Assured Guaranty Q3 2007 Earnings Call Transcript

Assured Guaranty Ltd (AGO)

Q3 2007 Earnings Call

November 7, 2007 8:00 am ET

Executives

Sabra Purtill - Manager Director, IR

Dominic Frederico - President and CEO

Bob Mills - CFO

Analysts

Geoffrey Dunn - KBW

Mike Grasher - Piper Jaffray

Darin Arita - Deutsche Bank

Mark Lane - William Blair & Company

Jeff Bernstein - Schroders

Heather Hunt - Citigroup

Tamara Kravec - Banc of America Securities

Bob Ryan - Merrill Lynch

Ken Scarborough - Fasa Capital

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2007 Assured Guaranty Earnings Conference Call. My name is Latasha and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions)

I would now like to turn the call over to Ms. Sabra Purtill, Manager Director, Investor Relations. Please proceed.

Sabra Purtill

Thank you, Latasha. And thank you all for joining us today for Assured Guaranty's third quarter 2007 earnings conference call. Our earnings press release and financial supplement were released yesterday evening after the market close, and these materials, as well as other information on Assured are post in the Investor Information section of our website. I would also note that our 10-Q for the quarter will be filed by the end of the week and will also be available on our website.

On todays call Dominic Frederico, President and Chief Executive Officer of Assured Guaranty Limited and Bob Mills, Chief Financial Officer, who will provide a brief overview of the quarter, including comments about our credit experience. After their remarks, the operator will poll the audience for questions.

Please note that this call is being held for the benefit of analysts and investors in Assured Guaranty. Members of the media welcome to listen, but are requested to please call me directly for any questions that they would like management to address.

You may reach me in our Bermuda office all day, today and tomorrow morning at 441-278-6665. I would also like to remind everyone that management’s comments or responses to questions may contain forward-looking statements, such as statements relating to our business outlook, growth prospects, market conditions, credit spreads, pricing, credit experience and other items that are subject to change.

Our future results may differ materially from these statements. In addition, our outlook on these items may change. For those listening to the webcast, please keep in mind that more recent information on Assured may be available in later webcasts, press releases on SEC filings. Please refer to the Investor Information section of our website for the most current financial information on Assured. Please also refer to our most recent SEC filings for information on factors that could affect our forward-looking statements.

I’d now like to turn the call over to Dominic Frederico.

Dominic Frederico

Thank you Sabra, and thanks to all of you on the call and webcast for your interest in Assured. As all of you are aware, the last few weeks have been very challenging for the financial guaranty industry with enormous scrutiny being implied to our portfolio compositions, credit performance and mark-to-market calculations. I want to start by affirming to you that since our inception, Assured has believed in credit discipline, risk management and financial disclosure transparency.

During these tumultuous times, we will continue to expand our disclosure where possible, to meet your request for additional information. Before turning to a discussion of the impact on our credit experience of our residential-related asset exposures, I do want to cover a few of Assured’s accomplishments in the quarter and our evaluation of current business conditions.

Consistent with our track record since our IPO, we again made progress on each of our critical objectives, as we have in each and every quarter since our IPO. As we have previously announced on October 22, Assured posted its best business production quarter in the Company's history, with record production in our financial guaranty direct segment.

We had exceptional production in U.S. structured finance, and very solid contributions from both U.S. public finance and international. Our transaction count of 90 in the quarter easily surpasses all of our previous quarterly achievements, signaling increasing acceptance of Assured Guaranty. Our direct business opportunities continue to expand, as our pipeline at the end of the quarter was again at a record level.

We did receive the long awaited AAA rating from Moody's Investors Services for Assured Guaranty Corp. on July 11, which we have been able to rapidly put to use given the widening of credit spread, and the increase in the investor demand for Assured's credit enhancement product. I would also note that we received our last State License for Assured Guaranty Corp. from Wisconsin and we are now licensed at all 50 States.

Direct PVP was $133 million, an all-time record for the company. Public finance production was strong due to -- however, deal count was up with our U.S. public finance team closing 36 transactions up from the previous record of 33 in the quarter. As I mentioned in last quarter, we entered the competitive bid market and are making strides in that large market, although our market share is extremely small, providing significant opportunities ahead.

Our structured finance business continues to generate outstanding results with a 68% rise in PVP over the prior year. The quarter had good mix of business in various asset classes, such as two consumer auto deals, 11 U.S. residential mortgage-backed deals, and 15 U.S. corporate pool debt obligations and trust preferred transactions.

On the mortgage side, I would note that our activity was largely in the secondary market this quarter as existing investors sought credit protection on recent vintage deals. All these transactions have been carefully underwritten with our revised modeling assumptions, including higher loss severity and frequency. We expect to expand our presence in the flow or new public issue mortgage business, but the current combination of market conditions and loan new mortgage issuance, it means that there are limited new deals in the marketplace.

I would highlight that we did not underwrite any CDOs of ABS as it has been our policy since 2003, and we will maintain that position. Our direct international PVP was up 23%, despite of difficult comparison with the prior year.

Overall, the international franchise continues to develop nicely. We wrote four international pool corporate or CLO transactions, 17 European prime residential deals in addition to five U.K. utility transactions. I would also note that we are the lead sponsor of the upcoming Australia Securitization Forum and recently signed a lease to open an office in Sydney in conjunction with the conference at the end of November.

Our reinsurance production results were also good at $32.8 million. As we have stated in the past, the impact of large deals tend to exacerbate the volatility of recorded production in our facultative business, which is the principal growth driver of this segment. Facultative PVP comprised 67% of total PVP in the quarter and 61% year-to-date. This is in accordance with our strategy. I would also note that the prior year’s quarter is the last quarter in which we recorded any material PVP from the Ambac treaty, which totaled $9.5 million in last year’s quarter.

Let me now turn to the credit discussions. As many of you are aware, Assured has always taken a conservative underwriting approach. This is currently manifested by our lack of material exposure to several distressed asset classes, which has put us in a very solid position compared to the industry given rising concerns about U.S. RMBS and related credit exposures.

As you know, we have not written CDOs of ABS since 2003 and the $2.2 billion of remaining exposure that we have in that asset class which is rated all AAA with static pools of AAA rated collateral is performing as expected. None of the collateral in those transactions has been downgraded by any rating agency or by Assured. Performance has been strong and does not suggest any potential losses.

On a more granular level, in this class we have only one exposure, where a sub prime residential mortgage exposure represents 32% of the collateral pool. All of the collateral is still rated AAA today. Additionally, this specific CDO exposure expires at April of 2008. Fitch recently recognized the strength of our capital base and our solid risk profile, when they announced this Monday that they were beginning a capital analysis project for the Financial Guaranty industry.

In this announcement they bracketed the guarantors by probability of potential additional capital requirements to maintain their fixed AAA ratings. Assured was only one of two companies to be identified as having the least exposure to additional capital requirements from this new study. This was due to our negligible exposure to CDOs of ABS and the high credit quality of our mortgage book of business.

As we disclosed in our financial supplement and press release, our portfolio continues to be highly rated, based on our own internal rating standards, which generally results in ratings at or below the rating agencies shadow ratings on our foreign shore. While market opportunities have expanded, we have maintained our underwriting standards across all asset classes.

Our total net par outstanding continued to have an average rating of AA- with over 40% of outstanding par rated AAA based on these internal standards. Our below investment grade and CMC list decreased again this quarter to the lowest level on a dollar and percentage of par outstanding basis since our IPO.

During the quarter, we continue to be very selective ensuring that all deals written, meet our stringent standards that have been updated to reflect current market experience in certain asset classes. Specifically our assumptions for frequency and severity for RMBS exposures represent a current stress view of recent market conditions.

77% of the business written in the current quarter was rated AAA. Our U.S. RMBS book, which totals $16.4 billion is spread across four types of asset classes, prime, Alt-A, HELOC and subprime. While underlying mortgage delinquency and foreclosure severity have risen, and we expect them to continue to rise, our policy of AAA attachment points on subprime since our IPO has provided us with excellent credit protection.

Our post 2003 direct subprime book currently has an average over collateralization of 39% and our current conservative expectation is for cumulative losses of 14% to 15%. We recently did an updated breakeven analysis on each transaction, and we determined that the underlying cumulative losses would need to rise on average about 29% of the original pool balance before we would incur losses.

Cumulative losses on the underlying collateral in our transactions thus far have been only 1%. More recently, we have been focused on an examination of our HELOC book of business, which totaled $2.5 billion at September 30, 2007, of which $1.6 billion or 65% is in the direct segment and the remainder is in the reinsurance segment.

In the direct segment, we have a short list of transactions, only seven deals with three different services. 91% of the exposures with Countrywide and the preponderance of that exposure is in two public deals. Countrywide HELOC 2005-J, where we underwrote classes one and two in the fourth quarter of 2005, and Countrywide HELOC 2007-D, which we underwrote in the second quarter of 2000, under tightened underwriting standards.

You should note that we did not write any direct deals in 2006 due to our concerns about terms and conditions such as the use of HELOC as piggyback seconds that are used to buy investment properties and the general deterioration in first and second lien underwriting standards.

We also stopped writing facultative reinsurance on HELOC business early in 2006 for our reinsurance book. Today, our direct HELOC exposure is experiencing increased delinquency. We have not paid any losses. Our 2005 and 2007 countrywide transactions, which have public data on Imtech have experienced a spike in collateral losses in September and October, but still have significant credit enhancement remaining.

Additionally excess spread, which maybe higher than originally expected due to the slowing of prepayment fees, is being used to fund future losses and any excess will be used to build up further credit enhancements. We continue to closely monitor our performance and stress test to remaining loans. Even in high stress scenario losses if any, are not expected to be material given the modest level of our exposure and the level of credit support engineered in each transaction.

In summary, Assured's portfolio of RBS risk will experience some credit stress compared to original expectations principally in our HELOC exposure. But in most instances we continue to believe that the probability of meaningful loss, which we would define as an aggregate loss of $100 million is extremely remote. We are completely fluent in the details of our portfolio, and we will continue to keep you praised of our experience as the pool of insured mortgages continues to mature.

Finally, through all the crisis and stress we will experience over the past few weeks, a few further observations can be made. First, Assured has clearly demonstrated underwriting principles and competency in this market and has garnered broad market acceptance. Secondly, the market will reset itself as we pass through these challenging times as to our trading differential to our peer companies, and incredibly, critical element of our strategy and future success.

We believe, based on a host of factors, including the current credit default swap prices for the entire Financial Guaranty industry that we should significantly accelerate our timeframe for trading parity to our longer established peers. This will have the significant impact in terms of production, profitability and capital.

Now, I’d like to turn the call over to our CFO Bob Mills, who will discuss the financial results for the quarter in more detail.

Bob Mills

Thanks Dominic, and good morning. I want to remind everyone to refer to our press release and financial supplement for segment level details and further explanations of our financial position and results of operation.

Now turning to our performance for the quarter. Operating income, which we calculate as net income excluding after-tax realized gains and losses on investment, and after-tax unrealized gains and losses on derivative financial instruments for the third quarter of 2007 was $48.2 million or $0.70 per diluted share, compared to $39 million or $0.53 per diluted share for the third quarter of 2006. Assured had a net loss for the third quarter of 2007 of $115 million or $1.70 per diluted share, compared to net income of $37.9 million or $0.51 per diluted share for the third quarter of 2006.

Let's look at the results for the quarter in further detail. PVP or the present value of gross written premiums totaled $165.5 million for the quarter, up 30% compared to $127.4 million for the third quarter of 2006. PVP for the direct segment was $132.7 million for the quarter, up 46% from the third quarter of 2006 and was the principal contributor to the company’s record PVP in the quarter.

Production in the direct segment included strong performance across all sectors of the business, as widening spreads resulted in increased demand and improved pricing. PVP for the reinsurance segment totaled $32.8 million, a decrease of 10% from the third quarter 2006 amount from $36.5 million, which was largely due to the non-renewal of the Ambac treaty, which had generated PVP of approximately $9.5 million in the third quarter of 2006. As Dominic mentioned, facultative activity was the principle source of new business in the quarter rising more than 100% over that of the prior year.

Net earned premium for the quarter totaled $56.2 million, up 8% from the third quarter 2006 amount of $51.9 million. For the Financial Guaranty direct segment, net earned premiums totaled $31.7 million for the quarter, compared to $21.8 million in the third quarter of 2006, an increase of 45% from the prior year, which is reflective of the overall continued expansion in our direct book of business, as well as $1.1 million in refunding net earned premium from the U.S. public finance transaction.

Net earned premiums for the reinsurance segment were $21.6 million, a decrease of 15% from the third quarter 2006 amount of $25.4 million. The decrease was the result of decreased refundings as well as the fact that a number of shorter-dated structured contracts are maturing while much of the recent business has been longer-dated contract.

Net earned premiums for the mortgage segment were $2.9 million down from the third quarter amount of $4.9 million in 2006. The decrease reflects the continued run-off for the business in this segment during the quarter, as well as the $900,000 premium received in the third quarter of 2006 due to a commutation of our reinsurance agreement. There was no new business written during the quarter as was our expectation.

Loss and loss adjustment expenses incurred totaled $3.7 million for the quarter, compared to $0.9 million for the third quarter of 2007. There was a net increase in case loss and LAE reserves in the reinsurance segment related to an aircraft transaction underwritten prior to our IPO, but no major changes in other case reserves. The largest item impacting the expense for the quarter was the updating of rating agency severity factors in our portfolio reserving model based on recently issued data, which totaled $6.4 million.

The investment portfolio increased to $149 million from the balance as of December 31, 2006, the result of normal operating cash flow. Yields were up slightly comparing to third quarters of 2007 and 2006 with pretax book yield of 5.2% at the end of the current quarter, while we increased the duration to 4.4 years. There has been no significant change in the investment portfolio asset allocation during the quarter, and the average credit quality for the portfolio remains at the AAA level.

Operating expenses increased by $3.4 million or 21% in the third quarter of 2007 compared with the third quarter of 2006. The increase was attributable to a number of factors including expanded headcount since the end of the third quarter of 2006, as well as expenses related to share grants vesting over a four-year cycle, and share-based grants to retirement eligible employees, which are recorded on an accelerated basis. The level of all other operating expenses remains relatively flat in the third quarter of 2007 and continues to be in line with our expectations.

Income taxes on operating results for the quarter were a recovery of $1.3 million. This is the result of a $6 million reduction in our estimated U.S. Federal tax liability, due to the finalization of an IRS audit associated with 2004 and before for some assured subsidiaries.

Absent this recovery, the effect of tax rate on operating income was 10% for the current quarter. As many of you are aware, Financial Guaranty contracts that are written in credit derivative form must under U.S. GAAP be mark-to-market and provide protection against payment default on underlying security, not a change in market value. As disclosed in our press release stated October 22, 2007, we had after tax unrealized losses on derivatives of $162.9 million. This was totally attributable to spreads widening and included no credit losses.

The derivative business is an expansion of our Financial Guaranty business, and these guarantees in derivative form are not traded, nor we generally require to post collateral based on changes in market value. If these instruments approach maturity, market fluctuations, gains or losses will revert to zero, absent is specific credit event. Changes in the mark-to-market have no impact on statutory capital for rating agency models. More than 70% of the mark-to-market was due to our corporate CLOs and in particular our high yield corporate cash flow CLOs, 100% of which are rated AAA.

I would note that the widening of the spreads in the CLO market is due to a mismatch of supply and demand in that market, as underlying corporate credit performances remain strong. The balance of the mark-to-market was mostly attributable to the decline in subprime secondary market prices for our RMBS and commercial MBS book, which is almost entirely, rated AAA. The net position on the balance sheet related to the mark-to-market of derivatives as of September 30, 2007 is now a liability of $202 million before tax benefit.

With considerable volatility continuing in the market, this amount will fluctuate in future periods. There is the little movement in the mark-to-market since September 30 for corporate CLOs, the largest component of our mark. I would note that the subprime market prices have continued to deteriorate since the end of the quarter.

The actual mark-to-market for the fourth quarter will of course depend on market prices as of December 31, 2007. You should note that our 10-Q which will be filed shortly will include a sensitivity table for mark-to-market valuations, which should provide some clarity in to our mark-to-market valuation level.

Our book value per share was $23.69, a decrease of 1% from the $24.2 book value per share at the end of the third quarter of 2006. Our book value per share number includes about $2.20 a share for the net unrealized loss on derivative contracts, as of September 30, 2007.

Adjusted book value, which reflects the book value and adds the embedded value from after-tax net present value of estimated future installment premiums in-force, and after-tax net unearned premium reserves net of DAC was $37.57 per share at quarter end, up 9% compared to $34.43 per share at the end of the third quarter of 2006.

The growth in adjusted book value reflects strong new business production over the last 12 months. It was partially offset by the mark-to-market unrealized loss on derivatives.

The company's operating ROE, which is calculated by dividing our annualized quarterly operating income by average shareholders equity, excluding accumulated other comprehensive income in the effect of the unrealized mark-to-market loss was 11.4% in the quarter and year-to-date, compared to 9.4% for the third quarter of 2006 and year-to-date 2006.

With that, I would like to turn the call over to the operator to poll for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And your first question comes from the line of Geoffrey Dunn with KBW. Please proceed.

Geoffrey Dunn - KBW

Thank you. Good morning.

Dominic Frederico

Good morning, Dunn.

Geoffrey Dunn - KBW

We're hearing some feedback out there, that the rating agencies are getting maybe a little overly aggressive on downgrades, I’m actually looking at full transaction merits, but maybe basing the average just on collateral performance. I'm in the camp, I don't think you are going to have material losses, nor do I think any your peers will. But incrementally, do any of the rating agencies' actions worry you that maybe more indiscriminate downgrades could pressure capital charge requirements inside the company with losses not really being an issue?

Dominic Frederico

Geoff, our view is we rate everything internally, so that the rating agency ratings are like either a secondary check guidepost, but principally, we rely on our own ratings. We assess our own capital requirements off of that. And although, as you point out we are subject to their current requirements and that’s why our current conservative is over our capital, because quite honestly, we don’t know where this is going to go relative to capital needs based on the downgrading and then their stress modeling.

So, we don’t have that influence on our underwriting that’s one of our internal structure and system and standards. We are mindful of their current concerns and the potential reactions of the current market and therefore position the company to ensure that we have the capital required that continue to maintain a very strong levels of AAA ratings.

Geoffrey Dunn - KBW

Right. Thank you.

Operator

Next question comes from the line of Mike Grasher with Piper Jaffray. Please procced.

Mike Grasher - Piper Jaffray

Good morning.

Dominic Frederico

Good morning.

Mike Grasher - Piper Jaffray

Dominic, you mentioned some discussion there on trading differentials. Where are those differentials now? How have they changed over the past 90 days?

Dominic Frederico

Mike, we’ve had historically been pulling in the trading differential, and probably starts back two years ago, as we started to move up the rating scale in terms of the AAA ratings. It's harder to now provide real point, because there's not a lot of transactions being done.

On the structured finance side, we’ve no real side-by-side comparisons, but market participants typically point to the default swap levels, and we are quickly becoming a preferred provider and we there would price it very close. Obviously, the real issue for us and the real opportunity is in public finance.

And in public finance, we’ve been able to get to a position of parity for floating rate. For the fixed rate, and this goes back to the issue of how many transactions we’re going to actually be able to point to. We are currently in a rating or a differential of about 5 to 7 points, and yet obviously, our argument is extremely powerful, we always stick to the rationales of why we should be trading flat, if not inside, by pointing to a whole host of different data points, including the credit default swap prices for ourselves against those other guarantors.

So, as I said in my opening comments, there is our expectation that this market should re-price. It should re-price significantly in our favor, and that being the case, even though it will take some time that will provide us tremendous opportunity for the company to grow in that very valuable asset class called public finance.

Mike Grasher - Piper Jaffray

Right. And then just a follow-up -- which leads me to my follow-up, which is, how much is the market changed for Assured or what is your pipeline look like today? Has it accelerated given the current environment?

Dominic Frederico

Yeah, our pipeline today, as I said earlier, is at record levels, and I would tell you that its record level is almost in a multiple. So, we don’t typically give out the exact number. The only thing I can say to you is, on a year-over-year basis, we look like a very different company. You are looking at in terms of, just giving you a quantification, triple of what it was last year at this time.

Mike Grasher - Piper Jaffray

That's helpful. Okay, thanks. And then Bob, I just wanted to, I guess pry a little bit here on, as a former banker, there seems to be a lot of confusion out there around the mark-to-market between the banks and between the financial guarantors. Can we get your thoughts in terms where some of the confusion may lie in terms of how the banks perform their mark-to-markets versus what the financial guarantors do?

Bob Mills

It’s somewhat difficult to comment on what each bank is doing since I am not in there. Certainly, I worked on that side of the fence too, and I believe the discipline or the mark-to-market concept is the same, regardless of where you are. From the mark-to-market standpoint, I believe we use a rigorous approach to this, to the extent that we can, we use direct quotes. Beyond that, we rely on market indices, the JP Morgan high-yield cash flow AAA index for our high yields.

The ABX index and CMBX index for our residential and commercial mortgages. Beyond that, it becomes more limited views of counterparty marks or similar transactions, but that's very limited. You must remember too, that 97% of our CDS are all AAA rated. So, it’s hard to comment on what the others are doing. I do it at the same way as I did when I was on the bank side, use a very strict methodology.

Dominic Frederico

I'm going to step out on the big limb here and get on a little bit of ramp. Part of what you're seeing in the hysteria in the market today, I believe is because of the mark and the misunderstanding of the mark relative to Financial Guaranty companies. We are not priced on a spot basis. We do not have exposure relative to a change in price. We pay only on credit events. A significant portion of the mark deterioration today comes out of the residential side.

We’ve gone through in this call and our website, an exhaustive explanation of our exposure, we’ve quantified for you the worst possible, maximum exposure we have. It has nothing to do with our mark. Our biggest exposure today that we believe that could result in losses is HELOC exposure, which is not even in the mark, because they're Financial Guaranty contracts.

The mark is not a surrogate for losses. It can't be looked at that way. Each of us has to come to recognition of our exposures relative to the residential marketplace, as it is today, and recognize those potential losses, period end quote and the market is not relevant at all to that discussion.

Mike Grasher - Piper Jaffray

Thank you for that feedback, that’s helpful and hopefully the market will figure it out someday?

Dominic Frederico

We hope and pray along with you.

Operator

Your next question comes from the line of Darin Arita with Deutsche Bank. Please proceed.

Darin Arita - Deutsche Bank

Hi, good morning.

Dominic Frederico

Good morning.

Darin Arita - Deutsche Bank

I was hoping to talk more about your HELOC exposures. Can you give us a sense of what sort of cumulative losses those can sustain, what happens if prepayments slow, and then also give us a sense of what sort of stress testing you put these through?

Dominic Frederico

Okay. Darin, this is an extremely complicated exercise, because there are so many assumptions that go into the ability to forecast expected outcome. So, if you think of the result, these are basically second for HELOC, so they sit on top of prime. So, the first thing is, you really have to understand, what are the mortgages below you, the type of loans they are, because that has an impact on the second position.

We look at that in terms of starting to develop our expectation of what I’ll call default factors, right. So that delinquencies that ultimately conferred to a default. We do stress it significantly beyond by looking at today's current array, of our current borrowers, delinquency and stress each class to an assumption of how much will go into the default.

So for the sake of argument, everybody above, say a 180 days we consider even though there only delinquently listed today. They are 100% going to go into default. We then also further stressed, if by saying everything is a 100% severity. There will be no recovery. So, every time we look at our expected loss in that model. We take the worst position.

The real wild card here is the excess spread. As you know, these deals start out with virtually no over-collateralization or credit enhancement, and it's built up by the trapping of the excess spreads. So you hit the pre-agreed level of credit enhancement. As prepayments slow, the amount of excess spread which is typically in excess of 200 basis points then continues to build; it's pays losses as well as builds up additional protection. That is the wildcard today. We normally assume a prepayment rate, kind of in the 30% level.

And based on what we are seeing today, that's starting to slowdown, so probably down to a level of 15 that has a significant impact on the level of buildup of credit enhancement. We think our deal structure today can absorb a lot somewhere in the 8% to 12% range of the original pool balance. Current default or current losses today in the structure are at 1.4%.

The 2007 deals are written even tighter, so there we think we can get up to a size of 14% enhancement before we would ever be looked at the payer loss. Also remember, these are spread over 7 deals, so they are not huge and of their own rights, and for instance, if you look at the Countrywide deal with roughly about $700 million of par still outstanding, 1% movement above our expectation of loss containment is a whopping $7 million.

So, as you can see, even if our expectation is, it will go to 10 and we cover it. If it goes to 20, that’s $70 million of impairment before tax. So, we are looking at tight. We try to estimate it as best we can. The negative side, which is the foreclosures and the severity which we take very conservative years, the wildcard is how much we continue to enhance or build from the excess spread and that's really related to the prepayment factor, and we look at that at 30% now. We think it’s probably really around 15, and does that modifies, it will give us more enhancement to protect losses. But as I said, even in the absolute expectation of, it doesn't come out the way we think, everyone points about $7 million.

Darin Arita - Deutsche Bank

That's very helpful, Dominic. I guess turning to a different subject on reinsurance, if some of your competitors do come under capital pressure and they are looking for ways to free up capital and they seek reinsurance as a solution, would Assured Guaranty be willing to offer that?

Dominic Frederico

My gentleman, who runs the direct businesses madly scribbling on a pad of paper, perhaps he would rather not, but we are committed to both sides of this industry, both on reinsurance side and the direct side. We will be opportunistic in how we utilize our reinsurance capital. The current market, as you point out, should send a lot of the existing guarantors to seek reinsurance protection. We're aware of that. That becomes in effect our market, and that’s kind of why we're here and that's what we're built for.

Darin Arita - Deutsche Bank

Great, thank you very much.

Dominic Frederico

You’re welcome.

Operator

Your next question comes from the line of Mark Lane with William Blair & Company. Please proceed.

Mark Lane - William Blair & Company

Good morning everyone.

Dominic Frederico

Good morning Mark.

Bob Mills

Good morning.

Dominic Frederico

How are you doing?

Mark Lane - William Blair & Company

Congratulations on getting that last state license in Wisconsin, by the way.

Dominic Frederico

It was a significant point, Mark. I want to make sure you understood that.

Mark Lane - William Blair & Company

Yeah. I've been waiting for that. My question is, on excess capital. I don’t know if I missed it, but Bob can you talk about, quantify that potentially, at least within a range based on the different of ways the rating agencies look at that?

Bob Mills

Yeah. It is done differently by all three rating agencies. And when you look at our last published data, the excess capital would be depending upon who you are looking at somewhere between $300 and $685 million, depending upon which rating agency you are looking at. So, there is quite a substantial amount of excess capital that still exists today.

Mark Lane - William Blair & Company

And why your credit quality is extremely good on the RMBS side. Can you give us any sense of what sort of downgrade risk in terms of capital requirements you might have?

Bob Mills

I mean not surprisingly, we have looked at downgrade risk associated with our subprime and prime exposure. And we clearly have enough capital under a reasonably severe downgrade scenario from core subprime or were prime exposure from any of the rating agencies at this point. I don’t see it to be a big problem.

Mark Lane - William Blair & Company

Okay. And the last question is, and I don’t know if there has been enough time. The markets have been kind of seized up. But with regarding the business on a day-to-day basis, you mentioned trading differential, but what is the dialogue right now among your customers, their comfort with the Financial Guaranty product right now. I mean, at least anecdotally, what sort of discussions are you having? Are you concerned at all about wavering demand or just the scrutiny on the business? Has there really been a change in the last week or two or is it just more rumors and, etcetera?

Dominic Frederico

The biggest change, Mark, were obviously committed and believe in the industry and its viability and its necessity in today’s capital market as the means to accomplish financing that would get done in any other format. If you look at dialogue, obviously the easiest thing we can point to is our pipeline, as we said it’s triple to what it was last year, and no one is walking away from the table.

Deals are getting postponed due to liquidity criseses, but it separates the market. International goes on as it goes. Public finance goes on as it goes. It’s really in the structured credit, where true cash deals or public deals are drying up for the short-term as liquidity has kind of left the market. However, there are tremendous opportunities relative to basically on balance sheet risk management that are kind of filling up our coffers.

And the neat thing about this business is, it really gets us the ability to choose the asset classes. Obviously going forward as the market works its way out, some of these non-bank SIBs will obviously go away, and that's not a real loss for the industry.

Obviously, we don’t expect to see CDOs of ABS to be a very popular item going forward. And once again, since we didn't write any of that business, it’s not a concern of ours. So, are we necessary? Absolutely. Are we involved in active dialogue with all of our constituents out there in the marketplace? Yes, we are. Is there are lot of activity today? Sure there is. But there are segments of the market that because of liquidity crisis, which we do believe corrects itself.

At the end of the day these things have to get openly taken care of or done in the market. We are I would say on the lips of most people, they are looking for credit protection as one of the premiere guarantors that they want to do business with on a go-forward basis.

Mark Lane - William Blair & Company

Okay. And last quick one, Bob. The portfolio reserve in indirect. You mentioned some change in the rating agencies stress analysis or something. I mean, which rating agency or what sector are we talking about?

Bob Mills

We do this every year. But on September 6, the S&P put out some new severity information for ABS, and we put that new information as we always do into our model, and that resulted in an increase in the portfolio reserve, I said its $6.4 million.

Mark Lane - William Blair & Company

Okay.

Dominic Frederico

And remember Mark, we do portfolio reserves and every risk in our portfolio. It really keys off of default assumptions and severity assumptions that we use published from the outside, so it’s very independent. It’s the S&P, default and severity, and because they changed as of September 6, which they typically do every year in the third quarter, we then update our statistics. So, when our machine runs, our portfolio reserve now has the higher severity, quickly with severity this time. Higher severity risk that cost us a $6.4 million increase in reserves.

Mark Lane - William Blair & Company

Got it. Thanks a lot.

Dominic Frederico

No problem.

Operator

Your next question comes from the line of Jeff Bernstein with Schroders. Please proceed.

Jeff Bernstein - Schroders

Hi. I guess, very similar question to the one before, but I'll ask it again. I guess, from your customer standpoint with what‘s going on in the press, the equity markets, and your own CDS levels. How does the customer remain comfortable that it's a good decision given with the way the market, and I agree it’s irrational, but the way the markets currently valuing you and your peers, both equity and fixed income?

Dominic Frederico

Well. It’s kind of almost a parallel shift, right. So, our spreads have widened in terms of default pricing, but in most cases on the ABS side some of the underlying assets. So, since both of why now the amount of benefit that you're going to achieve from us providing the wrap is still providing a benefit.

Number two, although we bring around those credit default swap prices table with us, we goes to the certain desks in terms of pricing our risk, they are not that widely adhere to or used in the upcoming argument. So, we still provide value. We still provide the access to the capital markets in liquidity. And therefore, we are not having those kind of halting conversations that you might expect based on the other kind of noises going on today in the marketplace.

Jeff Bernstein - Schroders

Thank you.

Bob Mills

You are welcome.

Operator

Next question comes from the line of Heather Hunt with Citigroup. Please proceed.

Heather Hunt - Citigroup

Thank you and good morning.

Dominic Frederico

Good morning, Heather. How are you?

Heather Hunt - Citigroup

Good. How are you?

Dominic Frederico

Good.

Heather Hunt - Citigroup

I wonder if you could talk about the dynamics of your new business this quarter. It looks like you went toward more conservative products given that your premiums to par didn’t really increase very much, and just looking the schedule, it looks like its more GOs, etcetera. Can you describe why you've moved toward that? I’m assuming because you continue to get better pricing for lower par, but it seem like you could get some really good pricing this quarter?

Bob Mills

Heather, as we've talked a little about our book will start to transition as our current AAA ratings across the board take hold, where we're going to be able to see more of that traditional very safe business and you remember, in the old days we were under a market share requirement from Moody's, which we've always taken strong exception to in terms of financial strength rating.

But it forced us the right high par low premium, but we never skipped on the credit qualities, so we wrote those AAA attachments. There we have to look at a broader mix of the business in all asset classes, yet for us in today's market, we are being very conservative in how we utilize that new found pricing power, and those areas of the market that we're willing to put our capital at risk.

Because part of this we believe that there are significantly better times ahead. Part of it is, you definitely walk before you run, and that we are building up our diversification of the book of the portfolio as well across these kind of new areas that we haven’t previously written before. And we obviously handle the opportunities we get and what our marketing efforts have provided us. That will continue to evolve and change quarter-to-quarter.

Heather Hunt - Citigroup

Okay.

Dominic Frederico

So the book is, if you would have asked me a year ago, so post the AAA what would be the mix in terms of rating of your business, I’d say we’ll be moving out of the AAA world. We see no reasons to do that at this point in time. You are getting paid very, very well for taking that very high rated, very safe level risk, preserve capital, but at the same time, move up profitability and overall production. So, it’s a good part of how we are looking at it today.

Heather Hunt - Citigroup

Okay. I thought it was something like that. And are you seeing opportunities in the last few weeks to maybe deals where some of your competitors who are a little bit more in the headlines are not as active just in the last few weeks. Is there at all a change in tone?

Dominic Frederico

We are doing a lot of secondary deals how they are exactly as you pointed out. And one of the comments underlying Bob’s remarks on mark-to-market exposure, some of our current fluctuation potential mark is relative to the swap pricing on our peers, and how it is going to affect the mark. So, we’re doing a lot of wrap-on-wraps, is that your question.

Heather Hunt - Citigroup

Okay, thank you very much.

Dominic Frederico

You are welcome.

Operator

Your next question comes from the line of Tamara Kravec with Banc of America Securities. Please proceed.

Tamara Kravec - Banc of America Securities

Thank you. Good morning everyone.

Dominic Frederico

Good morning.

Tamara Kravec - Banc of America Securities

A couple of questions, reinsurance transaction, the HELOC, the $1.8 billion, any thoughts on risk of further downgrades of that or do you think, it’s kind of been reviewed and that's it. And then, on the reserve increase in the direct business, just a follow-up to somebody’s question about, how different now do you think your severity assumptions are? Were you just kind of moving to rating agency assumptions or did you take an extra look at it and move even more conservatively beyond that in terms of assumptions there?

And then, my final question is just on headcount and looking at the pipeline that you’ve got, given the market conditions. Do you anticipate your operating expenses or headcount having to rise more dramatically than you may have thought?

Bob Mills

Okay. If I can remember them, we already gave him. On the HELOC side, remember, we only have about $2.5 billion, almost $1.7 is direct, so the rest is reinsurance. And now reinsurance is spread over a host of transactions, 66 deals to be exact the largest being $90 million. We've got everyone of those listed, posted, stressed, we are concerned that there could be some loses arising, because a lot of them are written at the BBB level.

But individually, if you look at the mean, the mean exposure is probably about $7 million in any one given deal. So once again, use the percentage methodology, even if we blow the expected out come, one percentage point is $700,000. It’s not going to be material, right.

Tamara Kravec - Banc of America Securities

Okay.

Dominic Frederico

And we did no facultative in ’06, we would see kind of a larger size session coming to us, because the treaty has a very limited view of what can be ceded to us. In terms of the reserve, if you can go back over that question again on the reserve side?

Tamara Kravec - Banc of America Securities

Yeah. I'm wondering what your, you had increased your severity assumptions just based on S&P and I’m wondering if, I guess, you commented that you use your own internal ratings, the rating agencies are kind of a check. But are you, was the discrepancy, would you move beyond what the rating agencies are assuming, just to be overly conservative. In other words, I guess, would you feel like, you’d have to review this again and again and perhaps it could be higher?

Dominic Frederico

Well, remember that we are talking about the portfolio reserves here, which is us being extremely prudent in how we assess potential credit exposure across the entire book of business. Number two; and I should have maybe highlight this, the critical element, the key of the portfolio reserve process is the rating of the transaction, because at different rating levels that kicks up higher levels of probability of default and severity. They are our rating levels and about 30% of our book has a rating level lower than what the published rating agency level is. So, it’s our conservative view of the rating.

It then does speed the standard default and severity statistics that get updated annually by S&P, and we do that surely for independence, surely for ease of audit, and understandability and transparency. Obviously, that’s only for the portfolio. Once we start to look at the specific credit issue in any other content besides portfolio, we then start to apply our own reserving process.

So, the portfolio, think of it as a booked market, it’s a place holder to ensure that we can constantly look at our entire portfolio and understand the ultimate potential expected exposure that it contains today based on our rating and based on what we consider very reasonable estimates of severity and frequency.

Once we start talking through loss possibility, that goes out the window and it’s all done with our own internal view of losses, right. Our underwriting standard chose our severity, so separate that from when we underwrite new business.

Tamara Kravec - Banc of America Securities

On the headcount?

Dominic Frederico

The headcount, that.

Bob Mills

From a headcount standpoint, we have grown in the last year at September 30, '06 the headcount was 131. Today, the headcounts are 144. We are expecting to continue to grow headcount into 2008. Naturally in this market has probably some subjectivity as to how and when that will grow. But considering the opportunities that we see, we will continue to expand our headcount to meet those needs.

Dominic Frederico

We have obviously completed our 2008 plan and in the plan the headcount addition is I think 7% to 8%, and there's around 10 or 11 people in total.

Bob Mills

144 in that or 156 in the plan.

Dominic Frederico

So, but that will depend on opportunity obviously, I think we have been trying to manage that very reasonably. We had to build it before it came early on to make sure we can handle business and assure execution. We now have adding to the staff as opportunity arise and obviously, based on the change in this market, you could see some significant opportunities develop, that we would then have to be responsive in terms of stepping upward. And currently our plan is for a very reasonable, moderate level of increase.

Tamara Kravec - Banc of America Securities

Okay, great. Thank you so much.

Dominic Frederico

You are welcome.

Operator

Your next question comes from the line of Bob Ryan with Merrill Lynch. Please proceed.

Bob Ryan - Merrill Lynch

Good morning.

Dominic Frederico

Hi, Rob.

Bob Mills

Hi, Rob.

Bob Ryan - Merrill Lynch

Okay. My question is in your ancillary mortgage business. What was the last time that you took on any new exposure there, and what’s the nature of those exposures?

Dominic Frederico

The last time, all I can tell you is the deals expire in three years, as the last deal. So, they were like 10-year deals. They are excess of loss, soft capital type programs written under the old company structure and business plan. We did do a reinsurance deal on the U.K. in ’04, and that was the last year that we’ve ever written.

So, they are high up, principally excess of loss. At one point in time, we did get them rated, because we felt that they were sort of like RMBS, but a very high AAA double detachment, they are highly seasoned, so they are long outstanding deals. So, they don’t kind of suffer some of the current pang. And we’ve got 1.4 billion of pars still out there and that continues to amortize them.

Bob Ryan - Merrill Lynch

Great, thank you.

Dominic Frederico

You are welcome.

Operator

Your next question comes from the line of [Ken Scarborough with Fasa Capital]. Please proceed.

Ken Scarborough - Fasa Capital

Yes. Good morning. Hi, Dominic and Bob.

Dominic Frederico

Good morning.

Ken Scarborough - Fasa Capital

I wanted to ask a couple of numbers questions and then a bigger picture on the reinsurance side. On the numbers side, when we think about total capital resources, obviously qualified statutory capital, present value of installment premiums, one element that I didn’t see and I might have missed was the soft capital facilities. Could you just remind us what if any you have in that regard and/or any other items that we should be thinking about?

Bob Mills

Sure. We’ve two soft capital facilities. One is a bank soft capital facility, which is at AGR in the $200 million, which was put into place just recently in 2007 replacing an older facility. And we’ve a capital market facility of $200 million at AGC. That was put along really as a term facility, and that facility rose over, is up to be reissued in April of 2008.

Ken Scarborough - Fasa Capital

Bob, on that second one is, in the event you would need to tap it for whatever reason, even its just to give the agencies greater comfort. Is that facility dependent on, the availability and the opening of the asset-backed mark? Do you still rely on the current type of market?

Bob Mills

No, it’s a funded facility. It’s not subject to auction, but I must tell you I cannot conceive of the circumstance, where I would have to draw upon that facility.

Ken Scarborough - Fasa Capital

Excellent, thanks for clarifying it. And maybe Dominic, on the reinsurance side of the business, I guess first by way of disclosure, have you guys provided much granularity about some of the other financial guarantors that you have exposure to and I guess given an environment where one would suggest that the terms of trade would favor reinsurance. How do you think that growing that on a go forward basis?

Dominic Frederico

In terms of granularity exposure to the other model lines, remember, we underwrite every deal on the reinsurance side that we see facultatively with regards of who is the primary writer. So, it's got to pass our underwriting standard. On the treaty side, we only have the one treaty, and now I guess we have two today.

Where we specified parameters that in effect determine the type of business that can be seemed to us, so in both cases if that’s your question on exposure to the other model lines, we are very comfortable with the underwriting risk, and obviously it goes to the same process that we use when we underwrite on the primary side as well.

Ken Scarborough - Fasa Capital

And Dominic, just to clarify, you don’t have exposure below AA, AAA folks, do you? I mean, I guess, the question…

Dominic Frederico

As reinsured that cede to us now. We only take reinsurance from the existing AAA model lines.

Ken Scarborough - Fasa Capital

Excellent, thanks. And then, just finally on the environment for growth given your strong ratings and obviously the demand pull?

Bob Mills

We’re blessed on both sides. We see tremendous market opportunity on both the reinsurance side and the direct insurance side, and there is a constant [tap you pull] in our company relative to capital and limit allocation between the two groups. As a company that does service the third party ceding reinsurance marketplace, meaning the other AAA model lines, we’re serious about that business.

We have to allocate capital to them and service their market. Obviously, we see tremendous opportunity there. We are well positioned by being headquartered in Bermuda with that specific entity. So, that the in effect economics that we get on a reinsurance basis is as good, if not better than the primary company ceding to us. So, there is no loss, and we will call profitability from that point of view.

However, the direct business that we also utilize through that reinsurance mechanism, gets also further enhanced. So, there is a good argument on both sides of the fence. The one thing we’ve always liked about having to put in reinsurance through our as it does spread our portfolio out. It does allow us to look at basically every opportunity in the marketplace, where we can be further selective from an underwriting point of view.

Ken Scarborough - Fasa Capital

Thanks very much.

Bob Mills

You are welcome.

Operator

(Operator Instructions) And your next question comes from the line of [Adam Star]. Please proceed.

Dominic Frederico

Hello?

Operator

Mr. Adam Star, your line is open.

Sabra Purtill

You can go to the next question, operator.

Operator

I show no further questions in the queue.

Sabra Purtill

Thank you. Many thanks to you all for joining us today. And we certainly appreciate your interest in Assured Guaranty. As I mentioned, you can reach me in our Bermuda office today at 441-278-6665, if you have any follow-up questions. And I would also note that a replay of this call will be available on our website, as well as by telephone at 888-286-8010 in the U.S. and at 617-801-6888 for international callers. The password is 12378747.

Please call me, if you have any additional questions and we look forward to talking to you soon. Thank you, and have a good day.

Operator

This concludes the presentation. And you may all now disconnect. Good day.

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