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MBIA Inc. (NYSE:MBI)

Q3 2008 Earnings Call

November 5, 2008 11:00 am ET

Executives

Greg Diamond - Director of Investor Relations

Jay Brown - Chairman and CEO

Chuck Chaplin - Vice Chairman and CFO

Mitchell Sonkin - Head of Insured Portfolio Management

Analysts

Darin Arita - Deutsche Bank

Si Lund - Morgan Stanley

Jeb Bentley - Northwestern Mutual

Ming Zhang - Barclays Capital

Terry Shu - Pioneer Investment

Bryce Doty - SIT

Gary Ransom - Fox-Pitt, Kelton

Tony Spencer - Macquerie Funds

Nic Caiano - Paulson & Co.

Operator

Good morning and welcome to the MBIA third quarter 2008 financial results conference call. At this time, all lines are in a listen-only mode to prevent any background noise. After the prepared remarks from the company, there will be a question-and-answer session, which will begin with questions that have been submitted in advance of the call.

After those questions have been addressed, the Company will take questions from callers. (Operator Instructions). I would now like to turn the conference over to Greg Diamond, Director of Investor Relations of MBIA. Please go ahead, sir.

Greg Diamond

Thank you, Brandy. Welcome to MBIA's conference call for third-quarter 2008 financial results. A presentation for this event is available on MBIA's website. We have also posted on our website the information to access the recorded replay of today's call, which will be available later this afternoon.

The MBIA team assembled for today's event is Jay Brown, CEO; Chuck Chaplin, CFO; and Mitch Sonkin, Head of Insured Portfolio Management. Joining them for the question-and-answer session of today's call will be Cliff Corso, Chief Investment Officer, and Anthony McKiernan, Managing Director and Head of Structured Finance Insured Portfolio Management.

Following our prepared remarks, we will hold a question-and-answer session for up to one hour. Let's begin. The second slide of the presentation deck shows our Safe Harbor disclosure statement, which I will now read. This presentation and our remarks may contain forward-looking statements. Important factors such as general market conditions and the competitive environment could cause actual results to differ materially from those projected in these forward-looking statements.

Risks factors are detailed in our 10-K, which is available on our website, www.mbia.com. The Company undertakes no obligation to revise or update any forward-looking statements to reflect changes in events or expectations. In addition, the definitions of the non-GAAP terms that are included in this presentation may be found on our website.

Now, I will turn it over to Jay Brown.

Jay Brown

Good morning everyone, and thank you Greg. It's no surprise when I say that we are experiencing the most challenging time in the financial markets in almost a century. We saw conditions deteriorate almost to the point of total collapse in the third quarter. Throughout the quarter, however, we adhered to our own objectives and made important progress towards strengthening our portfolio through a combination of deleveraging and by substantially increasing our liquidity.

We continued to satisfy all our obligations and pursued opportunities to enhance shareholder value such as the $159 billion FGIC reinsurance transaction. We're able to progress in our business transformation because we began early to play defense to shore up our balance sheet in preparation for more difficult times to come, which is exactly what happened this last quarter.

As a result of the greater-than-expected continued deterioration in the housing markets and the virtual absence of liquidity in the capital markets, we increased our loss expectations and our realized losses for the third quarter. While these increased losses are painful, they do not threaten the viability of our company and while conditions in the credit markets and the economy around the world could well get worse before they get better, we are in a very good position to weather this financial storm.

As I mentioned during our last conference call, and as we continue to demonstrate our ability to satisfy our obligations, as insured bondholders continue to receive their interest and principal payments, MBIA will be much more appreciated in the years in the future, but it's going to take time as the next several quarters are likely to remain challenging until the housing market stabilizes and the capital markets regain their footings.

In the meanwhile, let me discuss some of the specific accomplishments and disappointments of the quarter. Among our accomplishments was the closing of the reinsurance transaction for most of FGIC's public finance insured portfolio. This transaction is testament to the hard work and persistence of our employees and the confidence of our standing in the financial guaranty industry.

We are very proud to provide greater security to insured bondholders, and we are also happy to have the boost to our investments and our earnings. We continue to actively pursue similar transactions in the weeks and months ahead. Also, as we noted in our last call, even though we had largely addressed the immediate liquidity requirements of our Asset Liability Management program that resulted from the Moody's downgrade of MBIA to A2, we decided to aggressively increase the liquidity of that program to minimize any additional adverse impacts from any. Let me be clear, any potential rating actions in the future.

However, as Chuck will cover in greater detail, we have paid a price of approximately $0.75 billion for this increased protection against rating downgrades. In addition to reducing our spread earnings and our ALM program, we have realized losses on the sales and securities that might not otherwise have been realized. With the further downturn in the performance of the housing market during the third quarter, we estimate that our insured second lien RMBS credits will in fact experience greater losses.

Mitch will provide some of the additional perspective on the changes in our assumptions that have resulted in our higher loss estimates. Clearly conditions in the housing market, particularly housing prices, default rates, and severities on defaulted mortgage loans have worsened. But negligent and deficient lending standards have also played an extremely large role in our RMBS losses.

We have officially initiated legal action against the two largest mortgage lenders of our second lien RMBS exposure to recover a significant portion of the harm that we have already suffered. It's still too early to determine the ultimate outcome of our legal actions, so we have not offset any of our loss reserves at this point in time.

All in all, our company's adjusted book value is about $37 per share at the end of the quarter. We remain committed to preserving that value and we will continue to add to it wherever and in whatever way possible. Our need to bolster liquidity for our operations and reduce the potential downside impact of adverse developments, such as rating downgrades has moderated our near-term opportunities to significantly enhance shareholder value through debt and equity repurchases.

We will continue to be active as opportunity presents itself and additional deleveraging of our asset liability management portfolio occurs. Before I conclude, I'd like to make a few points which may anticipate some of your questions. We are continuing to assess the opportunity to establish a new MBIA public finance insurance company. We received enough input from the marketplace to be convinced that this is a truly viable option and we are now actively exploring with the various insurance regulators and rating agencies how to best accomplish this.

We will keep you updated as things unfold in the weeks ahead. Similarly, it's premature for us to comment on what may or may not develop for MBIA specifically regarding the Treasury Department's TARP provisions and/or other government-sponsored efforts to address the current economic conditions. However, MBIA does not need any direct assistance from any of these programs to benefit from the programs.

As long as the government is successful in achieving its objectives to return liquidity to the capital markets and stabilize the ultimate housing market, we should experience lower losses on our insured credits. We have also said we would provide updates on commutations of our insured credit derivative contracts. There were no commutations this quarter that required any settlement payment from MBIA. More importantly, it is unlikely that negotiations on contract commutations will show much progress until there is greater clarity and specificity regarding the usage of funds under the TARP program.

We expect this will occur over the next few months as the TARP program kicks into action. Lastly, we have produced a presentation as we have committed to provide perspective on MBIA's commercial real estate exposure. This will be posted on MBIA's website later this afternoon.

In closing, I continue to expect as we've noted earlier in the year that the rest of this year and perhaps all of next year will remain challenging. While substantial uncertainty remains for the performance of the housing and financial markets and the economy, we remain prepared to weather this extremely difficult financial climate and we feel will be better appreciated in the long-term for doing so.

Chuck and Mitch will now take you through the status of our financial condition and our insured portfolio. Afterwards I will join them to respond to any questions you have on this call. With that, I will turn it over to Chuck.

Chuck Chaplin

Thanks, Jay. Since 2008 continues to be the year of the balance sheet, I will spend only a few minutes on our income statement, and focus in on other financial highlights and our balance sheet conditions, and try to provide some additional color on what we've published this morning in our press release and the 10-Q on which Jay has just commented.

If you would turn to slide five, first, our net income was a loss of $806 million for the third quarter, compared to a loss of $37 million in last year's third quarter. Pretax operating income was a $786 million loss dominated by the increase of reserves for RMBS of $961 million. After that increase, pretax operating income would have been $175 million. I will come back and talk about reserves more specifically in a minute, and then Mitch will take you through the credits themselves.

This performance, excluding the RMBS reserves, reflects the inherent strength and staying power of our business model. As we wrote, essentially no new direct business in the quarter, we are reflecting only earnings from business previously written. The FGIC transaction, which closed on September 30, doesn't affect the third quarter's income. The investment management segment had negative operating income of $14 million as we significantly increase the liquidity of the asset portfolio in the Asset Liability Management business.

At this point, more than half the portfolio is in cash and short-term securities, more than the amount of our GICs that are terminable upon a rating downgrade. This part of the portfolio has a negative spread that is the rate we pay on the GICs is higher than the earnings rate on the cash and near cash assets. Perhaps ironically if we were to be downgraded, the operating income of this portfolio would increase, as we would get rid of the negative spread.

The corporate segment had a $22 million operating loss in the quarter, about $5 million over the recent run rate. This is due to legal expense related primarily to class actions and derivative litigations. On the non-operating side, we had $155 million of realized losses in the quarter. About $64 million of that was due to our holdings of Lehman Brothers' senior hold co debt and the balance represents miscellaneous other impairments and net realized losses upon sale of assets in the ALM portfolio.

The mark-to-market this quarter is dominated by losses related to the rebalancing of the ALM book, which I'll go over in some detail in a moment. We had $243 million of gains on debt buybacks in the quarter, of which $207 million is attributable to investment management, $11 million to insurance, and $25 million to the corporate segment. The gains in the investment management segment helped to offset the realized losses we are sustaining to reposition the portfolio.

Finally, we had an income tax benefit equal to 23% of the pretax loss. We do not expect to get the full benefit of the capital losses in the ALM portfolio from an accounting perspective, because we do not have sufficient embedded gains today to offset them. So if you will go on to slide six, given that our business model is going to have to go through significant change, we have tried to be very careful about expenses. This slide provides some details.

Compensation is by far our largest expense and you can see that the expense in the third quarter of 2008 is higher than the same period last year and that is primarily due to severance payments that were made of approximately $5 million. The insurance division headcount shown at the bottom here is down on a run rate basis by 20% over a year ago. The run rate for comp expense is now approximately $30 million per quarter.

Fees and professional services in the quarter were higher due to legal fees and the cost of our soft capital facility where we are paying the maximum rate as auctions continue to fail, and I'll touch on that again later. Loss prevention expense is also higher due to remediation work on our CDOs.

Now, slide seven shows the thing that allows the business model to continue to throw off earnings despite periods of low production. It's the reservoir of deferred premium revenue and the present value of future installments, which grew in the third quarter due to the FGIC transaction to a new high of $5.7 billion. The pattern of release of those earnings and the assets of refundings is shown in the bottom panel.

Of course, we've recently seen record levels of refundings with $88 million and $94 million in the second and third quarters respectively, so we do expect some acceleration of the trend that you see here. Bottom line though, the FGIC transaction puts us on a new and higher earnings trajectory and is expected to contribute approximately $50 million of premiums and investment income in the fourth quarter of 2008.

Slide eight brings us to the biggest number on the income statement this quarter, the addition to loss reserves. Here is a picture of the reserve and loss development on our book over the last four quarters. The first line is our formulaic addition to unallocated reserves, which we continue to view as sufficient to cover our non-mortgage related exposures. The second line shows the special additions to reserves that we've taken for our second line RMBS exposures.

In the fourth quarter and '07 and first quarter 2008, we had additions for case reserves of $814 million and $265 million respectively totaling $1.1 billion. In the second quarter of 2008, those deals performances trended in accordance with our expectations and we had no additions to reserves. Payment activity in the second quarter, which is shown on the next line on the table was generally as we expected.

In the third quarter, however, performance deterioration and paid loss both exceeded our expectations, leading to the increase in incurred loss of $961 million. We now know that the vast majority of the mortgages that are defaulting in these securitizations were ineligible loans and that the seller/servicers have contractual obligations to repurchase them.

How that plays out in terms of our ultimate payouts and recoveries is difficult to estimate at this point from an accounting perspective, and therefore we are not recording any salvage amounts relating to the litigation we are pursuing against seller/servicers over ineligible loans at this time.

In addition, we analyze our insured derivatives for potential cash payment obligations and we disclose them as credit impairments. Although the impairments are relevant to understanding our financial results, they do not affect the GAAP financial statements, unless the impairment amount were to be greater than the mark-to-market on an individual case.

Our operating income disclosures, however, do consider impairments of insured credit derivatives as expenses similarly to our loss reserves on financial guaranty policies. We continue to expect that we will pay out approximately $1.1 billion in present value on our insured multi-sector CDOs. So the total incurred loss for all of MBIA's residential mortgage-related exposures is approximately $3.2 billion, which ultimately will be significantly offset by recoveries in the RMBS litigations. To date, we have paid out approximately $1 billion.

Slide nine provides the total cost of our portfolio rebalancing in the ALM business. We anticipated a total pretax loss on sales of $742 million when we reported second-quarter results based on asset prices and market conditions of the time. The $742 million is the sum of the $306 million of realized losses and $436 million of impairments shown here.

Ultimately, market prices and liquidity of financial assets of all kinds continued to fall right up until today, so we needed to sell more assets faster than we expected, and we realized greater losses, which totaled $786 million between the two quarters. The conditions that led to the rebalancing however, also gave us the opportunity to engage in some reverse temporary debt buybacks that resulted in a $285 million offset to the realized losses over several quarters.

The impact of debt buybacks is recorded in the extinguishment of debt line on our income statement, and it is backed out of our operating income statistics. The hedge gains are an important part of this story. We had total return swaps that were being marked up through our income statement as the corresponding assets were being marked down on the balance sheet in other comprehensive income overtime.

By the third quarter, we had accumulated $305 million of positive mark-to-market on those positions. A loss on the assets was realized in the third quarter, and the hedge terminated. So in the third quarter, there's a realized gain on the hedge, which is embedded in the $44 million net realized loss and an offsetting unrealized loss, that is to say, there's no third-quarter bottom-line impact of those hedges, we had taken it all in prior quarters.

Economically of course, the hedge does offset our realized loss. So the net impact of rebalancing this portfolio after hedge gains and after extinguishment of debt gains was $501 million pretax. We are now substantially protected, we believe against any liquidity risk in this business.

Slide 10 provides details on our mark-to-market. In the last few quarters, the mark on insured credit derivatives has dominated our results and generated significant earnings volatility. This quarter that part of the market is relatively benign at $105 million and it can be broken into two pieces.

The mark before the impact of the adjustment for MBIA's credit was a negative $538 billion driven by increases in spreads on collateral in the multi-sector and corporate CDOs. The MBIA credit adjustment then added $606 million of positive marks. Now that part of the calculation is highly volatile, and I note that our insurance swap spreads as of yesterday had declined by nearly 50% since September 30.

Perversely, the more favorable view the market has of our credit quality, the more negative will the mark-to-market become. Beyond that, we had a negative mark in the Investment Management Services segment largely related to the swap terminations that I talked about a moment ago. In corporate, we reflect a negative mark on the warrants issued to Warburg Pincus in relation to their investment in the company earlier this year. Both our stock price and volatility rose in the third quarter, triggering growth in this liability.

Slide 11 depicts the de-levering of our portfolio which continues. Par outstanding, other then in the FGIC transaction, fell about $60 billion from year-end to September 30, including refunded par of $22 billion related to public finance exposures and $13 billion of terminations of structured deals. This contributes to a continued reduction in capital requirement for the portfolio, as well as accelerated earnings from the upfront premium deals. The FGIC transaction adds $159 billion of high-quality par to our book of business.

On slide 12, I will spend a few minutes on our liquidity position. The investment portfolio of our insurance company has been repositioned over the third quarter to hold at 9/30, approximately $2.4 billion of cash and cash equivalents. This increase in cash of approximately $1.3 billion primarily came from sales of municipals, US governments, mortgage backed securities, and commercial paper.

We have continued to add liquidity to the insurance company in the fourth quarter, including additional asset sales and the exercise of our option to exchange preferred shares for $400 million of cash in the trust that has issued our CPCT or auction rate securities. Having taken these steps, we will be in a position to provide cash to the Asset Liability Management portfolio under the $2 billion intercompany secured borrowing facility that we recently put in place, and still have the same roughly $1.1 billion of cash that the insurance company held as of June 30, 2008.

On slide 13, we go into cash flows in the insurance company and demonstrate that they continue to be adequate to cover our loss payments. We had positive operating cash flows for the third quarter and for the year to date in the insurance company even with payment of over $1 billion in gross loss payments.

Now, slide 14 turns to the Asset Liability Management business again. Here is the balance sheet with the assets shown at both market value and book value. The difference between book value of assets and the liabilities measures the impact of asset repositioning, the cost of asset repositioning, and impairments in the portfolio this year.

We previously announced that we had raised sufficient cash to cover any terminations that might result from further rating actions, as Jay referenced a moment ago, thus the excess of cash and governments over the terminable GIC portfolio shown here. In addition, we've arranged contingence source of liquidity that currently totaled approximately $2.6 billion, which we expect will protect us from having to sell assets at current buyer sale values and realizing any of the current market value deficit through the liability par amount.

The contingent sources involved the use of holding company free cash and the $2 billion intercompany secured borrowing line from the insurance company. Cash flows from maturing assets and these contingent sources can cover all liability outflows without any asset sales or refinancing. Also, we've been successful so far in redeeming some liabilities at discounts upon request of investors, and while most of those liabilities have been MTNs, we've also redeemed some of the terminable gigs.

On slide 15, in the holding company's, but outside of the ALM business, are corporate level assets and liabilities. As of June 30th, we held $1.4 billion of free cash and investments at that level and buyback of corporate debt and common stock in the quarter really drove the reduction to $1.2 billion at the end of the third quarter.

Since then, we've used $600 million of that cash to bolster the liquidity of the ALM business as I just referenced. Our commitment to maintaining unquestionable liquidity at the holding company level though remains the same. We've said that we'll maintain a cushion of five years of debt service in cash principal net interest and that amount is currently about $480 million. After funding this $600 million, we will still have over $100 million of cushion to that policy requirement.

Now, if you turn to slide 16, as we've discussed several times in the past, we believe that adjusted book value is a useful tool for thinking about the value of our company. This slide shows the components of ABV and compares our status with that of the second quarter.

The boxed items reflect major changes from Q2. We take our reported book value and factor out timing related gains and losses that we expect to be reversed upon the maturities of the instrument and that includes both the mark-to-market on insured credit derivatives and unrealized investment gains or losses in the so called FAS 115 adjustment or OCI.

We do take account of credit impairments that insured derivatives that GAAP does not recognize, and that's the third part here. Those adjustments bring us to an analytical book value of $25.47 per share. Beyond that we have usual summation of future revenues already contracted and a provision for credit losses related to that future revenue.

The deferred premium revenue item is higher as a result of the FGIC transaction, and you'll note now that the asset liability adjustment is a negative number where it had always been a positive in the past that is an artefact of the asset repositioning and negative spread that we've been talking about.

Adjusted book value is $37.55 at quarter end, down from $42.16 per share at the second quarter. The difference between ABV and our current stock price suggest another $10 billion of pre-tax losses for which we do not at this time see any credible evidence or any third party analytic support.

Finally, slide 17, which focuses on capital. Traditionally I'd have talked to you about capital from the rating agency model perspective, but as the agencies are all in the process of rethinking their capital models, we're not doing at this time, so let's just talk about the over all capital position.

MBIA had a strong position at the beginning of this year with $15 billion in claims paying resources and a portfolio that was perceived to be very clean other than for our mortgage related exposures. We knew at that time that losses and elevated capital requirements would stress our rating levels, so we went into the market early this year and raised $2.6 billion. That's the three lowest slices of the bar on the left here. We improved our capital position by approximately $1.5 billion since then through portfolio amortization and active risk reduction particularly in the asset-liability portfolio.

The capital position has improved by about $4.1 billion. The amount of expected and incurred loss that we have recognized in our mortgage related portfolio, both RMBS and impairment of CDOs is about $2.1 billion after-tax. We have also taken about $500 million in losses on our ALM portfolio repositioning and as I said we do not expect to recover the tax benefit associated with that loss from an accounting perspective.

That $500 million is on a pretax basis. So at this point, we have removed substantial risk and uncertainty from the ALM portfolio and from the mortgage related exposures in the insurance portfolio and the capital position relative to the rest of our portfolio is stronger now than it was at year-end 2007.

While we have clearly not been able to clear the rating agencies moving goalposts for AAA ratings, our commitment to maintaining significant capitalization relative to potential claims remains strong. With that I would turn this over to Mitch Sonkin.

Mitchell Sonkin

Thank you Chuck, and good morning everyone. I am Mitch Sonkin, Head of Insured Portfolio Management. This quarter I am going to focus primarily on the increases to loss reserves we have taken on a second lien RMBS portfolio, as well as walking through the next phase remediation on the portfolio, which commenced with the filings of litigation against countrywide and ResCap. In the filing, I put that claims IndyMac over the past 45 days.

These three institutions were the originators and are the servicers, on $14.7 billion of MBIA insured transactions, which represent approximately 88% of our $16.6 billion second lien mortgage portfolio. Unfortunately, loans originated by these three issuers are responsible for the majority of MBIA mortgage back losses to-date.

In addition, I will also provide an update on our multi-sector CDO book, where we stand today and what could impact impairment levels on that portfolio in the coming quarters. Before I turn to the RMBS and multi-sector books, I would like to comment on the rest of the insured portfolio.

First, we are continually scrutinizing our book with season and subject matter experts utilizing as granular data as possible, not only to monitor ongoing performance of deals, but also to detect potential areas of uncertainty or potential stress in the Muni and structured finance arenas.

The current crisis in the residential mortgage market has now expanded to general economic mirage that is everyone asking about the depth and length of the economic down turn and its impact. We have seen the unprecedented collapse of several financial institutions, government enforced financial intervention and crisis management, and the introduction of the TARP program and FGIC mortgage guarantee concepts.

The full impact of these programs, however will not be known for quite sometime and while this intervention may well spell opportunity to achieve a level of stability here being elusive these past 18 months for the mortgage and housing markets.

We have not made any assumptions regarding potential positive impact in our loss reserve. However, because we closely and continuously monitor all of our concerned transactions, we're able to revise our modeling to adjust to a changing macroeconomic environment and loan level conditions. We believe we have the best capabilities in the industry of doing just that and we are consistently looking for strategies to handle what could be versus weighting a reaction.

With that introduction, please turn to page 19. In addition to my discussion today the supplemental material provided along with this presentation provides more detail on the performance of both our mortgage related sectors as well as other relevant sectors that would be noteworthy given current market conditions. To provide you with a few headlines of sectors beyond the residential mortgage related block realm I have a few takeaways for you.

First our consumer related exposures are holding up well with solid credit projections and short remaining average life. We have no remaining primary market ensured credit card exposure, our order books transactions are all fully funded to require enhancement levels and while unemployment rate increases could impact that portfolio we are well positioned for material increases in the falls due to that strong credit enhancement.

Student loan performance, both federally guaranteed and private, had held up well from an asset performance standpoint, but clearly there are funding issues in that space with the collapse of the auction rate and variable rate funding markets that we are dealing with now before we begin to see any material issue in a otherwise currently satisfactory parity levels.

Second, commercial real estate is increasingly becoming a topic of discussion as pressure increases on the office and retail sectors despite the fact that delinquencies remain generally low. Near-term refinancing risk has been cited as one of the biggest concerns for this sector.

We are fortunate that the majority of our booked future tenure fixed rate collateral with vintages in the 2004 to 2007 time periods, so the impact of refinancing volatility over the next three years should not be a major issue in those deals. In addition these deals do feature enhancement levels commensurate with the risk profile. For instance, with deals primarily BBB collateral they have enhancement of 30 to 35% generally.

That said, due to the inherently high leverage associated with CMBS over the last several years, we are very focused on monitoring our long-term position in this market, especially on our deals with primarily BBB rated collateral mind towards the risks inherent in commercial real estate and it should be your economic downturn.

Third, given the reasons for the corporate failures and restructuring we are also heavily focused on our investment grade corporate pools portfolio. Our corporate book has experienced minimal impact from the credit events associated with Lehman, WAMU, Fannie and Freddie; with average enhancement on the portfolio down only about 1% at this point.

Clearly this has been aided by the ability to restructure and recapitalize several institutions without closing as the credit events under CDS contracts, which has aided portfolio performance so we continue to keep a very close eye on this sector as well.

And fourth, our Muni book continues to perform satisfactorily and we are in the midst of integrating FGICs Muni book. We continue to actively lead the remediation of raincoat tunnel which is the primary of remediation in the book at this time.

Now let's shift our progress to our residential mortgage related exposures and quarterly activity. With that please join me on slide 20. If you look at the slide you'll see that we separate our RMBS exposure in four areas.

First, Prime which includes international covered bond deals in capital relief trades and First Lien Alt-A, which was generally insured at triple-A levels. Second, direct sub-prime. Third, HELOC; fourth, Closed-End-Seconds, which together with HELOC comprised our second lien portfolio. I'll spend the majority of the direct mortgage discussion on the secondly portfolio.

As of the end of the third quarter, our direct RMBS net par outstanding totaled $33.7 billion, a decrease of approximately $2.9 billion in the first quarter. The decrease is due primarily to amortization of some capital relief trades with our international book, amortization of our subprime portfolio, and a combination of amortization and increased patrols on the second lien portfolio.

If you turn to slide 21, I'll provide more detail. Our subprime book totals $4 billion. We provided you with a slide that takes a look at the asset quality metrics of the subprime book. You can see that current subordination levels generally ran 30% remained strong in these deals.

MBIA remains cautiously optimistic that regardless of the current REO (that's Real Estate-Owned) and foreclosure buckets, as well as mortgage industry projected loss rates or wrap tranches will not be materially impacted. MBIA provided insurance on first lien product only as a triple A class of subprime yield structure since the beginning of 2004, and we have almost zero 2007 exposure.

Due to substantial subordination and deal loss protection on these deals and the selective strategy taken towards direct sub-prime exposure, we consider the current risk of material loss to be low.

Now let's take a brief look at our Alt-A exposure. We are closely monitoring this $3.5 billion Alt-A portfolio, because of the increases in Alt-A delinquencies. This slide gives you a snapshot of current performance trends, enhancement averaging a bit over 8% and then closed foreclosure activity.

We wrapped a majority of the portfolio at AAA attachment levels and we did not ensure any transactions that contain pay option ARM loans, which many consider the most volatile loan type in the space. We are seeing loss severities less than 35%, so we remain cautiously optimistic on this portfolio as well, there are a few deals that we are watching closely at this time.

Let's turn to the next slide to discuss where we are on our HELOC enclosed and second deal as the areas where have been experiencing significant stress in our RMBS portfolio. Please join me on slide 22.

It has been an eventful quarter on all fronts for a second lien RMBS portfolio. We continue to vigil, we monitor and analyze this portfolio working with loan level forensic review experts, consultants as well as through the collection of loan level data. Our ability to capture and review data has allowed us to aggressively review performance trends.

I will discuss the fact patterns within the insured portfolio and ongoing macro uncertainty that caused us to increase our loss reserves associated with second lien deals quite approximately $1 billion. It is impossible to discuss the increase, however to the reserves and ongoing poor performance without discussing Countrywide, ResCap and IndyMac transactions in which our losses almost heavily concentrated.

Let me put this into context. Approximately 74% of the total reserves we have taken on the second lien book are associated with transactions with Countrywide and ResCap which are part of the litigation we commenced. Over 72% of declines was $723 million paid-to-date on the second lien book are associated with the deals subject to this litigation.

We began our review of loan level data in conjunction with our forensic loan review experts in February 2008, as we have reported all the way through. The results of their analysis has lead us to the conclusion that a very high percentage of loans in our insured deals, in some cases over 80% of the loan sampled, should not have been there. Meaning those loans are the violated loan level representations and warranties or they didn't adhere to underwriting guidelines.

We believe strongly in the finding of our experts and we are rigorously pursuing these matters. To summarize our actions for the quarter, we increased our reserves for several reasons. This quarter verus last, we saw a higher level of volatility in our second lean portfolio that caused us to adjust our loss reserves.

Based upon our analysis of loan performance, especially on deals where we believe there is a substantially amount of malfeasance and ineligible loans in our transactions, the level of new delinquencies significantly increased during the quarter.

Based upon the current performance trend, we believe that this factor in concert with stable roll rates will result in peak defaults, being higher than we had originally anticipate.

Now, we also believe that the majority of government programs and private bank initiative being pursued are currently concentrated on first lien. Furthermore, our review of existing loan level information seems to indicate that a disappointingly low level of modifications have taken place at this point.

Additionally, the amount of loan modification, repayment or forbearance plans thus far appears to be very low for our second liens. Consequently, we are experiencing elevated level of monthly loss volatility, which has been sustaining itself at high levels for the last few months, and we believe it will likely continue over the next quarter.

These facts we use to believe that due to a combination of worse than expected HP decline that's housing price decline for which we are now experiencing defaults as well as the fact that many of our deals we believe that they are a material number of ineligible loans have led to severely elevated defaults levels. In addition, the inordinate number of ineligible loans has created enormous challenges to the vendors with regard to modifications.

Based upon on all these information, and until we see evidence of stabilization or improvement, we felt it prudent to increase our reserves at this time recognizing the fact that the level of volatility is greater when trying to assess the behavior pattern of ineligible borrowers.

As of the end of the third quarter, MBIA has reserves on 73% of the second lien net par exposure and essentially all of the 2006, 2007 exposures to countrywide and RiskCap and in [demand]. MBIA's total net par exposure for the HELOC enclosed in second book was $16.7 billion as of the end of the quarter, broken down by $9 billion of [close] and second and 7.7 on the HELOC cost. The majority of these deals were originated over the last two years.

The key takeaway here is that we continue to give zero credit towards recoveries associated with the litigation we've commenced beside countrywide and RiskCap and the claim we have filed against IndyMac when considering our loss reserving levels.

We feel strongly about our cases and believe that they may in fact materially reduce ultimate losses expected for this portfolio. Let's examine the performance trends that led to the billion dollars of reverse we've taken on the second lien.

Please turn to slide 23. If you look at this slide, you can see the weighted average conditional default rate trends of the second lien book. HELOC and closed-end-second performance continues to be negative. If you can recall from our prior earnings call, particularly second quarter call. We indicated that roll rates were somewhat flat.

We believed at that time that the flat roll rates combined with what appeared to be a flattening CDR curve with the HELOCs and in line second-lien CDRs were tracking the lost estimates that we established in the fourth quarter of 2007 and the first quarter of 2008.

Furthermore, if you look at the chart, quarter-to-quarter change in new delinquencies as illustrated by the second chart on this slide, you can see that the delinquencies were actually lower in the second quarter of 2008.

However, as you can also see clearly, we had a large spike in delinquencies on a quarter-to-quarter basis in the third quarter, where delinquencies actually increased by 12% if you compare the third quarter to the second quarter. So what you have is a barbell situation where we have new delinquencies entering the pipeline and services putting through a continuing increase in losses, which are the prime drivers for our reserve increases.

What we are seeing is that we believe speculation has generally flushed from the portfolio, and aside from the lag effect of higher housing price declines we are seeing macro factors creep into overall pool performance.

Rising unemployment, continued lockout of the refinance market, and service [working] situation have begun to manifest themselves more clearly in delinquencies.

Let's turn to the next slide for more color. Please turn to Slide 24. Roll rates have behaved consistently with what we indicated last quarter. As you can see from this slide, there has not been a dramatic change in roll to loss rates in the third quarter.

One could characterize roll rates again as flat, so the question we have been faced with is, if we have flat roll to loss rates, how can MBIA now have new mortgage related reserves of almost $1 billion. The answer is that flat roll to loss rates cannot necessarily be characterized as an improvement, and when you combined flat roll rates with a spike and delinquencies from the second quarter to the third quarter, combined to get a significant increase into falls and losses as you roll these trends forward.

What does all this means for the future. Should we expect losses to continue in excess of the billion additional reserves we are taking this quarter. After all, housing prices continue to fall and are predicted to continue to decrease for the near future, which could mean additional losses.

As Wall Street journal reported in October that approximately 16% of home owners are underwater, meaning they own more under mortgages than their homes are worth. However, we may not necessarily continue to see more home loans has become delinquent on your mortgages at the same rate we re currently experiencing.

We've done some analysis on this and the relationship of delinquencies to housing price declines in our portfolio for one of our issuers, and CES&HELOC housing price declines to our loans. For three quarters, 2007, quarter four through 2008, quarter two, we actually review the loan that because of the housing prices declines now had CLTVs and excess of their loan value and their delinquency status.

What we found was that as housing prices decline from minus 5% in the fourth quarter,'07 to approximately minus 12% in the first quarter, '08, the percentage of loans have became delinquent, also increased from 5% to over 15%. However, as housing prices continue to decline in the second quarter of this year, the percentage of loans are rolled into delinquencies decreased.

We believe this reduction insensitivity to home price declines may have occurred because those borrowers who do not really intend to keep a home as a primary residence defaulted when home prices decline significantly and at this point the borrowers left in our pools are the ones who would be more likely to wish to continue staying in their homes.

This could well indicate the change in future losses, although we acknowledge it is early to tell and we will continue to monitor the trends. Now, let's go to the next slide to sum up what this means for claims we have paid to-date and our expected losses in the second lien portfolio.

Please turn to slide 25. From September of 2007, when this downturn truly began to impact our second lien book. Through the third quarter '08, we have paid claims of approximately $1 billion. As we stated earlier, approximately 74% of the total loss reserves we have taken are related to transactions which are part of our litigation against Countrywide and ResCap. Of the $1 billion in claims we have paid to-date approximately $723 million of the claims have been paid on those subject transactions.

In addition, we have paid a $153 million in claims on our three IndyMac transaction. Now this slides sets out our projected collateral losses on the segment of deals in the portfolio on which we increased reserves this quarter. As you can see, due to our individual deal level analysis there is a wide range of outcomes with losses ranging from 16% to 46% of the collateral pools, which are material losses.

But, it is important when looking at the collateral losses that those do not translate dollar-for-dollar to MBIA, these are the ultimate losses we will incur. Based upon performance to-date and individual deal metrics there is a benefit to excess spread on these deals and that excess spread will act as a buffer to provide some level of credit enhancement such that our actual losses are expected to be lower than collateral loss expectations.

As you can see from the deals listed here, MBIA has paid approximately $1 billion in claims through the third quarter for the transaction posted on the slide. However, actual collateral losses were nearly $3 billion. Now, every deal is different, and some deals have pool policies that will potentially reduce ultimate losses, but we do provide the collateral losses to provide you with some insight into how the portfolio is performing as a benchmark to market projections against which we believe we are in line with. Ultimately, the benefit of excess spread will be a determinant in ultimate credit losses on the second lien portfolio.

Additionally, we believe that these transactions continue to season. They will ultimately be a reduction in the percentage of loans that default. Accordingly, we expect a larger percentage of MBIA losses to be covered by excess spread.

Now let's turn to the next slide for some comments on our remediation strategy. So join me on slide 26. I want to conclude this section with a very important takeaway. We have told you in the past that we would aggressively pursue remediation efforts and that we take actions as required. As has been mentioned several times during my comments and elsewhere on the call, we have filed law suits against Countrywide and ResCap for material breaches of representations and warranties of your underwriting standard, as well as your refusal to honor repurchase requirements for ineligible loans.

The exception rates to underwriting criteria as a result of our forensic analysis are staggering. Upwards of 80% to 90% in certain transactions was tested loss. The fact that 74% of the total reserves we have taken on this portfolio are related to transactions featuring these levels are ineligible loans, and resulted in claims to-date of $723 million emphasizes the correlation and our strong resolve to pursue these actions vigorously, and we feel our case is extremely strong.

We are going to continue to monitor portfolio, and employ experts to review problem loans in our insured transactions and continue to take the necessary steps to ensure the removal of these loans, including pursuing actions as necessary.

Before I conclude this section, I want to briefly touch on IndyMac, and our remediation strategies there. As you know, we've got about $900 million in exposed IndyMac in the form of two closed and second deals and one HELOC transaction.

On July 11, the FGIC placed IndyMac under its control. Our main goal has been and continues to be a coordinated effort with the FGIC to ensure the stability of the servicing platform, and to work towards the transfer of servicing rights.

Furthermore, prior to IndyMac's placement into receivership, we were pursuing quit that claims based upon findings from our forensic review experts. We believe that we have a valid claim that allows us to put back a substantial number of loans to IndyMac and we have filed those claims with the FGIC according to their requested procedure.

That concludes my review of this second lien lean book this quarter. Now let's turn briefly to our CDO and structured pools book.

Please join me on slide 27, where we'll briefly review MBI's overall CD owned structured pool portfolio. As you can see in your slide, MBI's $126 billion CD owned structured pool exposure is primarily classified into five collateral types, only one of which is experiencing stress related to the US mortgage crisis, the multi-sector CDO portfolio totaling $30.4 billion.

The slight increase in exposure quarter-over-quarter was due to reinsurance paid backs. You'll also note the increase to the high-yield portfolio, and corresponding decrease in the investment-grade corporate book. That was due to one international CDS deal reclassification; however that transaction action actually paid off after the end of the quarter on October 23.

Let me briefly update you on the four primary collateral type portfolios. First, the investment grade portfolio of $38.3 billion is comprised of diversified pools of corporate names, ensured with the detectable to cover losses to credit events.

During the last quarter several credit events occurred, including Lehman Brothers, WAMU, Fannie and Freddie and three islanded banks. Based upon the final CDS protocols for Lehman, Freddie and Fannie, and assumed crisis for WAMU and the islanded banks, the actual aggregate impact on our portfolio was small with overall weighted average enhancements declining only 1%.

Clearly the use of ordinary course of business restructuring versus bankruptcy or receiverships in the financial arena have muted the potential impacts on the portfolio to-date. But at this time deal deductibles remain strong despite the large names that hit the corporate thus far.

The high yield portfolio $13.7 billion is largely comprised of low leverage corporate loan obligations with a concentration in middle-market loans and to a much lesser extent broadly syndicated bank, HELOs, and all advantage corporate high yield bonds. Yields in this category are diversified by both advantage in geography with European and US collateral.

Given macroeconomic conditions in the credit market lockup, obviously the middle market space requires attention. The underlying collateral or generally senior secured loans the transactions are managed by high quality non-bank lenders who have their interests aligned by equity positions in these MBIAs ensured debt.

The commercial real-estate portfolio of $42.7 billion is a diversified global portfolio of high quality and highly rated structured deals in the global commercial real-estate sector. $33 billion of our net exposure in this sector is structured CMBS scores that are not truly CDOs.

These scores are comprised of statics CMBS reference securities ranging from up or underlying BBB minus to AAA bonds with vintage focused on the 2005 to 2007 subject to a deductible. Almost all of this exposure is currently rated AAA and delinquencies to-date remain relatively low at this point, obviously there are many divergent views on where commercial real estate performance is headed. But these deals are supported by deductibles commensurate with a risk profile.

We expect delinquencies to increase over the next year given stress in the office and retail sectors and that there could be downgrade potential for some of the portfolio depending on those levels. We have some slides on performance in the supplemental information showing the composing of this book and the worst delinquencies the portfolio is experiencing.

As Jay said at the outset, we will be posting materials going into substantially more detail regarding our commercial retail estate book of business later today.

Now let's go to slide 28 for a review of our multi-sector CDO portfolio. The multi-sector CDO portfolio is where we've been experiencing stress related to the US subprime mortgage prices. We've had substantial rating downgrades and impairments on our insured book and there remains some uncertainty over where ultimate impairments will wind up given the continued volatility in the residential mortgage market.

We provide a breakout of the multi sector CDO portfolio along with a total permanent credit impairments on that portfolio and associated mark-to-market as of the end of the quarter. This quarter we recorded only one new impairment for $44 million related to a high grade CDO and we are closely monitoring ongoing RMBS collateral performance vis-à-vis our expected in stress case scenario. The mark-to-market certainly reflects the ongoing volatility of the underlying RMBS collateral.

In total, we now have $1.1 billion in impairments against the Multi-sector CDO book, with potential stress case is that could exceed $2 billion depending on future subprime RMBS performance, and whether the impacts of TARP and other government and servicer programs are material or not vis-à-vis stemming the foreclosure tied.

We believe that these impairments reflect the potential future losses we could experience, and certainly reflect the position on ABS CDOs, relative to defaults that has not fully manifested itself yet, but we expect (inaudible) over the coming few years.

The performance of the RMBS collateral and these deals will alternatively determine the future impairments. But the next several months will certainly be illuminating as to determining the ultimate direction and loss expectations for 2006 and 2007 subprime RMBS and therefore our direction on impairments.

Looking at the 2006 subprime RMBS collateral supporting our Multi-sector CDO book, to-date about 35% of the bonds have been paid down and looses have totaled 5.2%. Loss severities have been running in the mid to high 50% range. That leaves us with about 60% of the collateral remaining to determine where ultimate losses may wind up.

Given the slow movement of foreclosure timelines, momentum building towards the implementation of TARP, FGIC guarantees and other foreclosure mitigation efforts, the next few months will be critical in determining the levels of impairments that could be required.

If it appears that solutions may be manifested later rather than sooner, we'll need to take a view on remaining collateral that would likely result in increases that are in the arena of mark-to-marker levels this quarter.

In addition, we continue to move along with remediation and commutation discussions, which could have a major impact on ultimate impairments, but we will not go into that in detail at this time.

So to sum up, the key takeaways on the portfolio this quarter; first, our new Muni exposure continues to perform well on difficult market conditions and we continue to take a lead position in the (inaudible) curve remediation.

Second, our consumer and commercial real estate portfolios exhibit low delinquencies at this point, but we are watching these portfolios carefully for signs of degradation, given weakening economic conditions.

Third, our RMBS and RMBS related CDO portfolios continued to exhibit the stress perform resulting in the billion dollar increased reserves on a second lien book we discussed and it viewed that continued volatility in the subprime market could you lead to further impairments of the Multi-Sector CDO book.

And fourth, we are actively pursuing substantial claims against originators and servicers who we believe are responsible for significant losses on the second-lien book due to improper origination and servicing.

This concludes my portion of our presentation, which we designed to try to answer many questions we received on our RMBS and the CDO book.

As I mentioned, we have provided slides in the Appendix as a supplement to the general data we have released, which provides deal names and portfolio metrics in majority of the structured finance portfolio.

With that, I will turn this back over to Greg.

Greg Diamond

Jay will go first.

Jay Brown

We have actually now spoken for approximately an hour, and it's important that we just kind of recap the key issues or the key observations on the quarter.

From MBIA's perspective, the most important thing we focused on for the last three months, for the last six months, the last nine months is to make sure we had adequate liquidity for any event that might happen. Clearly as we began the year, none of us anticipated we would have the markets that we've encountered, and that is required the additional steps that took place during third quarter and at the end of the fourth quarter.

The company is now in a position that if the current market conditions continue for another year or two in terms of an inability to say it sold any asset and whatever rating agency actions might take place, we would not have any kind of liquidity problems occurring from that. That's a very important position for the company to be in, in these uncertain times.

In terms of the losses that we incurred during the quarter, Mitch covered all of the key points, but the key point here is, we saw a significant difference in the third quarter in the second lien portfolio that we didn't observed that same kind of a change in the primary market, and the second lien market is in fact behaving substantially worse and is gone off our original trend line. That is what is necessitated the change that you've seen.

As we enter into, going into the year-end, we have a lot of opportunity in terms of adding value to the company. We had mentioned earlier in the presentation that we are actively in discussions in terms of getting our new public finance company up and running. We are also actively in discussions on a large variety of different types of commutation which once there is clarity around TARP, we expect to see the ability for us to mitigate and reduce the amount of volatility that exists in and around this portfolio.

With that, I'll turn it over to Greg and we will take some questions.

Question-And-Answer Session

Gregory Diamond

Now we will begin the Q&A session which will last up to one hour. We are going to start with questions that have been submitted to us in writing. We have few of those. And we will address those first and then we will open up the phone lines.

All three questions that we have were anonymously submitted. First question is, are the terms of the repurchase agreement between the insurance company and the holding company established?

Chuck Chaplin

Yes, I'll respond to that. This is Chuck. The terms are established for the intercompany repo. The holding company will be paying the insurance company about LIBOR plus 200 and for drawers under this facility, it is collateralized with assets from the asset liability portfolio. The other important thing to note is that as part of the approval from the New York Insurance Department to put this in place, we used $600 million of holding company free cash into the asset liability portfolio to bolster it's liquidity, and we have agreed that that 600 will be available to the asset liability business until such time as the intercompany repo is repaid. Those are the critical terms of that agreement.

Greg Diamond

The next question. What are the terms of preferred stock being put maximum rate redemption et cetera? Are they're preferred of the insurance company or the holding company and are the puts being honored?

Chuck Chaplin

All of the terms of the preferred, which were exercised in the options on are already set in this transaction that was entered many years ago. So I believe that the documents are a matter of record. This was being financed in the auction rate market. The auctions have been failing since sometime in 2007. We have been paying the auction fail rate of LIBOR plus 200, since we were downgraded to the A2 level back in June. So all that will happen now is that we will replace the cash that’s in the trust with the preferred stock.

And the auctions will continue, although the auction period density does change after the exercise of the option goes from a 28 days cycle to a 49 day cycle. But we're expecting that those auctions continue, we continue paying a rate that's based on LIBOR plus 200. The deal does have the option to be converted to a fixed rate, but we're not considering that at this point.

The preferred stock, is preferred stock of MBIA Insurance Corp. not of MBIA Inc. and finally are the puts being honored. There really isn't any counter party risk here, because the cash is already sitting in the trust. So all that's going to happen, is that we're going to exchange with the trust, preferred stock for cash.

Greg Diamond

The last question before we open up the phone lines. Where does the cash come from for all the buy ins, the repurchases? From Insurance Co or from HELOC?

Jay Brown

The buy ins for our corporate debt and for equity the common stock of MBI both came from the holding company. The buy ins for MTN and medium term notes and GICs came from the ALM portfolio and the buy ins for the surplus notes came from the insurance company.

Greg Diamond

Now we'll open up the phone lines to accept questions. We'll use the same queuing priority as we did last quarter. We'll give first priority to MBIA shareholders, second will be sell-side equity analysts, third will be fixed income investors and then lastly we'll take question from everybody else. So now we'll start with that. Randy will you please remind the callers what to do if they'd like to ask a question? And then introduce the first caller in the queue.

Operator: Thank you. (Operator Instructions). Your first question comes from Darin Arita with Deutsche Bank.

Darin Arita - Deutsche Bank

Thank you. With respect to the new public finance subsidiary, what have you seen that convinces you that there would be a need for this entity?

Jay Brown

I think in terms of looking at the marketplace and the continued disruption, and for every person you can find it says there's no need for insurance, you're going to find an equal number of, particularly in the retail sector a large number of people who believe insurance, if it could become from a clean company reconstituted will in fact be an effective way to continue to help effect sales in that area. It's a gut instinct.

It's based on a lot of research and a lot of dialogue and a lot of observations, plus the fact that we have inside of our company over 30 plus years of experience and we've been through this before when the business was first established. There is initial resistance, but we do believe that there are a large number of institutions that would welcome us back. We have heard that in many, many parts of the country and from many regulators. And so we believe that the conditions that now exist make it a viable option for us to pursue.

Darin Arita - Deutsche Bank

And as you look at the financial situation as many state and local governments across the country, how do you think about the credit risk in your insured portfolio?

Jay Brown

Well, it's call underwriting. We don’t underwrite and take every risk that is out there. We have a significant difference in those risks that are approved versus the ones that aren’t. if you look at actually MBI's experience over the years, we've insured about 40% of the available credits that are out there in the market and that is the distinguishing factor.

There are credits that will from time-to-time have stress. We have an enormous reservoir of talent that has dealt with all of the different types of stress we've seen and we certainly think that the stress that we're going to see in the public finance market over the next two or three years is going to create a lot of opportunity for new issuance and a lot of refunding opportunities which already exist will continue over this time period. It's at times of stress that our product becomes far more valuable to both issuers and buyers of the product and it's that particular environment that we think we are going into.

Greg Diamond

Thanks, Darin. I would like to remind callers that we are going to limit the caller to one question. And if you have a follow-up question, then you can reenter the queue for that please. Thank you Brandy.

Operator

Your next question comes from Arun Malick with CQS.

Unidentified Analyst

Hello.

Operator

Arun your line is open.

Unidentified Analyst

Yes, as an MBIA insured bond policyholder, could you please explain with bonds trading at $0.40 on the dollar in the secondary market, could you explain why you are spending cash buying back junior capital?

Chuck Chaplin

The question is why buy back for example the surplus note as opposed to buying back insured debt. Is that really the question?

Unidentified Analyst

Yes, basically the bonds are trading at $0.40 in the secondary market, which kind of implies that there is a probability that you're going to default on your obligation. So why spend capital buying back junior parts of the capital structure instead of putting money towards debt obligation?

Jay Brown

We can't control how our bonds trade in the market and that's a simple fact. The variety of different levels it trades at are enormous, as you well know. We have in fact purchased for our own portfolio a certain small amount of deeply discounted MBIA insured bonds, because we believe that in fact we will get a very good return on them, because we expect we are going to pay out 100% on the principal and interest.

As we've seen in this particular marketplace as it exists today, there is nothing MBI could do within its current capital structure with the current views of the rating agency that it's going to fundamentally alter in the short-term the trading level of our securities that are in the market. As such, what we're trying to do and what we continue to do is improve our balance sheet, improve our economics, and position ourselves for a different marketplace as it returns to stability in the days and the years ahead.

Unidentified Analyst

Okay, thank you.

Operator

Your next question comes from Si Lund with Morgan Stanley

Si Lund - Morgan Stanley

Good afternoon. Just a quick question on the slide on the second lien RMBS portfolio. In the prior quarter slides, there was a sensitivity case for losses on the second lien, the closed-end seconds. We're looking at $2.1 billion now as of September 30th. Do we assume that's a base case and also is there a sensitivity case that you care to disclose?

Chuck Chaplin

Sure, the $2.1 billion that we have now obviously taken with respect to the losses that we expect on the portfolio, if you look at the 10-Q released today, you will see that we had an additional sensitivity analysis in there that would reach Technical Difficulty this duration of the peak defat periods. We have to increase reserves by another $500 million.

Si Lund - Morgan Stanley

Okay, thanks. I'll jump back into queue.

Chuck Chaplin

Sorry.

Si Lund - Morgan Stanley

I will go ahead and jump back in to queue, I have a follow-up.

Operator

Your next question comes from Jeb Bentley with Northwestern Mutual.

Jeb Bentley - Northwestern Mutual

Maybe you could comment with respect to the $2 billion intra-co facility, what kind of dialogue you had. Just elaborate around regulatory view of that and why the regulators felt like that was a prudent use of capital at the insurance sub.

Jay Brown

It's very straightforward and the fact that the insurance guarantees the performance of the Asset Liability Management business and that performance guarantee if you have a liquidity shortfall, the size of the loss, we had forced asset sales would be substantially in excess of what exists today.

So it's very prudent for the insurance company as a mitigation technique to provide additional liquidity to avoid those forced sales and the losses that would occur that if in fact there was an eventual shortfall the insurance company would be due for it.

The dialogue with the insurance department was extremely straightforward. There is nothing unknown here. It's a risk that's been understood in our company since we entered the business almost a dozen years ago and it is certainly something we've discussed with them over the past several quarters, including at the time we raised additional capital why we were keeping capital at the holding company.

One of the risks that we were concerned about was liquidity risk associated with downgrades from the rating agencies. That's why we were very comfortable with agreeing with the insurance regulators that we use $600 million of the capital available at the holding company in addition to having access to the $2 billion intra-company facility.

Jeb Bentley - Northwestern Mutual

Thank you.

Operator

Your next question comes from [Ming Zhang] with Barclays Capital. Ming your line is open.

Ming Zhang - Barclays Capital

Yeah. Hi, sorry about that. I appreciate the additional color on the CMBS CDO portfolio, but I was wondering could you breakdown the underlying buckets between BBB, A, AA, and AAA?

Jay Brown

Sure. We can do that. In the CMBS pool portfolio it's about $33 billion net par. About 33% of that collateral, underlying collateral was AAA, about 2.5%of it is AA, 15.8% is A, up 36% is BBB, with 13% less than BBB. And this will be posted on the website this afternoon, but those are the underlying collateral characteristics in CMBS pools.

And when you look at these pools, obviously the subordination and deductible levels rather associated with these deals will be commensurate with that level of collateral attachment point.

Ming Zhang - Barclays Capital

Thank you.

Jay Brown

Sure.

Operator

Your next question comes from Terry Shu with Pioneer Investment.

Terry Shu - Pioneer Investment

Hi, I want to go back to ask question about the surplus notes. You spend quite a bit of time talking about and with the slide as well holding company liquidity that you can meet most of your obligations.

Under what circumstances do you think servicing the surplus notes would be at risk? I assume you have done extensive cash flow forecast for the insurance subsidiary. Other than some kind of regulatory intervention do you see any scenario where you would miss payments on the surplus notes? Debt service?

Jay Brown

No.

Chuck Chaplin

No.

Terry Shu - Pioneer Investment

No?

Jay Brown

No.

Terry Shu - Pioneer Investment

Okay.

Jay Brown

I mean basically the surplus notes were put in place with an expected pay off at the end of five years.

Terry Shu - Pioneer Investment

Right.

Jay Brown

We certainly intend to take advantage of buying back some of that early if the market presents that opportunity. In all of our planning horizon, we've assumed that those are going to be paid off, nothing we are doing inside the insurance company assumes that those surplus notes would remain in place past five years.

And based on all of the scenarios, we are looking at right now Terry, it just isn't question. You identified the key issue, which is that surplus notes are subject to regulatory approval.

We believe that the New York Insurance Department, which was very supportive of our use of surplus notes to enhance the capital insurance company is fully aware of all our plans.

We have constant dialogue with them and we have nothing any of our dialogue with them to suggest that there would be any discomfort with continuing on their regular six month payoff.

Terry Shu - Pioneer Investment

Yes, we would all hope so since the GSEs also issued preferred stock with the encouragement of regulators, and they sort of change their mind afterwards.

Chuck Chaplin

Terry this is Chuck. I would just point out that, if you look at one of the slides in the presentation shows operating cash flow, it's a company with the nine months of 2008. And we think that we are in a period, where we are going to be making some of the heaviest cash payment for office that we expect. And there is a plenty of operating cash flow left over to cover the interest on the surplus notes. We don't envision any circumstance in which there is a shortfall of liquidity.

Terry Shu - Pioneer Investment

Right, one just worries again about regulatory kind of arbitrary or regulatory actions which seems the drop from the sky these days.

Jay Brown

It has been a surprising six-month period and a lots of surprises that none of us would have anticipated. I do think we have been very fortunate to be domiciled in the state of New York.

We have a regulator that's been extraordinarily active in our space, and who as worked carefully with each of the companies and particularly has worked with each of the companies that have very different issues and opportunities in front of them and has not imposed a universal answer or a single course of action for every company.

They've allowed each company to work within its own capital space and our belief is that our relationships with New York continue to be first class, and that based on what we see over the near term in the next two or three years, this should not be an issue that should concern people.

That said, you know as well as I do it's a world of very, very big surprises out there right now, although I do believe it's a lot better than it was a month ago or six weeks ago in terms of the gradual return of liquidity in the market that we are starting to see.

We're seeing it in credit spreads, and we fully expect that we've put in place will now in fact need to be fully utilized because the assumptions we've used is that we will not be able to sell any assets forever.

And that is a very harsh assumption to prepare yourself on that kind of portfolio, and we fully expect that once TARP is up and running and a large variety of assets start to trade hands again, that our near-term liquidity backstop that we've put in place will not be anything that will be needed over the long term.

Terry Shu - Pioneer Investment

Thank you.

Jay Brown

Sure.

Operator

Your next question comes from Si Lund, Morgan Stanley.

Si Lund - Morgan Stanley

A follow-up question. In the 10-Q, there is a mention of $420 million that was posted to your derivative counterparties. First of all, I believe it was zero as of June. If you could give us an update on why there was the increase in the derivative counterparty posting? And also, if there is a downgrade, what type of increase would we see related to these specific derivative counterparties?

Jay Brown

We do have collateral that's posted with some derivative counterparties, that is hedging-related derivatives, and I don't know, Cliff, if you know what the balance was at June?

Cliff Corso

I don't have the exact balances but basically the (inaudible) was with the freeze up in the capital markets in September into October the price of the security dropped and in essence what that did, drive an additional increase in collaterals posting the net derivatives. some attention to detail, but I don't have it now at the top of my head.

Si Lund - Morgan Stanley

If there were a potential downgrades, given the reviews that are out there from the agencies, what type of increase could we expect to see or is this just a function of market dislocation this post and we see it September 30?

Chuck Chaplin

Yes. It's a more a function of market dislocation, because as we've talked about throughout this call, we are really immunized against the rating downgrade of MBIA. So really what is flowing there is just mark-to-market moves on the hedging primarily between the assets and the liabilities.

Si Lund - Morgan Stanley

Okay, so if there were Moody's downgrade, December would not increase materially?

Chuck Chaplin

No. It would be related to what interest rates might be doing in the market at that point in time.

Si Lund - Morgan Stanley

Okay, thank you.

Operator

Your next question comes from Bryce Doty with SIT.

Bryce Doty - SIT

Hello, my question is really a question I get from a number of my customers regarding your admirable efforts to discover these ineligible loans in the closed-end portfolio. And that is what processes were in place in terms of being able to verify the quality or status of those loans, when these deals were done concerning the high rate of frequency of ineligible loans? It seems that a simple spot checking process could have revealed the problem at that time.

Mitch Sonkin

Yes, let me try to answer that in a very general way, because as you know we had remarked that we're involved in litigation, and I don't want to provide any specifics.

We have said today and we have said over the course of the past several quarters that we have had a painstaking process ongoing with forensic experts, large teams of varying types of experts that have been looking at individual loan files and have been looking at other relevant data provided by the servicers and beyond.

It is an ongoing process. It has resulted thus far in the three separate claims that have been filed and it's a process that will continue to cover any other loans that we have in the second lien book, so that we can cleanse it all and determine whether or not the same issues that we have in the claims that have been filed exist elsewhere and if they are, there will be dialogue and then if necessary there will be additional claims.

Bryce Doty - SIT

Okay.

Operator

Your next question comes from Terry Shu with Pioneer Investments.

Terry Shu - Pioneer Investments

I have a different question. With respect to the second lien performance, and what has happened this past quarter, how does that compare with the rating agencies various stress tests? Now that base cases are getting closer to stress cases, I have a hard time sorting out what is the base case and what is a stress case. So how does that compare and does that mean after they see your quarter's results that they will more likely they'll not initiate a downgrade or put you on watch again or for a downgrade?

Jay Brown

One is we've been sharing our results with the rating agencies continually through most of this year, Terry. Their assumptions continue to be, the assumptions they've used previously and the assumptions that they have been suggesting for the last three or four months are consistently higher than what we have used.

We have moved a bit closer to their stress cases probably or what would be their expected cases in the case of Moody's. And I don't believe anything in our numbers will cause them to change their views based on the dialogue we've had with them.

They are assuming in some particular types of transactions, particularly in the second lien, they are basically assuming the kind of performance we have had in the third quarter will continue all the way until the end of the deal.

Terry Shu - Pioneer Investments

Is that the base case?

Jay Brown

And then on top of it, they add another 30%, just in case they didn't get it right. So it's very hard for us to talk about their models, because the models that they used were designed for a benign environment and they don't deal very well for once you get into a severe stress environment like we're in today, they're modeling as if that's the everyday appearance and using the same 367 standard deviation off of that. And it results in Armageddon type losses.

Terry Shu - Pioneer Investments

Right.

Jay Brown

I mean, that is in fact what some of the numbers you've seen come out of the rating agencies and it's one of the points of dialogue we have with them is if you're trying to model to a stress and in fact you are taking today's world and calling it the normal world and then turning it into a stress environment on top of that.

We think that leads to unrealistic numbers. But that said, because we can't control what their opinions are, we have no influence out of that outside of explaining what we think is going to happen, we have prepared ourselves for whatever adverse outcome they might come with in terms of trying to think of our overall capital.

So we've tried to deal with the negative effect versus trying to figure out, there's no real point in us having an ongoing argument publicly with the rating agencies, because it's not going to influence how they ultimately reach their decision. Hopefully we will be able to explain if they actually run capital models and show us how they came up with their estimate of losses, we will be able to dialogue with interested investors and explain how their assumptions work and why we don't believe those are the correct assumptions.

But as of right now, Terry, we don't have the adequate information. They have not disclosed to us how those models work. So it puts us in a very difficult position in responding to why did they come up with a different answer?

Terry Shu - Pioneer Investments

So bottom line is that your current experience is close to the Moody's current base case and they've stressed it beyond that and they've been more or less kept abreast of your development. So today's announcement is no surprise to them. Is that sort of the bottom line?

Jay Brown

There is no surprise. We had briefed them far earlier in the past few weeks as to what was going to happen with our portfolio, what was happening with the ALM portfolio and so they are fully apprised of today's numbers.

I do think that the important thing to understand though is that we are trying to model what we think is the expected future of the company. And trying to push down our GAAP according to GAAP rule, which is put your best estimate out there, identify the areas of uncertainty, give investors an opportunity to understand what if things turn out differently, what the effects on you might be.

What the rating agencies are doing they are trying to replicate a modeling exercise that was designed for a benign normal environment that might go into stress some day. It's a very, very difficult task and they are struggling with it in terms of trying to come up with and say what is the right answer in terms of capital stress.

Terry Shu - Pioneer Investments

Right, but your results to date is closer to Moody's base case, something like that.

Jay Brown

Our results in the second lien performance area?

Terry Shu - Pioneer Investments

Yes, in the second-lein.

Jay Brown

Yes. Our results in the CDO area, I believe are still below what they would identify as the base case. And that's the last published numbers we saw from them. That has been quite a while since they've published numbers, so I don't know what their current base case or stress case might be.

Terry Shu - Pioneer Investments

Okay, thank you.

Chuck Chaplin

To add a thought to that, Jay. First of all, it's worthwhile to note that although we have prior to this fully briefed the rating agencies on the topics that are going to be covered on this call including our loss reserve changes, we are on review for downgrade with Moody's. So I just wanted to make sure everybody understands that.

Number two, is that we have moved to protect the company against any rating outcome that we might learn as a result of the agencies rethinking their stress model. So just two things to keep in mind is one, the process is ongoing and we haven't received the output yet. Number two, we believe that we are immunized from any downside business impact of any ratings change.

Terry Shu - Pioneer Investments

Thank you.

Operator

Your next question comes from Gary Ransom, Fox-Pitt, Kelton.

Gary Ransom - Fox-Pitt, Kelton

Yes, my question is probably for Chuck on the deferred tax asset. I believe you mentioned that you have taken a valuation allowance related to the ALM realignment of the portfolio. But when you assess the recovery of that tax asset, are you looking at the cash flows of the entire organization or is it just the ALM product outside of the insurance company?

Chuck Chaplin

Yes, it's a good question, Gary. There are multiple elements to our deferred tax asset, which is approximately $1.5 billion as of September 30th. The provision that we've taken is against the portion of the deferred tax asset that relates to the realized losses upon the sale of assets in the ALM portfolio. And the reason is that those are capital losses, not ordinary losses, and they can only be offset by capital gains.

From an accounting perspective, in order to not impair if you will the deferred tax asset, we would need to have the gains in the portfolio today and we don't have sufficient gains that could be realized in a carry back and carry forward period to amortize that entire deferred tax asset.

With respect to essentially the balance of the deferred tax assets, they are all generated by operating activities including the mark-to-market loss on the insured credit derivatives. Two issues on that is that our expectation is that the mark-to-market reverts to zero over the lives of those insured transaction and therefore there is a built-in gain.

If those losses were to be manifest as actual realized losses, they would be ordinary and not capital, and therefore the tax benefit would be recoverable from ordinary income that the company would expect in the future.

So we do a test of that every quarter, and we have kind of a severe stress of taxable income analysis that we perform to determine the recoverability of the deferred tax asset related to ordinary losses. We have plenty of capacity there. We don't have very much capacity on the capital side.

Gary Ransom - Fox-Pitt, Kelton

Thanks for that, Chuck. Just to be clear, though, there's no other valuation allowance against any other part of that deferred tax asset? Correct?

Chuck Chaplin

That's correct, there is not.

Gary Ransom - Fox-Pitt, Kelton

Okay. Thank you very much.

Operator

Your next question comes from [Tony Spencer], Macquarie Funds.

Tony Spencer - Macquerie Funds

Hello, I was wondering if you could give us some more background to the like tunnel exposure. What's your gross exposure, what's your net exposure? If you have been able to offset that in any way, and whether you had raised any case reserves for that specific transaction?

Mitchell Sonkin

I'm sorry, I can tell that the first part of your question. Could you just repeat the second part of your question?

Tony Spencer - Macquerie Funds

Just whether you had raised any case reserves (inaudible) to that exposure?

Mitchell Sonkin

Okay, let me start with that. No, we have not posted case loss reserves. (inaudible) Tunnel is an approximate $700 million exposure that we have. You are probably familiar with your credit if you're asking me that question. It's a tunnel in Sydney Australia, which we have been working on and continue to work on a mediation strategy, which is well under way. The outcome is something that we can't really comment on and won't for a while, but it is an act of remediation, and we have not taken any reserving activity thus far.

Tony Spencer - Macquerie Funds

Thank you.

Operator

Your next question comes from Nic Caiano with Paulson & Co.

Nic Caiano - Paulson & Co.

Hi, how are you.

Jay Brown

Morning.

Nic Caiano - Paulson & Co.

I just have a question regarding page 10 on the presentation, regarding the mark-to-mark fair value and foreign exchange net gain loss. So the net amount is 405, but when I just look at the income statement, the amount on the income statement is $234 million. Why is that a differential?

Chuck Chaplin

Yes, you're looking at the consolidated income statement.

Nic Caiano - Paulson & Co.

Right, but it says at the bottom of page 10 MBI in consolidated.

Chuck Chaplin

Right. What you're seeing is a difference in the presentation between the consolidated income statements and the segmented income statement that we also provide. If you look at the supplement on page five, you will see both sets of numbers and the reconciliation.

Nic Caiano - Paulson & Co.

Page five of the supplement?

Chuck Chaplin

Page five is the nine months, okay. So for the quarter, on page four, what you see is the build up of the consolidated financials. And if you want, we can take this off-line.

Nic Caiano - Paulson & Co.

Sure, we can take it off-line. That's fine.

Chuck Chaplin

But what the reconciliation is there on four, the column that's called subtotal in the very center of the page will include the unrealized gain on insured derivatives, a $104.8 million. And then a few lines below that there is a net gain loss on financial instruments at fair value on foreign exchange negative $509.8 million. Net of those two is the $405 million. So it's just a difference in the presentation.

Nic Caiano - Paulson & Co.

Okay, I see.

Chuck Chaplin

But if you want to go into it in more depth…

Nic Caiano - Paulson & Co.

Yes, could we? That would be great if someone could call.

Jay Brown

Sure, great.

Operator

And you have no other audio questions at this time.

Jay Brown

Okay, we will wrap up then. Thanks, Brandy.

Operator

This concludes today's conference call. You may now disconnect.

Jay Brown

Thank you.

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Source: MBIA Inc. Q3 2008 Earnings Call Transcript
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