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Assured Guaranty Ltd. (NYSE:AGO)

Q2 2011 Earnings Call

August 9, 2011, 7:30 a.m. ET

Executives

Robert Tucker – Managing Director IR

Dominic J. Frederico – President, CEO, Assured Guaranty Ltd.

Robert Bailenson - CFO

Analysts

Michael Grasher - Piper Jaffray

John Palmer – Sweet Water Capital

Brian Meredith – UBS

Sean Dargan – Wells Fargo Securities

Nathaniel Otis – Keefe, Bruyette & Woods

Larry Vitale – Moore Capital

Andrew [Goth] – [Goth] Capital

Scott Frost – Bank of America/Merrill Lynch

Randy Rasman – Chatham

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2011 Assured Guaranty, Limited earnings conference call. My name is Gina and will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. (Operator instructions).

As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s conference, Mr. Robert Tucker, Managing Director of Investor Relations. Please go ahead.

Robert Tucker

Good morning, and thank you for joining Assured Guaranty for our second quarter financial results conference call. Today’s presentation is made pursuant to Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. It may contain forward-looking statements about our new business and credit outlook, market conditions, credit spreads, financial ratings, loss reserves, financial results, future reps and warranty settlement agreements, or other items that may affect our future results.

These statements are subject to change due to new information or future events, therefore you should not place undue reliance on them as we do not undertake any obligation to publically update or revise them except as required by law.

If you’re listening to this replay, or reading a transcript of the call, please note that our statements made today may have been updated since this call. Please refer to the financial – please refer to the inventor information section of our website for our most recent presentations, SEC filings, most current financial filings or for risk factors.

Please note that we plan to release our second quarter 2Q – second quarter 10-Q at the end of the call today.

Turning to our presentation, our speakers today ar Dominic Frederico, President and Chief Executive Officer of Assured Guaranty, Limited, and Rob Bailenson, our Chief Financial Officer.

After their remarks, we will open up the call to questions. I will now turn the call over to Dominic.

Dominic Frederico

Thank you, Robert. And thanks to all of you for your interest in and support of Assured Guaranty.

Before I begin a discussion of our recent quarter, I want to assure you that today, Assured Guaranty is the same company with a solid capital base, good business prospects, and many strategic alternatives that existed prior to the past few months and before the U.S. downgrade.

Now, I like to review our quarterly results, the performance of our Assured portfolio, our new business activity and future opportunities, and the status of our S&P and Moody’s ratings reviews.

We reported operating income of $136 million, or $0.73 per share, a strong result. Our reported income would have been higher except that there was a charge of $60 million related to the discount rate required by GAAP to calculate our present value of future losses to be paid.

For new business, I was pleased that municipal originations, the PVP, were 32% higher in the second quarter than in the first quarter as issuance volume increased in the municipal market.

Our total economic loss development was $71 million for the quarter, with the single biggest – single biggest contributing factor, as mentioned previously, being the decrease in the risk-free discount rates used to calculate the present value of future expected losses.

This change is not reflected of any credit impairment in our insured portfolio. In fact, if the accounting rules allowed us to use our own portfolio invested rates of return as the discount factor instead of the risk-free rates, we would have recorded very little economic loss development this quarter.

And in reality, it is our investment portfolio and it’s returns that are the exact resources we use to fund these discounts for future loss payments.

In terms of other loss developments, for the municipal market, massive defaults had been predicted. But as expected and previously communicated, there’s been no sign of that, not in the market as a whole, and certainly not in our insured portfolio.

Of course, state and local governments are facing budget challenges, but fiscal stress does not necessarily mean that a large number of defaults will occur. And equally important, a default does not necessarily result in an ultimate economic loss to our insured portfolio.

Interestingly, for the market as a whole, the level of municipal defaults that carry in the first half of 2011 is actually much lower than the 2009 and 2010 levels.

First half 2011 results reflect $746 million of default versus 2009 and 2010 full-year levels at $8 billion and $3 billion respectfully.

Additionally, it’s important to recognize that some of those defaulted credits were not investment grade and some would not have met our strict underwriting standards, and therefore would not affect the performance of our insured municipal portfolio.

Further, Assured Guaranty typically has conveyance and our contractual rights in our insured transactions that afford us remedies not readily available to uninsured bondholders further impacting the potential for economic loss.

Regarding the downgrade of the U.S. government’s credit rating by Standard & Poors, over the last several weeks, since U.S. was put on credit watch negative, we analyzed the potential impact on Assured Guaranty of rating agency downgrades of the U.S. government.

We currently believe the impact of the downgrade of the U.S. government to Assured’s insured portfolio, should not be material, as related downgrades should be limited to higher rate of state to municipalities, and therefore, the related increase in capital charges should be small.

And looking at our investment portfolio, we may see a one-notch decrease in the average credit quality, from AA to AA- based on the direct U.S. government, agency, and agency RMBS securities we own, which represent about 18.5% of our investment.

From a new business perspective, while we are not trying to make a prediction, if credits spread widen on municipality increasing their cost of funding, this could create additional opportunities for Assured insuring new issues.

And yesterday, S&P did put out a research update saying that because of their policy that the sovereign local credit rating creates a ceiling for the financial strength rating of insurers, they’ve decided to reverse the outlooks of five U.S. insurance groups from stable to negative, and downgraded five others.

S&P said this rating action did not reflect the change in their view or the fundamental credit characteristics of these companies.

While Assured Guaranty’s outlook was changed from stable to negative, our AA+ rating was affirmed, and it was nice to be mentioned with the other lead company’s on that list.

Regarding lost mitigation strategies for RMBS, we have continued to transfer loan portfolios to services we’ve approved to help reduce delinquencies, defaults and loss severities. The goal of this service or intervention is to achieve significant reductions in both 90-day plus delinquencies and low modification re-default rates. Also, we are encouraging the use of low modification and short sales, which should improve loan performance and collateral recoveries.

We are continuing to pursue our contractual rates through rep and warrant to recoveries in RMBS. In the second quarter, we announced an agreement with Bank of America, on 29 first and secondly in RMBS transactions for a payment of 1.1 billion for the lien deals reimbursement of 80% of the paid losses, up to 6.6% of collateral losses. This was a landmark agreement for the company and we were able to recover previously -osses as well as limit future losses.

As we said from the start, we want to reach comprehensive agreements with rep and warranty providers without the use of litigation if possible.

Since closing the Bank of America agreement, we re-allocated resources towards the other counter parties, who provide us with rep and warranty protection; specifically Credit Suisse, UBS, JPMorgan Chase, Deutsche Bank and Flag Star, which are among our largest remaining counter parties.

We continue to find significant breaches in a large percentage of loan files, which include misrepresented income, appraised value in employment as well as the occupancy status of the borrower.

Using Credit Suisse as an example of a counter party who has not been living up to its contractual commitment to repurchase defective mortgage loans, we’ve reviewed files for approximately $1.9 billion of mortgage loans on Credit Suisse deals, and found that 93% or $1.8 billion contained breeches of reps and warranties.

As of June 30, we have submitted $1.1 billion of loan request for repurchases and currently have an additional $694 million to submit in the third quarter.

Today, Credit Suisse has not repurchased a single loan even though our put-back process has resulted in approximately $2 billion in collections from repurchases or other payments from other counter parties.

The amounts billed represent a multiple of Assured Guaranty’s share of the losses, and although these funds would pass through the securitization waterfall, Assured would significantly benefit from the recoveries.

And Assured is not alone in seeking readdress against Credit Suisse. Credit Suisse is a subject of numerous RMBS related lawsuits and investigations. Credit Suisse has been fined by the Financial Industry Regulatory Authority for failure to report any delinquencies on subprime RMBS and is also subject to subpoenas from the SEC and the FHFA.

To date, we count 18 pending RMBS-related lawsuits against Credit Suisse by the Federal Home Loan banks, Monoline insurers, and other RMBS holders.

In one of these suites, MBIA alleges Credit Suisse put back loans to originators, and then just pocketed the proceeds, rather than passing them on to the securitization trust for distribution to RMBS holders. Clearly a no-no if accurate.

As I stated, our goal is to negotiate comprehensive agreements. We are well beyond the days of debating whether mortgage loans and RMBS transactions breeched rep and warranty’s and who was liable. It’s time for settlement and Assured Guaranty will pursue all of its rights including litigation. And if forced to litigate, we will pursue not only rep and warranty claims, but also damages and all other remedies that would be available to us.

Sadly, the situation with Credit Suisse is not unique, and we note similar behavior in not fulfilling contractual obligations among the other rep and warranty providers like UBS, JPMorgan, and Deutsche Bank. And I expect to release similar statistics regarding these counter parties in my upcoming presentations.

Turning to the rating agencies, S&P continues to consider changes to their proposed financial guarantee rating criteria, in response to market feedback. While it’s difficult for us to anticipate the final outcome, we believe that most market participants agree with our public comments regarding S&Ps leverage test, capital charges and single-risk limit proposals.

In addition, based on that primarily criteria, Assured Guaranty implemented capital enhancement strategies, which we believe would meet the majority of any new requirements.

Also, the Moody’s annual review is currently in process and we are waiting information regarding assumptions and stress loss estimates prior to their capital evaluation.

However, our Moody’s capital adequacies should benefit from the same successful strategies to enhance capital that we deployed to meet the new S&P proposed requirements.

Turning to new business activities, in the second quarter new business originations totaled $51.9 million, slightly below the first quarter’s $52.5 million, largely due to a smaller contribution from structure finance transactions. Even with the continued uncertainty caused by the S&P proposed ratings criteria changes, we originated 32% more municipal PVP than in the first quarter as market volumes increased.

Based on transaction count, we insured 12.1% or approximately 1 out of every 8 transaction sold in the municipal market in the second quarter which is up from 10.8% in the first quarter and 10.3% in the fourth quarter of 2010. Our market penetration of new issue public financial par volume also increased to 6% in the second quarter up from 4.9% in the first quarter and 4.4% in the fourth quarter of 2010.

We continue to see good demand for our product in the municipal area as many small issuers rely on insurance to access the market. In fact, in the second quarter almost 90% of our originations were for issues of $25 million or less.

We believe that with rating stability at our current rating levels, we should be in a good position with respect to our efforts to increase our market penetration rate, not only in U.S. public finance, but also in the international and structure credit markets.

While most of our recent businesses originations have been in the municipal market, we are seeing increasing opportunities in international structured finance areas. One of the new opportunities within the international area includes the replacement of downgraded guarantors on existing transactions, something we believe could be replicated in many other parts of the market.

In the structure finance area, we continue to see more submissions and are cautiously optimistic for the balance of the year.

Overall, I am pleased with the progress we made in the second quarter. We increased public finance originations, we reached an important agreement regarding rep and warranty claims with Bank of America, and we improved our capital position by purchasing securities we’ve assured and executing termination agreements.

We are at an important crossroad, and we believe we have positioned the company and move successfully beyond these turbulent times.

Lastly, we had a few internal changes during the quarter. I like to congratulate Bob Mills, our former Chief Financial Officer who is now our Chief Operating Officer. Bob has been instrumental in the company’s formation in growth, and has been with us since the IPO.

I’d also like to congratulate Rob Bailenson in becoming our CFO. Rob has been our Chief Accounting officer and has over 20 years of experience in the field.

Finally, I am pleased that Robert Tucker, who has been the head of our fixed income investor relations, and has over 25 years’ experience in the capital markets, has stepped up to lead both equity and fixed income investor relations.

These appointments show the quality, expertise and depth of our management team.

And now, for the first time, I will introduce Rob Bailenson, our CFO, who will talk about our financial results in greater detail.

Rob Bailenson

Thank you, Dominic, and good morning to everyone on the call. Today I will briefly review the financial highlights, and then provide you with more detail on the individual components of operating income, followed by a summary of economic loss development in the insured portfolio for the quarter.

I refer you to our press release in financial supplement for explanations and reconciliations of our non-GAAP operating income and GAAP reported income.

I am pleased to report strong operating income for the second quarter 2011 of $136.3 million or $0.73 per diluted share, which brings our year-to-date total operating income to $385.2 million or $2.06 per diluted share.

On the year-to-date basis, operating income has increased by 35.3% largely due to the execution of the Bank of America agreement in April, and the resulting increase and the benefit for breeches of reps and warranties.

The comparable operating income for second quarter 2010 was 172 million or $0.91 per diluted share. In second quarter of 2011, we received over 900 million in recoveries under the Bank of America agreement, which we invested and as a result, helped to increase net investment income when compared with the second quarter of 2010.

Second quarter 2011 gross operating expenses, before deferrals, were also lower compared with the prior year, and I expect this cost savings to recur in future quarters.

These positive trends in second quarter 2011 operating income were offset primarily by a decline in net premiums earned, which was consistent with our expectations based on scheduled amortization of net par. Despite the market challenges working against us, we have continued to generate new business, we have managed to maintain a strong and steady adjusted book value compared with the year-end 2010, as new business written, commutations, and loss mitigation efforts offset changes in expected losses.

Operating shareholders’ equity per-share was 27.84 up 7.4% from year-end 2010, which equates to an annualized year-to-date operating ROE of 15.6%.

I will now turn to the components of second quarter operating income. Net earned premiums and credit derivatives revenue total 296.7 million down 17.4% from 359.4 million in second quarter 2010.

A decline in net earned premiums and credit derivatives reflect the expected schedule net par amortization of the structured finance book of business and associated [inaudible] premiums.

Some of the decline of the second quarter was offset by refunding of 21 million in credit derivative premium accelerations of 6.1 million due to agreements we entered into with our counterparties to terminate certain credit defaults who have contracts.

Terminating CDS transactions benefits our [inaudible] capital position and is part of our capital adequacy enhancement strategy.

Net investment income was 101.5 million in second quarter 2011, which represent an 11.7% increase over second quarter 2010.

We have been shifting the portfolio to longer-duration bonds from short-term funds which has improved our investment yield. Also, income from bonds purchased for loss mitigation purposes and from amounts received under the BofA agreement, help drive net investment income higher compared with second quarter 2010.

As I mentioned earlier, we have received over 900 million in cash in the second quarter under the BofA agreement. We will also collect an additional 172 million related to second lien transactions by March of 2012.

The yield on the investment portfolio was 3.75% in the second quarter of 2011 compared with 3.5% in the second quarter 2010. The average size of the investment portfolio increased to 10.8 billion with the duration of 4.9 years in second quarter 2011 from 10.3 billion and a duration of 4.3 years in the second quarter of 2010.

Operating expenses were 48.5 million in the second quarter 2011 compared with 47.4 million in the second quarter 2010.

Gross operating expenses before deferral of policy acquisition cost were down 8.7% due primarily to a decline in compensation cost. These cost savings were offset by lower deferrals of policy acquisition cost in 2011 compared with 2010.

I expect operating expenses to be approximately 48 to 52 million for quarter for the remainder of the year. The effective tax rate on operating income was 20% in second quarter 2011, down from 30.4% in second quarter 2010.

The effective tax rate fluctuates due to the amount of income in different tax jurisdictions. This quarter’s improvement in the effective tax rate reflects higher operating income in our Bermuda operations. I expect the effective tax rate on operating income to be 24 to 28% for 2011, but it will fluctuate from quarter to quarter. I will now turn to Losses.

As many of you already know, our insured portfolio may fall in to one of three different accounting models for GAAP; insurance, derivative, or consolidated VIE’s.

However, my commentary encompasses the entire insured portfolio, as it would be presented in the FG insurance accounting model, regardless of the GAAP accounting convention.

Loss expense in operating income is recognized when expected losses exceeds unearned premium reserve on a transaction by transaction basis. This is a very simplified explanation, and I refer you to our loss accounting policy in the 10-K for further information describing some of the complexities involved in the timing of loss recognition. Expected loss to be paid is a measure of future cash flows, net of salvage in R&W discounted at the risk-free rate.

Economic loss development, where the change in ultimate expected loss to be paid reflects changes in assumptions based on observed market trends, changes of discount rates, accretion of discount, and the economic effects of our various loss litigation efforts. It is the measure management uses to calculate the loss experience of the insured portfolio, but keep in mind, that it also includes changes that are due at discount re-fluctuations.

Total economic loss development was 7.9 million, or 49.6 million after tax during the second quarter of 2011. Most of which was associated with insured U.S. RMBS transactions. As Dominic mentioned earlier, the largest individual factor contributing to net economic loss development, was a decline in the risk free rate used to discount losses, which counted for approximately 60 million of the total economic loss development.

The component of loss expense that is attributed to the change in discount rate, is not indicative of additional credit loss. Interest rate movements will always cause fluctuations in our loss expense, as the accounting rules require us to reset the discount rates every quarter.

This change was most pronounced with long dated expected loss payments principally in the RMBS sector where discount rates decrease by approximately 30 basis points to an average of 4.1% for these transactions.

The difference between our economic loss development, of 70.9 million and 144 million in loss expense is essentially expected losses that were absorbed in the [inaudible] reserve in prior periods and are now recognized in the income statement.

I discussed in our first quarter earnings call, we entered the BofA agreement in April of 2011, which provided us with certainty regarding R&W recoveries for 29 BofA transactions. The BofA agreement is accounted for a salvage in subrogation.

As we update estimates of loss for the first lien of BFA transactions each quarter, we include an 80% of R&W up to 6.6 billion of collateral losses.

As of June 30th, 2011, cumulative collateral losses on the 21 first lien transactions, were approximately 1.6 billion, and as of June 30th 2011, we estimated that lifetime collateral losses on these transactions will reach a total of 4.8 billion.

I’ll now turn the call over to our operator, Gina, to give you the instructions for the Q&A period.

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Mike Grasher from Piper Jaffray. Please go ahead.

Michael Grasher - Piper Jaffray

Thank you, and good morning, everyone. The – Dominic, the first question I have is sort of how much capital would you estimate that you raised internally with the debt repurchase in the quarter, and then the contract cancels?

Dominic Frederico

Since we initiated the process, Mike, including everything we’ve done, so the rep and warranty settlements and terminations, the purchase of secured securities, we estimate capital in excess – in run off, capital in excess of $2 billion as in freed up and/or created through those specific transactions.

So that takes us back to when S&P announced the criteria, potential changes back in January.

Michael Grasher - Piper Jaffray

So the number is in excess of $2 billion at this point in time?

Dominic Frederico

Yeah, per our models. Remember, these are our models, not theirs, so we try to be as, you know, accurate as we can, but that doesn’t mean that’s exactly on the nose, but we think around that kind of number.

Michael Grasher - Piper Jaffray

Okay. Next question, just with regard to sort of the rating issues that are occurring with S&P, what’s the change in the multiplier when a downgrade occurs on one of your exposures in your portfolio, say it goes from AA to A+? And then what’s the degree of change if you have an issue that’s sort of downgraded from say A- to A, or even A to BBB+?

Dominic Frederico

Mike, I guess you’re referring to the cap charges in their models based on the rating of the underlying security?

Michael Grasher - Piper Jaffray

Exactly.

Dominic Frederico

Well, obviously, this would affect, you know, predominately municipal and although the municipal criteria’s changing, so we really can’t be exactly accurate for an S&P point of view. From a Moody’s point of view because severities are very low, and even probability of default going from a AAA to a AA+ is rather insignificant.

As I said in our earlier comments, we don’t expect any significant changes in capital requirements. In other words, that number should be incredibly small, probably with, my guess, $100 million, but that’s a guess, and that’s probably at the far end of the spectrum.

We don’t expect this to be a significant issue relative to the, you know, individual downgrades of outstanding municipal transactions.

Michael Grasher - Piper Jaffray

Okay. And then just sort of the rate of change, I mean, if you go down the ladder to a little riskier holding…

Dominic Frederico

Yeah, the big change, Mike, which is the fallout of investment grade. There’s a huge clip in these deals. So going from AAA to AA, or even AA to an A+ is not significant, it’s only if you fall out of investment grade that you really see significant changes in capital requirements.

Michael Grasher - Piper Jaffray

Okay, thank you. And then, final question, just your commentary around Credit Suisse. Just to confirm, this is not currently in your receivable for the R&W put backs, is that correct?

Dominic Frederico

That’s a good question. If there is a number out there, it’s under – it’s a low number if I remember correct. Hold on a second, we’re pulling the number for you.

Michael Grasher - Piper Jaffray

So you’re saying you’ve submitted 1.1 billion?

Dominic Frederico

Yeah, we might have like 130 million receivable up; it’s not significant.

Michael Grasher - Piper Jaffray

Okay. Thanks, very much.

Dominic Frederico

You’re welcome.

Operator

Your next question…

Dominic Frederico

Yeah, Mike, Credit Suisse, we have $56 million to give you an exact answer.

Operator

Your next question comes from the line of John Palmer with Sweet Water Capital. Please go ahead.

John Palmer – Sweet Water Capital

Hey, guys. Dominic, thanks for taking my call. I – my question here is, why would you not, in this current uncertain environment, consider stock purchases because we obviously, the goal is to have the best credit rating possible, but I would imagine even 200 million spent buying stock here given the massive [inaudible] between ABV and the stock price, and that same 200 million, you would expect, would not make a critical difference in your end rating. And waiting until you do get confirmation would give you a much lower, you know, probably opportunity to buy your stock at a low price.

Dominic Frederico

So far, we disagree with nothing that you’ve said. Remember, we are in blackout period. We also have to consider ourselves with other information that we are aware of.

John Palmer – Sweet Water Capital

I don’t mean yourselves. I guess I mean the company itself.

Dominic Frederico

Oh, the company. Even the company can’t – it’s pretty much subject to the same rules as we are. So we’ve got to look at blackout periods, we also have to look at other information known. But we are well aware of the usually accretive nature of a stock buyback. As you know, or as we’ve communicated previously, we would have liked to have gotten more clarity around rating agency capital required levels. We appreciate that the amount of our authorization is rather insignificant relative to that total, and we will consider and take appropriate measures once we clear blackout and we’re confident that we know no other material information that’s not disclosed to the public.

John Palmer – Sweet Water Capital

So it is possible – that is in the consideration?

Dominic Frederico

We have a play book that we look at on a daily basis and that’s one of the plays in the playbook.

John Palmer – Sweet Water Capital

Obviously, it seems like the more uncertainty there is for a rating agency perspective, the more, you know, the bigger the cost is for you guys. And to a degree, you know, I mean, I happen to be in Warren Buffet’s camp that U.S. should be a AAAA if anything. Their credibility is only going down, so investing, obviously, and having their stamp of approval has arguably less value as we go forward.

Dominic Frederico

Yeah, but we live and die by that sword, so you know, we appreciate the comment and we obviously appreciate the significance of the accretiveness of a buyback. We understand where our authorization is for buyback today. It should not have a material impact, like I said, we’ve got issues to deal with internally regarding blackout and other considerations. [Inaudible], we will continue to evaluate.

John Palmer – Sweet Water Capital

Well, the last thing on that, Dominic, and – is – in your opinion, is adjusted book value the best measure to think of when one looks at the longer-term investor, like Sweet Water, is thinking about the underlying intrinsic value of the business?

Dominic Frederico

Well, the only issue with adjusted book is it really don’t forecast further expenses, and obviously, there’s a very little loss content based on a more normalized portfolio. So that’s the only real issue I have. We like to look at operating book value as a reasonably strong measure, and I think that number’s in the $27 range at this point in time. So it’s still usually, you know, our stock price is usually undervalued considering that measurement.

John Palmer – Sweet Water Capital

Thank you very much.

Dominic Frederico

You’re welcome.

Operator

Your next question comes from the line of Brian Meredith with UBS. Please go ahead.

Brian Meredith – UBS

Hey, good morning, Dominic. I’m wondering if you could talk about where you stand on your leverage ratios, if you kind of take a look at what the S&P post model had? How do you stand, you know, from a capital standpoint when applying current, your current portfolio to that model?

Dominic Frederico

Well, you know, good question. So they came out with the leverage test, which is just a hard [inaudible], par against capital. Obviously they look at debt capital. The big question there is whether they’re going to allow either all or some considerations for the UPR as part of the denominator.

We believe, with no changes, that we would meet the leverage test by year end. Since we’ve accelerated more termination than what was in that original forecast, I think we’re probably close to that. It might be a third quarter achievement number because we continue to look at opportunities in terms of the negotiating terminations. We just accomplished another one yesterday, as we speak, for roughly about 2.2 billion of par.

So we continue to do that pretty well, and that’s the whole issue around leverage. It’s simply the par number. So as I said, we thought that we would get comfort by year end. I think we might be ahead of that schedule, and that was considering no benefit from the UPR, which we believe was one of the most popular comments that S&P did receive. So if we think there is going to be a modification, that’s probably one of the easier ones that would probably have some change to it.

But be that as it may, the original question, we think we’re pretty close. We had an original forecast of 12/31. We’re probably ahead of that schedule today.

Brian Meredith – UBS

Great. And then, Dominic, my second question is looking at your R&BS kind of portfolio right now, what’s the sensitivity current, particularly for additional losses if we go into another recession?

Dominic Frederico

Well, you know, we’ve been trying to factor in, you know, kind of the double bit in housing and what would another 20% decline in housing values do. A couple things to consider there. One, you know, ultimately, our net loss exposure, ultimate results for R&BS is going to be predicated on the rep and warranty’s success or activity that we have.

Obviously, we feel very comfortable with our position. I think the Bank of America agreement was a real statement in that regard.

As we look at litigation out in the marketplace, we’re very pleased with most of the direction being very positive to the mono lines and other people perusing rights and remedies. So that’s all going in our favor, so that’s ultimately going to dictate how much money we win or lose on residential mortgage-backed.

But looking at it, you know, from the standpoint of just pure loss, one, those exposures continue to pay down at roughly $1 billion a quarter. I think today we only have about 16 billion that’s below investment grade in that area. So it’s a lot smaller number than when we started this thing, say back in 2008.

Two, these are very seasoned, you know, as you look at the portfolio today, you know, the majority of debentures are ’05, ’06, ’07. So even the ’07 year is now four years old. And if people made the decision to defend their mortgage and defend their house for that four-year period, we’re confident that their default rate, other than if there’s a huge spike in unemployment, should proceed on a lot more less, you know, dramatic result than what we’ve seen in the past. So the exposures are the last. The borrowers are stronger. Most of the misrepresentative borrowers have either defaulted or are in the seriously delinquent category, which we already default anyway in our reserve model.

So we don’t anticipate that big of a difference to be achieved or to be absorbed if there is a setback, if there is another dip. And the same could be said of corporates in our [inaudible]. You know, all those exposures are down reasonably, low or better than they were. Most of the bad guys are the guys that were weak in those portfolios that were already defaulted. The level of say, bank failures are a lot less, the level of bank failures in [inaudible] are a lot less.

So we’re seeing a lot of positive trends. And although yeah, you can expect some further fallout, you know, from the current economic situation what we’re in, we’re comfortable with where we’re at, vis-à-vis, total exposures and the individual risks and protections that are still remaining in those exposures, that we feel we would be in pretty good shape in that regard.

Brian Meredith – UBS

Okay. And then one last one. Just to question your thoughts on the impact of the debt ceiling on municipal finances and what do you think about that going forward?

Dominic Frederico

Well, you know, we looked at all the credits in our portfolio that rely on federal intervention and there wasn’t that many. Obviously, there – you know, the healthcare part is probably the biggest one from Medicare and Medicaid perspective. You know, they’re all in south economic times, I think, but in most cases, you know, varies states, municipalities have balanced budget requirements, which kinds of keeps the kind of focus on the ball.

We do expect, you know, a shortfall or a drop in state-aided funds, and obviously, federal to the state. But we think the portfolio’s in a reasonably good enough shape that it will be able to withstand those numbers. As I said, if you look at the economy we’ve been in, really, we sit here and talk about two municipal credits that are troubled significantly being Jefferson County and Harrisburg, and if you looked at the press, both have deals on the table today that we as a bond insurer are supportive of. We think obviously, it significantly improve the position and we hope that they will be passed in the upcoming days or weeks, and let those credits move on to a lot more stabler, healthier position.

So you know, we haven’t seen a whole lot. We think the portfolio is very well protected. Where there is troubled exposure, the exposures are down and what’s left if still pretty stable and solid, and I think it could withstand a fairly reasonable amount of further stress. And we continue to look for other solutions that will further mitigate either those exposures or potential losses within these portfolios.

Brian Meredith – UBS

Thank you.

Dominic Frederico

You’re welcome.

Operator

Your next question comes from the line of Sean Dargan with Wells Fargo Securities. Please go ahead.

Sean Dargan – Wells Fargo Securities

Thank you, and good morning. I was just wondering if you had any inside as to the timing of when S&P would release the bond insurance criteria. I mean, originally they had said early in the third quarter.

Dominic Frederico

Yeah, I’ll tell you that you need to ask them that question. Obviously, we had anticipated early third quarter with our individual determination being resolved by the end of the third quarter. We hope to be still –meet that second timetable. We don’t think it’s too complicated once you lock in to the final criteria to run our numbers. Obviously, we just had a review, as you well know, by them that confirms our AA+ stable. This is prior to the government downgrade, but our AA+ stable about a month and a half ago, using the old criteria.

Well remember, even in the new criteria, about 60% of the requirements are what I’ll call qualitative, not quantitive. So it’s like risk management, governance, controls, enterprise, risk management, portfolio, those types of things. Well, they’re not going to change from new to old criteria, you know. If you liked our risk management then, you’re going to love it now. If you liked the underwriting guidelines and discipline that shouldn’t change.

So you know because of that 40% is going to be quantitive and these are typically the major impacts of the quantitative ones. We hope to see a very quick turnaround of that and we’re hopeful that it happens before the end of the third quarter because we’d like to look at the fourth quarter kind of on a very stable-solid ratings base that allows us to really be, you know, more accepted and more beneficial to issuers in the marketplace.

Sean Dargan – Wells Fargo Securities

Sure. Thanks. And as in regards to the discount rate, can you give any sensitivity to what say a move in the ten year – I don’t know if that’s the benchmark, but what a move in interest rates translates into in terms of the impact to your losses because, I mean, the yield on the ten-year is down roughly 70 basis points or so since the end of June.

Dominic Frederico

Yeah, I’ll let our new CFO answer that question.

Robert Bailenson

Yeah, we see, Sean, about a 30-basis point movement in the 15 to 20 year range on the yield curve, actually, 15 to 20 to 25. That 30-basis point movement would be about a $60 million adjustment to our reserves.

So is it linear? I wouldn’t say it’s exact linear, but I would say 70 basis points could be anywhere from 70 to $100 million.

Sean Dargan – Wells Fargo Securities

Okay, thank you.

Dominic Frederico

You’re welcome.

Operator

Your next question comes from the line of Nat Otis with KBW. Please go ahead.

Nathaniel Otis – Keefe, Bruyette & Woods

Hey, good morning. All my questions have been answered. Thank you.

Operator

Okay, your next question comes from the line of Larry Vitale with Moore Capital. Please go ahead.

Larry Vitale – Moore Capital

Hi. Thanks, Dominic. Can you hear me okay?

Dominic Frederico

Yeah, Larry. How are you?

Larry Vitale – Moore Capital

I’m good. Good morning. I have just a few sort of housekeeping questions. There was a question earlier about how much in the way of tare ups and that that you’ve done, and you said $2 billion. My recollection is it was roughly that at the end of Q1. Do you have handy what you guys did during Q2?

Dominic Frederico

Yeah, we do. But the $2 billion number, Larry, just to be clear, was something we tore up yesterday. So I'm just saying, we continue to effect that capital, you know, mining technique and looking for opportunistic changes to terminate current insured balances.

We’ve done, prior to that most recent tear up, we’ve done 8.8 billion year to date, to kind of give you the number. So if it was 2 in the first, it was 6 in the second and we’ve got another 2 so far in this quarter, if not more.

Larry Vitale – Moore Capital

And that’s notional amount or the amount of capital relief that you would experience?

Dominic Frederico

That’s notional part. The capital relief, Larry, that we talked about, the approximately the 2 billion, is made up of all of the strategies. So it includes the benefit from the settlement with Bank of America and other rep and warranty activity.

It includes tear ups of CNBS transactions as well as the pooled corporates. It includes the repurchasing of our insured securities. It includes the runoff in the portfolio. So that’s the overall total.

So we quote par on terminations. We quote capital when we refer to all the capital enhancement strategies.

Larry Vitale – Moore Capital

Okay. That’s helpful. And then just on the Muni side, do you have handy the states on Muni downgrades in – or and upgrades I suppose in Q2 and year to date?

Dominic Frederico

Downgrades have been outpacing the upgrades by about 2 to 1, which is obviously very different than what was previously, say in the ’09 and ’10 when we were 6 to 1 going the other way. Obviously, we rate everything internally so although we look at the external ratings, it’s our internal ratings that drive our reserves and how we look at the portfolio, our below investment grade et cetera dip in our rating. So we monitor them because it will affect the cap charges that we get from the rating agencies. But it’s a monitoring, so yeah, we notice that the downgrade, updates, upgrades, we expect that to continue through the balance of this year at least.

Larry Vitale – Moore Capital

And that’s 2 to 1 is on your ratings?

Dominic Frederico

Yeah, it on the rating agency’s rating. But our rating, it’s probably similar. Remember, we had them lower on average anyway because we didn’t have a recalibration.

Larry Vitale – Moore Capital

Right. Understood.

Dominic Frederico

For a guarantee.

Larry Vitale – Moore Capital

Okay. And then finally, you got $900 million in cash from Bank of America, and I’m – you don’t, at least if you do I missed it. I’m trying to figure out where that cash went by comparing the Q1 balance sheet to the Q2 balance sheet. It seems that most of it ended up in the investment portfolio, but I can’t reconcile where all of it went. So if you could help me out with that, that would be great.

Dominic Frederico

Yeah, I’d say 90% of it went to the investment portfolio. I mean, we have positive cash flow over the six months. Obviously, that would be a lot of – obviously, we do pay dividends and expenses, but we should have enough, you know, coming out of the investment portfolio to meet most of that requirement.

So yeah, we’ll provide you with a reconciliation or we’ll make sure that that information is in the supplement.

Larry Vitale – Moore Capital

Okay. And then finally, just on the whole discussion on a buyback, your equity market cap closed yesterday at 1.9 billion. And you said the present value of the BofA settlement is 1.6 billion, and I just sort of leave it at that.

Dominic Frederico

Yeah, thanks for that fine statement, Larry. I appreciate it.

Larry Vitale – Moore Capital

Okay.

Dominic Frederico

I’ll take out my razor and I’ll be with you in a moment.

Larry Vitale – Moore Capital

Thanks, Dominic.

Dominic Frederico

You’re welcome.

Operator

Your next question comes from the line of Michael [Pang] with [Goth] Capital. Please go ahead.

Andrew [Goth] – [Goth] Capital

Hi. Actually it’s Andrew Goth. I was just wondering if you could just take us through, if you’d be willing, kind of how you think about – if you just wanted to run off right now and bought back stock, like what kind of value you could potentially realize?

Dominic Frederico

That’s the old question, like if you hanged yourself, how long would it take you to die. Obviously, we consider a lot of scenarios. It’s not one that we think is the most beneficial for the company. I think we can run numbers, as you could as well. You know, you’ve got adjusted book of 50, you’ve got an operating books of 27, you’re currently selling in the 10 range. How much stock could you buy back. You know, it’s a mathematical question at that point. Since we’re very comfortable with our financials, with our reserves, with how we state everything on the record, that those books values and adjusted book values, as I said, the adjusted book has got some adjustments in it that you’d have to make. But we think they’re all a reasonable approximations of ultimate value in the company, so do your math. If you buy back at 10, what does it do to book, what does it do to adjusted book.

I think it’s a very positive number. Now, could you free up all that capital to do it? Would the regulators allow you to move that strongly in creating dividends and buyback the stock? These are some of the fundamental administrative-type questions that you’d have to answer. But we have some strategies that would allow us to deploy a certain amount of – significant certain amount of capital to do that. And we’ll continue to look at those numbers and continue to go through that thought process as we see the events unfold.

Andrew [Goth] – [Goth] Capital

I mean, is it fair to say just based on what you just said, and the adjusted book value that’s on it, I mean, you think in a scenario like that, the ultimate value of the company is a multiple of where it is right now, like 30, 40?

Dominic Frederico

Well, it has to be higher, right? If you’re going to buy it back…

Andrew [Goth] – [Goth] Capital

Well, no, what I mean is like, if you’re saying the adjusted book value – if the adjusted book value or some approximation is the – some kind of indicator of the value of the company, then the – and you’d be buying it back at kind of a 20th of that, or whatever,- I mean, a 10th of that, whatever. I mean, doesn’t it stand to reason that, I mean, you could, you know, triple whatever the stock price is from doing that? I mean, it’s just – I just wonder why it makes sense to keep running it if this adjusted book value really does represent kind of the intrinsic value of the company and you could just kind of play that out and triple the value?

Dominic Frederico

Yeah, I don’t want to cut you off, but obviously, we’ve had a lot of discussion around buybacks. We appreciate the significance of that opportunity. We obviously were very concerned of where ratings capital was going to go. Obviously, we think we’ve done a lot of things to really modify the impact of that and therefore, we put ourselves in a better position to continue all parts of the capital management strategy, the shareholder value creation strategy and as I said, we’re in blackout, we’ve got some other strategic things we need to clear prior to us being able to be active in the stock, and we’re doing all those things as we speak today.

Andrew [Goth] – [Goth] Capital

Okay.

Dominic Frederico

Thank you.

Operator

(Operator instructions). And your next question comes from the line of Scott Frost with Bank of America/Merrill Lynch. Please go ahead.

Scott Frost – Bank of America/Merrill Lynch

Hi, thank you. You touched a little bit on the portfolio’s surveillance process I guess for the effects on – of a downgrade. And with respect to the debt ceiling, it’s understandable that you wouldn’t expect a downgrade to really have a whole lot of – from AAA to AA+, to have a serious impact but one of the things I’m worrying about is the longer-term effects on munis will depend on federal support, a consideration of potential budget cuts that are contemplated as well as future cuts that might be necessary if we gain the AAA rating as a goal. Can you sort of touch a little bit more on the mechanics of your portfolio surveillance process with respect to potential budget cuts?

I mean, the first round, I guess is defense non-essential spending and another round is supposed to be inact in November. How have you thought about potential cuts and the effect on muni bonds that you wrap?

Dominic Frederico

Sure. Well, first and foremost, any cuts, we believe, will be more impactful on new projects and new financing going forward than the past. Right? And in most cases, we look at our exposures, which already have either a dedicated revenue stream, tax obligations or the general obligation of the specific issuer as the support structure for those debt service payments. And that’s kind of been locked over the past. And as I said, we did take a look at the portfolio to see where there was any reliance on government-type funding, which principally has been the specific project area, like transportation or in the healthcare field for Medicare and Medicaid.

So we know those credits, we know what our revenue coverage is. And you know, we’re very comfortable with those exposures and the impact of the downgrade. And as I said, we think most of that debt ceiling and the very much further pressures of a put on the ability of the government to finance other things, will really be more new project specific.

And you know, we monitor our underwriting very, very closely. To give you a statistic that we have, if I’ll pull up the right one here in a second. So we looked at our submission activity that we have in the quarter and a good example would be, in a quarter, we declined to even consider underwriting 30% of all submission. We reviewed and rejected another 15% for credit or legal structure issues.

So you’re looking at about 45% declination just to kind of show you that we pay attention to essential services. We pay attention to the support of the foundation of the revenue backing each obligation that we consider for insurance.

So that’s kind of how we’re taking this on a prospective basis. And as I said, we did the retrospect, the review of the portfolio, for specifically that reliance on U.S. support and are very comfortable with the exposures that we have.

Scott Frost – Bank of America/Merrill Lynch

Is there any sort of contemplation of if the federal government is a significant part of the local economy, for example, if a military base is closed, something like that, is that also part of the surveillance?

Dominic Frederico

Yes, military housing would be one of the big issues. But we have very, very small exposures in that area. But you’re exactly right, military housing is a big one in that regard.

Scott Frost – Bank of America/Merrill Lynch

Okay, all right. Thanks.

Dominic Frederico

You’re welcome.

Operator

Your next question comes from the line of Randy Rasman with Chatham. Please go ahead.

Randy Rasman – Chatham

Hi. Can you guys address the – just the increase in the loss, in the loss adjustment expense reserves in AGMC from Q1 to Q2, from like 37 million to 491 million in just the supplement?

Dominic Frederico

Well, remember, in the – go ahead, Rob.

Rob Bailenson

It’s going to be more predicated on the receipt of the rep and warranties because depending on what you’re looking at, net reserves would be the reserve minus the asset. As the asset gets paid down, then the reserve goes up but it doesn’t go up because the offset against it is smaller.

Randy Rasman – Chatham

So you should net the – what you expect to receive from rep and warranty against that? Is that the way to think about it?

Dominic Frederico

It depends on the presentation. Obviously, we felt that there was economic loss of development of about 140 in the quarter. If you take out the P-gap, it’s down to 70, and we said the 70, the majority of that, 60 of it was the change in the discount rates.

Robert Bailenson

Yeah, I mean, the economic loss development, just to be clear, is $70 million. That’s – 60 of it was related to discount rates. The additional 74 was already embedded within the premium reserve and was set to go regardless of any change in credit. So there’s 144 coming through the income statement and there is – of that 144, 70 million was related to economic development and 60 million of that was interest rate.

Randy Rasman – Chatham

Okay.

Dominic Frederico

It depends on what presentation you’re looking at. In some cases for status net, for GAAP, it’s not. So I don’t know what you’re referring to specifically, but the collection of the rep and warranty at the asset or individual company basis on a STATE basis will increase reserve.

Robert Bailenson

And if you’re looking at the claims page in the supplement, you’re seeing the increase in reserves. What that is the collection of the cash from the [inaudible] transaction by collecting your cash you effectively increase your reserve and you get a benefit from claim [inaudible] resources.

Randy Rasman – Chatham

Okay. Thank you.

Dominic Frederico

Yeah, it’s complicated. We apologize for that, but the accounting doesn’t leave for a simple, you know, path or reconciliation.

Randy Rasman – Chatham

Got it.

Operator

Due to the interest in time, that concludes the Q&A session. I would now like to turn the call over to Mr. Robert Tucker for closing.

Robert Tucker

Thank you, operator, and thanks to all of you for joining us today for our conference call. If you have additional questions, please feel free to call either Ross, Aaron or myself. Thanks again.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation, you may now disconnect. Have a great day.

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