Assured Guaranty Ltd (AGO) 2005 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Assured Guaranty third quarter 2005 earnings conference call.

(OPERATOR INSTRUCTIONS)

I would now like to turn the call over to your host for today's presentation, Ms. Sabra Purtill, Managing Director of Investor Relations.

Thank you, Rachel, and thank you all for joining us today for Assured Guaranty's third quarter 2005 earnings conference call.

We released our earnings yesterday evening and our press release and financial supplement are available on our website at www.assuredguaranty.com. We also updated the information that we had previously released on our exposure to Hurricane Katrina to reflect our exposure as of September 30th, 2005. This information is also available on our website.

The speakers on our call today will be Dominic Frederico, President and Chief Executive Officer of Assured Guaranty Ltd., and Bob Mills, Chief Financial Officer. Following their prepared remarks, they and other members of senior management will be available to address your questions.

Before turning the call over to Dominic, I'd like to remind you that our commentary today may contain forward-looking statements, such as statements relating to our financial outlook, business strategy, growth prospects, ratings, goals, personnel demands and other market conditions. Actual results may differ materially.

In addition, for those of you listening to the webcast or a replay of this call, please be advised that more recent information may be available on Assured Guaranty. Please refer to our most recent SEC filings as well as our earnings press release and financial supplements, which are available on our website, for more information on factors that could affect our forward-looking statements.

Now I'll turn the call over to Dominic.

Thank you, Sabra, and thanks to all of you on the call and webcast for your interest in Assured Guaranty.

Our third quarter results are a further indication of the continuing progress our team has achieved in building a dynamic financial guaranty organization over the last six quarters. We closed 40 deals in the quarter in our direct segment, the most deals in any quarter post-IPO. I am particularly pleased with this result considering that the third quarter is generally a slow quarter and that credit spreads continue to be tight, reducing the industry's opportunities as a whole and ours specifically due to our trading differential.

Similarly, in the reinsurance segment, we received our highest number of facultative submissions in this quarter, although weak industry conditions are putting pressure on our volume of treaty business.

Bob will talk in more detail about our financial results, but I wanted to highlight some areas of interest. Our direct new business production, or PVP, was $39 million, up almost 400% over the third quarter last year. This is solid evidence that we continue to gain traction with issuers, investors and underwriters. We are still reliant on large deals in our structured credit area, but this will abate as we continue to increase our presence in other markets and flow transactions.

During the quarter, we also wrapped our first future flow issue and our first home equity line of credit deal, laying the groundwork to expand our market presence in these important asset classes, where we have not previously been active. Furthermore, we continue to build our presence in other markets. In the quarter, we closed 16 U.S. and international structured finance deals, the highest since our IPO, including the Dekania transaction, the first European insured trust preferred security CDO ever done.

Our ABS and MBS teams continue to make progress, although this market is challenging right now given tight credit spreads and our underwriting criteria for MBS. We closed 13 deals in the quarter, 10 of which were AAA-rated. In addition to the HELOC deal and the future flow deal, we did two AAA-rated commercial mortgage-backed deals, one equipment lease deal, and nine residential mortgage deals. Five of those sold to retail investors.

Our public finance team is also building momentum, closing 11 transactions in the quarter for a total of 40 since our IPO. There is still a significant amount of untapped opportunity in this critical area. This area is the most rating sensitive, but several large institutional investors approved us during the quarter, another indication of our progress.

We continue to execute our plan and I remain confident that we have a strategy and a team that are creating long term shareholder value. As we have always said, this is a marathon, not a sprint. But I think you can all look at the results of this quarter, our fifth full quarter as a public company, and conclude we are on the right track.

I would like to take just a minute to comment on the hurricane activity in the quarter. Historically, the financial guaranty industry has not been materially affected by natural catastrophes. Hurricane Katrina was unique given the extensive damage in the region. We continue to monitor our $220 million in Katrina exposure and Bob will talk about what we've done there in a minute.

There continues to be a great deal of uncertainty about the amount and the form of state and federal assistance in the region and when and how many people will return to New Orleans. Most of our exposures are in our reinsurance segment. We will update investors as to any change in our estimate of losses based on future information we receive from our ceding companies. To date, no primary company has posted case reserves on any of these exposures.

Looking forward, we hope to continue to expand our presence in the financial guaranty market. We believe that we can grow even during challenging market conditions. The financial guaranty industry offers a solid growth opportunity for Assured Guaranty and our team is fully engaged in expanding into more asset classes and geographic markets.

Now I'd like to turn the call over to Bob Mills to discuss our financial results in more detail.

Thanks, Dominic, and good morning to everyone.

Before I begin, I'd like to remind everyone to refer to our press release and financial supplement for segment level details and further explanations on our financial position and results of operation.

Net income for the quarter -- the third quarter of 2005 was $39.2 million, or $0.53 per diluted share, compared to $44.5 million, or $0.59 per diluted share, for the third quarter of 2004. The third quarter of 2005 was relatively straightforward with one unusual item, the salvage litigation recovery of $1.3 million included in the other segment. Comparisons this quarter are hopefully a bit more straightforward than they've been in prior quarters.

Our operating income per share, which we calculated net income excluding realized gains and losses on investments and unrealized gains and losses on derivative financial instruments, was $38.9 million, or $0.52 per diluted share, compared to $33.6 million, or $0.45 per diluted share, in the third quarter of 2004.

Earnings from municipal bond refundings included in our reinsurance segment contributed approximately $0.03 per share in the third quarters of both 2005 and 2004. Refundings are reported on a one-quarter-lag basis.

Let's review the results of the quarter in a bit more detail. The PVP, or present value of written premiums, totaled $61.9 million for the quarter, an increase of 29% over the $48 million total PVP for the third quarter of 2004. PVP for the direct segment totaled $39.4 million, an increase of almost 400% from the third quarter 2004 amount of $7.9 million.

Production in the direct segment this quarter included continued progress in the public finance sector, as well as extremely strong production in the structured finance sector. These amounts also compare favorably with the second quarter direct segment PVP of $22.7 million. The current quarter had the benefit of one large transaction and in total we closed 40 deals, up from 29 deals closed last quarter.

PVP for the reinsurance segment totaled $22.5 million, a decline of 42% from the third quarter 2004 amount of $38.9 million. The decline reflects a $9.4 million decrease in PVP, because of the non-renewal of two quota share treaties that occurred in mid-2004 and lower levels ceded under an existing treaty, partially offset by facultative reinsurance where we continue to see increased activity. This segment reports PVP and par written on a one-quarter-lag basis for installment business due to the delay in receiving new business information from the primary companies. There was no production in the mortgage segment in the third quarter of 2005 compared to $1.1 million of PVP in the third quarter of 2004.

Looking at the embedded value of our business, the present value of installment premiums in force and net unearned premium reserve at September 30, 2005 was $893.4 million for the third quarter, an increase of 4% over the September 30, 2004 balance of $859.5 million. The change versus 2004 levels reflects net increases in business being somewhat offset by the impact of the FSA Healthcare transfer, which took place in the second quarter of 2005, and the sale of the single name CDS book in the first quarter of 2005. Net earned premium for the quarter totaled $54.5 million compared to $53.4 million for the third quarter of 2004.

Loss and loss adjustment expenses incurred totaled a $0.8 million benefit for the quarter compared to a $4.2 million expense for the third quarter of 2004. During the third quarter of 2005, there were $3.0 million of incurred case-based losses, offset by recoveries and advisement of reductions of reserves and loss adjustment expenses from ceding companies of $3.1 million. In the other segment, there was also a salvage recovery of $1.3 million.

Net portfolio reserve additions for the quarter for the financial guaranty segments totaled $0.6 million. During the quarter, there were changes in portfolio characteristics, including the impact of Hurricanes Katrina and Rita, and other movements in the closely monitored credits list, which I'll discuss in a moment, that predominantly affect the reinsurance segment and the continued runoff of the historical CDO book in the direct segment. In the normal course, we also updated certain rating agency probability and severity statistics.

At September 30, 2005, the closely monitored credits list contained 82 credits with net par outstanding of $1.51 billion, up $147.4 million from the $1.36 billion amount at June 30, 2005, but down 17.9% from the $1.83 billion amount at September 30, 2004. The most significant change for the quarter was the addition of 18 credits with total net par outstanding of $143.0 million to category one and $2.12 million to category three as a result of the impact of Hurricanes Katrina and Rita on our public finance exposures in the affected areas of the states of Alabama, Louisiana, Mississippi and Texas.

This exposure is totally within our reinsurance segment. These exposures have been subjected to our standard portfolio reserving methodology and no case reserves as yet have been ceded to us by the primary companies. Thus far, we have paid claims totaling $61,000 as a result of those events.

There was also some increase in categories one, two and three of the CMC list associated with other credits. This activity is almost exclusively in the reinsurance segment. The movement from category two to category three represented net par outstanding of $24.7 million related to subprime mortgage exposure.

The investment portfolio grew approximately $57 million from the beginning of the quarter due to operating cash flow, including the receipt of cash from the CFS litigation settlement. Yields were increased slightly comparing the third quarters of 2005 and 2004. The current pre-tax book yield was 4.8%, increased slightly from 4.7% in the third quarter of 2004, and the duration has decreased from 5.2 to 4.4 years during that time. There's been no significant change in the investment portfolio during the quarter and the average credit quality for the portfolio remains at the AAA level.

As I mentioned last quarter, as investment opportunities change, I would expect the duration will extend slightly and that the average credit quality will return to the AA+ level. During the quarter the market value of our investment portfolio depreciated by $24.3 million net of tax as a result of higher interest rates. Since the portfolio is long-term investment in nature, changes in value were reflected in the accumulated other comprehensive income account. Other operating expenses increased by $1.0 million, or 7%, in the third quarter of 2005 compared with the third quarter of 2004 due largely to increases in staffing.

Our book value per share was $21.81, increased 11% from $19.58 per share at the end of the third quarter of 2004. Adjusted book value, which adds the embedded value of the after-tax installment premiums in force and the after-tax unearned premium reserves net of DAC, was $29.96 per share at quarter end, increased 13% from the $26.56 per share total at the end of the third quarter of 2004.

The company's operating ROE in the quarter, which is calculated by dividing annualized quarterly operating income by average shareholders equity, excluding accumulated other comprehensive income, was 10%.

We expect to release our fourth quarter and year-end 2005 earnings during the first week of February and we'll update you on the time and date as we get closer to that point.

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

Thank you, sir.

(OPERATOR INSTRUCTIONS)

Our first question comes from the line of Mark Lane with William Blair.

A couple of questions. First of all, can you share with us either execution this quarter versus last quarter or whatever statistics you may have regarding trading value of your wrap relative to the prior quarters? Was there any movement or improvement over the past three months?

Okay. From the standpoint of execution, obviously we talk to you guys about monitoring our submission activities as a key indicator of where we see quarterly production and opportunities availing themselves to us. And a part of that has been the improvement in ratings through the year, which has had the impact of narrowing our trading margins, which gives us the opportunity to look at more business. So it's general that I can talk to you about certain parameters, but it's different on an obligation-by-obligation basis.

So, for instance, we would say to you, in general, margins or differential has come in on the municipal side, as a general rule, in the 10 to 15 points range, 15 to 20, where on the ABS side we'd say it's in the 5 to 7 type of range. However, we did a transaction on the ABS side where the trading differential was 3 this quarter. So it really is going to revolve around the specific asset or the specific sector in the marketplace as to what it ultimately results in. But it has narrowed over the year and obviously we look for a continuing narrowing in that differential.

Is one quarter too short of a time period to compare?

Yes, absolutely. And as I said, it'll be different transaction to transaction.

Okay. Second question is in terms of the number of deals, how do you -- you said one large deal. How do you define a large deal?

Anything above $5 million PVP.

Okay. So this year on a comparative basis in terms of number of transactions, tell me if I'm right, but this quarter was 40, last quarter was 29, first quarter was 23, fourth quarter last year was 36?

Well, we have different statistics and it's really sometimes we'll do two executions on a single deal, so the counting sometimes revises itself. But our official statistics, if you want to call them that, would show 40 in the current quarter, what you had, 29 in the second quarter of '05, which was correct, 19 in first quarter of '05, 26 in fourth quarter of '04, and 11 in third quarter of '04. So the progress has been 11 to 26, but year-end we expect to be more active, then 19, 29 and 40 in the current year.

Great. Okay, and last question, can you just give us your updated thoughts about where you stand with Moody's?

Sure. I'll make one other point on the transactions. Obviously, we're still counting transactions. Hopefully there's going to be a day we're not going to count transactions, but we're not there yet. And that's part of what the challenge and the opportunity is for us.

Understood.

In terms of Moody's, a couple of things. One, they did release a routine update of our rating, but the important thing to note there is that it did not -- or was not part of a Credit Committee action. Moody's is different than S&P in that they go to Credit Committee when they feel necessary, not on some sort of a regular annual basis.

Moody's did, earlier in the quarter, produce some statistics on behalf of the entire marketplace and we were very pleased to see where Assured Guaranty ranked in those statistics. And specifically, they give out five statistics -- credit risk ratio, which we ranked fourth among the seven companies; tail risk ratio, where ranked third among the seven; dispersion ratio, where we ranked second among the companies; hard capital ratio, where we ranked third among all companies; and total cap ratio, where we ranked second. So as you can see, in that five parameters we ranked second twice, third twice and fourth once, never fifth, sixth or seventh.

So I think it makes a strong case where we believe we've been able to achieve our commitment to the strategy of moving the ratings up and we can't predict when they will take us to Committee or the results of when they go to Committee, but we think we keep the blocking and tackling that we need to do to continue to make our case for a change in our outlook for ratings.

Okay.

Thank you, sir. Our next question comes from the line of Darin Arita with Deutsche Bank.

With respect to stock option expensing, can you help us with how we should think about this for 2006?

Yes, I'll let Bob answer the question on stock option expense.

There is disclosure in our existing financial statements on FAS 123R and what the expense would be on a pro forma basis in the current year. We have -- we have done a calculation of that yet so far. Naturally that is a Black Scholes calculation, involves volatility inputs as well as estimated life inputs. The impact on 2006, estimated at this point in time, because it's not finalized, is probably $4 million pre-tax.

Okay. And in the reinsurance segment, can you give us the percentage of facultative reinsurance PVP in the quarter?

Sure. The percentage of facultative in the quarter was 23.1 on a PVP basis. And for the year to date, it would bring us to 41.6. The important thing to note there is, as I talked on the -- in my prepared remarks, it was our largest quarter for facultative submissions where we received 44 and we executed, once again, our largest number of facultative deals at 17. But once again, it gets down to the average premium size. And the absence of large deals will affect, on a PVP basis, what the contribution of facultative to treaty.

But we continue, as we've talked in the past, to see a significant increase in facultative opportunity. We're extremely busy down here in handling that volume and that's a good thing for us in terms of continuing to validate the reinsurance franchise and the opportunity it's going to see on a go forward basis.

Okay. And just one other question. I guess given that the company has grown total unearned premium reserves and installment premiums over the past year and I guess there's a potential for changes to the investment portfolio, is it fair to say that a 10% ROE is sustainable with your current readings?

Well, as we've said in the past, we don't give projections of ROE. However, I will caution you to look at the unearned premium growth. Although it is growing, it is growing at a significantly slower rate than our capital and that's going to pressurize ROE. And part of that is, remember, we've got this issue that we talk about in the loss reserving where the book of business that's running off was both different in terms of type of execution, different in terms of its rating, which contributed two things, one, higher reserves, but also higher unearned premium, and although we're writing good new business volume, the rating of that business and its nature, as I referred to in my remarks, say, the residential mortgage deals, well, the majority, as I said, 10 out of 13, are AAA.

At the AAA level, they don't take a lot of capital, but they also don't throw up a whole lot of premium, and specifically unearned, and yet what's running off; the quarter share mortgage book of business, which would have a lot thicker unearned premium that's earning through the quarter. So we have that mismatch today in terms of new business versus runoff. It's affecting our loss reserves and it's also affecting our unearned premium reserve.

All right. Thank you very much.

Thank you. Our next question comes from the line of Chad Klatt with Piper Jaffray.

Just wondering if you could potentially give us an update on what the pipeline looks like in 4Q or what it's looked like here in October?

Yes. As I typically look at, from our point of view, pipeline activity continues to be strong. We're seeing a rise in, say, our international opportunities through our UK operation. Obviously, public finance now seems to have a record number of opportunities in the pipeline. And the structure credit ABS side, the ABS side in the traditional mortgage world, has been a very tough market, So we're seeing a little bit of decline in activity, but yet we've had a tremendous amount of opportunity in structure credit. So overall, our submission activity is continuing to trend in a very positive way. And already for the quarter we've closed a number of deals, even at a very early date, such as today, when typically fourth quarter is a late quarter activity.

Okay. And then one more question. On the CDO book, it looks like there's some pretty solid improvement in credit quality there. Is that primarily the rolling off of business or is there actual upward credit migration there?

A combination of both.

Okay.

We write typically in that market very highly rated, predominance being AAA, and yet, as you're well aware, what's running off has a rather hodgepodge mix of both mezzanine and other structures in the credit scale would not have the same rating as we're writing today. And part of that is also an underwriting decision as well.

Okay, great.

Thank you. Our next question comes as a follow-up from the line of Mark Lane with William Blair.

Do you know is the direct business similar to this quarter or are there any -- or can you quantify what sort of reserves you have off of portfolio or case reserves for CDOs or other structured business in the direct that's going to runoff in the fourth quarter?

Mark, we do look at that. We could tell you that there is some fourth quarter benefits that we see. I'm not one to go through and give you the exact number, but there is benefit that we're aware of as contributing to what would be a low loss quarter in the fourth quarter once again.

As I said, we're very focused on the new business and we continue to refer that we write a lot of high quality business today, the majority being AAA. Obviously, its contributions to the loss portfolio reserves is going to be significantly less than the runoff that we're going to see from both the CDO book, as well as the quota-share mortgage book.

Now understand, our comments, as my general counsel just passes under my nose, assumes that we have no other losses. Obviously, Katrina's still out there and of course we don't know what we don't know, but we do see credits rolling off of the CDO book in the fourth quarter.

Everything else equal, of course.

Exactly, and Mr. Michener was kind enough to remind me of that fact.

Right. And last question would be, can you just, to the extent you can, update us on the quality of your relationship with FSA and any potentially anticipated changes with your treaty relationship there?

Obviously on the reinsurance side, FSA represents a significant customer. We are already involved in discussions regarding their renewal of that treaty relationship. We are very aware of the strong relationship that we have and the significant relationship that both of us represent to each other.

Good enough. Thanks.

Thank you, sir. Your next question comes from the line of James Shanahan with Wachovia.

Can you please comment on your progress towards Sarbanes-Oxley compliance...

Sure.

...any deadlines that may be upcoming?

I'd be glad to do that. We've complied with Sarbanes-Oxley Section 302 certification ever since we went public. As a new registrant in 2004, the requirement for us to comply with Section 404 on the internal control certification is for year-end 2005. That's a major project for us, needless to say, as it has been with all public companies, and we've used internal and external resources to prepare for that to document and test our controls.

Our entire documentation process is done, we've done our internal testing up to this point in time, and we've completed remedial steps based on our test results. The outside auditors are now doing their test work, which will extend through year-end, and I think we're confident it'll be a positive conclusion. When we issue our year-end financial statements, it will have a 404 certification along with it. I mean it's been a valuable endeavor, I think as most public companies have found, although it's been a very costly endeavor.

As we look ahead to year two in that, we've also installed some new computer applications to monitor the process and the controls in that area as really part of our overall enterprise risk management structure.

Are there elements of your operating expenses in, say, the third quarter or second quarter that would be then related to your Sarbanes-Oxley compliance issues and would be non-recurring in nature or, conversely, are there additional expenses that you might expect to accrue in Q4?

There will be some expenses in '04. I think the significant external expenses were we've utilized consulting expertise to help us with the documentation, because everyone is fully busy with the day-to-day work of developing business. So we have incurred expenses throughout the year and we do expect that expenses will, for this consulting type expense, will decrease in 2006, but it won't totally go away. I mean this is clearly something that we have to live with and, as we make it a process rather than a project in 2006, I think there will be some ongoing expenses. But compared to 2005, it will -- we will probably save a significant amount of money, I would think probably somewhere in the vicinity of 0.75 to $1 million.

Thank you.

Thank you, sir. At this time, I'd like to turn the call back to Sabra Purtill for any closing remarks.

Thank you and many thanks to you all for joining us today. We certainly appreciate your interest in Assured Guaranty and 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 passcode is 34984651. If you have any more questions or information needs, please feel free to contact me.

Thanks again and have a good day.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude your presentation and you may now disconnect. Have a great day.