Nov 9, 2007
Executives
Sabra Purtill - Manager Director,IR Dominic Frederico - President andCEO Bob Mills - CFO
Analysts
Geoffrey Dunn - KBW Mike Grasher - Piper Jaffray Darin Arita - Deutsche Bank Mark Lane - William Blair & Company Jeff Bernstein - Schroders Heather Hunt - Citigroup Tamara Kravec - Banc of AmericaSecurities Bob Ryan - Merrill Lynch Ken Scarborough - Fasa Capital
Operator
Good day, ladies and gentlemen,and welcome to the Third Quarter 2007 Assured Guaranty Earnings ConferenceCall. My name is Latasha and I will be your coordinator for today.
At thistime, all participants are in a listen-only mode. We will be facilitating aquestion-and-answer session towards the end of this conference.
(OperatorInstructions) I would now like to turn the callover to Ms. Sabra Purtill, Manager Director, Investor Relations.
Pleaseproceed.
Sabra Purtill
Thank you, Latasha. And thank youall for joining us today for Assured Guaranty's third quarter 2007 earningsconference call.
Our earnings press release and financial supplement werereleased yesterday evening after the market close, and these materials, as wellas other information on Assured are post in the Investor Information section ofour website. I would also note that our 10-Q for the quarter will be filed bythe end of the week and will also be available on our website.
On todays call Dominic Frederico,President and Chief Executive Officer of Assured Guaranty Limited and Bob Mills,Chief Financial Officer, who will provide a brief overview of the quarter,including comments about our credit experience. After their remarks, theoperator will poll the audience for questions.
Please note that this call is beingheld for the benefit of analysts and investors in Assured Guaranty. Members ofthe media welcome to listen, but are requested to please call me directly forany questions that they would like management to address.
You may reach me in our Bermuda office all day, today and tomorrow morning at 441-278-6665.I would also like to remind everyone that management’s comments or responses toquestions may contain forward-looking statements, such as statements relatingto our business outlook, growth prospects, market conditions, credit spreads,pricing, credit experience and other items that are subject to change. Our future results may differmaterially from these statements.
In addition, our outlook on these items maychange. For those listening to the webcast, please keep in mind that morerecent information on Assured may be available in later webcasts, pressreleases on SEC filings.
Please refer to the Investor Information section ofour website for the most current financial information on Assured. Please alsorefer to our most recent SEC filings for information on factors that couldaffect our forward-looking statements.
I’d now like to turn the callover to Dominic Frederico.
Dominic Frederico
Thank you Sabra, and thanks toall of you on the call and webcast for your interest in Assured. As all of youare aware, the last few weeks have been very challenging for the financialguaranty industry with enormous scrutiny being implied to our portfoliocompositions, credit performance and mark-to-market calculations.
I want tostart by affirming to you that since our inception, Assured has believed incredit discipline, risk management and financial disclosure transparency. During these tumultuous times, wewill continue to expand our disclosure where possible, to meet your request foradditional information.
Before turning to a discussion of the impact on ourcredit experience of our residential-related asset exposures, I do want tocover a few of Assured’s accomplishments in the quarter and our evaluation ofcurrent business conditions. Consistent with our track recordsince our IPO, we again made progress on each of our critical objectives, as wehave in each and every quarter since our IPO.
As we have previously announcedon October 22, Assured posted its best business production quarter in the Company'shistory, with record production in our financial guaranty direct segment. We had exceptional production in U.S.
structured finance, and very solidcontributions from both U.S.public finance and international. Our transaction count of 90 in the quartereasily surpasses all of our previous quarterly achievements, signalingincreasing acceptance of Assured Guaranty.
Our direct business opportunitiescontinue to expand, as our pipeline at the end of the quarter was again at arecord level. We did receive the long awaitedAAA rating from Moody's Investors Services for Assured Guaranty Corp.
on July11, which we have been able to rapidly put to use given the widening of credit spread, and theincrease in the investor demand for Assured's credit enhancement product. Iwould also note that we received our last State License for Assured GuarantyCorp.
from Wisconsin and we are now licensed at all 50 States. Direct PVP was $133 million, anall-time record for the company.
Public finance production was strong due to --however, deal count was up with our U.S. public finance team closing 36transactions up from the previous record of 33 in the quarter.
As I mentionedin last quarter, we entered the competitive bid market and are making stridesin that large market, although our market share is extremely small, providingsignificant opportunities ahead. Our structured finance businesscontinues to generate outstanding results with a 68% rise in PVP over the prioryear.
The quarter had good mix of business in various asset classes, such astwo consumer auto deals, 11 U.S.residential mortgage-backed deals, and 15 U.S. corporate pool debtobligations and trust preferred transactions.
On the mortgage side, I would notethat our activity was largely in the secondary market this quarter as existinginvestors sought credit protection on recent vintage deals. All thesetransactions have been carefully underwritten with our revised modelingassumptions, including higher loss severity and frequency.
We expect to expandour presence in the flow or new public issue mortgage business, but the currentcombination of market conditions and loan new mortgage issuance, it means thatthere are limited new deals in the marketplace. I would highlight that we did notunderwrite any CDOs of ABS as it has been our policy since 2003, and we willmaintain that position.
Our direct international PVP was up 23%, despite ofdifficult comparison with the prior year. Overall, the internationalfranchise continues to develop nicely.
We wrote four international poolcorporate or CLO transactions, 17 European prime residential deals in additionto five U.K.utility transactions. I would also note that we are the lead sponsor of theupcoming Australia Securitization Forum and recently signed a lease to open anoffice in Sydneyin conjunction with the conference at the end of November.
Our reinsurance productionresults were also good at $32.8 million. As we have stated in the past, theimpact of large deals tend to exacerbate the volatility of recorded productionin our facultative business, which is the principal growth driver of thissegment.
Facultative PVP comprised 67% of total PVP in the quarter and 61%year-to-date. This is in accordance with our strategy.
I would also note thatthe prior year’s quarter is the last quarter in which we recorded any materialPVP from the Ambac treaty, which totaled $9.5 million in last year’s quarter. Let me now turn to the creditdiscussions.
As many of you are aware, Assured has always taken a conservativeunderwriting approach. This is currently manifested by our lack of material exposureto several distressed asset classes, which has put us in a very solid positioncompared to the industry given rising concerns about U.S.
RMBS and relatedcredit exposures. As you know, we have not written CDOsof ABS since 2003 and the $2.2 billion of remaining exposure that we have inthat asset class which is rated all AAA with static pools of AAA ratedcollateral is performing as expected.
None of the collateral in thosetransactions has been downgraded by any rating agency or by Assured.Performance has been strong and does not suggest any potential losses. On a more granular level, in thisclass we have only one exposure, where a sub prime residential mortgageexposure represents 32% of the collateral pool.
All of the collateral is stillrated AAA today. Additionally, this specific CDO exposure expires at April of2008.
Fitch recently recognized the strength of our capital base and our solidrisk profile, when they announced this Monday that they were beginning acapital analysis project for the Financial Guaranty industry. In this announcement they bracketedthe guarantors by probability of potential additional capital requirements tomaintain their fixed AAA ratings.
Assured was only one of two companies to beidentified as having the least exposure to additional capital requirements fromthis new study. This was due to our negligible exposure to CDOs of ABS and thehigh credit quality of our mortgage book of business.
As we disclosed in our financialsupplement and press release, our portfolio continues to be highly rated, basedon our own internal rating standards, which generally results in ratings at orbelow the rating agencies shadow ratings on our foreign shore. While marketopportunities have expanded, we have maintained our underwriting standardsacross all asset classes.
Our total net par outstanding continuedto have an average rating of AA- with over 40% of outstanding par rated AAAbased on these internal standards. Our below investment grade and CMC listdecreased again this quarter to the lowest level on a dollar and percentage ofpar outstanding basis since our IPO.
During the quarter, we continueto be very selective ensuring that all deals written, meet our stringentstandards that have been updated to reflect current market experience incertain asset classes. Specifically our assumptions for frequency and severityfor RMBS exposures represent a current stress view of recent market conditions.
77% of the business written inthe current quarter was rated AAA. Our U.S.
RMBS book, which totals $16.4billion is spread across four types of asset classes, prime, Alt-A, HELOC and subprime. While underlying mortgagedelinquency and foreclosure severity have risen, and we expect them to continueto rise, our policy of AAA attachment points on subprime since our IPO hasprovided us with excellent credit protection.
Our post 2003 direct subprimebook currently has an average over collateralization of 39% and our currentconservative expectation is for cumulative losses of 14% to 15%. We recentlydid an updated breakeven analysis on each transaction, and we determined thatthe underlying cumulative losses would need to rise on average about 29% of theoriginal pool balance before we would incur losses.
Cumulative losses on theunderlying collateral in our transactions thus far have been only 1%. Morerecently, we have been focused on an examination of our HELOC book of business,which totaled $2.5 billion at September 30, 2007, of which $1.6 billion or 65%is in the direct segment and the remainder is in the reinsurance segment.
In the direct segment, we have ashort list of transactions, only seven deals with three different services. 91%of the exposures with Countrywide and the preponderance of that exposure is intwo public deals.
Countrywide HELOC 2005-J, where we underwrote classes one andtwo in the fourth quarter of 2005, and Countrywide HELOC 2007-D, which weunderwrote in the second quarter of 2000, under tightened underwritingstandards. You should note that we did notwrite any direct deals in 2006 due to our concerns about terms and conditionssuch as the use of HELOC as piggyback seconds that are used to buy investmentproperties and the general deterioration in first and second lien underwritingstandards.
We also stopped writingfacultative reinsurance on HELOC business early in 2006 for our reinsurancebook. Today, our direct HELOC exposure is experiencing increased delinquency.
Wehave not paid any losses. Our 2005 and 2007 countrywide transactions, whichhave public data on Imtech have experienced a spike in collateral losses inSeptember and October, but still have significant credit enhancement remaining.
Additionally excess spread, whichmaybe higher than originally expected due to the slowing of prepayment fees, isbeing used to fund future losses and any excess will be used to build upfurther credit enhancements. We continue to closely monitor our performance andstress test to remaining loans.
Even in high stress scenario losses if any, arenot expected to be material given the modest level of our exposure and thelevel of credit support engineered in each transaction. In summary, Assured's portfolioof RBS risk will experience some credit stress compared to originalexpectations principally in our HELOC exposure.
But in most instances wecontinue to believe that the probability of meaningful loss, which we woulddefine as an aggregate loss of $100 million is extremely remote. We are completelyfluent in the details of our portfolio, and we will continue to keep you praisedof our experience as the pool of insured mortgages continues to mature.
Finally, through all the crisisand stress we will experience over the past few weeks, a few furtherobservations can be made. First, Assured has clearly demonstrated underwritingprinciples and competency in this market and has garnered broad market acceptance.Secondly, the market will reset itself as we pass through these challengingtimes as to our trading differential to our peer companies, and incredibly,critical element of our strategy and future success.
We believe, based on a host offactors, including the current credit default swap prices for the entire FinancialGuaranty industry that we should significantly accelerate our timeframe for tradingparity to our longer established peers. This will have the significant impactin terms of production, profitability and capital.
Now, I’d like to turn the callover to our CFO Bob Mills, who will discuss the financial results for thequarter in more detail.
Bob Mills
Thanks Dominic, and good morning.I want to remind everyone to refer to our press release and financialsupplement for segment level details and further explanations of our financialposition and results of operation. Now turning to our performancefor the quarter.
Operating income, which we calculate as net income excludingafter-tax realized gains and losses on investment, and after-tax unrealizedgains and losses on derivative financial instruments for the third quarter of2007 was $48.2 million or $0.70 per diluted share, compared to $39 million or$0.53 per diluted share for the third quarter of 2006. Assured had a net lossfor the third quarter of 2007 of $115 million or $1.70 per diluted share,compared to net income of $37.9 million or $0.51 per diluted share for thethird quarter of 2006.
Let's look at the results for thequarter in further detail. PVP or the present value of gross written premiumstotaled $165.5 million for the quarter, up 30% compared to $127.4 million forthe third quarter of 2006.
PVP for the direct segment was $132.7 million forthe quarter, up 46% from the third quarter of 2006 and was the principal contributorto the company’s record PVP in the quarter. Production in the direct segmentincluded strong performance across all sectors of the business, as wideningspreads resulted in increased demand and improved pricing.
PVP for thereinsurance segment totaled $32.8 million, a decrease of 10% from the thirdquarter 2006 amount from $36.5 million, which was largely due to thenon-renewal of the Ambac treaty, which had generated PVP of approximately $9.5million in the third quarter of 2006. As Dominic mentioned, facultativeactivity was the principle source of new business in the quarter rising morethan 100% over that of the prior year.
Net earned premium for thequarter totaled $56.2 million, up 8% from the third quarter 2006 amount of$51.9 million. For the Financial Guaranty direct segment, net earned premiumstotaled $31.7 million for the quarter, compared to $21.8 million in the thirdquarter of 2006, an increase of 45% from the prior year, which is reflective ofthe overall continued expansion in our direct book of business, as well as $1.1million in refunding net earned premium from the U.S.
public financetransaction. Net earned premiums for thereinsurance segment were $21.6 million, a decrease of 15% from the thirdquarter 2006 amount of $25.4 million.
The decrease was the result of decreasedrefundings as well as the fact that a number of shorter-dated structuredcontracts are maturing while much of the recent business has been longer-datedcontract. Net earned premiums for themortgage segment were $2.9 million down from the third quarter amount of $4.9million in 2006.
The decrease reflects the continued run-off for the businessin this segment during the quarter, as well as the $900,000 premium received inthe third quarter of 2006 due to a commutation of our reinsurance agreement.There was no new business written during the quarter as was our expectation. Loss and loss adjustment expensesincurred totaled $3.7 million for the quarter, compared to $0.9 million for thethird quarter of 2007.
There was a net increase in case loss and LAE reservesin the reinsurance segment related to an aircraft transaction underwrittenprior to our IPO, but no major changes in other case reserves. The largest itemimpacting the expense for the quarter was the updating of rating agencyseverity factors in our portfolio reserving model based on recently issued data,which totaled $6.4 million.
The investment portfolioincreased to $149 million from the balance as of December 31, 2006, the resultof normal operating cash flow. Yields were up slightly comparing to thirdquarters of 2007 and 2006 with pretax book yield of 5.2% at the end of thecurrent quarter, while we increased the duration to 4.4 years.
There has beenno significant change in the investment portfolio asset allocation during thequarter, and the average credit quality for the portfolio remains at the AAAlevel. Operating expenses increased by$3.4 million or 21% in the third quarter of 2007 compared with the thirdquarter of 2006.
The increase was attributable to a number of factors includingexpanded headcount since the end of the third quarter of 2006, as well asexpenses related to share grants vesting over a four-year cycle, and share-basedgrants to retirement eligible employees, which are recorded on an acceleratedbasis. The level of all other operating expenses remains relatively flat in thethird quarter of 2007 and continues to be in line with our expectations.
Income taxes on operating resultsfor the quarter were a recovery of $1.3 million. This is the result of a $6million reduction in our estimated U.S.
Federal tax liability, due to thefinalization of an IRS audit associated with 2004 and before for some assuredsubsidiaries. Absent this recovery, the effectof tax rate on operating income was 10% for the current quarter.
As many of youare aware, Financial Guaranty contracts that are written in credit derivativeform must under U.S. GAAP be mark-to-market and provide protection againstpayment default on underlying security, not a change in market value.
As disclosedin our press release stated October 22, 2007, we had after tax unrealizedlosses on derivatives of $162.9 million. This was totally attributable tospreads widening and included no credit losses.
The derivative business is anexpansion of our Financial Guaranty business, and these guarantees inderivative form are not traded, nor we generally require to post collateralbased on changes in market value. If these instruments approach maturity,market fluctuations, gains or losses will revert to zero, absent is specificcredit event.
Changes in the mark-to-market have no impact on statutory capitalfor rating agency models. More than 70% of the mark-to-market was due to ourcorporate CLOs and in particular our high yield corporate cash flow CLOs, 100%of which are rated AAA.
I would note that the widening ofthe spreads in the CLO market is due to a mismatch of supply and demand in thatmarket, as underlying corporate credit performances remain strong. The balanceof the mark-to-market was mostly attributable to the decline in subprimesecondary market prices for our RMBS and commercial MBS book, which is almost entirely,rated AAA.
The net position on the balance sheet related to the mark-to-marketof derivatives as of September 30, 2007 is now a liability of $202 millionbefore tax benefit. With considerable volatilitycontinuing in the market, this amount will fluctuate in future periods.
Thereis the little movement in the mark-to-market since September 30 for corporate CLOs,the largest component of our mark. I would note that the subprime market priceshave continued to deteriorate since the end of the quarter.
The actual mark-to-market for thefourth quarter will of course depend on market prices as of December 31, 2007.You should note that our 10-Q which will be filed shortly will include asensitivity table for mark-to-market valuations, which should provide someclarity in to our mark-to-market valuation level. Our book value per share was$23.69, a decrease of 1% from the $24.2 book value per share at the end of thethird quarter of 2006.
Our book value per share number includes about $2.20 ashare for the net unrealized loss on derivative contracts, as of September 30,2007. Adjusted book value, whichreflects the book value and adds the embedded value from after-tax net presentvalue of estimated future installment premiums in-force, and after-tax netunearned premium reserves net of DAC was $37.57 per share at quarter end, up 9%compared to $34.43 per share at the end of the third quarter of 2006.
The growth in adjusted book valuereflects strong new business production over the last 12 months. It waspartially offset by the mark-to-market unrealized loss on derivatives.
The company's operating ROE,which is calculated by dividing our annualized quarterly operating income byaverage shareholders equity, excluding accumulated other comprehensive incomein the effect of the unrealized mark-to-market loss was 11.4% in the quarterand year-to-date, compared to 9.4% for the third quarter of 2006 andyear-to-date 2006. With that, I would like to turnthe call over to the operator to poll for questions.
Operator
Thank you. (OperatorInstructions) And your first question comes from the line of Geoffrey Dunn withKBW.
Please proceed.
Geoffrey Dunn - KBW
Thank you. Good morning.
Dominic Frederico
Good morning, Dunn.
Geoffrey Dunn - KBW
We're hearing some feedback outthere, that the rating agencies are getting maybe a little overly aggressive ondowngrades, I’m actually looking at full transaction merits, but maybe basing theaverage just on collateral performance. I'm in the camp, I don't think you aregoing to have material losses, nor do I think any your peers will.
Butincrementally, do any of the rating agencies' actions worry you that maybe moreindiscriminate downgrades could pressure capital charge requirements inside thecompany with losses not really being an issue?
Dominic Frederico
Geoff, our view is we rateeverything internally, so that the rating agency ratings are like either a secondarycheck guidepost, but principally, we rely on our own ratings. We assess our owncapital requirements off of that.
And although, as you point out we are subjectto their current requirements and that’s why our current conservative is overour capital, because quite honestly, we don’t know where this is going to gorelative to capital needs based on the downgrading and then their stressmodeling. So, we don’t have that influence onour underwriting that’s one of our internal structure and system and standards.We are mindful of their current concerns and the potential reactions of thecurrent market and therefore position the company to ensure that we have thecapital required that continue to maintain a very strong levels of AAA ratings.
Geoffrey Dunn - KBW
Right. Thank you.
Operator
Next question comes from the lineof Mike Grasher with Piper Jaffray. Please procced.
Mike Grasher - Piper Jaffray
Good morning.
Dominic Frederico
Good morning.
Mike Grasher - Piper Jaffray
Dominic, you mentioned somediscussion there on trading differentials. Where are those differentials now?
Howhave they changed over the past 90 days?
Dominic Frederico
Mike, we’ve had historically beenpulling in the trading differential, and probably starts back two years ago, aswe started to move up the rating scale in terms of the AAA ratings. It's harderto now provide real point, because there's not a lot of transactions being done.
On the structured finance side,we’ve no real side-by-side comparisons, but market participants typically pointto the default swap levels, and we are quickly becoming a preferred providerand we there would price it very close. Obviously, the real issue for us andthe real opportunity is in public finance.
And in public finance, we’ve beenable to get to a position of parity for floating rate. For the fixed rate, andthis goes back to the issue of how many transactions we’re going to actually beable to point to.
We are currently in a rating or a differential of about 5 to7 points, and yet obviously, our argument is extremely powerful, we alwaysstick to the rationales of why we should be trading flat, if not inside, bypointing to a whole host of different data points, including the credit defaultswap prices for ourselves against those other guarantors. So, as I said in my openingcomments, there is our expectation that this market should re-price.
It shouldre-price significantly in our favor, and that being the case, even though itwill take some time that will provide us tremendous opportunity for the companyto grow in that very valuable asset class called public finance.
Mike Grasher - Piper Jaffray
Right. And then just a follow-up-- which leads me to my follow-up, which is, how much is the market changed forAssured or what is your pipeline look like today?
Has it accelerated given thecurrent environment?
Dominic Frederico
Yeah, our pipeline today, as Isaid earlier, is at record levels, and I would tell you that its record level isalmost in a multiple. So, we don’t typically give out the exact number.
The onlything I can say to you is, on a year-over-year basis, we look like a verydifferent company. You are looking at in terms of, just giving you a quantification,triple of what it was last year at this time.
Mike Grasher - Piper Jaffray
That's helpful. Okay, thanks.
Andthen Bob, I just wanted to, I guess pry a little bit here on, as a formerbanker, there seems to be a lot of confusion out there around the mark-to-marketbetween the banks and between the financial guarantors. Can we get yourthoughts in terms where some of the confusion may lie in terms of how the banksperform their mark-to-markets versus what the financial guarantors do?
Bob Mills
It’s somewhat difficult tocomment on what each bank is doing since I am not in there. Certainly, I workedon that side of the fence too, and I believe the discipline or themark-to-market concept is the same, regardless of where you are.
From themark-to-market standpoint, I believe we use a rigorous approach to this, to theextent that we can, we use direct quotes. Beyond that, we rely on marketindices, the JP Morgan high-yield cash flow AAA index for our high yields.
The ABX index and CMBX index forour residential and commercial mortgages. Beyond that, it becomes more limited viewsof counterparty marks or similar transactions, but that's very limited.
Youmust remember too, that 97% of our CDS are all AAA rated. So, it’s hard tocomment on what the others are doing.
I do it at the same way as I did when Iwas on the bank side, use a very strict methodology.
Dominic Frederico
I'm going to step out on the biglimb here and get on a little bit of ramp. Part of what you're seeing in thehysteria in the market today, I believe is because of the mark and themisunderstanding of the mark relative to Financial Guaranty companies.
We arenot priced on a spot basis. We do not have exposure relative to a change inprice.
We pay only on credit events. A significant portion of the markdeterioration today comes out of the residential side.
We’ve gone through in this calland our website, an exhaustive explanation of our exposure, we’ve quantifiedfor you the worst possible, maximum exposure we have. It has nothing to do withour mark.
Our biggest exposure today that we believe that could result inlosses is HELOC exposure, which is not even in the mark, because they're FinancialGuaranty contracts. The mark is not a surrogate forlosses.
It can't be looked at that way. Each of us has to come to recognitionof our exposures relative to the residential marketplace, as it is today, andrecognize those potential losses, period end quote and the market is notrelevant at all to that discussion.
Mike Grasher - Piper Jaffray
Thank you for that feedback,that’s helpful and hopefully the market will figure it out someday?
Dominic Frederico
We hope and pray along with you.
Operator
Your next question comes from theline of Darin Arita with Deutsche Bank. Please proceed.
Darin Arita - Deutsche Bank
Hi, good morning.
Dominic Frederico
Good morning.
Darin Arita - Deutsche Bank
I was hoping to talk more aboutyour HELOC exposures. Can you give us a sense of what sort of cumulative lossesthose can sustain, what happens if prepayments slow, and then also give us asense of what sort of stress testing you put these through?
Dominic Frederico
Okay. Darin, this is an extremelycomplicated exercise, because there are so many assumptions that go into theability to forecast expected outcome.
So, if you think of the result, these arebasically second for HELOC, so they sit on top of prime. So, the first thing is,you really have to understand, what are the mortgages below you, the type ofloans they are, because that has an impact on the second position.
We look at that in terms ofstarting to develop our expectation of what I’ll call default factors, right.So that delinquencies that ultimately conferred to a default. We do stress itsignificantly beyond by looking at today's current array, of our currentborrowers, delinquency and stress each class to an assumption of how much willgo into the default.
So for the sake of argument,everybody above, say a 180 days we consider even though there only delinquentlylisted today. They are 100% going to go into default.
We then also furtherstressed, if by saying everything is a 100% severity. There will be norecovery.
So, every time we look at our expected loss in that model. We takethe worst position.
The real wild card here is theexcess spread. As you know, these deals start out with virtually no over-collateralizationor credit enhancement, and it's built up by the trapping of the excess spreads.So you hit the pre-agreed level of credit enhancement.
As prepayments slow, theamount of excess spread which is typically in excess of 200 basis points thencontinues to build; it's pays losses as well as builds up additionalprotection. That is the wildcard today.
We normally assume a prepayment rate,kind of in the 30% level. And based on what we are seeingtoday, that's starting to slowdown, so probably down to a level of 15 that hasa significant impact on the level of buildup of credit enhancement.
We thinkour deal structure today can absorb a lot somewhere in the 8% to 12% range ofthe original pool balance. Current default or current losses today in thestructure are at 1.4%.
The 2007 deals are written eventighter, so there we think we can get up to a size of 14% enhancement before wewould ever be looked at the payer loss. Also remember, these are spread over 7deals, so they are not huge and of their own rights, and for instance, if youlook at the Countrywide deal with roughly about $700 million of par stilloutstanding, 1% movement above our expectation of loss containment is a whopping$7 million.
So, as you can see, even if ourexpectation is, it will go to 10 and we cover it. If it goes to 20, that’s $70million of impairment before tax.
So, we are looking at tight. We try toestimate it as best we can.
The negative side, which is the foreclosures andthe severity which we take very conservative years, the wildcard is how much wecontinue to enhance or build from the excess spread and that's really relatedto the prepayment factor, and we look at that at 30% now. We think it’s probablyreally around 15, and does that modifies, it will give us more enhancement toprotect losses.
But as I said, even in the absolute expectation of, it doesn'tcome out the way we think, everyone points about $7 million.
Darin Arita - Deutsche Bank
That's very helpful, Dominic. Iguess turning to a different subject on reinsurance, if some of yourcompetitors do come under capital pressure and they are looking for ways tofree up capital and they seek reinsurance as a solution, would Assured Guarantybe willing to offer that?
Dominic Frederico
My gentleman, who runs the directbusinesses madly scribbling on a pad of paper, perhaps he would rather not, butwe are committed to both sides of this industry, both on reinsurance side and thedirect side. We will be opportunistic in how we utilize our reinsurancecapital.
The current market, as you point out, should send a lot of theexisting guarantors to seek reinsurance protection. We're aware of that.
Thatbecomes in effect our market, and that’s kind of why we're here and that's whatwe're built for.
Darin Arita - Deutsche Bank
Great, thank you very much.
Dominic Frederico
You’re welcome.
Operator
Your next question comes from theline of Mark Lanewith William Blair & Company. Please proceed.
Mark Lane - William Blair & Company
Good morning everyone.
Dominic Frederico
Good morning Mark.
Bob Mills
Good morning.
Dominic Frederico
How are you doing?
Mark Lane - William Blair & Company
Congratulations on getting thatlast state license in Wisconsin,by the way.
Dominic Frederico
It was a significant point, Mark.I want to make sure you understood that.
Mark Lane - William Blair & Company
Bob Mills
Yeah. It is done differently byall three rating agencies.
And when you look at our last published data, theexcess capital would be depending upon who you are looking at somewhere between$300 and $685 million, depending upon which rating agency you are looking at.So, there is quite a substantial amount of excess capital that still existstoday.
Mark Lane - William Blair & Company
And why your credit quality isextremely good on the RMBS side. Can you give us any sense of what sort ofdowngrade risk in terms of capital requirements you might have?
Bob Mills
I mean not surprisingly, we havelooked at downgrade risk associated with our subprime and prime exposure. Andwe clearly have enough capital under a reasonably severe downgrade scenariofrom core subprime or were prime exposure from any of the rating agencies atthis point.
I don’t see it to be a big problem.
Mark Lane - William Blair & Company
Okay. And the last question is,and I don’t know if there has been enough time.
The markets have been kind ofseized up. But with regarding the business on a day-to-day basis, you mentionedtrading differential, but what is the dialogue right now among your customers, theircomfort with the Financial Guaranty product right now.
I mean, at leastanecdotally, what sort of discussions are you having? Are you concerned at allabout wavering demand or just the scrutiny on the business?
Has there reallybeen a change in the last week or two or is it just more rumors and, etcetera?
Dominic Frederico
The biggest change, Mark, wereobviously committed and believe in the industry and its viability and itsnecessity in today’s capital market as the means to accomplish financing thatwould get done in any other format. If you look at dialogue, obviously theeasiest thing we can point to is our pipeline, as we said it’s triple to whatit was last year, and no one is walking away from the table.
Deals are getting postponed dueto liquidity criseses, but it separates the market. International goes on as itgoes.
Public finance goes on as it goes. It’s really in the structured credit,where true cash deals or public deals are drying up for the short-term asliquidity has kind of left the market.
However, there are tremendousopportunities relative to basically on balance sheet risk management that arekind of filling up our coffers. And the neat thing about thisbusiness is, it really gets us the ability to choose the asset classes.Obviously going forward as the market works its way out, some of these non-bankSIBs will obviously go away, and that's not a real loss for the industry.
Obviously, we don’t expect to seeCDOs of ABS to be a very popular item going forward. And once again, since wedidn't write any of that business, it’s not a concern of ours.
So, are we necessary?Absolutely. Are we involved in active dialogue with all of our constituents outthere in the marketplace?
Yes, we are. Is there are lot of activity today?
Surethere is. But there are segments of the market that because of liquiditycrisis, which we do believe corrects itself.
At the end of the day thesethings have to get openly taken care of or done in the market. We are I wouldsay on the lips of most people, they are looking for credit protection as oneof the premiere guarantors that they want to do business with on a go-forwardbasis.
Mark Lane - William Blair & Company
Okay. And last quick one, Bob.
Theportfolio reserve in indirect. You mentioned some change in the rating agenciesstress analysis or something.
I mean, which rating agency or what sector are wetalking about?
Bob Mills
We do this every year. But onSeptember 6, the S&P put out some new severity information for ABS, and weput that new information as we always do into our model, and that resulted inan increase in the portfolio reserve, I said its $6.4 million.
Mark Lane - William Blair & Company
Okay.
Dominic Frederico
And remember Mark, we doportfolio reserves and every risk in our portfolio. It really keys off ofdefault assumptions and severity assumptions that we use published from theoutside, so it’s very independent.
It’s the S&P, default and severity, andbecause they changed as of September 6, which they typically do every year inthe third quarter, we then update our statistics. So, when our machine runs,our portfolio reserve now has the higher severity, quickly with severity thistime.
Higher severity risk that cost us a $6.4 million increase in reserves.
Mark Lane - William Blair & Company
Got it. Thanks a lot.
Dominic Frederico
No problem.
Operator
Your next question comes from theline of Jeff Bernstein with Schroders. Please proceed.
Jeff Bernstein - Schroders
Hi. I guess, very similarquestion to the one before, but I'll ask it again.
I guess, from your customerstandpoint with what‘s going on in the press, the equity markets, and your ownCDS levels. How does the customer remain comfortable that it's a good decisiongiven with the way the market, and I agree it’s irrational, but the way themarkets currently valuing you and your peers, both equity and fixed income?
Dominic Frederico
Well. It’s kind of almost aparallel shift, right.
So, our spreads have widened in terms of defaultpricing, but in most cases on the ABS side some of the underlying assets. So,since both of why now the amount of benefit that you're going to achieve fromus providing the wrap is still providing a benefit.
Number two, although we bringaround those credit default swap prices table with us, we goes to the certaindesks in terms of pricing our risk, they are not that widely adhere to or usedin the upcoming argument. So, we still provide value.
We still provide theaccess to the capital markets in liquidity. And therefore, we are not havingthose kind of halting conversations that you might expect based on the otherkind of noises going on today in the marketplace.
Jeff Bernstein - Schroders
Thank you.
Bob Mills
You are welcome.
Operator
Next question comes from the lineof Heather Hunt with Citigroup. Please proceed.
Heather Hunt - Citigroup
Thank you and good morning.
Dominic Frederico
Good morning, Heather. How areyou?
Heather Hunt - Citigroup
Good. How are you?
Dominic Frederico
Good.
Heather Hunt - Citigroup
I wonder if you could talk aboutthe dynamics of your new business this quarter. It looks like you went towardmore conservative products given that your premiums to par didn’t reallyincrease very much, and just looking the schedule, it looks like its more GOs,etcetera.
Can you describe why you've moved toward that? I’m assuming becauseyou continue to get better pricing for lower par, but it seem like you couldget some really good pricing this quarter?
Bob Mills
Heather, as we've talked a littleabout our book will start to transition as our current AAA ratings across theboard take hold, where we're going to be able to see more of that traditionalvery safe business and you remember, in the old days we were under a marketshare requirement from Moody's, which we've always taken strong exception to interms of financial strength rating. But it forced us the right highpar low premium, but we never skipped on the credit qualities, so we wrotethose AAA attachments.
There we have to look at a broader mix of the business inall asset classes, yet for us in today's market, we are being very conservativein how we utilize that new found pricing power, and those areas of the marketthat we're willing to put our capital at risk. Because part of this we believethat there are significantly better times ahead.
Part of it is, you definitelywalk before you run, and that we are building up our diversification of thebook of the portfolio as well across these kind of new areas that we haven’tpreviously written before. And we obviously handle the opportunities we get andwhat our marketing efforts have provided us.
That will continue to evolve and changequarter-to-quarter.
Heather Hunt - Citigroup
Okay.
Dominic Frederico
So the book is, if you would haveasked me a year ago, so post the AAA what would be the mix in terms of ratingof your business, I’d say we’ll be moving out of the AAA world. We see noreasons to do that at this point in time.
You are getting paid very, very wellfor taking that very high rated, very safe level risk, preserve capital, but atthe same time, move up profitability and overall production. So, it’s a goodpart of how we are looking at it today.
Heather Hunt - Citigroup
Okay. I thought it was somethinglike that.
And are you seeing opportunities in the last few weeks to maybedeals where some of your competitors who are a little bit more in the headlinesare not as active just in the last few weeks. Is there at all a change in tone?
Dominic Frederico
We are doing a lot of secondarydeals how they are exactly as you pointed out. And one of the commentsunderlying Bob’s remarks on mark-to-market exposure, some of our current fluctuationpotential mark is relative to the swap pricing on our peers, and how it isgoing to affect the mark.
So, we’re doing a lot of wrap-on-wraps, is that yourquestion.
Heather Hunt - Citigroup
Okay, thank you very much.
Dominic Frederico
You are welcome.
Operator
Your next question comes from theline of Tamara Kravec with Banc of America Securities. Please proceed.
Tamara Kravec - Banc of AmericaSecurities
Thank you. Good morning everyone.
Dominic Frederico
Good morning.
Tamara Kravec - Banc of AmericaSecurities
A couple of questions,reinsurance transaction, the HELOC, the $1.8 billion, any thoughts on risk offurther downgrades of that or do you think, it’s kind of been reviewed andthat's it. And then, on the reserve increase in the direct business, just afollow-up to somebody’s question about, how different now do you think yourseverity assumptions are?
Were you just kind of moving to rating agencyassumptions or did you take an extra look at it and move even moreconservatively beyond that in terms of assumptions there? And then, my final question is juston headcount and looking at the pipeline that you’ve got, given the marketconditions.
Do you anticipate your operating expenses or headcount having torise more dramatically than you may have thought?
Bob Mills
Okay. If I can remember them, wealready gave him.
On the HELOC side, remember, we only have about $2.5 billion,almost $1.7 is direct, so the rest is reinsurance. And now reinsurance isspread over a host of transactions, 66 deals to be exact the largest being $90million.
We've got everyone of those listed, posted, stressed, we are concernedthat there could be some loses arising, because a lot of them are written atthe BBB level. But individually, if you look atthe mean, the mean exposure is probably about $7 million in any one given deal.So once again, use the percentage methodology, even if we blow the expected outcome, one percentage point is $700,000.
It’s not going to be material, right.
Tamara Kravec - Banc of AmericaSecurities
Okay.
Dominic Frederico
And we did no facultative in ’06,we would see kind of a larger size session coming to us, because the treaty hasa very limited view of what can be ceded to us. In terms of the reserve, if youcan go back over that question again on the reserve side?
Tamara Kravec - Banc of AmericaSecurities
Yeah. I'm wondering what your,you had increased your severity assumptions just based on S&P and I’mwondering if, I guess, you commented that you use your own internal ratings,the rating agencies are kind of a check.
But are you, was the discrepancy,would you move beyond what the rating agencies are assuming, just to be overlyconservative. In other words, I guess, would you feel like, you’d have toreview this again and again and perhaps it could be higher?
Dominic Frederico
Well, remember that we aretalking about the portfolio reserves here, which is us being extremely prudentin how we assess potential credit exposure across the entire book of business.Number two; and I should have maybe highlight this, the critical element, the keyof the portfolio reserve process is the rating of the transaction, because at differentrating levels that kicks up higher levels of probability of default andseverity. They are our rating levels and about 30% of our book has a ratinglevel lower than what the published rating agency level is.
So, it’s ourconservative view of the rating. It then does speed the standarddefault and severity statistics that get updated annually by S&P, and we dothat surely for independence, surely for ease of audit, and understandabilityand transparency.
Obviously, that’s only for the portfolio. Once we start tolook at the specific credit issue in any other content besides portfolio, wethen start to apply our own reserving process.
So, the portfolio, think of it asa booked market, it’s a place holder to ensure that we can constantly look atour entire portfolio and understand the ultimate potential expected exposurethat it contains today based on our rating and based on what we consider veryreasonable estimates of severity and frequency. Once we start talking throughloss possibility, that goes out the window and it’s all done with our owninternal view of losses, right.
Our underwriting standard chose our severity,so separate that from when we underwrite new business.
Tamara Kravec - Banc of AmericaSecurities
On the headcount?
Dominic Frederico
The headcount, that.
Bob Mills
From a headcount standpoint, wehave grown in the last year at September 30, '06 the headcount was 131. Today,the headcounts are 144.
We are expecting to continue to grow headcount into2008. Naturally in this market has probably some subjectivity as to how andwhen that will grow.
But considering the opportunities that we see, we willcontinue to expand our headcount to meet those needs.
Dominic Frederico
We have obviously completed our2008 plan and in the plan the headcount addition is I think 7% to 8%, and there'saround 10 or 11 people in total.
Bob Mills
144 in that or 156 in the plan.
Dominic Frederico
So, but that will depend onopportunity obviously, I think we have been trying to manage that veryreasonably. We had to build it before it came early on to make sure we canhandle business and assure execution.
We now have adding to the staff as opportunityarise and obviously, based on the change in this market, you could see somesignificant opportunities develop, that we would then have to be responsive interms of stepping upward. And currently our plan is for a very reasonable,moderate level of increase.
Tamara Kravec - Banc of AmericaSecurities
Okay, great. Thank you so much.
Dominic Frederico
You are welcome.
Operator
Your next question comes from theline of Bob Ryan with Merrill Lynch. Please proceed.
Bob Ryan - Merrill Lynch
Good morning.
Dominic Frederico
Hi, Rob.
Bob Mills
Hi, Rob.
Bob Ryan - Merrill Lynch
Okay. My question is in yourancillary mortgage business.
What was the last time that you took on any newexposure there, and what’s the nature of those exposures?
Dominic Frederico
The last time, all I can tell youis the deals expire in three years, as the last deal. So, they were like10-year deals.
They are excess of loss, soft capital type programs writtenunder the old company structure and business plan. We did do a reinsurance dealon the U.K.in ’04, and that was the last year that we’ve ever written.
So, they are high up, principallyexcess of loss. At one point in time, we did get them rated, because we felt thatthey were sort of like RMBS, but a very high AAA double detachment, they arehighly seasoned, so they are long outstanding deals.
So, they don’t kind ofsuffer some of the current pang. And we’ve got 1.4 billion of pars still outthere and that continues to amortize them.
Bob Ryan - Merrill Lynch
Great, thank you.
Dominic Frederico
You are welcome.
Operator
Your next question comes from theline of [Ken Scarborough with Fasa Capital]. Please proceed.
Ken Scarborough - Fasa Capital
Yes. Good morning.
Hi, Dominicand Bob.
Dominic Frederico
Good morning.
Ken Scarborough - Fasa Capital
I wanted to ask a couple ofnumbers questions and then a bigger picture on the reinsurance side. On thenumbers side, when we think about total capital resources, obviously qualifiedstatutory capital, present value of installment premiums, one element that Ididn’t see and I might have missed was the soft capital facilities.
Could youjust remind us what if any you have in that regard and/or any other items thatwe should be thinking about?
Bob Mills
Sure. We’ve two soft capital facilities.One is a bank soft capital facility, which is at AGR in the $200 million, whichwas put into place just recently in 2007 replacing an older facility.
And we’vea capital market facility of $200 million at AGC. That was put along really asa term facility, and that facility rose over, is up to be reissued in April of2008.
Ken Scarborough - Fasa Capital
Bob, on that second one is, inthe event you would need to tap it for whatever reason, even its just to givethe agencies greater comfort. Is that facility dependent on, the availability andthe opening of the asset-backed mark?
Do you still rely on the current type ofmarket?
Bob Mills
No, it’s a funded facility. It’snot subject to auction, but I must tell you I cannot conceive of the circumstance,where I would have to draw upon that facility.
Ken Scarborough - Fasa Capital
Excellent, thanks for clarifyingit. And maybe Dominic, on the reinsurance side of the business, I guess firstby way of disclosure, have you guys provided much granularity about some of theother financial guarantors that you have exposure to and I guess given anenvironment where one would suggest that the terms of trade would favorreinsurance.
How do you think that growing that on a go forward basis?
Dominic Frederico
In terms of granularity exposureto the other model lines, remember, we underwrite every deal on the reinsuranceside that we see facultatively with regards of who is the primary writer. So, it'sgot to pass our underwriting standard.
On the treaty side, we only have the onetreaty, and now I guess we have two today. Where we specified parametersthat in effect determine the type of business that can be seemed to us, so in bothcases if that’s your question on exposure to the other model lines, we are verycomfortable with the underwriting risk, and obviously it goes to the sameprocess that we use when we underwrite on the primary side as well.
Ken Scarborough - Fasa Capital
And Dominic, just to clarify, youdon’t have exposure below AA, AAA folks, do you? I mean, I guess, the question…
Dominic Frederico
As reinsured that cede to us now.We only take reinsurance from the existing AAA model lines.
Ken Scarborough - Fasa Capital
Excellent, thanks. And then, justfinally on the environment for growth given your strong ratings and obviouslythe demand pull?
Bob Mills
We’re blessed on both sides. Wesee tremendous market opportunity on both the reinsurance side and the directinsurance side, and there is a constant [tap you pull] in our company relativeto capital and limit allocation between the two groups.
As a company that doesservice the third party ceding reinsurance marketplace, meaning the other AAAmodel lines, we’re serious about that business. We have to allocate capital tothem and service their market.
Obviously, we see tremendous opportunity there.We are well positioned by being headquartered in Bermudawith that specific entity. So, that the in effect economics that we get on areinsurance basis is as good, if not better than the primary company ceding tous.
So, there is no loss, and we will call profitability from that point ofview. However, the direct business thatwe also utilize through that reinsurance mechanism, gets also further enhanced.So, there is a good argument on both sides of the fence.
The one thing we’vealways liked about having to put in reinsurance through our as it does spreadour portfolio out. It does allow us to look at basically every opportunity inthe marketplace, where we can be further selective from an underwriting pointof view.
Ken Scarborough - Fasa Capital
Thanks very much.
Bob Mills
You are welcome.
Operator
(Operator Instructions) And yournext question comes from the line of [Adam Star]. Please proceed.
Dominic Frederico
Hello?
Operator
Mr. Adam Star, your line is open.
Sabra Purtill
You can go to the next question,operator.
Operator
I show no further questions inthe queue.
Sabra Purtill
Thank you. Many thanks to you allfor joining us today.
And we certainly appreciate your interest in AssuredGuaranty. As I mentioned, you can reach me in our Bermudaoffice today at 441-278-6665, if you have any follow-up questions.
And I wouldalso note that a replay of this call will be available on our website, as wellas by telephone at 888-286-8010 in the U.S. and at 617-801-6888 forinternational callers.
The password is 12378747. Please call me, if you have anyadditional questions and we look forward to talking to you soon.
Thank you, andhave a good day.
Operator
This concludes the presentation.And you may all now disconnect. Good day.