $0.5 million upon the termination of transactions following a downgrade by Moody’s below A3. The actual amounts we could be required to pay in the event of a mark-to-market settlement following a downgrade trigger could be significantly greater than the amounts set forth above depending on market conditions at the time of termination, including if the fair values of these transactions were to deteriorate. The maximum amount that we could be required to pay on all these transactions in the aggregate is: $60.3 million in the event of a downgrade below A- by S&P; $413.5 million in the event of a downgrade below investment grade by S&P; and $8.0 million in the event of a downgrade below A3 by Moody’s.

In addition, approximately 80.1% of our 177 credit default swap transactions could be terminated by counterparties upon a downgrade of Radian Asset Assurance, generally below A- by S&P, without any obligation on our part to settle the transaction at fair value.

 

67


Table of Contents

Radian Group Inc. currently has been assigned a senior debt rating of A- (CreditWatch with negative implications) by S&P, A2 (under review for possible downgrade) by Moody’s and A- (Ratings Watch Negative) by Fitch. In addition, the trusts that have issued money market committed preferred custodial trust securities for the benefit of Radian Asset Assurance have been rated A by S&P and BBB+ (Evolving Outlook) by Fitch. Our credit ratings generally impact the interest rates that we pay on money that we borrow. A downgrade in our credit ratings could increase our cost of borrowing, which could have an adverse affect on our liquidity, financial condition and operating results. In addition, under our existing $400 credit facility, our senior debt ratings, as provided by S&P and Moody’s, may not (1) at the same time be lower than A- for S&P and A3 for Moody’s, or (2) be lower than either BBB for S&P or Baa2 for Moody’s. If this were to occur, we would be in default under our credit agreement and the lenders representing a majority of the debt under our credit agreement would have the right to terminate all commitments under the credit agreement and declare the outstanding debt due and payable. If the debt under our credit agreement were accelerated in this manner and not repaid, the holders of 10% or more of our publicly traded $250 million 7.75% Debentures due in June 2011 and the holders of 25% or more of our publicly traded $250 million 5.625% Senior Notes due in February 2013, each would have the right to accelerate the maturity of that debt. In the event the amounts due under our credit agreement or any series of our outstanding long-term debt are accelerated, we may not have sufficient funds to repay any such amounts.

A prolonged period of losses could increase our subsidiaries’ risk-to-capital or leverage ratios, preventing them from writing new insurance.

Rating agencies and state insurance regulators impose capital requirements on our subsidiaries. These capital requirements include risk-to-capital ratios, leverage ratios and surplus requirements that limit the amount of insurance that these subsidiaries may write. Most of the individual states limit a mortgage insurer’s risk to capital ratio to 25-to-1. At December 31, 2006, the risk-to-capital ratio of our mortgage insurance subsidiaries was 10.4-to-1. As a result of their net losses during 2007, the risk-to-capital ratio grew to 14.4-to-1 at December 31, 2007. A material reduction in the statutory capital and surplus of any of our insurance subsidiaries, whether resulting from additional underwriting or investment losses or otherwise, or a disproportionate increase in risk in force, could increase that subsidiary’s risk-to-capital ratio or leverage ratio. This in turn could limit that subsidiary’s ability to write new business or require that subsidiary to lower its ratio by obtaining capital contributions from us or another of our insurance subsidiaries or by reinsuring existing business, which may not be available to us on attractive terms or at all. If we are required to contribute capital to a subsidiary, it would adversely affect our liquidity.

If the estimates we use in establishing loss reserves for our mortgage insurance or financial guaranty business are incorrect, we may be required to take unexpected charges to income and our ratings may be downgraded.

We establish loss reserves in both our mortgage insurance and financial guaranty businesses to provide for the estimated cost of claims. However, because our reserves represent an estimate, these reserves may be inadequate to protect us from the full amount of claims we ultimately may have to pay. Setting our loss reserves involves significant reliance on estimates of the likelihood, magnitude and timing of anticipated losses. The models and estimates we use to establish loss reserves may prove to be inaccurate, especially during an extended economic downturn or in a period of extreme credit market volatility as has existed for most of 2007. If our estimates are inadequate, we may be required to increase our reserves, including by raising additional capital, which we may not be able to access on acceptable terms, if at all. Failure to establish adequate reserves or a requirement that we increase our reserves, including through a downgrade or warning of potential downgrade of our credit and financial strength ratings, would have a material adverse effect on our financial condition, including our capital position, operating results and business prospects.

In our mortgage insurance business, in accordance with GAAP, we generally do not establish reserves until we are notified that a borrower has failed to make at least two consecutive payments when due. Upon notification that two payments have been missed, we establish a loss reserve by using historical models based on a variety of loan characteristics, including the type of loan, the status of the loan as reported by the servicer of the loan, and

 

68


Table of Contents

the area where the loan is located. We are required under GAAP to establish a premium deficiency reserve for our second-lien business, equal to the amount by which the net present value of expected future losses and expenses for this business exceeds expected future premiums and existing reserves. All of our mortgage insurance reserves are therefore based on a number of assumptions and estimates that may prove to be inaccurate.

It also is difficult to estimate appropriate loss reserves for our financial guaranty business because of the nature of potential losses in that business, which are largely influenced by the particular circumstances surrounding each troubled credit, including the availability of loss mitigation, and therefore, are less capable of being evaluated based on historical assumptions or precedent. In addition, in our reinsurance business, we generally rely on information provided by the primary insurer in order to establish results. If this information is incomplete or untimely, our loss reserves may be inaccurate and could require adjustment in future periods as new or corrected information becomes available.

On April 18, 2007, the Financial Accounting Standards Board (“FASB”) issued an exposure draft, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60” (“Exposure Draft”). The Exposure Draft clarifies how Statement of Financial Accounting Standards (“SFAS”) No. 60, “Accounting and Reporting by Insurance Enterprises” applies to financial guaranty insurance contracts and provides guidance with respect to the timing of claim liability recognition, premium recognition and the related amortization of deferred policy acquisition costs, specifically for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS No. 133. The goal of the proposed statement is to reduce diversity in accounting by financial guaranty insurers, thereby enabling users to better understand and more readily compare insurers’ financial statements. Final guidance from the FASB regarding accounting for financial guaranty insurance is expected to be issued in 2008. If the Exposure Draft is issued as proposed, the effect on our consolidated financial statements, particularly with respect to revenue recognition and claims liability, could be material.

Our success depends on our ability to assess and manage our underwriting risks.

Our mortgage insurance and financial guaranty premium rates may not be adequate to cover future losses during 2008, and possibly beyond. Our mortgage insurance premiums are based upon our long-term expected risk of claims on insured loans, and take into account, among other factors, each loan’s LTV, type (e.g., prime vs. non-prime or fixed vs. variable payments), term, coverage percentage or the existence of a deductible in front of our loss position. We adjusted our underwriting standards in 2007 and are in the process of adjusting our pricing to reflect deterioration in the housing and related credit markets and our revised expectations regarding risk of claims on insured loans. Our financial guaranty premiums are based upon our expected risk of claim on the insured obligation, and take into account, among other factors, the rating and creditworthiness of the issuer and of the insured obligations, the type of insured obligation, the policy term and the structure of the transaction being insured. In addition, our premium rates take into account expected cancellation rates, operating expenses and reinsurance costs, as well as profit and capital needs and the prices that we expect our competitors to offer.

We generally cannot cancel or elect not to renew the mortgage insurance or financial guaranty insurance coverage we provide, and because we generally fix premium rates for the life of a policy when issued, we cannot adjust renewal premiums or otherwise adjust premiums over the life of a policy. Therefore, even if the risk underlying many of the mortgage or financial guaranty products we have insured develops more adversely than we anticipated, national and regional economies undergo unanticipated stress, and the premiums our customers are paying for similar coverage has increased, we generally cannot increase the premium rates on this in-force business, or cancel coverage or elect not to renew coverage to mitigate the effects of adverse developments. Our premiums earned and the associated investment income on those premiums may ultimately prove to be inadequate to compensate for the losses that we may incur. An increase in the amount or frequency of claims beyond the levels contemplated by our pricing assumptions could have a material adverse effect on our business, financial condition and operating results.

 

69


Table of Contents

Our success depends, in part, on our ability to manage risks in our investment portfolio.

Our income from our investment portfolio is one of our primary sources of cash flow to support our operations and claim payments. If we underestimate our policy liabilities, or if we improperly structure our investments to meet those liabilities, we could have unexpected losses, including losses resulting from forced liquidation of investments before their maturity. Our investments and investment policies and those of our subsidiaries are subject to state insurance laws. We may be forced to change our investments or investment policies depending upon regulatory, economic and market conditions and the existing or anticipated financial condition and operating requirements, including the tax position, of our business segments.

Our investment objectives may not be achieved. Although our portfolio consists mostly of highly-rated investments and complies with applicable regulatory requirements, the success of our investment activity is affected by general economic conditions, which may adversely affect the markets for interest-rate-sensitive securities, including the extent and timing of investor participation in these markets, the level and volatility of interest rates and, consequently, the value of our fixed-income securities. Volatility or illiquidity in the markets in which we directly or indirectly hold positions could have a material adverse effect on our business, financial condition and operating results.

As a holding company, we depend on our subsidiaries’ ability to transfer funds to us to pay dividends and to meet our obligations.

We act principally as a holding company for our insurance subsidiaries and do not have any significant operations of our own. Dividends from our subsidiaries and permitted payments to us under our expense- and tax-sharing arrangements with our subsidiaries, along with income from our investment portfolio, are our principal sources of cash to pay stockholder dividends and to meet our obligations. These obligations include our operating expenses and interest and principal payments on long-term debt and other borrowings. The payment of dividends and other distributions to us by our insurance subsidiaries is limited by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In addition, our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the rating agencies for us to maintain our ratings. If the cash we receive from our subsidiaries pursuant to dividend payment and expense- and tax-sharing arrangements is insufficient for us to fund our obligations, we may be required to seek capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all. The need to raise additional capital or the failure to make timely payments on our obligations could have a material adverse effect on our ratings and our business, financial condition and operating results.

Our reported earnings are subject to fluctuations based on changes in our credit derivatives that require us to adjust their fair market value as reflected on our income statement.

Our business includes the provision of credit enhancement in the form of derivative contracts. The gains and losses on these derivative contracts are derived from internally generated models, which may differ from models used by our counterparties or others in the industry. We estimate fair value amounts using market information, to the extent available, and valuation methodologies that we deem appropriate. The gains and losses on assumed derivative contracts are provided by the primary insurance companies. Considerable judgment is required to interpret available market data to develop the estimates of fair value. Since there currently is no active market for many derivative products, we have had to use assumptions as to what could be realized in a current market exchange. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Derivative Instruments and Hedging Activity.” Temporary market changes as well as actual credit improvement or deterioration in these contracts are reflected in changes in fair value of derivative instruments. Because these adjustments are reflected on our income statement, they affect our reported earnings and create earnings volatility. In addition, although these mark-to-market gains and losses do not directly impair our liquidity, they have the potential to significantly affect our GAAP consolidated net worth, which must be maintained at $2.0 billion (currently $2.7 billion as of December 31, 2007) in order to avoid a default under our

 

70


Table of Contents

credit agreement. If our GAAP consolidated net worth was to fall below $2.0 billion, we would be in default under our credit agreement and the lenders representing a majority of the debt under our credit agreement would have the right to terminate all commitments under the credit agreement and declare the outstanding debt due and payable. If the debt under our credit agreement were accelerated in this manner and not repaid, the holders of 10% or more of our publicly traded $250 million 7.75% Debentures due in June 2011 and the holders of 25% or more of our publicly traded $250 million 5.625% Senior Notes due in February 2013, each would have the right to accelerate the maturity of that debt. In the event the amounts due under our credit agreement or any series of our outstanding long-term debt are accelerated, we may not have sufficient funds to repay any such amounts.

The performance of our strategic investments could harm our financial results.

Part of our business involves strategic investments in other companies, and we generally do not have control over the way that these companies run their day-to-day operations. Our 21.8% equity interest in Sherman currently represents our most significant strategic investment. Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets that it generally purchases at deep discounts from national financial institutions and major retail corporations and subsequently seeks to collect. In addition, Sherman originates subprime credit card receivables through its subsidiary CreditOne and has a variety of other similar ventures related to consumer assets. Consequently, Sherman’s results could be adversely impacted by:

 

   

Sherman’s ability to obtain or renew financing, which will be required in 2008, and its ability to accomplish this on reasonable terms;

 

   

increased pricing competition for the pools of consumer assets it purchases;

 

   

macroeconomic or other factors that could diminish the success of its collection efforts on the variety of consumer assets it owns; and

 

   

the results of its credit card origination business, which are sensitive to interest-rate changes, charge-off losses and the success of its collection efforts, and which may be impacted by macroeconomic factors that affect a borrower’s ability to pay.

As a result of their significant amount of collection efforts, there is a risk that Sherman could be subject to consumer related lawsuits and other investigations related to fair debt collection practices, which could have an adverse effect on Sherman’s income, reputation and future ability to conduct business. In addition, Sherman is particularly exposed to consumer credit risk as a result of its credit card origination business and unsecured lending business through CreditOne. National credit card lenders recently have reported decreased spending by card members and an increase in delinquencies and loan write-offs, indicating that the recent turmoil in the mortgage credit markets may be impacting other consumer credit markets. In addition, recent economic indices have indicated that the likelihood of a recession in the U.S. is increasing. A continuation of current economic trends could materially impact the future results of Sherman, which, in turn, could have an adverse effect on our results of operations or financial condition.

Our international operations subject us to numerous risks.

We have committed significant resources to our international operations, particularly in the European Union, Hong Kong and Australia. Accordingly, we are subject to a number of risks associated with our international business activities, including:

 

   

dependence on regulatory and third-party approvals;

 

   

changes in ratings or outlooks assigned to our foreign insurance subsidiaries by rating agencies;

 

   

challenges in attracting and retaining key foreign-based employees, customers and business partners in international markets;

 

   

foreign governments’ monetary policies and regulatory requirements;

 

   

economic downturns in targeted foreign mortgage origination markets;

 

   

interest-rate volatility in a variety of countries;

 

71


Table of Contents
   

our lack of significant institutional experience (compared to the domestic U.S. market) with foreign mortgage credit risks and foreclosure proceedings and customs;

 

   

political risk and risks of war, terrorism, civil disturbances or other events that may limit or disrupt markets;

 

   

the burdens of complying with a wide variety of foreign regulations and laws, some of which are materially different than the regulatory and statutory requirements we face in our domestic business, and which may change unexpectedly;

 

   

potentially adverse tax consequences;

 

   

restrictions on the repatriation of earnings;

 

   

foreign currency exchange rate fluctuations; and

 

   

the need to develop and market products appropriate to the various foreign markets.

Any one or more of the risks listed above could limit or prohibit us from developing our international operations profitably. In addition, we may not be able to effectively manage new operations or successfully integrate them into our existing operations, which could have a material adverse effect on our business, financial condition or operating results.

We may lose business if we are unable to meet our customers’ technological demands.

Participants in the mortgage insurance and financial guaranty industries rely on e-commerce and other technologies to provide and expand their products and services. Our customers generally require that we provide aspects of our products and services electronically, and the percentage of our new insurance written and claims processing that we deliver electronically has continued to increase. We expect this trend to continue and, accordingly, we may be unable to satisfy our customers’ requirements if we fail to invest sufficient resources or otherwise are unable to maintain and upgrade our technological capabilities. This may result in a decrease in the business we receive, which could impact our profitability.

Our information technology systems may not be configured to process information regarding new and emerging products.

Many of our information technology systems have been in place for a number of years, and many of them originally were designed to process information regarding traditional products. As new products with new features emerge, when we modify our underwriting standards as we’ve done recently or when we insure structured transactions with different features, our systems may require modification in order to recognize these features to allow us to price or bill for our insurance of these products appropriately. Our systems also may not be capable of recording, or may incorrectly record, information about these products that may be important to our risk management and other functions. In addition, our customers may encounter similar technological issues that prevent them from sending us complete information about the products or transactions that we insure. Making appropriate modifications to our systems involves inherent time lags and may require us to incur significant expenses. The inability to make necessary modifications to our systems in a timely and cost-effective manner may have adverse effects on our business, financial condition and operating results.

A material weakness relating to our internal control over financial reporting could result in errors in our reported results and could have a material adverse effect on our operations and investor confidence in our business.

We have determined that material weakness existed in our internal control over financial reporting at December 31, 2007. We experienced increased turnover in key positions in our accounting and finance organization as a result of our proposed, but subsequently terminated, merger with MGIC. As a result, as of December 31, 2007, we did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP commensurate with our financial

 

72


Table of Contents

reporting requirements. Specifically, this deficiency resulted in audit adjustments to Derivative Liabilities and Change in Fair Value of Derivative Instruments line items in the consolidated financial statements for the year ended December 31, 2007 primarily arising from insufficient (1) identification of derivative instruments; (2) review, approval and testing of complex derivative valuation models, including assumptions, data inputs and results; and (3) identification of contract terms and transactions requiring consolidation in accordance with generally accepted accounting principles, related to such financial statement line items. We have been actively engaged in corrective actions to address this material weakness, including: (i) hiring in January 2008 a new corporate Controller to fill the recent vacancy in this position; (ii) hiring consultants to assist with the evaluation and application of complex accounting matters; (iii) reviewing and reorganizing our accounting organization to provide improved lines of responsibility, review and authority; and (iv) strengthening a compensation program aimed at retaining critical accounting and finance personnel. Notwithstanding these actions, we have not yet fully remedied this material weakness in our internal controls, which could result in errors in our financial or other reporting, cause us to fail to meet our reporting obligations on a timely basis and ultimately decrease investor confidence in our reported information.

A third-party acquisition of 20% or more of our outstanding shares will trigger a “change in control” under our Equity Compensation Plan, Performance Plan and other benefit plans.

A “change of control” will occur under our Equity Compensation Plan, Performance Plan and other benefit plans if an unaffiliated third-party acquires beneficial ownership of 20% or more of our outstanding shares of common stock. On February 14, 2008, Third Avenue Management LLC, an unaffiliated third-party (“Third-Avenue”), filed a Form 13G with the Securities and Exchange Commission, reporting that as of December 31, 2007, Third Avenue beneficially owned approximately 18.78% of our total common shares outstanding. If Third-Avenue or any other third-party were to acquire beneficial ownership of 20% or more of our outstanding common stock, a significant portion of the equity issued under our Equity Compensation Plan, including performance shares granted to executive officers under our Performance Plan, would become fully vested and transferable. We estimate that this would result in a pre-tax accounting charge to us of approximately $25 million to $35 million, representing an acceleration of compensation expense under SFAS No. 123R, “Share-Based Payment”. In addition, we believe the deferred vesting of our equity awards helps us retain executives and other employees, and therefore, serves as an important component of our compensation program, particularly in light of the current difficult operating environment for mortgage and financial guaranty insurers. The vesting of our outstanding equity grants could reduce their retention aspect and could result in our losing significant employees. The acquisition of 20% or more of our outstanding shares also would result in a “change of control” under agreements with our executive officers. These agreements are “double-trigger” agreements, meaning that amounts would be paid out to executives only upon the occurrence of both a “change of control” and one or more of the other triggering events specified in these agreements. Our consent is not required in order for a third-party to acquire beneficial ownership of 20% of more of our common shares, and we cannot provide any assurances as to whether this may or may not occur.

We are subject to litigation risk.

We face litigation risk in the ordinary course of operations, including the risk of class action lawsuits. In August and September 2007, two purported stockholder class action lawsuits, Cortese v. Radian Group Inc. and Maslar v. Radian Group Inc., were filed against us and individual defendants in the U.S. District Court for the Eastern District of Pennsylvania. The complaints, which are substantially similar, allege that we were aware of and failed to disclose the actual financial condition of C-BASS prior to our declaration of a material impairment to our investment in C-BASS. While it is still very early in the pleadings stage, we do not believe that these allegations have any merit; and we intend to defend this action vigorously.

In addition to the above litigation, we are involved in litigation that has arisen in the normal course of our business. We are contesting the allegations in each such pending action and believe, based on current knowledge and after consultation with counsel, that the outcome of such litigation will not have a material adverse effect on

 

73


Table of Contents

our consolidated financial position or results of operations. In the future, we cannot predict whether other actions might be brought against us. Any such proceedings could have an adverse effect on our consolidated financial position, results of operations or cash flows.

Our inability to obtain financial statements for C-BASS, in which we hold a 46% equity interest, in final form on a timely basis, could delay our ability to file timely reports with the SEC

We were unable to timely file our Form 10-Q for the third quarter of 2007 because we did not receive third-quarter financial statements in final form from C-BASS, which is an unconsolidated investment of ours, before the prescribed due date for filing the Form 10-Q. In addition, we are required to file financial statements of C-BASS for the year ended December 31, 2007 as part of this Form 10-K. C-BASS’s management is expected to issue financial statements by the end of March 2008, and we expect to file an amendment to this 10-K as soon as practicable to reflect such financial statements. We are not involved in the preparation of the C-BASS financial statements and cannot provide any assurance as to whether they will be completed and, if completed, whether we will receive them in a timely manner. Because the carrying value of our investment in C-BASS has been fully written down, we do not expect that any change to the summarized C-BASS financial information will have a material impact on our consolidated financial statements. If there is a delay in our receipt of the C-BASS financial statements for the current period, or for any future period for which the financial statements are required, we may be unable to timely file reports with the SEC, which could make it more difficult for us to raise capital, if necessary, and satisfy our obligations under our $400 million credit facility. Under this facility, we are required to furnish financial statements to the administrative agent for the facility within certain prescribed time periods. If we fail to meet our delivery obligations on more than two occasions in any twelve month period, we would be in default under our credit agreement.

Risks Particular to Our Mortgage Insurance Business

A decrease in the volume of home mortgage originations could result in fewer opportunities for us to write new insurance business.

Our ability to write new business depends on a steady flow of high-LTV mortgages that require our mortgage insurance. The deterioration in the credit performance of non-prime and other forms of non-conforming loans during 2007 has caused almost all lenders to substantially reduce the availability of non-prime mortgages and most other loan products that are not conforming loans, and to significantly tighten their underwriting standards. Fewer loan products and tighter loan qualifications, while improving the overall quality of new mortgage originations, have in turn reduced the pool of qualified homebuyers and made it more difficult for buyers (in particular first-time buyers) to obtain mortgage financing or to refinance their existing mortgages. In addition, the significant disruption in the subprime market has led to reduced investor demand for mortgage loans and mortgage-backed securities in the secondary market, which, until recently, has been an available source of funding for many mortgage lenders. This has significantly reduced liquidity in the mortgage funding marketplace, forcing many lenders to retain a larger portion of their mortgage loans and mortgage-backed securities and leaving them with less capacity to continue to originate new mortgages. To date, the potential negative effect on our business from the decreased volume of mortgage originations has been offset by an increase in the demand for mortgage insurance on conforming loans as the lending industry embraces more prudent risk management measures. However, if the volume of new mortgage originations continues to decrease or persist at low levels for a prolonged period of time, we may experience fewer opportunities to write new insurance business, which could reduce our existing insurance in force and have a significant negative effect on both our ability to execute our business plans and our overall franchise value.

An increase in the volume of cancellations or non-renewals of our existing policies would have a significant effect on our revenues.

Most of our mortgage insurance premiums earned each month are derived from the monthly renewal of policies that we have previously written. As a result, a decrease in the length of time that our mortgage insurance

 

74


Table of Contents

policies remain in force reduces our revenues and could have a material adverse effect on our business, financial condition and operating results. Fannie Mae and Freddie Mac generally permit homeowners to cancel their mortgage insurance when the principal amount of a mortgage falls below 80% of the home’s value and most private mortgage insurance must be automatically cancelled once the LTV reaches 78%. Factors that are likely to increase the number of cancellations or non-renewals of our mortgage insurance policies include:

 

   

falling mortgage interest rates (which tends to lead to increased refinancings and associated cancellations of mortgage insurance);

 

   

appreciating home values; and

 

   

changes in the mortgage insurance cancellation requirements applicable to mortgage lenders and homeowners.

Ongoing deterioration in the U.S. housing market, combined with a lack of liquidity in the mortgage funding market, has significantly reduced the level of mortgage refinancings during 2007. This has contributed to an overall increase in our mortgage insurance risk in force. Because housing markets tend to be cyclical, however, we expect that we will again experience a period of home price appreciation and low-interest rates at some point in the future. If this were to occur, we would likely experience a decrease in our mortgage insurance in force, which could have a negative effect on our revenues.

Because our mortgage insurance business is concentrated among a few significant customers, our revenues could decline if we lose any significant customer.

Our mortgage insurance business depends to a significant degree on a small number of lending customers. Our top ten mortgage insurance customers are generally responsible for half of both our primary new insurance written in a given year and our direct primary risk in force. Accordingly, maintaining our business relationships and business volumes with our largest lending customers is critical to the success of our business. Challenging market conditions during 2007 have adversely affected, and may continue to adversely affect, the financial condition of a number of our largest lending customers. Many of these customers have experienced ratings downgrades and liquidity constraints in the face of increasing delinquencies and the lack of a secondary market for mortgage funding. These customers may become subject to serious liquidity constraints that could jeopardize the viability of their business plans or their access to additional capital, forcing them to consider alternatives such as bankruptcy or, as has occurred recently, consolidation with others in the industry. In addition, as a result of current market conditions, our largest lending customers may seek to diversify their exposure to any one or more mortgage insurers or decide to write business only with those mortgage insurers that they perceive to have the strongest financial position. The loss of business from even one of our major customers could have a material adverse effect on our business franchise and operating results. Our master policies and related lender agreements do not, and by law cannot, require our mortgage insurance customers to do business with us, and we cannot be certain that any loss of business from a single lender will be recouped from other lending customers in the industry.

Our business depends, in part, on effective and reliable loan servicing, which may be negatively impacted by the current disruption in the mortgage credit markets.

We depend on reliable, consistent third-party servicing of the loans that we insure. Dependable servicing generally ensures timely billing and better loss mitigation opportunities for delinquent or near-delinquent loans. Many of our customers also serve as the servicers for loans that we insure, whether the loans were originated by such customer or another lender. Therefore, the same market conditions affecting our customers as discussed in the prior risk factor also will affect their ability to effectively maintain their servicing operations. In addition, if current housing market trends continue or worsen, the number of delinquent mortgage loans requiring servicing could continue to increase. Managing a substantially higher volume of non-performing loans could create operational difficulties that our servicers may not have the resources to overcome. If a disruption occurs in the servicing of mortgage loans covered by our insurance policies, this, in turn, could contribute to a rise in delinquencies among those loans and could have a material adverse effect on our business, financial condition and operating results.

 

75


Table of Contents

A large portion of our mortgage insurance risk in force consists of higher risk loans, such as Alt-A and subprime loans, which have resulted in increased losses in 2007 and may result in further losses in the future.

Non-Prime Loans. Until recently, we have faced significant competition for prime loan business from lenders offering alternative arrangements, such as simultaneous second mortgages. As a result, a large percentage of our mortgage insurance written during the recent past and, consequently, our mortgage insurance risk in force, is related to non-prime loans. In 2007, non-prime business accounted for $23.9 billion or 41.8% of our new primary mortgage insurance written (81% of which was Alt-A), compared to $17.5 billion or 43.7% in 2006 (80.2% of which was Alt-A) and $17.8 billion or 41.7% in 2005 (63.3% of which was Alt-A). At December 31, 2007, our non-prime mortgage insurance in force, including Alt-A, was $49.5 billion or 34.6% of our total primary insurance in force, compared to $37.0 billion or 32.5% of primary insurance in force at December 31, 2006 and $34.7 billion or 31.7% of primary insurance in force at December 31, 2005. Historically, non-prime loans are more likely to go into default and require us to pay claims than prime loans. In addition, our non-prime business, in particular Alt-A loans, tends to have larger loan balances relative to other loans, which results in larger claims. Throughout 2007, in conjunction with the disruption in the subprime market, we have experienced a significant increase in mortgage loan delinquencies related to Alt-A loans originated in 2006 and 2007. These losses have occurred more rapidly and well in excess of historical loss patterns for this product, and have contributed in large part to the significant increase in our provision for losses during the second half of 2007. If delinquency and claim rates on non-prime loans continue to increase, or if there is a further decline in the current housing market, in particular in California, Florida and other states where the Alt-A product is prevalent, our results of operations and financial condition would be negatively affected.

High-LTV Mortgages. We generally provide private mortgage insurance on mortgage products that have more risk than those mortgage products that meet the GSEs’ classification of conforming loans. A portion of our mortgage insurance in force consists of insurance on mortgage loans with LTVs at origination of 97% or greater. In 2007, loans with LTVs in excess of 97% accounted for $13.1 billion or 23.0% of our new primary mortgage insurance written, compared to $5.7 billion or 14.2% in 2006. At December 31, 2007, our mortgage insurance risk in force related to these loans was $6.5 billion or 20.7% of our total primary risk in force, compared to $3.5 billion or 14.0% of primary insurance risk in force at December 31, 2006. Mortgage loans with LTVs greater than 97% default substantially more often than those with lower LTVs. In addition, when we are required to pay a claim on a higher LTV loan, it is generally more difficult to recover our costs from the underlying property, especially in areas with declining property values. Throughout 2007, we experienced a significant increase in mortgage loan delinquencies related to high-LTV mortgages. As a result, we have altered our underwriting criteria, in part, to limit our exposure to high-LTV loans in markets experiencing a decline in home values. While we believe these changes will improve our overall risk profile, in the near term, we will likely continue to be negatively affected by the performance of existing insured loans with high-LTVs.

Pool Mortgage Insurance. We offer pool mortgage insurance, which exposes us to different risks than the risks applicable to primary mortgage insurance. Our pool mortgage insurance products generally cover all losses in a pool of loans up to our aggregate exposure limit, which generally is between 1% and 10% of the initial aggregate loan balance of the entire pool of loans. Under pool insurance, we could be required to pay the full amount of every loan in the pool within our exposure limits that is in default and upon which a claim is made until the aggregate limit is reached, rather than a percentage of the loan amount, as is the case with traditional primary mortgage insurance. At December 31, 2007, $3.0 billion of our mortgage insurance risk in force was attributable to pool insurance.

Credit Default Swaps. We also have provided credit enhancement on residential mortgage-backed securities in the form of credit default swaps. A credit default swap is an agreement to pay our counterparty should an underlying security or the issuer of such security suffer a specified credit event, such as nonpayment, downgrade or a reduction of the principal of the security as a result of defaults in the underlying collateral. This type of insurance generally has higher claim payouts than traditional mortgage insurance products. In addition, unlike with most of our mortgage insurance and financial guaranty products, our ability to engage in loss mitigation is

 

76


Table of Contents

generally limited. We have less experience writing these types of insurance and less performance data on this business, which could lead to greater losses than we anticipate. At December 31, 2007, we had $212 million of risk in force related to domestic credit default swaps on residential mortgage-backed securities. Credit default swaps in our mortgage insurance business are subject to derivative accounting, requiring mark-to-market valuations. As of December 31, 2007, we had a cumulative unrealized loss of approximately $84 million related to these domestic credit default swaps. We could incur additional credit losses on this business.

A portion of our mortgage insurance risk in force consists of insurance on adjustable-rate products such as ARMs that have resulted in significant losses in 2007 and may result in further losses.

At December 31, 2007, approximately 22% of our mortgage insurance risk in force consists of ARMs (12% of our mortgage insurance risk in force relates to ARMs with resets of less than five years from origination), which includes loans with negative amortization features, such as pay option ARMs. We consider a loan an ARM if the interest rate for that loan will reset at any point during the life of the loan. It has been our experience that ARMs with resets of less than five years from origination are more likely to result in a claim than longer-term ARMs. Our claim frequency on ARMs has been higher than on fixed-rate loans due to monthly payment increases that occur when interest rates rise or when the “teaser rate” (an initial interest rate that does not fully reflect the index which determines subsequent rates) expires. At December 31, 2007, approximately 10.5% of our primary mortgage insurance risk in force consists of interest-only mortgages, where the borrower pays only the interest charge on a mortgage for a specified period of time, usually five to ten years, after which the loan payment increases to include principal payments. Similar to ARMs, these loans have a heightened propensity to default because of possible “payment shocks” after the initial low-payment period expires and because the borrower does not automatically build equity as payments are made.

A lack of liquidity in the mortgage market, tighter underwriting standards, and declining home prices in many regions in the U.S. during 2007, have combined to make it more difficult for many borrowers with ARMs and interest-only mortgages to refinance their mortgages into lower fixed rate products. As a result, without available alternatives, many borrowers have been forced into default when their interest rates reset. This has resulted in significant defaults during 2007 for mortgage lenders and insurers as well as investors in the secondary market. Approximately 34% of our total increase in mortgage insurance loss reserves during the fourth quarter of 2007 was attributable to adjustable rate products, which represented approximately 22% of our mortgage insurance risk in force at December 31, 2007. Absent a change in the current lending environment or a positive mitigating effect from recent legislation aimed at reducing defaults from adjustable rate resets (See “Business—Regulation—Federal Regulation—Indirect Regulation” above), we expect that defaults related to these products will likely continue to increase. As of December 31, 2007, approximately 2.4% of the adjustable rate mortgages we insure are scheduled to reset during 2008, with most of our option ARMs and interest-only loans having first time resets in 2009 or later. If defaults related to adjustable rate mortgages were to continue at their current pace or were to increase as is currently projected, our results of operations will continue to be negatively affected, possibly significantly, which could adversely affect our financial position and capital reserves.

Our results of operations may continue to be negatively affected by NIMS and second-lien mortgages.

In the past, we have written mortgage insurance on second-lien mortgages and have provided credit enhancement on NIMS. Both of these products have been particularly susceptible to the disruption in the mortgage credit markets during 2007, resulting in significant credit losses to us. As a result, we ceased writing new insurance on these products in 2007 and expect that most of this business will have run-off by 2010. Although losses with respect to our second-lien business, much like in our traditional first-lien mortgage insurance business, will be incurred and paid over time as delinquencies develop and claims are filed, the net present value of expected future losses and expenses above expected future premiums and existing reserves on our second-lien business was recorded in the third quarter of 2007 as a $155.2 million premium deficiency reserve. This deficiency was increased by $40.4 million as of December 31, 2007 as a result of further

 

77


Table of Contents

deterioration in this insured portfolio. Because losses in our second-lien portfolio are particularly sensitive to changes in home prices, we cannot be certain that actual losses in our second-lien portfolio will not differ materially from the projections incorporated into our premium deficiency. If losses were to exceed our expectations, our future results of operations would be negatively impacted. During the third quarter of 2007, we incurred a mark-to-market loss related to NIMS of approximately $366.7 million, which increased our cumulative unrealized loss at September 30, 2007 to $432.0 million. Our cumulative unrealized loss at December 31, 2007 was $434.0 million.

We face the possibility of higher claims as our mortgage insurance policies age.

Historically, most claims under private mortgage insurance policies on prime loans occur during the third through fifth year after issuance of our policies, and under policies on non-prime loans during the second through fourth year after issuance of our policies. Low mortgage interest-rate environments tend to lead to increased refinancing of mortgage loans, resulting in a corresponding decrease in the average age of our mortgage insurance policies. On the other hand, increased interest rates tend to reduce mortgage refinancings and cause a greater percentage of our mortgage insurance risk in force to reach its anticipated highest claim frequency years. In addition, periods of growth in our business tend to reduce the average age of our policies. For example, the relatively recent growth of our non-prime mortgage insurance business means that a significant percentage of our insurance in force on non-prime loans has not yet reached its anticipated highest claim frequency years, although the recent disruption in the subprime credit markets has resulted in a significant acceleration of losses associated with our 2005 through 2007 non-prime insured loans. If the growth of our new business were to slow or decline, a greater percentage of our total mortgage insurance in force could reach its anticipated highest claim frequency years. A resulting increase in claims could have a material adverse effect on our business, financial condition and operating results.

Our delegated underwriting program may subject our mortgage insurance business to unanticipated claims.

In our mortgage insurance business, we enter into agreements with our mortgage lender customers that commit us to insure loans using pre-established underwriting guidelines. Once we accept a lender into our delegated underwriting program, we generally insure a loan originated by that lender even if the lender does not follow our specified underwriting guidelines. Under this program, a lender could commit us to insure a material number of loans with unacceptable risk profiles before we discover the problem and terminate that lender’s delegated underwriting authority. Even if we terminate a lender’s underwriting authority, we remain at risk for any loans previously insured on our behalf by the lender before that termination. The performance of loans insured through programs of delegated underwriting has not been tested over a period of extended adverse economic conditions, meaning that the program could lead to greater losses than we anticipate. Greater than anticipated losses could have a material adverse effect on our business, financial condition and operating results.

We face risks associated with our contract underwriting business.

As part of our mortgage insurance business, we provide contract underwriting services to some of our mortgage lender customers, even with respect to loans for which we are not providing mortgage insurance. Under the terms of our contract underwriting agreements, we agree that if we make mistakes in connection with these underwriting services, the mortgage lender may, subject to certain conditions, require us to purchase the loans or issue mortgage insurance on the loans, or to indemnify the lender against future loss associated with the loans. Accordingly, we assume some credit risk and interest-rate risk in connection with providing these services. In a rising interest-rate environment, the value of loans that we are required to repurchase could decrease, and consequently, our costs of those repurchases could increase. In 2007, we underwrote $3.9 billion in principal amount of loans through contract underwriting. Depending on market conditions, a significant amount of our underwriting services may be performed by independent contractors hired by us on a temporary basis. If these independent contractors make more mistakes than we anticipate, the resulting need to provide greater than

 

78


Table of Contents

anticipated recourse to mortgage lenders could have a material adverse effect on our business, financial condition and operating results.

Our loss mitigation opportunities are reduced in markets where housing values fail to appreciate or begin to decline.

The amount of loss we suffer, if any, depends in part on whether the home of a borrower who has defaulted on a mortgage can be sold for an amount that will cover unpaid principal and interest on the mortgage and expenses from the sale. If a borrower defaults under our standard mortgage insurance policy, we generally have the option of paying the entire loss amount and taking title to a mortgaged property or paying our coverage percentage in full satisfaction of our obligations under the policy. In the past, we have been able to take title to the properties underlying certain defaulted loans and to sell the properties quickly at prices that have allowed us to recover some of our losses. In the current housing market, in which housing values have failed to appreciate or have begun to decline in many regions, our ability to mitigate our losses in such manner has been reduced. If housing values continue to decline, or decline more significantly and/or on a larger geographic basis, the frequency of loans going to claim could increase and our ability to mitigate our losses on defaulted mortgages may be significantly reduced, which could have a material adverse effect on our business, financial condition and operating results.

Our mortgage insurance business faces intense competition.

The U.S. mortgage insurance industry is highly dynamic and intensely competitive. Our competitors include:

 

   

other private mortgage insurers;

 

   

federal and state governmental and quasi-governmental agencies, principally the VA and the FHA, which has increased its competitive position in areas with higher home prices by streamlining its down-payment formula and reducing the premiums it charges; and

 

   

mortgage lenders that demand participation in revenue-sharing arrangements such as captive reinsurance arrangements.

Governmental and quasi-governmental entities typically do not have the same capital requirements that we and other mortgage insurance companies have, and therefore, may have financial flexibility in their pricing and capacity that could put us at a competitive disadvantage. In the event that a government-owned or sponsored entity in one of our markets decides to reduce prices significantly or alter the terms and conditions of its mortgage insurance or other credit enhancement products in furtherance of social or other goals rather than a profit motive, we may be unable to compete in that market effectively, which could have an adverse effect on our business, financial condition and operating results. In addition, the intense competition we face in the mortgage insurance industry requires that we dedicate time and energy to the development and introduction of competitive new products and programs. Our inability to compete with other providers, including the timely introduction of profitable new products and programs, could have a material adverse effect on our business, financial condition and operating results.

In addition, in the recent past, an increasing number of alternatives to traditional private mortgage insurance developed, many of which reduced the demand for our mortgage insurance. These alternatives included:

 

   

mortgage lenders structuring mortgage originations to avoid private mortgage insurance, mostly through “80-10-10 loans” or other forms of simultaneous second loans. The use of simultaneous second loans increased significantly during recent years to become a competitive alternative to private mortgage insurance, particularly in light of (1) the potential lower monthly cost of simultaneous second loans compared to the cost of mortgage insurance in a low-interest-rate environment and (2) possible negative borrower, broker and realtor perceptions about mortgage insurance;

 

79


Table of Contents
   

investors using other forms of credit enhancement such as credit default swaps or securitizations as a partial or complete substitute for private mortgage insurance; and

 

   

mortgage lenders and other intermediaries foregoing third-party insurance coverage and retaining the full risk of loss on their high-LTV loans.

As a result of the recent turmoil in the housing credit market, many of these alternatives to private mortgage insurance are no longer prevalent in the mortgage market. If market conditions were to change, however, we again would likely face significant competition from these alternatives as well as others that may develop.

Because many of the mortgage loans that we insure are sold to Freddie Mac and Fannie Mae, changes in their charters or business practices could significantly impact our mortgage insurance business.

Freddie Mac’s and Fannie Mae’s charters generally prohibit them from purchasing any mortgage with a loan amount that exceeds 80% of the home’s value, unless that mortgage is insured by a qualified insurer or the mortgage seller retains at least a 10% participation in the loan or agrees to repurchase the loan in the event of a default. As a result, high-LTV mortgages purchased by Freddie Mac or Fannie Mae generally are insured with private mortgage insurance. Freddie Mac and Fannie Mae are the beneficiaries of the majority of our mortgage insurance policies.

Changes in the charters or business practices of Freddie Mac or Fannie Mae could reduce the number of mortgages they purchase that are insured by us and consequently reduce our revenues. Some of Freddie Mac’s and Fannie Mae’s more recent programs require less insurance coverage than they historically have required, and they have the ability to further reduce coverage requirements, which could reduce demand for mortgage insurance and have a material adverse effect on our business, financial condition and operating results. Freddie Mac and Fannie Mae also have the ability to implement new eligibility requirements for mortgage insurers and to alter or liberalize underwriting standards on low-down-payment mortgages they purchase. We cannot predict the extent to which any new requirements may be implemented or how they may affect the operations of our mortgage insurance business, our capital requirements and our products.

Further, both Freddie Mac’s and Fannie Mae’s eligibility requirements for “Type I” mortgage insurers currently require such insurers to maintain an insurer financial strength rating of AA- or Aa3 with the credit ratings agencies that customarily rate them. A downgrade below such levels could have an adverse affect on our ability to continue to do business with Freddie Mac and/or Fannie Mae. While we cannot predict if such eligibility requirements may be waived or altered by Freddie Mac or Fannie Mae in the event of such a downgrade, both Freddie Mac and Fannie Mae have indicated that loss of “Type I” mortgage insurer eligibility due to such a downgrade will no longer be automatic and will be subject to review if and when it occurs.

Freddie Mac’s and Fannie Mae’s business practices may be impacted by their results of operations as well as legislative or regulatory changes governing their operations and the operations of other government-sponsored enterprises. The liquidity provided by Freddie Mac and Fannie Mae to the mortgage industry is very important to support a strong level of mortgage originations. These entities recently have reported losses as a result of deteriorating housing and credit market conditions, which could limit their ability to acquire mortgages. Freddie Mac and Fannie Mae also are currently the subject of proposed legislation that would increase regulatory oversight over them. The proposed legislation encompasses substantially all of their operations and is intended to be a comprehensive overhaul of the existing regulatory structure. In 2007, the House of Representatives passed H.R. 1427, a comprehensive reform of Freddie Mac and Fannie Mae oversight. No companion legislation has been introduced in the Senate as of February 2008. Although we cannot predict whether, or in what form, this legislation will be enacted, the proposed legislation could limit the growth of Freddie Mac and Fannie Mae, which could reduce the size of the mortgage insurance market and consequently have an adverse effect on our business, financial condition and operating results.

As part of the Economic Stimulus Act of 2008, U.S. Congress passed legislation that temporarily raises (until December 31, 2008) loan limits for Freddie Mac and Fannie Mae conforming loans up to a maximum of

 

80


Table of Contents

$729,750. While we believe that this legislative change has the potential to increase the demand for private mortgage insurance by broadening the universe of loans that are subject to purchase by Freddie Mac and Fannie Mae, we cannot predict with any certainty the long term impact of this change upon demand for our products, or whether this change will be made permanent by Congress.

Legislation and regulatory changes and interpretations could harm our mortgage insurance business.

Our business and legal liabilities may be affected by the application of federal or state consumer lending and insurance laws and regulations, or by unfavorable changes in these laws and regulations. For example, legislation has passed both Houses of the U.S. Congress to reform the FHA, which, if enacted, could provide the FHA with greater flexibility in establishing new products and increase the FHA’s competitive position against private mortgage insurers. The legislation includes increases to the maximum loan amount that the FHA can insure and establishes lower minimum downpayments. We do not know whether this proposed legislation, which has passed the House and Senate in different versions, will be enacted, and if enacted what final form the legislation will take. However, as part of the Economic Stimulus Act of 2008, Congress passed legislation that temporarily raises (until December 31, 2008) the loan limits for FHA-insured loans up to a maximum of $729,750. We cannot predict with any certainty the long term impact of this change upon demand for our products, or whether this change will be made permanent by Congress. However, any increase in the competition we face from the FHA or any other government sponsored entities could harm our business, financial condition and operating results.

We and other mortgage insurers have faced private lawsuits alleging, among other things, that our captive reinsurance arrangements constitute unlawful payments to mortgage lenders under the anti-referral fee provisions of RESPA. In addition, we and other mortgage insurers have been subject to inquiries from the New York Insurance Department (“NYID”) relating to our captive reinsurance arrangements. We cannot predict whether the NYID’s inquiry will lead to further inquiries, or investigations, of our captive reinsurance arrangements, or the scope, timing or outcome of the present inquiry or any other inquiry or action by the NYID or other regulators. Although we believe that all of our captive reinsurance arrangements comply with applicable legal requirements, we cannot be certain that we will be able to successfully defend against any alleged violations of RESPA or other laws.

Proposed changes to the application of RESPA could harm our competitive position. HUD proposed an exemption under RESPA for lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all the settlement services associated with the loan, commonly referred to as “bundling.” In 2004, HUD indicated its intention to abandon the proposed rule and to submit a revised proposed rule to the U.S. Congress. HUD began looking at the reform process again in 2005 and there may be a new proposed rule as early as 2008. We do not know what form, if any, the rule will take or whether it will be approved. If bundling is exempted from RESPA, mortgage lenders may have increased leverage over us, and the premiums we are able to charge for mortgage insurance could be negatively affected.

Risks Particular to Our Financial Guaranty Business

Recent adverse developments in the mortgage and other asset-backed credit markets may continue to negatively affect our results of operations.

Our financial guaranty business is exposed to risks associated with the deterioration in the credit markets. Recently, credit spreads across most bond sectors have widened, reflecting credit erosion in U.S. residential mortgage loans, particularly to subprime borrowers, that are contained in the residential mortgage-backed securities and certain of the CDOs that we insure. In addition, credit default swap spreads on CDOs have also widened over concerns regarding the impact a general economic slowdown or recession would have on these obligations. Other asset-backed security sectors have also been affected due to concerns and preliminary indications that the credit erosion in RMBS may spread to other consumer and mortgage asset classes, including CMBS, for which we have written financial guaranty insurance.

 

81


Table of Contents

At December 31, 2007, our insured financial guaranty portfolio included:

 

   

$1,164.6 million of net par outstanding related to non-CDO U.S. RMBS, of which $423.1 million represented our financial guaranty exposure to subprime RMBS exposure; and

 

   

Subprime RMBS exposure through three directly-insured CDOs of ABS with an aggregate net par outstanding of $752.1 million.

As discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” during the third and fourth quarters of 2007, we experienced significant increases in our financial guaranty loss reserves due primarily to a reserve of $100 million, representing our entire exposure, related to one of the three CDOs of ABS that we currently insure and performance deterioration of our insured RMBS transactions. While we have sought to underwrite credits involving RMBS with levels of subordination designed to protect us from loss in the event of poor performance on the underlying collateral, we cannot be certain that such levels of subordination will protect us from future material losses in light of the significantly higher rates of delinquency, foreclosure and losses currently being observed among residential homeowners, especially subprime borrowers. Future underperformance of the collateral underlying our insured RMBS portfolios could result in: (i) additional incurred losses; (ii) an increase in fair value losses on our insured transactions; (iii) downgrades by the rating agencies of our exposures, which could require us to hold additional capital to maintain our current financial strength ratings; and (iv) fewer opportunities to write profitable business in the future.

Deterioration in the credit markets in which we and other financial guarantors participate has negatively impacted our business production. Due to losses incurred by financial guarantors on their RMBS CDOs of ABS and other credit positions, and perceived instability in the franchise values and ratings of many of the financial guarantors, credit and trading spreads for all financial guarantors, including us, have widened significantly, resulting in a material reduction in the financial benefit that our credit protection provides to issuers of both public and structured finance transactions that we insure and a reduced perceived benefit to holders of insured debt from the financial guaranty insurance we provide. As a result, many transactions that would normally have been marketed with some form of financial guaranty insurance protection are either not going to market or are being sold without the benefit of financial guaranty insurance. As a result, there is significant reduction in the volume of transactions for which our financial guaranty insurance is a viable option, particularly in our structured finance business, which makes it more difficult for us to write new business in the current credit environment, and reduces the volume of transactions written by companies that cede business to us.

In addition, the volume of transactions that our structured products business insures or provides credit protection for has dramatically decreased, making it unlikely that the volume of structured products transactions that we will insure in 2008 and possibly beyond will continue at historic levels. The types of transactions available for us to insure may be materially different from what has been available to us in prior years, and we may need to realign our structured finance business to meet the opportunities that are available, which we may be able to do in a profitable manner.

Our financial guaranty business may subject us to significant risks from the failure of a single company, municipality or other entity whose obligations we have insured.

The breadth of our financial guaranty business exposes us to potential losses in a variety of our products as a result of credit problems with one counterparty. For example, we could be exposed to an individual corporate credit risk in multiple transactions if the credit is contained in multiple portfolios of CDOs that we have insured, or if one counterparty (or its affiliates) acts as the originator or servicer of the underlying assets or loans backing any of the structured securities that we have insured. Although we track our aggregate exposure to single counterparties in our various lines of business and have established underwriting criteria to manage aggregate risk from a single counterparty, we cannot be certain that our ultimate exposure to a single counterparty will not exceed our underwriting guidelines, due to merger or otherwise, or that an event with respect to a single

 

82


Table of Contents

counterparty will not cause a significant loss in one or more of the transactions in which we face risk to such counterparty. In addition, because we insure and reinsure municipal obligations, we can have significant exposures to individual municipal entities, directly or indirectly through explicit or implicit support of related entities. Even though we believe that the risk of a complete loss on some municipal obligations generally is lower than for corporate credits because some municipal bonds are backed by taxes or other pledged revenues, a single default by a municipality could have a significant impact on our liquidity or could result in a large or even complete loss that could have a material adverse effect on our business, financial condition and operating results.

Our financial guaranty business is concentrated among relatively few significant customers, meaning that our revenues could decline if we lose any significant customer.

Our financial guaranty business derives a significant percentage of its annual gross premiums from a small number of customers. A loss of business from even one of our significant customers could have a material adverse effect on our business, financial condition and operating results. Our largest single customer in terms of premiums written for our financial guaranty business accounted for almost 21% of the premiums written by our financial guaranty business in 2007.

Some of our financial guaranty products are riskier than traditional guaranties of public finance obligations.

In addition to the traditional guaranties of public finance bonds, we write guaranties involving structured finance obligations that expose us to a variety of complex credit risks and indirectly to market, political and other risks beyond those that generally apply to financial guaranties of public finance obligations. We issue financial guaranties connected with certain asset-backed transactions and securitizations secured by one or a few classes of assets, such as residential mortgages, auto loans and leases, credit card receivables and other consumer assets, obligations under credit default swaps, both funded and synthetic, and in the past have issued financial guaranties covering utility mortgage bonds and multi-family housing bonds. We also have exposure to trade credit reinsurance (which is currently in run-off), which protects sellers of goods under certain circumstances against nonpayment of their accounts receivable. These guaranties expose us to the risk of buyer nonpayment, which could be triggered by many factors, including the failure of a buyer’s business. These guaranties may cover receivables where the buyer and seller are in the same country as well as cross-border receivables. In the case of cross-border transactions, we sometimes grant coverage that effectively provides coverage of losses that could result from political risks, such as foreign currency controls and expropriation, which could interfere with the payment from the buyer. Losses associated with these non-public finance financial guaranty products are difficult to predict accurately, and a failure to properly anticipate those losses could have a material adverse effect on our business, financial condition and operating results.

We may be forced to reinsure greater risks than we desire due to adverse selection by ceding companies.

A portion of our financial guaranty reinsurance business is written under treaties that generally give the ceding company some ability to select the risks that they cede to us within the terms of the treaty. In current market conditions, many of our ceding companies are looking to cede a large percentage of their risks. There is a risk under these treaties that the ceding companies will decide to cede to us exposures that have higher rating agency capital charges or that the ceding companies expect to be less profitable, which could have a material adverse effect on our business, financial condition and operating results. We attempt to mitigate this risk in a number of ways, including requiring ceding companies to retain a specified minimum percentage on a pro-rata basis of the ceded business and to limit the types of exposures that we will allow the ceding companies to cede to us without our approval. However, we cannot be certain that these mitigation attempts will succeed in limiting the amount of less desirable exposures that are ceded to us under our treaties.

Variations in credit spreads may decrease demand for our credit enhancement and reduce opportunities for us to write profitable business.

Our financial guaranty business is significantly influenced by credit spreads that are set by market factors, over which we have little or no control. Our insurance generally provides value by lowering an issuer’s cost of

 

83


Table of Contents

borrowing, by providing capital relief to an issuer or by improving on the market execution of an insured security. The difference or “credit spread” between the actual or anticipated benefit of credit enhancement, which may be influenced by a number of factors such as credit performance, the perceived financial strength of the insurer, market liquidity and an investor’s willingness to take on risk. The cost of credit enhancement relative to the “credit spread” is a significant factor in an issuer’s determination of whether to seek credit enhancement. As credit spreads tighten—or the cost of our insurance increases vis-à-vis the perceived market benefits of such insurance—the likelihood that issuers will choose to forego credit enhancement increases. This credit spread tightening can result from either a reduction in the credit spread applicable to the issuer or issuance or, as is currently occurring in the credit markets in which we participate, an increase in the credit spread applicable to our insurance due to the perceived uncertainty regarding the value of financial guaranty insurance and the franchise value of financial guarantors. As a result, notwithstanding the widening of credit spreads for issuers, we have experienced fewer opportunities to write profitable business in our financial guaranty business as well as increased competition among insurers for the limited opportunities that are available to us. If tight credit spreads continue to persist or if spreads further tighten, we may experience limited or no opportunities to write profitable business in these businesses, which would have an adverse affect on our business, financial condition and operating results.

Our financial guaranty business faces intense competition.

The financial guaranty industry is highly competitive. The principal sources of direct and indirect competition are:

 

   

other financial guaranty insurance companies, including some of which that have recently been downgraded from triple-A to ratings equal to or lower than our ratings from the rating agencies, which may revise their business plans to compete more directly against us for the transactions we currently insure;

 

   

derivative products companies, some of which may have higher ratings than we do and/or may have lower capital requirements for the transactions that we insure;

 

   

multiline insurers that have increased their participation in financial guaranty reinsurance, some of which have formed strategic alliances with some of the U.S. primary financial guaranty insurers;

 

   

other forms of credit enhancement, including letters of credit, guaranties and credit default swaps provided in most cases by foreign and domestic banks and other financial institutions, some of which are governmental enterprises, that have been assigned the highest ratings awarded by one or more of the major rating agencies or have agreed to post collateral to support their risk position;

 

   

alternate transaction structures that permit issuers to securitize assets more cost-effectively without the need for credit enhancement of the types we provide; and

 

   

cash-rich investors seeking additional yield on their investments by foregoing credit enhancement.

Competition in the financial guaranty reinsurance business is based on many factors, including overall financial strength, financial strength ratings, credit spreads, perceived financial strength, perceived benefit of the credit protection being provided, pricing and service. The rating agencies allow credit to a ceding company’s capital requirements and single risk limits for reinsurance that is ceded. The amount of this credit is in part determined by the financial strength rating of the reinsurer. Some of our competitors have greater financial resources than we have and are better capitalized than we are and/or have been assigned higher ratings by one or more of the major rating agencies. In addition, the rating agencies could change the level of credit they will allow a ceding company to take for amounts ceded to us and/or similarly rated reinsurers.

In 2004, the laws applicable to New York-domiciled monoline financial guarantors were amended to permit them to use certain default swaps meeting applicable requirements as statutory collateral (i.e., to offset their statutory single risk limits, aggregate risk limits, aggregate net liability calculations and contingency reserve

 

84


Table of Contents

requirements). This regulatory change, which makes credit default swaps a more attractive alternative to traditional financial guaranty reinsurance, could result in a reduced demand for traditional monoline financial guaranty reinsurance in the future. An inability to compete for desirable financial guaranty business could have a material adverse effect on our business, financial condition and operating results.

Legislation and regulatory changes and interpretations could harm our financial guaranty business.

The laws and regulations affecting the municipal, asset-backed and trade credit debt markets, as well as other governmental regulations, may be changed in ways that subject us to additional legal liability or affect the demand for the primary financial guaranty insurance and reinsurance that we provide. Due to current market disruptions in the financial guaranty business, our regulators are reviewing the laws, rules and regulations applicable to financial guarantors. It is possible that these reviews could result in additional limitations in our ability to conduct our financial guaranty business, including additional restrictions and limitations on our ability to declare dividends or more stringent statutory capital requirements for all or certain segments of our financial guaranty businesses, restrictions and limitations on the types of obligations that we are able to insure (such as limiting the asset classes we may insure, restricting our ability to insure credit default swaps or other synthetic forms of execution or limiting the size of the transactions we may insure for a given level of capital). In addition, the New York Insurance Department and the Governor of the State of New York have proposed permitting monoline financial guaranty insurance companies to split into multiple companies based on the type of obligation each resulting company will insure in the future (e.g., public finance vs. structured finance transactions). Any of these changes could have a material adverse effect on our business, financial condition and operating results.

Changes in tax laws could reduce the demand for or profitability of financial guaranty insurance, which could harm our business.

Any material change in the U.S. tax treatment of municipal securities, or the imposition of a “flat tax” or a national sales tax in lieu of the current federal income tax structure in the U.S., could adversely affect the market for municipal obligations and, consequently, reduce the demand for related financial guaranty insurance and reinsurance. For example, the Jobs and Growth Tax Relief Reconciliation Act of 2003, enacted in May 2003, significantly reduced the federal income tax rate for individuals on dividends and long-term capital gains. This tax change may reduce demand for municipal obligations and, in turn, may reduce the demand for financial guaranty insurance and reinsurance of these obligations by increasing the comparative yield on dividend-paying equity securities. Future potential changes in U.S. tax laws, including current efforts to eliminate the federal income tax on dividends, might also affect demand for municipal obligations and for financial guaranty insurance and reinsurance of those obligations.

We may be unable to develop or sustain our financial guaranty business if we were required, but were unable, to obtain reinsurance or other forms of capital.

In order to comply with regulatory, rating agency and internal capital and single risk retention limits as our financial guaranty business grows, we may in the future need access to sufficient reinsurance or other capital capacity to continue to underwrite transactions. The market for reinsurance recently has become more concentrated because several participants have exited the industry. If we are unable to obtain sufficient reinsurance or other forms of capital, we may be unable to issue new policies and grow our financial guaranty business. This could have a material adverse effect on our business, financial condition and operating results.

 

Item 1B. Unresolved Staff Comments.

None.

 

85


Table of Contents
Item 2. Properties.

At our corporate headquarters in Philadelphia, Pennsylvania, we lease approximately 163,031 square feet of office space under a lease that expires in August 2017. In addition, we also lease the following:

 

   

18,962 square feet of office space (3,813 square feet of which is subleased) for our mortgage insurance regional offices, service centers and on-site offices throughout the U.S. The leases for this space expire between 2009 and 2012;

 

   

Approximately 121,000 square feet of office space (approximately 55,000 square feet of which we sublease to others, including 28,386 square feet subleased to C-BASS and 2,616 square feet subleased to Sherman) for our financial guaranty operations in New York City. The lease for this space expires in 2015;

 

   

Approximately 6,600 square feet of office space for our international financial guaranty operations in London. The lease for this space expires in 2012;

 

   

Approximately 500 square feet of office space for our mortgage insurance operations in Hong Kong. The lease for this space expires in 2009;

 

   

Approximately 500 square feet of office space for our Australian operations in Sydney, Australia. The lease for this space expires in March 2008, and we have no present plans to renew this lease;

 

   

4,786 square feet of office space in Boca Raton, Florida for other operations. The lease for this space expires in 2012; and

 

   

15,269 square feet and 27,360 square feet of office space for our data centers in Philadelphia, Pennsylvania and Dayton, Ohio, respectively. The leases for these offices expire in August 2015 (Philadelphia) and September 2012 (Dayton). Under the Dayton lease, we have an early termination option that can be exercised anytime after April 2007, upon 90 days notice.

We believe we will be able to obtain satisfactory lease renewal terms, as necessary, with respect to all of our facilities. We believe our existing properties are well utilized, suitable and adequate for our present circumstances.

Our two data centers (Dayton and Philadelphia) serve as one another’s disaster recovery sites and support all of our businesses. In addition, we have established business continuity recovery plans for our offices in London, New York and Philadelphia.

 

86


Table of Contents
Item 3. Legal Proceedings.

In August and September 2007, two purported stockholder class action lawsuits, Cortese v. Radian Group Inc. and Maslar v. Radian Group Inc., were filed against Radian Group Inc. and individual defendants in the U.S. District Court for the Eastern District of Pennsylvania. The complaints, which are substantially similar, allege that we were aware of and failed to disclose the actual financial condition of C-BASS prior to our declaration of a material impairment to our investment in C-BASS. On January 30, 2008, the Court ordered that the cases be consolidated into In re Radian Securities Litigation and appointed the Institutional Investors Iron Workers Local No. 25 Pension Fund (“Iron Workers”) and the City of Ann Arbor Employees’ Retirement System (“Ann Arbor”) Lead Plaintiffs in the case. Iron Workers and Ann Arbor are represented by the law firm of Coughlin Stoia Geller Rudman & Robbins LLP, which has been appointed Lead Counsel, and the Law Offices of Bernard M. Gross, which has been appointed Liaison Counsel. A consolidated complaint is due to be filed by March 17, 2008. While it is still very early in the pleadings stage, we do not believe that the allegations in the consolidated cases have any merit; and we intend to defend against this action vigorously.

In addition to the above litigation, we are involved in litigation that has arisen in the normal course of our business. We are contesting the allegations in each such pending action and believe, based on current knowledge and after consultation with counsel, that the outcome of such litigation will not have a material adverse effect on our consolidated financial position and results of operations.

On October 3, 2007, we received a letter from the staff of the Chicago Regional Office of the Securities Exchange Commission stating that the staff is conducting an investigation involving Radian Group Inc. and requesting production of certain documents. We believe that the investigation generally relates to our proposed merger with MGIC and our investment in C-BASS. We are cooperating with the requests of the SEC. The SEC staff has informed us that this investigation should not be construed as an indication by the SEC or its staff that any violation of the securities laws has occurred, or as a reflection upon any person, entity or security.

 

Item 4. Submission of Matters to a Vote of Security Holders.

None.

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “RDN.” At March 6, 2008, there were 80,460,406 shares outstanding and approximately 87 holders of record. The following table shows the high and low sales prices of our common stock on the NYSE for the financial quarters indicated:

 

     2007    2006
     High    Low    High    Low

1st Quarter

   $ 67.35    $ 53.17    $ 61.41    $ 54.53

2nd Quarter

     63.95      50.82      65.80      57.68

3rd Quarter

     55.40      15.20      65.18      57.95

4th Quarter

     25.99      8.15      62.08      51.61

We declared cash dividends on our common stock equal to $0.02 per share in each quarter of 2007 and 2006. As a holding company, we depend mainly upon our subsidiaries’ ability to transfer funds to us in order to pay dividends. The payment of dividends and other distributions to us by our insurance subsidiaries is limited by insurance rules and regulations. For more information on our ability to pay dividends, see “Management’s

 

87


Table of Contents

Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” and Note 10 of Notes to Consolidated Financial Statements.

The following table provides information about repurchases by us during the quarter ended December 31, 2007, of equity securities that are registered by us pursuant to Section 12 of the Exchange Act of 1934, as amended:

Issuer Purchases of Equity Securities

 

Period

   Total Number of
Shares Purchased
   Average Price Paid
per Share
   Total Number of
Shares Purchased
as Part of Publicly
Announced Plans
or Programs (1)
   Maximum Number of
Shares that May Yet
Be Purchased Under
the Plans or
Programs (2)

10/01/07 to 10/31/07

   —      $ —      —      1,101,355

11/01/07 to 11/30/07

   —        —      —      1,101,355

12/01/07 to 12/31/07

   —        —      —      1,101,355
                 

Total

               —      $ —                  —      1,101,355

 

(1) On February 8, 2006, we announced that our board of directors had authorized the repurchase of up to 4.0 million shares of our common stock on the open market under a new repurchase plan. On November 9, 2006, we announced that our board of directors had authorized the purchase of an additional 2.0 million shares as part of an expansion of the existing stock repurchase program. Stock purchases under this program are funded from available working capital and are made from time to time, depending on market conditions, stock price and other factors. The board did not set an expiration date for this program.
(2) Amounts shown in this column reflect the number of shares remaining under the 4.0 million share authorization and, effective November 9, 2006, the additional 2.0 million share authorization referenced in Note 1 above.

 

88


Table of Contents
Item 6. Selected Financial Data.

The following table sets forth our selected financial data. This information should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the information included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

     2007     2006     2005     2004     2003  
     (In millions, except per-share amounts and ratios)  

Condensed Consolidated Statements of Income

          

Net premiums written

   $ 1,184.9     $ 1,112.0     $ 1,100.7     $ 1,082.5     $ 1,110.5  
                                        

Net premiums earned—insurance

   $ 912.3     $ 907.0     $ 917.1     $ 918.5     $ 917.8  

Net premiums earned—credit derivatives

     126.3       108.8       101.6       111.0       90.4  

Net premiums earned—total

     1,038.6       1,015.8       1,018.7       1,029.5       1,008.2  

Net investment income

     256.1       234.3       208.4       204.3       186.2  

Net gains on securities

     53.6       40.8       36.6       50.8       17.4  

Change in fair value of derivative instruments

     (1,340.7 )     16.1       9.2       47.1       4.1  

Gain on sale of affiliates

     181.7       —         —         —         —    

Other income

     11.7       20.9       25.2       32.3       63.3  

Total revenues

     201.0       1,327.9       1,298.1       1,364.0       1,279.2  

Provision for losses

     1,299.4       369.3       390.6       456.8       476.1  

Provision for second-lien premium deficiency

     195.6       —         —         —         —    

Policy acquisition costs

     113.2       111.6       115.9       121.8       128.5  

Other operating expenses

     192.2       242.6       226.0       205.7       211.1  

Interest expense

     53.0       48.1       43.0       34.7       37.5  

Equity in net (loss) income of affiliates

     (416.5 )     257.0       217.7       180.6       105.5  

Pretax (loss) income

     (2,068.9 )     813.3       740.3       725.6       531.5  

Net (loss) income

     (1,290.3 )     582.2       522.9       518.7       385.9  

Diluted net (loss) income per share (1)

   $ (16.22 )   $ 7.08     $ 5.91     $ 5.33     $ 3.95  

Cash dividends declared per share

   $ .08     $ .08     $ .08     $ .08     $ .08  

Average shares outstanding-diluted

     79.5       82.3       88.7       97.9       98.5  

Condensed Consolidated Balance Sheets

          

Total assets

   $ 8,210.2     $ 7,960.4 (5)   $ 7,230.6     $ 7,000.8     $ 6,445.8  

Total investments

     6,411.0       5,745.3       5,513.7       5,470.1       5,007.4  

Unearned premiums

     1,094.7       943.7       849.4       770.2       718.6  

Reserve for losses and loss adjustment expenses

     1,598.8       842.3       801.0       801.0       790.4  

Second-lien premium deficiency

     195.6       —         —         —         —    

Long-term debt and other borrowings

     948.1       747.8       747.5       717.6       717.4  

Derivative liabilities

     1,305.7       31.7       —         —         —    

Stockholders’ equity

     2,720.7       4,067.6       3,662.9       3,689.1       3,225.8  

Book value per share

   $ 33.83     $ 51.23     $ 44.11     $ 39.98     $ 34.31  

Selected Ratios—Mortgage Insurance (2)

          

Loss ratio

     142.4 %     42.9 %     44.5 %     49.2 %     40.7 %

Expense ratio

     23.5       29.2       26.7       26.6       25.8  
                                        

Combined ratio

     165.9 %     72.1 %     71.2 %     75.8 %     66.5 %

Selected Ratios—Financial Guaranty (2)

          

Loss ratio

     50.2 %     10.1 %     14.9 %     26.0 %     67.1 %

Expense ratio

     48.2       52.2       55.7       45.9       38.8  
                                        

Combined ratio

     98.4 %     62.3 %     70.6 %     71.9 %     105.9 %

Other Data—Mortgage Insurance

          

Primary new insurance written

   $ 57,132     $ 40,117     $ 42,592     $ 44,820     $ 68,362  

Direct primary insurance in force

     143,066       113,903       109,684       115,315       119,887  

Direct primary risk in force

     31,622       25,311       25,729       27,012       27,106  

Total pool risk in force

     3,004       2,991       2,711       2,384       2,415  

Total other risk in force (3)

     10,511       10,322       9,709       1,205       1,053  

Persistency (twelve months ended)

     75.4 %     67.3 %     58.2 %     58.8 %     46.7 %

 

89


Table of Contents
     2007    2006    2005    2004    2003
     (In millions, except per-share amounts and ratios)

Other Data—Financial Guaranty (4)

              

Net premiums written

   $ 230    $ 263    $ 223    $ 216    $ 369

Net premiums earned

     195      204      212      214      249

Net par outstanding

     116,022      103,966      76,652      66,720      76,997

Net debt service outstanding

     164,347      143,728      110,344      101,620      117,900

 

(1) Diluted net income per share and average share information in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share.” Amounts reflect the inclusion of shares underlying contingently convertible debt, which was redeemed on August 1, 2005. See Note 21 of Notes to Consolidated Financial Statements.
(2) Calculated on a GAAP basis using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses, excluding merger expenses, to calculate the expense ratio as a percentage of net premiums earned.
(3) Consists mostly of international insurance risk, second-lien mortgage insurance risk and other structured mortgage-related insurance risk.
(4) Reflects the 2004 and 2005 recaptures of previously ceded business.
(5) Total assets as of December 31, 2006, have been adjusted for amounts previously reported in other assets. See Note 2 of Notes to Consolidated Financial Statements.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the Risk Factors detailed in Item 1A of Part I of this report.

Business Summary

Overview

Our business segments are mortgage insurance, financial guaranty and financial services. The following table shows the percentage of our equity allocated to each business segment at December 31, 2007:

 

     Equity  

Mortgage Insurance

   58 %

Financial Guaranty

   37 %

Financial Services

   5 %

Mortgage Insurance

Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions located throughout the U.S. and select countries outside the U.S. We provide these products and services primarily through our wholly-owned subsidiaries, Radian Guaranty Inc., Amerin Guaranty Corporation, and Radian Insurance Inc. (which we refer to as “Radian Guaranty,” “Amerin Guaranty,” and “Radian Insurance,” respectively). Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made mostly to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to Freddie Mac and Federal National Mortgage Association (“Fannie Mae”). We sometimes refer to Freddie Mac and Fannie Mae as “Government Sponsored Enterprises” or “GSEs”.

Traditional Mortgage Insurance. Our mortgage insurance segment, through Radian Guaranty, offers primary and pool mortgage insurance coverage on residential first-lien mortgages. At December 31, 2007, primary insurance on domestic first-lien mortgages made up approximately 91% of our total domestic first-lien mortgage insurance risk in force, and pool insurance on domestic first-lien mortgages made up approximately 9% of our total domestic first-lien mortgage insurance risk in force.

 

90


Table of Contents

Non-traditional Mortgage Credit Enhancement. We used Radian Insurance to provide credit enhancement for mortgage-related capital market transactions and to write credit insurance on mortgage-related assets, including net interest margin securities (“NIMS”), international insurance and reinsurance transactions, second-lien mortgages, home equity loans and credit default swaps (collectively, we refer to the risk associated with these transactions as “other risk”). We also insured second-lien mortgages through Amerin Guaranty. We are no longer writing insurance on NIMS, second-lien mortgages or credit default swap business.

International Mortgage Insurance. We recently cancelled the authorization of Radian Europe Limited (“Radian Europe”) to engage in the business of insurance in the United Kingdom and other European Union member states. No business had been written by Radian Europe. The capital held by Radian Europe was distributed back to Radian Guaranty in the fourth quarter of 2007. We have written our existing international mortgage insurance business through Radian Insurance. On February 26, 2008, S&P downgraded Radian Insurance from AA- to A-. Radian Insurance had eight active international transactions at the time of the S&P downgrade. Of these transactions, five have early termination clauses that were triggered as a result of the downgrade which allow our counterparties to terminate these transactions. On March 4, 2008, Standard Chartered Bank in Hong Kong informed us that they wished to terminate their contract with Radian Insurance, effective immediately. While we still are in the process of assessing the validity of the notice and the potential impact of termination, there is a possibility that Radian Insurance could be required to return to Standard Chartered Bank, or to transfer to another insurer, unearned premium related to this transaction. Unless extended, this transaction was expected to expire at the end of 2009. If the remaining four transactions also are terminated, we could be required to return or transfer to another insurer additional unearned premiums. We believe the S&P downgrade will make it difficult for us to continue to write international mortgage insurance business through Radian Insurance, and we are in the process of exploring other alternatives for writing such business.

Financial Guaranty

Our financial guaranty segment mainly insures and reinsures credit-based risks. Financial guaranty insurance typically provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due.

Our financial guaranty segment offers the following products:

 

   

Public Finance. Insurance of public finance obligations, including tax-exempt and taxable indebtedness of states, counties, cities, special service districts, other political subdivisions and tribal finance and for enterprises such as airports, public and private higher education and health care facilities, project finance and private finance initiative assets in sectors such as schools, healthcare and infrastructure projects. The issuers of public finance obligations we insure are typically rated investment-grade without the benefit of our insurance;

 

   

Structured Finance. Insurance of structured finance obligations, including collateralized debt obligations (“CDOs”) and asset-backed securities (“ABS”), consisting of funded and non-funded (“synthetic”) obligations that are payable from or tied to the performance of a specific pool of assets. Examples of the pools of assets that underlie structured finance obligations include corporate loans and bonds, residential and commercial mortgages, a variety of consumer loans, equipment receivables and real and personal property leases. The structured finance obligations we insure are generally rated investment-grade at the time we issue our insurance policy, without the benefit of our insurance;

 

   

Financial Solutions. Financial solutions products (which we include as part of our structured finance business), including guaranties of securities exchange clearinghouses, excess-Securities Investor Protection Corporation (“SIPC”) insurance for customers of brokerage firms and excess-Federal Deposit Insurance Corporation (“FDIC”) insurance for customers of banks; and

 

   

Reinsurance. Reinsurance of domestic and international public finance obligations, including those issued by sovereign and sub-sovereign entities, as well as reinsurance of structured finance and financial solutions obligations.

 

91


Table of Contents

In October 2005, we exited the trade credit reinsurance line of business. Accordingly, this line of business has been placed into run-off and we have ceased initiating new trade credit reinsurance contracts.

We provide these products and services mainly through Radian Asset Assurance Inc., our principal financial guaranty subsidiary (“Radian Asset Assurance”) and through Radian Asset Assurance Limited (“RAAL”), an insurance subsidiary of Radian Asset Assurance authorized to conduct financial guaranty business in the United Kingdom and, subject to compliance with the European passporting rules, other European Union jurisdictions.

International Financial Guaranty Insurance. RAAL accounted for $14.4 million (or 12.0%) of financial guaranty’s direct premiums written in 2007, compared to $9.2 million (or 5.8%) of financial guaranty’s direct premiums written in 2006.

Financial Services

Our financial services segment includes the credit-based businesses conducted through our affiliates, Credit-Based Asset Servicing and Securitization LLC (“C-BASS”) and Sherman Financial Group LLC (“Sherman”). We currently hold a 46% equity interest in C-BASS and a 21.8% equity interest in Sherman.

C-BASS

C-BASS is an unconsolidated, less than 50%-owned investment that is not controlled by us. We and MGIC Investment Corporation (“MGIC”) each own 46% of C-BASS, with the remaining interests owned by the management of C-BASS. Historically, C-BASS has been principally engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages.

Beginning in February 2007 and continuing through approximately the end of March 2007, the subprime mortgage market experienced significant turmoil. After a period of relative stability that persisted during April, May and through approximately late June, market dislocations recurred and then accelerated to unprecedented levels beginning in approximately mid-July 2007. During the five month period from February 1, 2007 through June 30, 2007, C-BASS’s financial statements included the payment of approximately $290.3 million to satisfy lenders’ margin calls on loans to C-BASS, which it handled with its available liquidity.

Third Quarter Impairment. During the third quarter there were several events that significantly impacted C-BASS. Those events included the following:

 

   

On July 17, 2007, C-BASS completed its acquisition of Fieldstone Investment Corporation (“Fieldstone”), a mortgage banking company that originated, sold, and invested primarily in non-conforming single family residential mortgage loans, for approximately $187 million, including closing costs. C-BASS used approximately $90 million in cash to fund this acquisition.

 

   

On July 19, 2007, in order to support C-BASS’s liquidity position, we and MGIC, each entered into a $50 million unsecured revolving credit facility agreement with C-BASS that is payable on demand and was scheduled to expire December 31, 2007.

 

   

On July 20 and 23, 2007, C-BASS drew down the entire $50 million on each facility ($100 million in total.)

 

   

On July 26 and 27, 2007, C-BASS received approximately $200 million in margin calls bringing the total margin calls for the month to $362.7 million. As of the close of business on July 27th, C-BASS had paid only $263.5 million of the $362.7 million in outstanding margin calls. As a result of margin calls from lenders that C-BASS had not been able to meet, C-BASS’s purchases of mortgages and mortgage securities and its securitization activities ceased.

 

   

Prior to July 29, 2007, a number of qualified buyers showed a strong interest in C-BASS, and both we and MGIC received multiple preliminary indications of interest above C-BASS’s book value. Due diligence was ongoing until July 29, 2007 when the increase in margin calls over the prior few days significantly jeopardized C-BASS’s liquidity position, resulting in a withdrawal of all interested buyers at that time.

 

92


Table of Contents

On July 29, 2007, we concluded that there were indicators that a material charge for impairment of our investment in C-BASS was required under accounting principles generally accepted in the United States of America (“GAAP”); however, we could not determine the amount, or range of amounts, of the potential impairment until financial information was received from C-BASS. In November 2007, we received financial statements from C-BASS as of September 30, 2007, at which point we made a final determination with respect to impairment.

On July 30, 2007, in accordance with the terms of our credit facility with C-BASS, we demanded full and immediate payment of all amounts owed to us under the credit facility. This amount currently remains outstanding. Amounts drawn under this facility bear interest at a rate of one-month London Interbank Offered Rate (“LIBOR”) at the date the amount is drawn plus 2.875%. If the loan is called for payment, but remains unpaid as currently is the case, the facility bears interest at LIBOR plus 6.875%. In addition, a 0.375% facility fee is payable to us and MGIC.

Sale of Litton Loan Servicing LP (“Litton”). Since July 31, 2007, with the cooperation of its lenders, including us and MGIC, C-BASS has been working with its financial advisor and potential investors, to evaluate strategic alternatives for securing additional liquidity. As a result of that process, on September 27, 2007, C-BASS agreed to sell to Goldman Sachs substantially all of its interest in Litton for approximately $430 million in order to avoid bankruptcy. As a condition to this sale, on November 16, 2007, the C-BASS employees, lenders and creditors, including us, entered into an agreement (the “Override Agreement”) establishing (i) the terms for the distribution of the consideration from the sale, among all interested parties and (ii) an agreement among the outstanding lenders and creditors to continue to forebear from exercising any recourse rights under their existing obligations with C-BASS. There are certain agreements and covenants contained in the Override Agreement and to the extent C-BASS were to breach one of those agreements or covenants, C-BASS may have to seek bankruptcy protection.

In December 2007, C-BASS completed the sale of Litton to Goldman Sachs. In connection with this sale, Goldman Sachs also paid a nominal amount for the option to purchase from the current owners of C-BASS, including us, 45% of the equity of C-BASS for approximately $5 million. We estimated that this option had a fair value of $0 at December 31, 2007.

We account for our investment in C-BASS under the equity method of accounting in accordance with Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (“APB Opinion No. 18”). During the third quarter of 2007, C-BASS incurred a loss of $935 million and in accordance with APB Opinion No. 18, we recognized our portion of losses of approximately $441 million. This resulted in a reduction in our equity investment in C-BASS from $468 million to $27 million at September 30, 2007. In addition to the recognition of losses, we completed an impairment analysis which resulted in the charge-off of the remaining carrying value of $27 million in the equity investment in C-BASS at September 30, 2007.

Emerging Issues Task Force (“EITF”) No. 98-13, “Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee” (“EITF No. 98-13”), requires that when the recognition of equity losses reduces our equity investment to zero, we should continue to report our share of equity method losses in our income statement and should apply those equity method losses to our other investments in or loans to C-BASS. During the fourth quarter, operating results at C-BASS were negative due to a continuation of valuation reductions in their whole loan and securities portfolio. As a result of the additional losses at C-BASS, and continued application of APB Opinion No. 18 and EITF No. 98-13, we recorded a full write-off of our $50 million credit facility as of December 31, 2007. The ultimate collectibility of this facility is uncertain.

Sherman

Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets that it generally purchases at deep discounts from national financial institutions and major retail

 

93


Table of Contents

corporations and subsequently seeks to collect. In addition, Sherman originates credit card receivables through its subsidiary CreditOne and has a variety of other similar ventures related to consumer assets.

On September 19, 2007, we sold to Sherman Capital, L.L.C. (“Sherman Capital”), an entity owned by the management of Sherman: (1) all of our preferred interests in Sherman and (2) 1,672,547 Class A Common Units in Sherman, representing approximately 43.4% of our total common interests in Sherman, for a cash purchase price of approximately $277.6 million, plus a future contingent payment. The amount of the contingent payment, if any, will depend on the extent that Sherman Capital’s after-tax return on 1,425,335 of the Class A Common Units acquired in the transaction exceeds approximately 16% annually. The contingent payment is payable to us on December 31, 2013 or earlier upon the closing of a sale of Sherman. We recorded a gain of $181.7 million on the sale of our interest in Sherman.

On September 19, 2007, in connection with the sale of a portion of our equity interests in Sherman, we entered into an Option Agreement with Meeting Street Investments LLC (“MS LLC”), an entity owned by Sherman’s management. Under the Option Agreement, we granted to MS LLC an irrevocable option (the “Call Option”) to require us to sell to MS LLC all of our remaining interests in Sherman at any time during the one year period following September 19, 2007. The purchase price under the Call Option, if exercised, will be equal to: (1) the product of (a) our ownership percentage in Sherman as of the date of sale under the Option Agreement and (b) $1.5 billion, minus (2) 50% of all future distributions made by Sherman with respect to our remaining interests in Sherman through the date of sale under the Option Agreement. We estimated that this call option had a fair value of $0 at December 31, 2007.

Termination of Merger with MGIC Investment Corporation (“MGIC”)

On February 6, 2007, we and MGIC entered into an Agreement and Plan of Merger pursuant to which we agreed, subject to the terms and conditions of the merger agreement, to merge with and into MGIC, with the combined company to be re-named MGIC Radian Financial Group Inc.

On September 4, 2007, facing market conditions that had made combining the companies significantly more challenging, we and MGIC entered into a Termination and Release Agreement relating to the Agreement and Plan of Merger. As a result of this agreement, we and MGIC terminated the Agreement and Plan of Merger, abandoned the merger contemplated by the merger agreement and released each other from related claims. Neither party made a payment to the other in connection with the termination.

Overview of Business Results

As a holder of credit risk, our results are subject to macroeconomic conditions and specific events that impact the production environment and credit performance of our underlying insured assets. The current mortgage cycle, characterized by declining home prices in certain markets, deteriorating credit performance of mortgage assets—particularly Alternative A (“Alt-A”) and subprime—and reduced liquidity for many participants in the mortgage industry, has had, and we believe will continue to have, a significant impact on the results of operations for each of our business segments.

Mortgage Insurance

During 2007, the current housing and credit cycle resulted in significant losses in our traditional mortgage insurance business, as well as in certain non-traditional mortgage insurance products—NIMS, second-lien mortgages and mortgage-backed securities—that we insure.

Traditional Mortgage Insurance. Our traditional mortgage insurance business experienced increasingly poor financial results during the second half of 2007. We experienced an accelerating trend of higher delinquencies in

 

94


Table of Contents

the second half of 2007, primarily driven by the poor performance of the late 2005 through 2007 vintage books of business, a lack of refinance capacity in the current mortgage market, which has been forcing many borrowers, in particular those with adjustable rate mortgages (“ARMs”), into default, and from home price depreciation in many parts of the U.S. While losses generally have increased across all mortgage insurance product lines, a disproportionate percentage of our increased losses are attributable to Alt-A mortgages. Markets in California and Florida, where the Alt-A product and ARMs are prevalent, continue to have a significant negative impact on our mortgage insurance business results. Approximately 37% of the total increase in our mortgage insurance loss reserves during 2007 was attributable to these states, which together represent approximately 18% of our mortgage insurance risk in force.

In addition to the increase in new delinquencies during 2007, our mortgage insurance loss provision at December 31, 2007, when compared to December 31, 2006, was negatively impacted by higher loan balances on delinquent loans, higher rates of delinquencies moving into claim status (referred to as the “claim rate”), a decrease in the cure rate of defaults and an increase in claims paid. During 2007, an increase in both the claim rate and the amount that we will pay if a default becomes a claim (referred to as “claim severity”) resulted in incremental increases in our mortgage insurance loss reserves throughout the year. In addition, we refined our loss reserving methodology in the fourth quarter of 2007 to assume that the deteriorating trends in mortgage insurance claim rates will continue for the next three successive quarters. We believe this assumption is necessary to further align our claim rate expectations with our expectations for continuing home price depreciation, a lack of available credit for many borrowers seeking to refinance and a deficiency in underwriting standards on a portion of the 2005 through 2007 vintage mortgage production, each of which will make it more likely that existing defaults will ultimately result in a claim. This change increased our loss reserves for first-lien mortgages by an additional $136.4 million in the fourth quarter of 2007.

We expect to pay total mortgage insurance claims (including second-liens) of approximately $200 million in the first quarter of 2008 and approximately $1 billion in total in 2008. While we and the mortgage lenders have recently tightened our underwriting guidelines considerably, the early performance of business written in 2006 and much of 2007 has been poor, providing early evidence that this business will likely be unprofitable. Until these books of business have sufficiently seasoned, we expect to continue to experience poor results in our traditional mortgage insurance business. These results have been, and will likely continue to be, exacerbated by the deteriorating domestic housing market that has existed throughout 2007 and is predicted to continue into 2009 and possibly beyond.

It is likely that ultimate losses on our traditional mortgage insurance portfolio will continue to be driven mainly by declining home prices over the next three years in most of the U.S. In light of continuing declines, we expect incurred losses from our traditional mortgage insurance portfolio will be over 200% of earned premiums in 2008. Beyond 2008, given the current uncertainty in the credit and housing markets and the overall economy, we cannot predict with any degree of certainty what our ultimate losses on our traditional mortgage insurance portfolio will be. We have reviewed a number of stress scenarios that we believe are potentially reasonable, and in each of these cases we believe that our claims paying resources will be sufficient. In some of these scenarios, however, we may require additional capital, if not to support our capital position or ratings, then to ensure greater market confidence among our lending customers and others.

In response to current market conditions, we implemented changes to our underwriting criteria in the fourth quarter of 2007, and we are in the process of adjusting our pricing to improve our risk/reward posture and to generate appropriate returns on new business. The most important change to our underwriting criteria is the adoption of a declining market policy in which we reduce the maximum loan-to-value (“LTV”) that we will insure by 5% in any region of the U.S. that experiences a decline in value based on the most recent data produced by the Office of Federal Housing Enterprise Oversight. Based on this recent data, approximately 60% of the U.S. is experiencing declines and we are correspondingly reducing risk by reducing our maximum LTVs in these areas. In addition, in the third quarter of 2007, we made significant changes to our Alt-A guidelines by restricting our exposure to various combinations of reduced documentation and high-LTV loans. Although others in the

 

95


Table of Contents

industry have announced similar changes to pricing and underwriting standards, it is possible that our underwriting and pricing changes may negatively affect our business volume, growth of new insurance written and insurance in force. However, we believe these changes are necessary to improve our risk profile, and we have begun to see improvement in our fourth quarter mix of business as a result of these changes, our corporate-wide focus on prime business and the industry-wide shift to higher quality credit.

We have protected against some of the losses that may occur in excess of our expectations on some of the risk associated with non-prime and riskier products by reinsuring it through Smart Home transactions. In 2004, we developed Smart Home as a way to effectively transfer risk from our portfolio to investors in the capital markets. Smart Home mitigates our risk against catastrophic loss in extremely adverse conditions, concentrated positions and riskier products such as subprime mortgages. Approximately 5% and 10% of our primary mortgage insurance risk in force was included in Smart Home arrangements at December 31, 2007 and 2006, respectively. In these transactions, we reinsure the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions.

Since August 2004, we have completed four Smart Home arrangements. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2007 are as follows: