One of our favorite stocks over the last few years has been Assured Guaranty (AGO), which I have profiled on several occasions, most recently several weeks ago, after Moody's finalized its 9-month review of the company with a downgrade of Assured's municipal bond division to an A2 rating. Assured Guaranty is an exceptionally well-managed business with very strong financial strength, and significant deferred earnings that is priced at a very large discount to its liquidation value. There are a number of levers that management can pull to unlock shareholder value and I'm confident that over time, AGO will close the discount and its stock will trade much closer to intrinsic value. While Assured Guaranty's primary business model of selling municipal bond insurance is jeopardized over the short term due to low interest rates, ratings downgrades, and a complete lack of clarity from the ratings agencies' regarding their ratings criteria, Assured Guaranty's financial strength should allow it to continue to generate shareholder value.
On February 27th, Assured Guaranty reported solid 4th quarter and full-year earnings results. 4th quarter operating income of $184MM, or $.95 per diluted share, increased by 7% from 2011. Full-year 2012 operating income was $535MM, or $2.81 per share, which was down slightly from $601MM, or $3.24 per share in 2011. This is the 3rd consecutive year that the company was able to generate over $500MM of operating income. The decrease in full year operating income was primarily due to increases in loss expense on the company's Greek exposure, which has been written off completely at this point, meaning that it won't account for any more future losses to the company. GAAP results are very misleading for this company because they include significant non-economic data points, which are extremely volatile and unreliable. 4th quarter GAAP net income was $74MM, or $.38 per share, compared with a 4th quarter net loss of $84MM, or $.46 per share in 2011. Full year net income was $110MM, or $.57 per share, which was down from $773MM or $4.16 per share in 2011. The decline in GAAP net income was mostly due to a higher amount of non-economic net unrealized losses.
4th quarter PVP was $69MM, which was down from $88MM in the prior year. $37MM in PVP came from public finance while $32MM came from structured finance, which has been a very quiet market for AGO and other insurers since the Financial Crisis. AGO insured a large life insurance reserve financing in the U.S. structured finance sector. Although AGO avoided the worst parts of the structured finance market such as CDO squared time-bombs during the middle part of the last decade, I wouldn't want to see the company rely too heavily on this market for a large portion of its income moving forward. Right now the underwriting cycle might be fairly attractive though due to a lack of capital willing to insure complicated structured deals, but I certainly don't believe that betting too heavily in this area would be a wise decision, and I wouldn't expect management to do that.
During 2012, AGO executed re-assumption transactions with Radian Asset Assurance and with Tokio Marine and Nichido Fire Insurance Co. for a total economic benefit of $191MM. Full-year PVP was $210MM, down from $243MM in 2011. Ratings uncertainty and low interest rates limiting demand for bond insurance plagued AGO's production all year. The company insured a total of $620MM in par of new structured finance so the new exposure is certainly not something I am too worried about, and I hope management does continue to be opportunistic on attractive risk-adjusted return transactions. AGO was able to ensure a total $16.8 billion of par direct and reinsured transactions. In the U.S. public finance market, the company insured 1,770 new issues and secondary market positions during 2012, representing $14.5 billion of par. AGO's target market is single-A issuers and the company was able to insure 30% of the transactions sold and 12% of par in that crucial segment.
AGO has intelligently bought $396MM of bonds the company had previously insured at an average cost of 63% of the par value, which created approximately $250MM of future economic value. These purchases reduce losses on insured exposures, improve the company's capital position, and increase the future investment income. Assured Guaranty was able to terminate 53 policies totaling $4.1 billion of net par outstanding, while still being able to collect 96% of the expected premiums, which further enhances the company's capital position. The structured finance portfolio continues to run-off or amortize, and the below investment grade exposure was down a solid 13% during the year.
AGO has been one of the most successful companies in terms of negotiating deals with providers of representations and warranties to pay on faulty mortgages. During the year, the company arrived at deals with two new companies totaling payments of about $500MM. In total, AGO has negotiated $2.9 billion in payments from R&W providers and of course the company just won a landmark court case with Flagstar bank for $90MM plus fees to be determined, which more importantly sets a precedent of the rights of insurance companies in relation to representations and warranties. The decision established clear liability as it relates to originators and securitizers of RMBS. The decision also clarifies contested issues such as causation and statistical sampling, which ultimately should accelerate settlements. Assured Guaranty has put back $2.1 billion and $2.4 billion of defective loans to both Credit Suisse (CS) and UBS (UBS), respectively, using the same procedures as with Flagstar, but thus far the banks haven't come to the table for any settlement. Both banks are very well-capitalized and Assured Guaranty has the financial heft to fight them, so I wouldn't worry too much about coming to a deal, although it might take some time.
Management shared some additional information pertaining to Moody's (MCO) who downgraded the company on January 17th. On January 24th, the company published a credit opinion on AGM containing a financial strength scorecard, which listed the main factors used by Moody's to determine AGM's financial strength and provides a score based on Moody's published criteria for rating financial guaranty companies. This scorecard was only available to subscribers of Moody's ratings service as opposed to the downgrade, which was distributed via a press release. On the 2012 scorecard, AGM had an overall rating of AA2, which Moody's then adjusted down one notch to AA3 based on speculative concerns over subjective issues of market demand and penetration. Now ten months later, the scorecard shows that AGM earned a stronger rating score, resulting in an overall rating of AA1, a notch higher than in March 2012. Even though AGM's score is higher, Moody's adjusted the rating down without proper justification to come up with a lower overall adjusted rating of A2. Astonishingly, Assured Guaranty never even got a full capital model from Moody's showcasing the true lack of substance in the rating agencies' execution of their supposedly critical role in the markets. The ratings agencies are absolutely out of control and I'm not aware of any of the leading causes of the financial crisis of 2008 that has been so soft-handedly modified like the ratings agencies, which are just now actually facing some of the ramifications of their abysmal actions. Interestingly, since the Moody's downgrade, AGO's credit spreads have tightened and the 47 commitments for new U.S. municipal issues that had sold with AGM's insurance but had not yet closed at the time of the announcement have closed, or are in the process of closing with no pricing concessions.
In 2012, Assured Guaranty acquired MIAC, a financial guaranty company that was already licensed to 37 states and the District of Columbia, and renamed the company Municipal Assurance Corporation. The company intends to begin writing U.S. municipal business in MAC later in 2013 as an additional platform to AGM and AGC, both of which are rated AA- with a stable outlook by S&P. The company is rightfully or wrongfully, committed to the U.S. municipal business and MAC should allow it to compete effectively. MAC will be funded internally through AGM and AGC, which will technically own the company. AGM and AGC will be seeding MAC with a portfolio of municipal risks to leverage its capital based, to provide earnings at inception, and to respond to clients looking for a new municipal-only platform. AGO is funding the company with about $800MM of capital, which is $200MM more than what got Build America Mutual Insurance Co. a AA rating. The company will use its other entities to insure structured and international infrastructure transactions.
Assured Guaranty traded recently at $18.44, which equates to a market capitalization of $3.54 billion on 192MM shares outstanding. Operating shareholders' equity per share reached a record level of $30.05, increasing by 5% since the same time last year. This is quite impressive considering shares outstanding increased by 6% after a conversion of a note. Book value per share was $25.74 and shareholders' equity was $4.994 billion. Adjusted book value per share, which is a sort of run-off value approximation over time, ended the year at $47.17 or $9.151 billion. I believe that Assured Guaranty should likely trade somewhere between operating shareholders' equity and adjusted book value. The likely sources of the discount to these valuation metrics that the stock trades at are; a general pessimism towards financial stocks, and a lack of clarity about the company's business model after the ratings downgrades it has endured. In addition, I believe that the bond insurance business model is complicated and misunderstood by many in the investment community, which tends to lead to larger distortions in price to intrinsic value than in other areas of insurance.
The combination of reduced bond insurance demand and reduced ratings make Assured Guaranty over-capitalized relative to new business opportunities. Due to the run-off on its existing par in-force, particularly pertaining to structured finance, Assured Guaranty's insured leverage improved by 12% YoY. Insured leverage is the ratio of statutory-basis net par outstanding to qualified capital. Since the 2009 acquisition of FSA, which is now called AGM, the insured leverage ratio has decreased by 41%. Now obviously, the company cannot engage in capital allocation strategies that would jeopardize its existing par in-force for the sole benefit of shareholders', but there is clearly a balance that can be attained. The single most accretive activity AGO can partake in is an aggressive stock buyback campaign. After the downgrade, the company announced a $200M share buyback that is a start in the right direction but I believe it can do more, and if it means paying taxes on repatriated capital then I still believe it is worth it. The company is limited in buybacks to what the free cash is available to it in the Bermuda holding company. There are also a lot of legal and regulatory restrictions in terms of transferring capital among the entities. The company believes that according to the S&P capital model, AGO should have roughly $800MM of excess capital at the AAA. This is AGO's assessment but it gives you an idea of the level of over-capitalization the company is currently situated with.
Assured Guaranty recently raised its quarterly dividend to $0.10 per share, which is great, but I'd lean more heavily towards buybacks at these prices. The 2nd strategic priority should be investing in MAC and hopefully over time AGM and AGC's ratings will be upgraded, as their financial situation continues to improve. With a lower capital base and an improved interest rate environment, it isn't heroic to believe the company can obtain a 12-15% ROE over the course of a cycle. Assured Guaranty has proven itself through the worst financial crisis since the Great Depression, and emerged as a larger and vastly more profitable company. For investors that wait for the ratings agencies to figure out what is obvious to any reasonable and interested observer, this rocket will have already taken off much higher. The stock is very volatile so be sure to dollar cost average, and we sell puts when it is attractive.