Security Capital Assurance Ltd. Q1 2008 Earnings Call Transcript

Security Capital Assurance Ltd. (SCA)

Q1 2008 Earnings Call

May 9, 2008 8:30 am ET

Executives

Frank Constantinople – Group Managing Director, Head of Investor Relations

Paul S. Giordano – President and Chief Executive Officer

David P. Shea – Executive Vice President and Chief Financial Officer

Edward B. Hubbard – Executive Vice President and Chief Operating Officer, XL Capital Assurance Inc.

Presentation

Operator

Welcome to the Security Capital Assurance first quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce Frank Constantinople, Group Managing Director and Head of Investor Relations for SCA.

Frank Constantinople

Welcome to Security Capital Assurance’s first quarter 2008 earnings conference call. I’m Frank Constantinople, Group Managing Director and Head of Investor Relations at SCA. With me today are Paul Giordano, SCA’s President and Chief Executive Officer; David Shea, SCA’s Chief Financial Officer; and Ed Hubbard, Executive Vice President and President of SCA’s primary insurance subsidiary, XL Capital Assurance.

This call is also being broadcast online and can be accessed through the Investor Relations page on SCA’s website, www.scafg.com. Also on SCA’s website are our earnings press release, quarterly operating supplement, and a brief slide presentation that summarizes SCA’s 2008 first quarter results.

We also have updated the disclosure of our CDO and RMBS supplements and these supplements will be posted to the Investor Relations section of our website concurrent with the filing of our Form 10-Q with the Securities and Exchange Commission. At the conclusion of our prepared remarks we will respond to questions that have been submitted on our website.

Before I turn the call over to Paul I would like to remind everyone that certain matters that will be discussed here today are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on current plans, estimates, and expectations. Forward-looking statements involve inherent risks and uncertainties and a number of factors could cause actual results to differ materially from those contained in the forward-looking statements.

Forward-looking statements are sensitive to many factors, including those identified in our most recent report on Form 10-K and other documents on file with the SEC that could cause actual results to differ materially from those contained in the forward-looking statements. Forward-looking statements speak only as of the date on which they are made and we undertake no obligation publicly to revise any forward-looking statement, whether as a result of new information, future developments, or otherwise.

The presentation includes non-GAAP measures such as adjusted gross premiums, operating and core income and adjusted book value, which under SEC regulations we are required to reconcile with GAAP. The reconciliations of these measures to GAAP financial measures are included in our earnings press release and operating supplement, both of which are available on our website.

I will now turn the call over to Paul.

Paul S. Giordano

Welcome to our first quarter 2008 earnings call. I will begin today by reviewing where we stand, with respect to our restructuring efforts. I will then turn the call over to David Shea, our Chief Financial Officer, who will review our financial performance in the first quarter, together with some of the key financial metrics for our company. Ed Hubbard, President and Chief Operating Officer of our primary insurance operations at XL Capital Assurance, or XLCA, will conclude the management’s remarks portion of our call by reviewing the credit environment and the performance of our insured portfolio in the first quarter.

Let me begin by briefly recapping where we stand today. For the fourth quarter of last year we recorded large losses stemming from our exposure to U.S. residential mortgages contained in residential mortgage-backed securities, or RMBS, and asset-backed collateralized debt obligation, or ABS CDOs that we insured largely in the latter half of 2005 through the middle of 2007.

During the first quarter of 2008, as we previously reported, both of our operating subsidiaries, XLCA, which writes financial guarantee insurance, and XL Financial Assurance, which provides financial guarantee reinsurance, lost their AAA ratings and we ceased writing substantially all new business. This stemmed mostly from the extraordinary credit deterioration in the U.S. residential mortgage market and a large amount of additional capital that the rating agencies required to be set aside against such exposures.

Our rating today stand at A- from S&P, A3 for Moody’s, and DD from Fitch. In our opinion, perhaps the single largest risk we face today, with respect to our insured portfolio, is that of adverse development in our loss reserves, particularly for our ABS CDO exposures. Closely related to this risk is the risk of potential regulatory intervention or other action with respect to one or more of our operating subsidiaries, particularly if our financial conditions were to deteriorate materially in the future.

Our plan is focused on restructuring our business to try to reduce these risks, attain at least AA ratings, and resume writing new business to the extent possible. To achieve this, we need to increase our capital and claims paying resources relative to the exposures we retain. Our restructuring could involve the separation of our public finance and perhaps other lines of business from the mortgage-related portions of our insurance portfolio. We believe a AA-rated company, having no residential mortgage exposure and sufficiently large claims paying resources, should be able to participate in the financial guarantee reinsurance market and perhaps selected areas of the insurance market.

The basic elements of our plan remain very similar to our description of them in March, on our fourth quarter 2007 earnings call. The main features of our plan are as follows.

One, we have ceased writing substantially all new business. As our in-force book of business decreases the capital supporting expired policies should be freed up over time under our own internal and rating agency capital models, absent deterioration or other changes in our insured portfolio. While helpful, the amount of capital we could potentially generate from the expiration of our in-force book of business alone is not likely to be substantial enough over the short-to-medium term to restore us to AA or higher levels of capital.

Two, we continue to explore the potential for us to commute, restructure, or settle certain of our guarantees, particularly those covering ABS CDOs that we have insured. These types of actions, if they can be done on acceptable economic terms, can reduce the potential for adverse loss development and generate potentially significant amounts of capital under rating agency models. For this and other reasons we have assisted in organizing key members of our ABS CDO bank counterparties and we continue to work with their advisors.

Third, we are also continuing to examine the possibility of commuting or seeding back reinsurance business we have assumed from other financial guarantors. This, too, can result in capital generation under agency rating models, but will also lead to a reduction in our investment assets.

Fourth, we continue to explore with XL Capital, our 46% shareholder, ways to settle for fair value certain of the obligations and contingent obligations that they have to us, including their guarantee of pre-IPO policies and the $500 million excess of loss free insurance XL provides to us. We are seeking to generate additional capital resources through such actions. We remain in active dialogue with XL and its advisors on these and other matters.

Fifth, we are also in contact with prospective investors interested in providing capital in connection with the restructuring of our business. At this stage it is too early to make determinations with respect with the structure such transactions can take or the amount, form, or terms of such capital if available.

Finally, we continue to focus on lowering our operating expenses over time. At the end of the first quarter we took the difficult but necessary step of significantly reducing the size of our staff, particularly in our primary insurance origination and related areas. Many of those whom we let go in March had been with the company from its earliest days. We are sorry to see them go and wish them well in their future endeavors. We continue to work with our financial advisors, Goldman Sachs and Rothchild, on all elements of our plan. All of our restructuring initiatives are ongoing concurrently and depend on factors that we cannot fully control or predict.

Given the very constituencies involved, the number of legal, regulatory, and other considerations that we must take into account, the pursuit of our restructuring plan is very complex and difficult to execute. Because of the complexities and uncertainties with regard to our plan and potential future developments we can’t provide any assurance that we can successfully complete any of the components of our plan, adjust the rating agencies’ capital requirement for AA or higher ratings, or recommence writing new business. The elements of our plan also remain subject to change. Nevertheless, despite these challenges, all of us at SCA are committed to working hard to achieve a restructuring of our business if this is possible.

As we move forward with our restructuring initiatives we are maintaining a close dialogue with all of our principal regulators, including the New York State Insurance Department and the Bermuda Monetary Authority. We and our regulators agree on the importance of pursuing our restructuring plan as quickly as possible.

Our dispute with Merrill Lynch regarding the 70 ABS CDOs we terminated in February 2008 is proceeding. Litigation is now in the discovery phase and Merrill Lynch filed a motion for summary judgment on April 18, which we will oppose and which is scheduled to be argued in court in early June. The court has also entered a scheduling order under which the case is due to go to trial in September 2008.

Before handing the call over to David, I would like to welcome Fred Corrado and Paul Hellmers to SCA’s Board of Directors. Fred and Paul were nominated by XL Capital to replace former SCA Directors Brian O’Hara and Allen Senter. Following these two additions, SCA’s Board is returned to nine members.

In closing I would like to once again thank our employees for their dedication and efforts during these very challenging times. We are working within a dynamic environment that has required everyone to remain focused and committed. Their support, sacrifice, and professionalism are very much appreciated by me, our management team, and our Board of Directors.

With that I will now turn the call over to David.

David P. Shea

This morning I will start with a brief financial overview of the first quarter of 2008. And then we’ll spend some time reviewing the change in the fair value of derivative instruments and loss reserve provisions, along with a more detailed review of our financial performance. I will wrap up with a discussion of certain financial fundamentals, including our regulatory capital position, before handing the presentation over to Ed Hubbard.

For the first quarter of 2008 SCA reported a net loss to common shareholders of $96.8 million, or $1.51 per common share, compared to net income of $37.3 million, or $0.58 per common share, in the first quarter of 2007. The net loss in the quarter was driven by our change in the fair value of derivatives of $96.3 million, or $1.50 per common share, which I will discuss in more detail shortly.

Let’s now turn to operating income. As many of you know, management and financial analysts use operating income as a more representative measure of a financial guarantor’s performance. Operating income is a non-GAAP measure, which is defined at the end of this presentation as well as in our recent press release. For the first quarter of 2008 SCA posted a net operating loss of $2.7 million, or $0.04 per common share, compared to operating income of $44.1 million, or $0.68 per common share, for the first quarter of 2007.

As you look at our income statement you will notice the change in the presentation of our policies written in credit derivative form. As we have stated in the past, we view our policies in credit derivative form to be substantially the same as our guarantees written in traditional insurance form. Both are held to maturity and not traded.

This new presentation reclassifies the way we present our credit default swap contracts to conform to a newly adopted policy instituted by member companies of the Association of Financial Guaranty Insurers, or AFGI. A new industry-wide policy is being implemented by SCA after AFGI’s consultation with the staffs of the Office of Chief Accountant and Division of Corporate Finance of the Securities and Exchange Commission and with SCA’s external auditors.

The purpose of this reclassification is to promote a consistent and transparent presentation throughout the industry to help ensure that this complex topic is well understood among various market constituencies. Effectively, net premiums earned on credit default swaps have been reclassified to realize gains, losses, and other settlements on credit derivatives.

Net unpaid case losses and loss adjustment expenses have been reclassified from net losses and loss adjustment expenses, to unrealized gains or losses on credit derivatives, which previously had included only unrealized mark-to-market gains and losses on credit derivatives. Net paid losses and loss adjustment expenses on credit derivatives have been reclassified to realized gains, losses, and other settlements on credit derivatives.

The impact on the balance sheet follows the same general principal. Any balance sheet impact will be reclassified as either credit derivative assets or credit derivative liability, depending on the net position of the credit default swap contract at each balance sheet date.

Though the aforementioned reclassification affects specific revenue expense and balance sheet lines for credit default swaps, it does not change the amount of net income, shareholders’ equity, or operating income, in non-U.S. GAAP financial measures. However, the amount of net earned premiums and losses and loss adjustment expenses will change, as will the formulas that the company uses to calculate loss, loss expense, combined ratios, and operating income.

In order to assist shareholders in understanding the effect of the reclassification on the results for the first quarter of 2008 we have provided two tables at the end of this presentation that show the consolidated balance sheet and statement of operations presented in our fourth quarter earnings release, the impact of the reclassification adjustments, and the resulting unaudited pro forma re-classed balance sheet as of December 31, 2007, and statement of operations for the first quarter of 2008.

As a reminder, although we are required to fair value our credit default swap portfolio for financial reporting purposes, and although we are implementing a new way to present credit-default-swap-related information, it is important to note that any unrealized losses associated with the market value changes are not included in the calculation of SCA’s net worth and capital ratios under the covenants of this credit facility, nor are they included in the calculation of any regulatory capital to ratio for XLCA or XLFA.

I will now review our first quarter net change in the fair value of derivative instruments within the context of this new reclassification. The $96.3 million net change in the fair value of derivatives is comprised of $197.9 million realized gain and other settlements, and $294.2 million in net unrealized losses.

Let’s break these two line items down further. The $197.9 million realized gain and other settlements includes a $179.5 million settlement value associated with the XLFA Twin Reefs capital facility put option and $18.4 million of net premiums earned on credit default swaps.

The $294.2 million in net unrealized losses was comprised of $107 million related to the XLFA Twin Reefs capital facility put option representing the rate down of the December 31 value and $187.2 million net realized losses related to the fair value change of our CDS contracts.

The CDS net unrealized losses were primarily driven by $48.8 million related to pre-insured CDS contracts due to credit spread widening of the primary guantors, $25.7 million related to CDS indexed claim contracts due primarily to the continued widening of the CDS North American Investment Grade Index, $23.1 million related to CLO transactions due to wider spreads in the leveraged loan market, and $26 million of unrealized losses related to the change in fair value of ABS CDOs.

The turmoil in the structured credit markets we observed in the fourth quarter of 2007 continued in the first quarter of 2008. The market turbulence continued to cause the valuation models that market makers rely upon to become less dependable and as a result they have stepped away from their role as pricing information providers. Thus, we examined a broad array of market pricing information. This information included further deterioration and ratings downgrade of the ABS CDOs since December 31, an internal risk assessment of the ABS CDO portfolio, broker valuations of certain CDS contracts, and price discovery associated with our discussions with counterparties regarding potential commutation or restructuring of certain CDO contracts.

These data points were considered along with management’s judgment and included in our valuation model for each CDS asset class. Given the limited market price information available in the first quarter, SCA believes the various methodologies used in our valuation process incorporate indicative price evidence available to us and result in our best estimate of a fair value of our CDS contracts at March 31, 2008.

For the first quarter mark-to-market of our CDS portfolio, we continue to utilize the income approach fair value model consistent with our practice over the two prior quarters. The majority of our deals are valued using the income approach methodology. We believe the principal advantage of using our income pricing model is that it enables us to make a better estimate of the fair value we can receive and transfer to a knowledgeable market participant.

This income model calculates the fair value of our credit default swap portfolio by adjusting the present value of expected remaining future net cash flows under the contract to reflect the rate of return appropriate for the given transaction in the current market environment on the capital required by the rating agencies.

The rates of return that we assume would be required by a knowledgeable market participant were increased to reflect the credit environment in the first quarter. The net derivative liability based on the income approach totaled $1.4 billion as of March 31, 2008, or 82.6% of the net fair value.

Price discovery process associated with discussions with certain counterparties for possible commutation or restructuring of CDS contracts resulted in approximately $111.5 million of our net derivative liabilities, or 6.8% of the total.

Lastly, we have also had several exposures where we used quoted indices and vertical quotes as the basis for fair value that totaled $63.6 million, or 3.9% of the net derivative liability.

Turning now to our loss provision for the quarter. We increased case loss reserves by $42 million gross, or $37.7 million net of reinsurance, related to our direct RMBS exposure to HELOC and closed end second-lien transactions that we had been short. Ed Hubbard will discuss our RMBS portfolio and reserve actions for the first quarter in greater detail.

Given our back book of business we are able to generate premium earnings despite not writing new business. For the first quarter of 2008 SCA’s net premium earned was $58.4 million compared to $38.9 million in the first quarter of 2007. If we include premiums earned from the CDS contracts, total earned premiums in the first quarter of 2008 would have been approximately $76.7 million. The increase in net premium earned is due to the increase in premiums earned from refundings, calls, and other accelerations.

Refunding premiums accounted for $20.4 million of earned premium for the first quarter, an increase of $19.1 million from the refunding activity during the first quarter of 2007. We anticipate that refundings will continue at a heightened rate for the duration of the year, reflecting issuers preference to refinance their bonds at lower rates, with other guarantors, or without bond insurance.

Coordinate premiums earned, a non-GAAP measure that is reconciled at the end of this presentation, which exclude the impact of these refundings and accelerations, were $56.3 million for the first quarter of 2008, compared to $45.1 million in the first quarter of last year.

Net premiums earned from credit default swaps more than doubled, from $7.5 million in the first quarter of 2007, to $18.4 million in the first quarter of 2008.

Net investment income in the first quarter of 2008 was $32.3 million, which was 24% higher when compared to the $26.1 million for the first quarter of 2007. The increase was primarily due to higher average invested assets generated by the financing cash flows during the prior 12 months.

In the first quarter of 2008 SCA posted investment return on the portfolio as 4.71% net of fees, as compared to 2007 when it yielded 4.75%. The slight decrease in the portfolio’s return was the result of lower short-term interest rates in the first quarter of 2008.

As Paul mentioned, we are extremely focused on our operating expenses given our decline in new business generation. Although our operating expenses for the quarter increased 70%, these increased costs are associated with decreasing overall headcount and our restructuring efforts.

Let me take a moment and provide some additional granularity with regards to our total operating expenses of $49.9 million for the first quarter. First, our work force reduction required a charge of $10.3 million in the first quarter of 2008, but we estimate this action could result in approximately $30 million of annualized savings. Corporate expenses, which are included in operating expenses and are associated with SCA being a public company, were $7.5 million in the first quarter of 2008 versus $3.8 million in the 2007 comparable period. The increase was primarily due to higher expenses related to restructuring efforts but was partially offset by lower executive management compensation costs. Also, please note, that because we are no longer generating new business, we can no longer defer certain operating expenses. In the past, or during normal years, we have deferred approximately 32% of our net operating expenses. Lastly, while we expect the relatively high level of legal and advisory fees to continue in the second quarter, we are working to partially offset these increases by controlling other expenses for the remainder of the year.

Adjusted book value, or ABV, is a non-GAAP financial measure and is defined at the end of this presentation. ABV is used by equity analysts and investors to estimate the embedded value of the business that has been created by the company for the benefit of its common shareholders.

The company’s ABV was $1,320,000,000, or $20.54 per common share, as of March 31, 2008, versus $1, 520,000,000, or $23.39 per common share, as of December 31, 2007. The decline in ABV was due to the net change in the fair value of derivatives that we discussed earlier, in addition to the case loss provision that we established for the HELOC and closed end second-lien portfolios.

Let me spend a few minutes reviewing SCA’s financial fundamentals, including our current liquidity position. As of the end of the first quarter, the holding company’s current cash and cash equivalent position was $17.4 million. The primary source of our holding company’s liquidity is dividend and distributions received from our operating subsidiaries. XLFA currently had $95 million of prevented distribution capacity to SCA.

Prior to any dividend or other distribution from XLFA to SCA, XLFA has undertaken to obtain the consent of the Bermuda Monetary Authority.

XLCA currently cannot pay dividends to SCA due to its cumulative loss position without approval from the New York State Insurance Department. We do not expect XLCA to upstream any distributions to SCA during 2008.

We have not issued debt at the holding company for our operating subsidiaries. In addition, in the first and second quarters of 2008, the Board of Directors of SCA have not declared dividends on its common shares or on the hybrid preferred series securities in order to strengthen our capital position in 2008. This decision resulted in approximate cash savings of $9.9 million in the first quarter. Note that our $250 million hybrid preferred series is a non-mandatory and non-cumulative instrument. As previously mentioned, we exercised the put option on the Twin Reef securities in the first quarter of 2008, increasing XLFA’s cash position by $200 million.

In terms of cash flow for the first quarter SCA had a $44.6 million in net operating cash outflow on a consolidated basis. This decline from the first quarter of 2007 was primarily due to the succession of new business writings and gross planes payments on the HELOCs which total $63 million. This net outflow for the first quarter does not reflect recoveries due from affiliated and third-party reinsurers, including XL Assurance Bermuda Limited, totaling $50.1 million. To date, XL Assurance Bermuda Limited has not paid SCA any of the amounts we believe is due from it in respect of such CD claims as required by the agreement.

Let’s spend a minute on the investment portfolios. Our consolidate investment portfolio, including $480 million in cash and cash equivalent instruments, currently totals $2.8 billion. The portfolio is comprised of high-quality fixed income instruments with a weighted average rating of AA+. Of this amount approximately $1.3 billion consists of mortgage-backed and asset-backed securities of which $474 million are issues of the U.S. government agencies. The remaining $854 million of non-agency issued MBS and ABS are predominantly AAA rated.

In closing, I would now like to address our regulatory capital position. At the end of the first quarter under New York State Insurance Guidelines, XLCA has $212.4 million in qualified regulatory capital. Under the Bermuda Capital Guidelines in which XLFA operates, it has $918 million in regulatory capital. As of March 31, 2008, this represents a cushion of $83.9 million for the New York Insurance Department and $823 million for the Bermuda insurance purposes.

I would now like to turn the call over to Ed Hubbard.

Edward B. Hubbard

I would to provide you with an update on our insured portfolio and the loss reserve activity during the first quarter.

As you are aware, during the fourth quarter of 2007 SCA performed an extensive analysis on our ABS CDO and RMBS portfolios and established significant growth in case loss charges on derivatives, totaling $1.1 billion. This amount included $838.6 million gross and $651.5 million net credit impairment for the ABS CDOs and $214.3 million gross and $34.7 million net case reserves for direct RMBS credit.

Our reserve actions took into account data available at that time concerning the significant deterioration in the U.S. real estate market and the associated impact on our insured to exposure. As of the first quarter our observation is that the performance of our ABS CDOs and our direct RMBS for this quarter is generally consistent with our expectations at year end.

However, we did see some deterioration for two individual RBF deals which warranted further reserve action for the first quarter. We had case loss reserve provisions in the first quarter relating to RMBS transactions of $42 million gross and $38 million net of reinsurance, which is comprised of a $40 million increase in our loss expectation on two RMBS transactions and accretion of $2 million. In addition, the accretion of the discount rate on our credit impairment of our ABS CDOs totaled $7 million.

I would now like to provide more detailed observations on our RMBS and ABS CDO performance this quarter. Let me start with our RMBS book. At March 31, our RMBS portfolio totaled $9.2 billion of net par outstanding, down from $9.6 billion at year end. We will provide updated and detailed disclosure of our RMBS portfolio on our company’s website.

Overall we continue to observe delinquency rates and loss performance on our direct RMBS portfolio that are worse than expected at the origination of each individual deal. However, as compared to the loss review we conducted in the fourth quarter of 2007, losses are flowing through in most deals in a manner which is largely consistent with our recently revised assumptions and loss forecast with a few exceptions.

The exceptions relate to the two RMBS transactions for which we have increased our loss expectations. In addition, we have added several Alt-A first-lien transactions to our list for special monitoring. With respect to the two RMBS deals for which we have increased our loss expectation, one transaction is a home equity line of credit for a HELOC deal where the issuer has adopted a new credit line management policy and has suspended HELOC borrowing on some of the limits in its portfolio where property values have declined.

As we explained in prior quarters, after a ramp in amortization event occurs, drives or advances on HELOC lines are funded by the servicer and provide additional collateral for the deal. Thus, when a servicer suspends an individual credit line, the borrower is unable to make further draws against his account. At the aggregate collateral pool level this causes the average run rate to decline from the level of our original expectations, which in turn reduces the amount of additional collateral supporting the deal. As a result of the suspension of further draws of some accounts, we increase our expectation of loss on one HELOC in an amount of $15 million.

The other RMBS deal for which we added the case loss reserve was an Alt-A second-lien transaction that has had losses much greater than we expected and beyond what we had modeled. This transaction is an outlier. It is performing worse than many second-lien deals in its market sector and is our second worst performing RMBS deal. We are now modeling an expected loss on the collateral of 44% on this transaction. In addition, it had [inaudible] hard credit enhancements than other deals with similar vintage.

The combination of the high loss rate and amount of credit enhancement fired up to increase our view of the expected loss in this transaction by $25 million.

So to summarize the standard case reserves that come to our RMBS portfolio, as the result of reserve actions we took in the fourth quarter of 2007, we established case reserves for six transactions comprised of five HELOCs and one Alt-A closed-end second-lien transaction and in the first quarter of 2008 we increased our reserves on two of those transactions.

Of the five HELOCs, two are in rampant amortization and our remaining three are expected to hit rampant amortization in May and June. In rampant amortization all cash collections are used to pay down senior certificates and new draws by borrowers on their HELOCs are funded by the servicer rather than from the deal.

Since November 2007 we have paid claims on RMBS deals of $112 million through April 30, which includes paid claims of $63 million in the first quarter. Based on our revised loss modeling, we believe it likely that gross paid claims for our RMBS exposure could be approximately $250 million for the full year 2008. However, this amount, if it does materialize, is expected to net down to less than$450 million due to the reinsurance recoveries we have posted.

Our first quarter review of our other RMBS credits generally showed performance in line with our revised expectations at year end 2007. However, we continue to see a further deterioration in our Alt-A or mid-prime first-lien mortgage portfolio. It is important to note that these deals have passed at the AAA level. However, the deterioration in the performance of collateral supporting these deals justifies keeping a close eye on ongoing performance and we have therefore added five first-lien Alt-A transactions to our list for special monitoring.

Finally, I want to point out on our RMBS loss reserves that we do not generally take into account our remediation actions. We have been actually remediating our RMBS credits since the fall of last year. Since that time we have assessed our rates and remedies and have worked with issuers to obtain and evaluate one level information. In November we commenced one level review to breaches of representations and warranties on our troubled transactions. As a result of these efforts, we have identified a significant amount of loans that have breached representations or warranties were fraud and/or noncompliant with driving guidelines.

Through our remediation efforts we are also actively working with servicers to implement changes in servicings that could increase recovery of certain loans and reduce losses. In addition, we are active in investigating other legal actions as well. While our overall remediation efforts will likely require approximately 6-18 months to bear fruit, we believe that the results of these efforts could serve to reduce the loss estimates currently reflected in our case reserve. However, it is premature to estimate at this time the extent to which these efforts will be successful.

In looking forward we agree with some industry observers that April delinquency data for RMBS deals generally are showing the first time at some stabilization, meaning that the rate of rising delinquencies has slowed. However, this reflects one month of data and we want to see corroborating data in subsequent months before we feel this represents an indication delinquencies are in fact leveling off.

Specifically, as reported for the month of April, the rate of increase in later-stage delinquencies is slowing for the 2006 and 2007 Rules of the ADX, which is a widely observed index for sub-prime RMBS performance. This observation is further supported by our own analysis of actual delinquency data as reported by loan and performance systems, or LPF, which is a database of millions of sub-prime mortgages.

The rate at which loans are moving from performance status to the 30-day delinquency stage either remains steady or slowed down as reflected by the April data. We see this predominantly in the sub-prime and second-lien sectors for all vintages whereas Alt-A collateral for all vintages is showing continued and increasing deterioration. This is true for the market generally and for the deals guaranteed by XLCA. This is an important data point because once these enter the 30-day delinquency bucket, they do not recover, ultimately work through the delinquency pipeline until they are liquidated or charged off.

Thus, fewer loans entering and going through these pipelines implies lower losses for a collateral pool in subsequent months. To repeat, however, we need to see a continuation of this data before we are confident that it constitutes a trend. The performance of our RMBS collateral in the coming quarters is exposed to a variety of micro-factors, including the state of the U.S. economy and it’s associated levels of employment, the interest rate, further trends in home price depreciation, any potential enactment of a variety of bills between Congress and the Bush administration, granting relief to mortgage borrowers.

Now I would like to turn to our ABS CDOs. As we noted on our fourth quarter 2007 earnings call, our modeling indicates that under normal circumstances the vast majority of estimated case claims on our ABS CDOs will not occur for 30 years. The modeling we did perform involved an extensive sub-review of our ABS CDO exposure which was completed in the first quarter. We will continue to monitor on a periodic basis the performance of the collateral which supports our ABS CDOs.

In addition, we are also monitoring whether the assumptions we had built into our models continued to track actual performance behavior of our ABS CDOs. We will remodel our ABS CDO portfolio if it appears that either the performance of the underlying collateral is considerably off track or off track for an extended period of time, or if adjustments for our model assumptions are warranted. While we believe at this time that adjustments for loss expectations for our ABS CDOs are not warranted, we will monitor our exposure in the coming quarters. The performance of our ABS CDO portfolio is subject to the same range of macro economic factors that I described in connection with our RMBS portfolio.

As you have seen in our press releases and Merrill Lynch’s press releases, we have terminated 70 ABS CDOs credit default swaps with Merrill Lynch. Management’s best estimate of net anticipated claims on these losses is $429 million. Pursuant to GAAP accounting we still carry these claims on our balance sheet as a component of our net derivative liability. It is a matter that is subject to litigations and so I am not able to comment further at this time.

The rest of our CDO portfolio, which includes $14.7 billion of CDOs and $4.5 billion of commercial real estate CDOs continues to perform satisfactorily as we have not seen any material deterioration in the underlying collateral pool. The $1.6 billion CDO squared portfolio continues to perform well, also. As we noted in our last earnings call, the deals have very little exposure to 2006 and 2007 ABS CDOs, accounting for less than 2% in CDO squared and the average subordination for our CDO squared deal is 31.6%.

Let me now turn to an update on our exposure to Jefferson County, Alabama. We have insured $809 million, net of reinsurance, of sewer revenue debt issued by Jefferson County. I gave a brief update on our Jefferson County exposure last earnings call. The county’s problem came to our attention in February due to failed auctions on its auction-rate securities and remarketing funds at variable rate demand obligations as a result of insured downgrade and the county’s failure to raise sewer rates to meet its rate covenant.

XLCA insured $740 million of bank bonds, which are payable in quarterly installments, or roughly $50 million with interest each quarter. We have not made any payments on the bank bonds, as the banks have foreborn on payment while Jefferson County’s creditors try to work on a resolution with the county. The current forebearance period ends May 15 and we are discussing with the banks extending this forebearance period. If the banks do not extend we could owe a $47 million payment on June 1, followed by a slightly larger payment due July 1.

We have the liquidity to make these payments but any payment made by the insurers will be a payment default by the county, which the county would like to avoid. The banks, county, and insurers have all put forward debt-refinancing plans so we are encouraged that all parties are working together.

However, there are no certainties that a prompt and cooperative resolution will be worked out. Our primary security is a pledge of all the county’s net sewer revenues. The net sewer revenues as required under the indenture need to be sufficient to meet all of the county’s sewer debts through it’s obligations. In the event we pay claims we will have to evaluate the extent to which any monitors may need to be established, notwithstanding the county’s covenant to set sewer rates at a level position to cover debt through it. We stand ready to enforce the county’s obligations if necessary.

I would also like to comment briefly on the recent news that the city of Vallejo, California, is on the verge of filing for Chapter 9 bankruptcy protection. We have $7 million of hard exposure to the Vallejo School District. The city’s Chapter 9 bankruptcy filing should not have any effect on its ability to make the school district bond payment, as the school district is a separate entity and taxes are collected by the county and not the city. However, the bankruptcy of the city serves to underscore, once again, the potential value provided by bond insurance.

One last topic. Last quarter we had told you that we had guaranteed approximately $9 billion of variable-rate demand obligations, or VRDOs, and another $17 billion of auction-rate bonds. We described how both of these bond types were experiencing stress due to the conditions in the credit market, which in turn resulted in the decrease in the cost of funds for a municipality. We have been able to work constructively with the issuers to develop and implement solutions to this issue. As a result, during the first quarter of 2008 our exposure to auction-rate securities and VRDOs declined by approximately $8 billion, to $18 billion outstanding. The process of working with additional issuers of auction-rate securities and VRDOs is ongoing.

That concludes my prepared remarks, so let me now turn it over to Frank Constantinople.

Frank Constantinople

In order to run this call as efficiently and productively as possible, as indicated in my opening remarks, at this point we will now respond to questions that were submitted on our website over the past week. We have organized these questions by broad subject area such as strategy and short portfolio, etc. We’ve received a number of questions, many of which we’ve answered here on prepared remarks and some of which were duplicative. In that case, we chose the most representative question.

As was the case last quarter, we also received some questions more appropriate for XL Capital to answer and we are not in a position to comment on disclosures by XL.

Lastly, we received a number of questions surrounding the update on the CDS terminations discussed in the earnings press release. Our lawyers continue to advise us not to make any further comments with respect to the terminations at this time beyond what we’ve said in our press release and our remarks this morning. I would like to say that we continue to consider the terminations effective and we intend to enforce the terminations vigorously.

So let’s begin. The first few questions will be for Paul.

Question-and-Answer Session

Question

Have you had any success in your reinsurance discussions? Why has there not been a more significant outgoing reinsurance session? Are terms too onerous?

Paul S. Giordano

We continue to consider reinsurance of certain components of our book of business, however, current market pricing is not attractive and the options available to us, given the state of the current market, remain very limited. Nevertheless, we intend to continue to consider reinsurance as part of our overall restructuring plan.

Question

What conversations are you having with the rating agencies? How long is the path to an upgrade, even to a AA?

Paul S. Giordano

We do not expect to restore our AAA ratings in the near-to-medium term, but we do feel that AA ratings are reasonably achievable if we can execute a significant part of our restructuring plan. The capital requirements are significantly less onerous at the AA threshold as compared to the AAA. That said, restoring our ratings to AA would also involve a broader quantitative assessment than simply capital, as well as qualitative considerations on the part of the agencies. At this point in time we can’t get any assurance that we will be able to restore our ratings to AA or higher.

Question

Any chance that XL can buy out the guarantee clause that it still has in regards to its SCA policies and how would the rating agencies react if XLCA allowed XLLI to buy out it’s agreement to guarantee XLFA’s obligations to CA on all the [inaudible] business?

Paul S. Giordano

We feel it is possible to structure an arrangement with XL that would terminate or commute XL’s exposure under its guarantee to XLCA in exchange for fair value. We have, and continue to actively pursue discussions with XL towards this end. The rating agencies’ reaction to this would likely depend on the amount and form of consideration received. We currently receive no value for the XL guarantee and rating agency capital models. However, this could change depending on future events and the outcome of our restructuring efforts if successful.

Question

Can you outline your plans to remain listed on the New York Stock Exchange?

David P. Shea

On April 14 the company met with representatives from the New York Stock Exchange and we presented the key elements of our plan, which Paul reviewed in his opening remarks. I would say that we very highly value the relationship with the New York Stock Exchange. We’ve been proactively communicating with them. We value our listing on the New York Stock Exchange and we remain committed to maintaining our listing in good standing.

Question

How has the downgrades of XLCA and XLFA affected your reinsurance treaty with FSA?

David P. Shea

As a result of the XLFA downgrades FSA currently does have the right to reduce the amount of seating commissions for the business previously reinsured us. Also, as a result of the downgrades, FSA has the right in substantially all of the contracts to commute back such business, should they choose to.

It’s our understanding that FSA continues to receive good capital treatment from the rating agencies for the reinsurance that we provide to them and we do not expect FSA to voluntarily make an election to commute it.

It is also worth noting that FSA’s business reinsured to XLFA pre-IPO is also subject to a guarantee by XL Insurance Bermuda Limited for the timely payments of principle and interest. Should FSA decide to commute their reinsurance exposure they have with us, this would involve returning approximately $135 million of premium to FSA, which we are in a position to support if they so choose.

Question

If needed, how much more in surplus notes can XLCA sell to CLFA? Also, how much more can XLFA dividend to the holding company, with perhaps those proceeds being paid to XLCA?

David P. Shea

In December 2007 XLCA issued surplus notes of $75 million to XLFA. Any additional surplus notes between both companies need to be approved by both the New York Insurance Department and the Bermuda Monetary Authority. XLCA does not need the benefit of additional surplus notes at this time. And we discusses the dividend capacity earlier in my remarks.

Question

Is there any new in the FAS 157 disclosures? Specifically did you modify any of the mark-to-market methodologies during the quarter?

David P. Shea

Very interesting topic. There are some new elements in the FAS 157, fair value values. But let me first state that we were not required to change any of our mark-to-market methodologies and have not done so. These methodologies include the internal income model approach I discussed in my remarks, as well as examining all available data in the marketplace.

The one significant impact 157 has had is permitting companies to use their cost of debt or credit spreads in determining a discount rate that is utilized in their fair value calculations. Overall, this has had a beneficial impact on SCA’s mark-to-market of CDS contracts since SCA’s credit default swap spread widened from 616 basis points at December 31, 2007, to about 1,100 basis points at the end of March.

FAS 157 also impacts our disclosure of the source of pricing for investments in our fixed income portfolio.

Question

On a follow up to mark-to-market, where would the mark-to-market been at the end of April? Can people listening on the call assume it improved?

David P. Shea

As you know, we do not provide forward-looking commentary on this subject. We do track the mark-to-market periodically, report it quarterly, and I would say our credit default swap portfolio generally tracks their associated sectors of the credit markets.

Question

Let’s turn now to capital for a moment. We gave an indication of how much capital we would release by hibernating for a period of time. How much capital has been released due to run off of the portfolio in the first quarter.

David P. Shea

Under the Moody’s model the gross capital run off during the quarter was approximately $50 million-$70 million. Although on a net capital savings level we were close to flat for the quarter primarily as a result of increased expenses related to the severance and advisory fees and a wind up of XL Capitals mini [inaudible] business. Which reduced our overall funds paying resources. This number also reflects the additional downgrades taken in our portfolio during the quarter, including Jefferson County, which resulted in an increased capital requirement of approximately $60 million.

So that said, absent material downgrades in future quarters, we continue to expect our gross average 2008 quarterly capital run off to range from $80 million-$120 million at the AAA level and $70 million-$100 million at the AA level.

Question

And one final question involving mark-to-market as well as capital, if mark-to-markets move equity into negative territory, are there any covenants or agreements that are affected by the movement of GAAP book value below zero.

David P. Shea

First of all I would like to say that mark-to-markets do not affect our loan agreement. Some of our [inaudible] contracts, to which XLCA is a party, contain insolvency-related termination events. Our view is that insolvency has to do with the ability of a company to pay obligations as they come due, rather than having positive cap equity. SCA’s total claims paying resources stood at approximately $3.5 billion at the end of the first quarter of 2008, while cash flow was a net outflow of $44.5 during the quarter. In any event, GAAP equity at SCA, XLFA, and XLCA is a positive as of March 31, 2008.

Frank Constantinople

We will now move over to a few questions on the portfolio. Ed did a pretty thorough analysis of the portfolio so there may be some repetition here.

Question

To the extent your HELOC or closed-ended second invest deals have exhibited acceleration in delinquencies, please discuss your observations or the problems isolated to broker/dealers for example.

Edward B. Hubbard

I did cover a discussion of our HELOC deals in my prepared remarks, but to summarize we now see a significant deterioration. And just to give you a data point, for our HELOC book we do think that ultimately HELOC could reach as high as 25%, which is a good point higher than historical averages. Of the HELOCs, for which we have posted case reserves, two are bank shelf programs and while I agree that the conventional wisdom to [inaudible] bank shelf programs perform worse than directly originated programs, there is always an exception to the rule. And in our case our two worst performing HELOCs are actually finance company-originated programs. And really the driver for the poor performance is the underlying collateral which suffers from significant risk early on.

Question

With respect to the RMBS portfolio, did April progress as expected and do you have many investment bank shelf deals that caused Amback so much trouble?

Edward B. Hubbard

Again, I think I covered this in the prepared remarks and while it is true that some of our RMBS deals are bank shelf transactions as I just described, the weak performance that we see really appears to be more of a function of the [inaudible] rather than the fact that there are some differences between shelf and non-shelf programs.

Question

What has been the progress of reviewing compliance with [inaudible] warranties in the contracts? For example, have we found any mortgages that were supposed to be owner-occupied but were not?

Edward B. Hubbard

Okay. Well, again, I tried to cover a discussion of our remediation efforts in my prepared remarks. But what’s happening now is we are continuing to review contract data and compliance matters and at this point it doesn’t appear that fraud is most prevalent with respect to seeded income low documentation loans.

Question

What sort of additional remediation has SCA engaged in with respect to CDOs? Secondly, RMBS or other transactions?

Edward B. Hubbard

Again, I think I covered that pretty well in our prepared remarks with respect to our remediation efforts.

Question

David, holding company cash declined from $24 million at year end to $17 million at March 31, 2008. Can you describe the uses of holding company cash during the quarter and if you expect this level of expenditures to continue in future quarters?

David P. Shea

Yes. I think that’s an excellent question. Clearly the change in the level from $24 million to $17 million a cash run rate on a quarterly basis for the holding company, it is just a matter of timing on inter-company settlements and we expect the cash issues of the holding company really to support corporate obligations and supporting SEC filings, etc. so that should be running roughly about $3 million-$3.5 million a quarter.

Operator

This concludes the Q&A portion of the call. I will now hand the call back over to Paul Giordano for closing remarks.

Paul S. Giordano

I would like to thank everyone for participating in today’s call and we look forward to speaking with you in the future.

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