Ambac Financial Group Inc (AMBC) 2002 Q3 法說會逐字稿

Good morning. My name is Amanda and I will be your conference facilitator today. At this time I would like to welcome everyone to Ambac's Financial first quarter conference. After the speaker's remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star and the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. At this time, I would like to turn the conference to our host, Frank Birona. You may begin.

Thank you and welcome to Ambac's third quarter conference call. My name is Frank Birona and I am the CFO of Ambac. I have Tom Gonsalvo, our Controller and Peter Pollion here, head of Iinvestor Relations. As you know, we released earnings today at 8:00 a.m. Our earnings press release and statistical supplement are on the web and will be mailed out to those who have requested it. If you did not receive it and would like to, please feel free to contact us or please visit our website www..ambac.com. This call will also be replayed this afternoon at 2:00 p.m. Give us a call if you want the telephone number. The call is also being broadcast on the web and you can access it obviously from our website.

I ask you now to please mark your calendars for the fourth quarter 2002 earnings release which will be released on January 23rd, and that's at 8:00 a.m. in the morning. With a conference call to follow it at 11:00 a.m.

During this conference call, I may make statements that would be regarded at forward looking statements under the private securities litigation reform act of 1995. These statements are based on management's current expectations and I refer you to our press release for factors that could change actual results. Let me go through the highlights first of the third quarter. It was a strong quarter for Ambac. Our net income for the quarte was131.7 million or 1.21 per diluted share, up 19% from the third quarter of 2001.

As we have stated inour press release, Ambac is only reporting net income in accordance with gap accounting. However, the earnings research and estimates service have been adjusted their estimates accordingly. Therefore, we will continue to provide information on items that analysts adjust out of GAAP net income to arrive at their current estimates to eliminate any confusion.

First of all, first call adds back or eliminates net gains and losses from sales of investment securities and mark-to-mark credits on derivative contracts or simply net security gains and losses. In the third quarter of this year, that amounted to a negative 0.2 million, 0 impact on a per-share basis. This item compares to a net loss of 1.4 million or 1 cent per share in the prior period, third quarter of last year. Also, some analysts have tracked out accelerated premiums earned on guaranteed obligations that have been refunded or simply refundings and that number amounted to $15.7 million, or 8-cent per diluted share in the second quarter and that was up significantly from 10.5, or 5-cent per share over last year. Let me now move to the top line adjusted gross premiums written. It was an excellent top line for the third quarter, adjusted gross premium written, which is the -- really the production. It is the present value of premiums that we have either collected or will collect based on business written during the quarter. And in the third quarter that number came in at 305.6 million versus 180.6 million up 69%.

I would like to take you through detail of major writings and business, public finance, structured finance and international finance. First on the public finance side, A.G.P. written was 126.8 million. That grew 59% from the third quarter of last year. Municipal volume continues to be very high coming in at roughly $89 billion up 59% and market penetration was relatively flat period on period. But still very favorable at approximately 48%.

Ambac in particular continues to focus on the more highly structured segment of this market that carries higher premiums and higher risk-weighted returns. In fact, about 40% of our performance or premium that we have collected this year comes from this type of transaction in the public finance arena. Importantly, we accomplish this without compromising our historically high underwriting standards across the board. Also of note, public finance during this quarter experienced strong transaction flow, in particular from the transportation and health care segments.

Structured finance, A.G.P. written was 85.6 million growing 67% from the third quarter of last year. This sector includes an array of products including mortgage backed securities home equity ABS, other consumer finance transactions, collateralized debt obligations, lease back securitizations, investor owned utilities and asset backed paper conduits. Increases in this market or during this period were really driven by strong flow in several areas but most notably in consumer backed and auto backed and some in the credit card sector as well. On the international front, international AGP increased to 93.2 million, up 88% from the third quarter of last year. This certainly was a strong quarter for the international business and coming off a relatively slow second quarter it is indicative of the lumpy nature of thisbusiness. Large deal activity was strong across several sectors, including transportation once again utilities, and mortgage backed sectors while the flow of smaller sized CDO's was also steady.

The demand for our product is very solid in this growth market and pricing and structure is strong as well. As a general market commentary, in terms of what is going on out there in the general market conditions, as we have consistently stated through the course of the year, the competitive and pricing environment for our products remains very favorable. We do expect this favorable environment to be sustainable, at least until the near future, if not beyond, as credit spreads are at near historic highs and the investment community continues its flight to quality, creating great demand for our product.

Turning to premiums earned in total, net premiums earned and other credit enhancement fees in the quarter, excluding the effective refundings increased to 114 million, up a very strong 22% from the third quarter of 2001. This growth was driven by a 43% improvement in international earned premium, which is our smallest market, yet our highest return market. In contrast, public finance grew 11.9% which is impressive considering it is our most mature list line. Accelerated premiums which result from refundings were 15.7 million or 8-cents a diluted share, as I said earlier, and this compared to 10.5 million or 5-cent per diluted share in the third quarter of 2001.

Municipal refunding activity remains very high. Actually not very high, but high, generally high in the current interest rate environment. Additionally, this quarter, this current quarter, accelerated premiums was impacted by a 4.3 million refunding that we had on one international credit. And given the fact this transaction was somewhat unique, we really don't anticipate any kind of material refundings from the international sector in the future.

A word about production. If you can take those two lines combined, AGP came in at 306 million versus the $130 million in earnings which we earned, and what that basically says is that we are producing business at a 2.3 times rate of related to what we've earned it at, meaning that we are continuing to build our warehouse of future earnings. And, in fact, our warehouse of future earnings total is really growning to about $3.3 billion, representing future earnings that are in hand or contractually due to us that will come into earnings with the lapse of time. And that number, year on year, is also up about 22%. So that bodies well for -- that bodes well for the future.

Investment income was up 13.9% for the quarter, due to the investment portfolio from ongoing operations. This income line has also benefited from the fact we did a $200 million debt offering from October of last year for approximately the same time we're talking about now. Partially off settling the earnings growth is lower market interest rates on new money invested, and, you know, that has dampened the growth a little bit.

Just another word about our investment portfolio, it remains to be a high quality portfolio. 96% of the investment portfolio is rated A or better and is solely invested in fixed-income securities so a very high quality portfolio. Moving to financial services, we had revenues during the period of 13.6 million, up 33% for of the third quarter of last year. This growth was driven by investment -- or primarily by our investment agreement business., which where we exhibited growth and revenues nearly doubled to 7.2 million and much of that related to improved spreads in that business. So that business is doing quite well. And, in fact, during the period we even received a lower -- a reduction in our capital charts from the rating agencies so the return on equity in that business has improved drastically.

Both the swap and cash management revenues were solid but flat during the period. Operating expenses were up 15% quarter on quarter, reflective of a growing franchise. We continue to invest in our business and really that comes in the form of people costs. But this compares to revenues that grew at 22%. And, you know, this relative performance is really further improved our industry leading expense ratio that came in at a 14.2% level.

Lastly, return on equity. Return on equity declined to 15.2% during the period. That is due to higher equity valuation due to the interest rate impact on our investment portfolio. As the rates have gone down our investment portfolios gained in value and that flows through to the equity which has the effect of dampening our return on equity. But excluding these gains -- the investment gains on equity, our operating R.O.E. actually increased to an industry-leading 16.2%. So good progress there as well.

In summary, this was a very strong quarter with net income up a solid 19%. Excellent top line growth, A.G.F.R.P. of 305 and marvelous markets for Ambac's products.

Before I open it up to questions, would I just like to touch on a few things. First, as you know from our press release, Ambac will be adopting the fair-value based method of accounting for stock options as described in financial accounting standard 123 starting in the first quarter of 2003. The fair value method requires expensing the estimated cost of employees' stock options. We plan to adopt the statement prospectively, meaning that 2003's expense will only be for those options granted in 2003. Our estimate for the amount of stock option expense? 2003 is just that, it's an estimate that is likely to change as valuation methodologies are considered. Our current estimate, though, of the impact of stock option expense on our net income in 2003 is approximately one penny per share per quarter. So a pretty small amount.

Moving on to the next topic of guidance, I would like to discuss our net income guidance for 2002 first. Since we have decided to adopt FAZ123 in the first quarter of 2003, there's no longer really any need to provide an alternative measure of net income as we did in the last quarter. Therefore, our GAAP net income guidance for 2002 is 456 to 460. And I want to emphasize this guidance includes year to date net realized gains and losses on investment security and mark to market gains on credit derivatives of a loss of 5-cent per share incurred through the third quarter year to date. But, of course this does not provide gains for the remainder of the year, i.e., the fourth quarterer. To make this comparable with assistance guidance provided by analysts in the street, you would add back the 5-cent to come to 461 to 465 on a comparable first-call basis. So as you can see, we have upped our guidance from that, given in the beginning of the year. In the beginning of the year, we gave guidance of 450 to 460 and we're now at 461 to 465. All this said, this implies a range for the fourth quarter of net income, GAAP net income of 118 to 122 for the fourth quarter. As for guidance for 2003, we are certainly committed to our long-term established growth rate of 15% in underlying earnings, which excludes net security gains and losses and refundings. However, net income will also be impacted by level of refundings and may be lower than actually results that have come in this year, if and when interest rates rise. Additionally, our earnings will be lower for the impact of expensing stock options, as I mentioned earlier in this call.

So with that, I would like at this point, Amanda if you're there, if you could open it up for any questions anyone might have

Certainly, sir. At this time I would like to remind everyone, in order to ask a question, please press star and then the number 1 on your telephone keypad. We will pause just a moment to compile the Q and A roster. And your first question comes from Robert Ryan with Bank of America.

Good morning.

Good morning.

In the second quarter conference call, you indicated a transfer to the case basis reserve of 5 to $10 million for a first loss exposure on CDO's. I guess, number one, are there other such exposures? Number two, has that estimate of a potential loss held up? And then more generally, what are you thinking about your watch list? And finally, where is the unallocated reserve?

Frank Birona OK. There's a lot there. The first thing you mentiond is on the last call, I did mention -- first, let me start with our sympathetic CDO book, which is over $34 billion today. You know, first I want to say that I think -- let me just get the exact number. 98% of that book is investment grade. 89% is rated double-A or better so it's a high quality book of businessed and it's held up well during this period. However, as I said, and this is really no change whatsoever from the last time I spoke to you on the conference call, was that we did have one credit that was experiencing a problem and we were paying a claim. I think I said at that time we paid about $4 million in the claim, in terms of the claim, and that we had an expectation that the loss could be as much as 5 to $10 million.

And also that we have a reserve for that. And that's all true and that remains absolutely unchanged. There's been absolutely no negative development in that case, and it's performing as we expect it to perform. So that's -- you know, there's really no change there.

I think, with respect to the watch list, I think it's fair to say that that has grown a little bit [inaudible] period on period there's been a lot of activity, a lot coming off and a lot coming on. I think when I -- you know, I think specifically in areas of places like health care, where we traditionally have heavy names or heavy amount of credit that hit that list on and off that come on and they go off, we have seen some more CDO exposures go on and off. But I think generally the list is very healthy and not materially different from what we have seen in the past.

Lastly, on unallocated reserves, we currently have about $144 million of reserves. About 120 of that is of the unallocated ACR type, and the balance is really reserves, about $24 million in reserves, against our sympathetic CDO book, which is more than ample given our expectation of losses that I mentioned earlier.

OK, thank you.

You're welcome.

Your next question comes from Bob Hotenson with Goldman Sacs.

Hi, frank. Congratulations on a great, quarter.

Thanks, Bob.

I have a question on the securities gains and some of the items below the line that obviously are flowing into net income. Is there any relationship to the securities gains and the losses on the mark to mark adjustments for the derivative portfolios or is that just a happy coincidence this quarter?

And I would like to ask more broadly, you know, on that derivatives mark to market, what changes in the markets? Obviously [inaudible] wider debt spreads and so forth give rise to that adjustment. How can we eyeball that and get of sense of what is going on in the credit markets. And then the final part of this is how do you as a management team look at this philosophically in the context of other -- you know, what has been considered non-core adjustment such as securities gains and losses or accelerated premiums? How could you put this adjustment back into context of these other items on a philosophical basis?

OK. The first question was a happy coincidence one. I think clearly, you know, we did have mark to market losses on our credit derivative, synthetic CDO book of $6.9 million, a little less than we saw last quarter. That was related to the fact that there's been no deterioration of the book significantly at all. But what has happened is credit spreads and you've been reading it in the newspapers have really widened out here and that's going to affect the value of that portfolio since it is derivative.

We have also -- we always mark that market and continue to do so. So that's all utilities that will run through earnings and we want to make that clear to people. We also -- you know, interest rates are very low and we have huge gains in our investment portfolio. In Normal course of managing that portfolio, we do some small trading. In fact, we did have some gains. A lot of that came in certain areas of the mortgage market that we took gains in where we wanted to lighten up a bit, so it was -- I think it was a coincidence for the most part, and I think clearly we break that information out for people to see.

Now, the CDO mark, in terms of a barometer, if you will, I think you have to look at general credit spreads in the market. It's been well- publicized we're corporate credit spreads. The book that underlines these synthetic CDO's are market obligations so as the credit widens, we will have a mark to market loss on the book. The reverse is true. When spreads come in a bit, we see gains. You know, I think it's important to note that, if you take the two parts of what I have said as, one, that we don't expect any kind of material losses in this book, what that suggests is that those mark to market gains or losses that we booked over time will go away as the deals mature. So I think , you certainly have to pay attention to that number and look at it and we have to disclose it to you, but at the same time, I think it's important to consider the potential for loss.

Lastly, on the management team, in terms of how we , we run this business with regard to this, we think this is a profitable business and I think that has been proven. And I think, you know, additionally, we have to recognize that it does create some volatility in earnings and have to deal with that. So we actually limit to a degree the volatility in earnings by really focusing on very high quality securities to begin with. You know, in an era where we have seen absolute -- you know, near historic widening of credit spreads, the net impact on our portfolio has been relatively small because of the very high quality securities we ensure. If we continue to insure the very high end of AAA or better type securities, the mark to market is going to be relatively insignificant going forward.

Just one last little follow up. It just seems, and maybe you can comment. In other words, what is interesting is your investment portfolio, you know, if that changes in value from quarter to quarter, that adjustment effectively goes through, as you pointed out, the shareholders' equity line, and the biggest impact is really on you were return on equity. I mean, here is a portfolio that, in theory, is being held to maturity or being held over the life of an asset, and the mark to market, so to speak, is taken through the income statement at the same statement. That just seems to me to be a little -- I'm not criticizing you, but I just would like to understand that a little bit more philosophically and from an accounting point of view.

)) Well, you know, it's a derivative and that's the current accounting on derivatives. I happen to agree with that accounting. You know, I do think it causes some confusion, but, you know, I think there's a difference between owning a long-term 30-year bond and writing a credit derivative. So, I think it's appropriate that we do this and it's certainly in accordance with GAAP and we certainly disclose it. But we are going to limit that volatility by staying on the high end of it. I think that's the right thing to do.

I Do. Thanks a lot.

Your next question comes from Jeffrey Dunn with Keith, Briad and Wood.

Can you discuss some of the credit quality itemsin the quarter specifically in the structured and the municipal world.Also if you could discuss the prepayment impact on earned premium this quarter and also how you adjust your expectations for installment premium roll out given the changing prepayment speeds.

And lastly on the CDO market, since everybody is focused on the loss side of things, can you talk about the new business opportunities, what happened to pricing, structure, and what kind of benefits do you expect, say, over the next 12 months?

See if I have this right. First, was quality of new business written?

Right.

Generally the quality -- in a market where you can write a lot of business like we have experienced and the demand for our product is very, very high, it has given us a great ability to be more selective, not that we weren't selective before any evidence across the board shows that we are ensuring a very high quality book of business to begin with, and we have been able to have -- to be more selective and require more in terms of conditions for insurance as we have gone through this tougher period for credit. So the quality of the book we're writing is very, very solid and perhaps even better than it was even a year ago.

Prepayment risk, we do have a big percentage of our mortgage booker, our existing mortgage book, particularly in the home equity area are, that has been prepaying. This is not new. This has been going on almost two years now, at rates above 30%, prepayments above 30%. When we write the deals, we certainly don't expect that level of prepayment. But that's dampened our growth in earned premiums. With that, we're growing at a rate of about 22% so. I don't have an exact number. Can I get back to you in terms of what it would have been without that. But we do -- when we write this business, we do expect a pretty high level of refinancings, I don't think we have expected above 30%. We are probably in the mid 20's. So I think we have held up remarkably well given the prepaints.

As far as that's expectation for installment prepayment roll out goes, how often do you adjust the rate for your book value?

Every quarter. So what you see on our page, whatever of our supplement. It's 16 of our supplement in terms of the runout of earnings overtime, that is our updated estimate, based on current prepayment speeds, not estimated. It's current. So actually, it could actually be better than that. I don't want to, you know, lead there, but it could be better if prepayments slowed down. I don't know what is going to happen to prepayments though. So it's the most up to date. Pricing environment was your last --

The CDO market what is changing there as far as structure and pricing and given all of the concerns.

FSA made an announcement about their departure from -- or refrain from the business. I'm not sure exactly what they have said there. But I think that's given us an ability to increase our pricing in this particular sector. As I said before, we like this business. We continue to write it at high levels, and pricing has certainly improved. It's hard to give you a number on that at this point, because it's -- we're kind of still in the midst of it, but it has been a significant improvement in that area. Particularly, since FSA has kind of stepped, at least temporarily outside of it, and they were the largest market participant.

So conditions have actually gotten better as we -- more and more people are trying to tighten the language, including ourselves with respect to definitions to credit events.

Do you think what is happening on the CDO market now is comparable to what happened in the health care market after Allegheny?

Maybe, maybe not. I think their acompletely different bond types obviously, but I do think, there's -- that there's concern out there, this credit spread widening. With lesser competition, I guess on that parallel, I agree with you.

Thanks.

OK. Your next question comes from -- Caitlin Law with CSSE.

Frank, can you give us an update on what is happening in the airline E-C market department, what you see in terms of credit trends and also in terms of residual values, whether you feel comfortable and you will not have any losses there if the airline industry does take a turn for the worse? And also give us an idea for the sustainability for the revenues in the -financial services segment because obviously you had really good performance this quarter and it was up nicely sequentially. What shall we think of in the next few quarters. Thanks.

First, on the airline or aircraft exposure, equipment leases, they're called EETC structures. But our exposure today is about $1.1 billion. That's up from what it was on 9-11, which means that we continue to like this sector and continue to write business in this sector. You know, it's a very good book of business. We're very confident. We wouldn't be writing new business if we were not confident that this is a good secter and did not represent a problem. But, you know, the way these structures work is, you know, we're typically taking loan to values in 50% area or less and what we're doing there is taking the senior most part of securititizations to finance these airplanes and there's a lot of credit enhancement along the way and structure across the way that really helps us out. Our structure is on the highest quality planes, most actually efficient, growing Air Bus and Boeing models that are the most popular, and they're all virtually new planes. So we have a high degree of confidence in these structures and these deals. And we do not expect any losses at all in this book of business.

Financial services had a pretty decent quarter. I was happy to reporter outer investment business, which is really an annuity type business; doing very well. The spread is really improving there. So we're doing a good job there. I think that is very sustainable. The the volatility will come in our derivative area where we provide interest rate and currency swaps to deals along the way because there is some degree of inception income there related to that business. It's interesting to note, we have seen an increased demand for our product if that area. There are not many AAA companies in the world anymore. And Ambac's AAA in a derivative market is very valuable in the market, more than before, and we're being asked more and more to step in, in many instances, in an enter mediation role where a bank or investment bank would typically have played. So it's really doing well and I think it's sustainable, although there will be a degree of volatility because of the accounting there.

How much volatility do you think given that swaps business could become more important? Could it be, you know, swinging the revenue line by pa couple of million per quarter?

Frank Birona When I say volatility, typically you're not going to see volatility, you're only going to see positive -- not only but you're typically only going to see positive volatility. If we book a deal, there's earnings. There's earnings over time but some degree of inception. But it's not a -- it's really a small, small number, relative to our overall story. The whole -- the swap business probably represents 1 to 2% of our revenues so it's really a small -- that line in itself could move around a little bit, but in terms of our whole story, it's a small component. So I don't want anyone to overemphasize financial services. It is a very good complimentary business that helps us win deals across the board and is a profitable business. But, you know, it shouldn't drive the story of Ambac.

OK, that is helpful. Thanks.

Your next question comes from Jordan Himolitz with Fliescher Funds.

Two questions. One, regarding guidance, are you endorsing a 5.55 number? I was confessed on what you had said. Second question, in most of the models, it has net interest income growing with a 5% margin, and I'm wondering, you know, if the current -- in your current environment, how are you getting 5% on average if that is the case and if not, if it's closer to 4%, are other areas growing faster to make that up?

First of all, our guidance for next year is underlying growth and that's before we consider what refundings we will do and before we consider what security gains or losses would be. So the old core earnings that we used to report, we're saying 15%. That's our long-standing commitment is 15%. We can't control refundings. So, you know, your guess is as good as mine. I will give you more guidance next quarter in terms of where interest rates are. But I can't predict the interest rates. So I think what I'm trying to say there is, I think, implied in our guidance this year is about 22-cent for refinancings and refundings. We think, if interest rates rise here, that number could drop next year. How much? I can't really give you a good number right now.

So I'm not endorsing anything other than saying we're committed to 15% growth on our underlying business. With regard to models out there, I'm not sure that -- I don't know which models you're talking about. But our investment income is growing more than the rate of growth that related to the investment yield, because we have free cash flow. Last year it was $660 million of free cash flow that we got in the door that we take and then invest in our portfolio and that's allowed us to grow historically at higher rates than just the yield on a portfolio.

So currently, I think this quarter we grew that 13%. That would have been higher if we weren't investing in 5% yield in the market, but it was certainly boosted by the fact we wrote a lot of business and cash flow has been very positive.

Can you give -- what kind of balances you're then having for investment income next year on your models?

We don't give guidance on particular lines.

Thank you very much.

Thank you.

Your next question comes from Terry Shoe: with J.P. Morgan.

Yeah, hi, frank. I see there's always confusion about core earnings and earnings power. The fact that the 15% may be somewhat below earned premium growth, which seems to be built in to continue at its strong pace year over year for 2003, I guess, would be because you have an investment income component growing left. But then you have all of the other moving parts. But looking at the strong new business momentum growth as well as your, as you say, your kind of at the unearned premiums, which is earnings yet not shown through but warehoused earnings, at the confidence level of meeting that long-term market ought to be higher. Is that a fair way to look at it? Because I would say a year ago there were some other issues and earnings outlook seems to be moderating some with interest rates, etc., it etc. Am I looking right that the momentum is stronger because then earned premiums will certainly lead into future earnings?

Yeah. What is encouraging to me is that the environment for our products is very, very good right now. I think Phil says he has never seen it better.

I think that is a very important point to consider when you try to consider our future growth rate. Combine that with the fact that, as I mentioned, that store house of future earnings is $3.3 billion right now. Near on year grew 22%. And, you know, that is propelling our growth. It's not investment income.

That should continue, should it not, at that pretty high rate, whether it's 20 or 18, it's hard to tell, but it ought to continue at a pretty high pace?

Well, it's a big ship and it takes a long time to turn it. If you study our trend lines over a long period of time, you see it does not move quickly in any one direction.

And you also won't have the -- as much of a head wind in terms of lower investing yields on your overall portfolio, which was the impact over the last couple of quarters as rates were declining a lot, is that right?

That's correct.

And you hopefully should continue to benefit from positive operating leverage, if have you strong growth and you can hold expenses reasonably in check in.

Yeah. But I do want to say there that, you have seen our expenses grow. I even highlighted it this quarter. I think it's important to know that we are reinvesting in the business on a continuous basis. And that in itself is a bullish statement, but we've been able to improve our, you know, S and P leading efficiency ratios by even more by producing at very high levels.

Going back to the pricing question, this is always hard to tell by looking at the chart, the par versus AGP. But if you look at for the quarter, you had much higher A.G.P. growth than par growth for public finance. But for structured and international, it's quite the reverse, with a big increase in par but a much smaller percentage increase in A.G.P. Is there anything to be read into it or nothing, because it's so difficult to measure?

I think the net of it is probably nothing particularly to read into it, although say that overall pricing levels nominally have risen, particularly in public finance where we have seen a greater percentage of our deals being done in the area of structured finance in public finance. In those areas, we get paid very, very well to do that business, both on a nominal basis and on a risk-adjusted basis, so our returns have very re good there.

So public finance is probably more of that and the decline in the other areas is more deal-related. And, remember, when we do a CDO, there's a AAA supersenior traunch of a CDO, the notion amount or par amount is very high and the premium is typically pretty low.

Right, but is is it fair to say pricing remains strong in international and moved up in public finance? Is that the bottom line? Because the quote from your chairman in the press release says it's a best-pricing environment or something to that effect. Is that a fair comment?

Very fair.

The overall pricing remains strong.

A strong market, correct.

Last question, when you talk about this mark to market, and I would agree with you that you probably should reflect it and then can always disclose it, that it's the appropriate thing. I have been surprised, just looking at the mark to market losses, given your CDO portfolio, the size of it and such, that it's such a small number. Is it solely because, even in this environment with very dramatic widening and spreads that your quality is just so high that you don't have any? Why has it been so small? I've been surprised.

Well, I really do think it's exactly what you're saying, what I tried say before, was that, when 89% of it is double-A or better, the spread widening on individual credits has very little effect on the valuation of the most senior levels of CDO's. So, you know, that's what we have witnessed. And that's what the market has witnessed. And it's testament to the fact that we have a very high quality book of business.

Can one then say, even in this horrible environment where you hear, like, disasters every day, you don't see much, that if you look out next year, assuming things don't deteriorate even more, that the kind of fluctuation ought to be not that noticeable? Can we draw that conclusion or not?

I think you can, although, you know, that is, of course, subject to change. If we continue to see spread widening here, we -- we can see the opposite, too. We can see spreads coming in at some point and see gains in the portfolio, as well. Again, not material. I think we've seen as dramatic a widening the spread of last two quarters as one could imagine, and it's had relatively small impact on our business. Remember, what I said earlier is that management is clearly aware of this and clearly does not like the volatility that it brings. Yet, you know, we like the business. So we're compelled to do it because of the attractiveness of the business, while absorbing a very small mark to market through current earnings.

But fair to say the environment is about -- as horrible as one can imagine for the last couple of quarters with the headlines? Is that right? I don't know.

I think that's right.

Thank you.

Your next question comes from Eric foul -- I'm sorry. Mr. Foul has withdrawn his question. Your next question is from Bill Woltz: with Morgan Stanley.

Good morning. Could you comment on the rating actions in the reassurance area, I'm thinking of Radian, Axia, American RE as part of Munich RE and how that will operationally change your view onry insurance?

Yeah. As you know, recently I guess Radian was downgraded from a AAA to a double-A, and they are a pretty big reinsurer for us, and S&P 500 put some others on negative watch. It's important to note a downgrade to double-A does not preclude us in any way from doing business with them or anyone. Moody's for a couple of years has rated these companies double-A for a couple of years anyway. And there was actually a report published in July by S&P saying what if there were downgrades and the downgrades. The article says such a downgrade would have no material impact on our margin of safety or our creditworthiness. So we're not big reinsurers to begin with, but, you know, we -- we hope -- we think these are fine companies and we think they will continue to write business in an appropriate way and do business. So I don't think it has any real impact on us. I know there's been a lot said but I don't think it has any material impact on us at all.

I appreciate that. A follow up if I may. Could you just revisit the loss reserves and break that down by case and then the general reserve, and then, if you could, just tie that back into the comment earlier about $24 million of reserves against synthetic CDO's, if I have that correctly?

Yeah. Let me give that to you. Case reserves are about $45 million. And those, again, are specific losses that we think are claims that arism nent or some that have happened years and years ago. So that's against our book of business. Unallocateed, there's about $120 million of reserves that are of a general nature against the expectation of potential losses in our book. Which is roughly about 4 basis points of our financial guarantee book which is, you know, near where it's written for a long period of time. And given the fact that our actual experience over, you know, the last 11 years as a public company has been about 1 basis points or less, you know, that is certainly ample to protect us in the event of any problems.

Additionally, through mark to market on our credit derivative book, we have taken about $24 million of additional reserves, and that sits there to protect against losses our credit derivative book. I did mention that we had, you know, one problem credit there, and it's the only one that we have any expectation of paying a claim on, and that that number could be, you know, five to 10 million did bucks over time maybe. But, you know, you can see that we have ample coverage of that in that mark to market loss.

That's helpful, thanks.

You're welcome.

)) Operator: As a reminder, I would like to remind everyone, in order to ask a question, please press star and the number one. And your next question compress Craig, Hogland with Anderson Hogland.

Frank, I just was hoping you could connect for me the difference between the -- side of the 22% increase in the quote unquote store house future earnings versus when you compare AGP to net premiums earned, it's running over 100% increase and even when you look at net premiums earned that's running 40% year to date. Why are those numbers so much higher than the increase in the -- than what you have.

I don't think they are. Maybe we are miscommunicating. The earned premium, let me just get that in front of me. Earned premium during the period grew 22%, excluding refundings. So actually it's almost exactly in line with the --

Right. I'm trying to figure out, looking at your production today versus what you're earning out of that book, I'm trying to figure out which way -- what kind of acceleration in the growth might be upcoming?

I would like to what we keep calling the store house of future revenues as an indicator of what earned premium will be in the future in terms of the growth rate. Because that's the base we earn from. If you -- you really can't look at the writings during the period, the AGP. I always like to liken it to a big funnel where, you know, the $305 million we wrote during the period goes through funnel and comes out somewhat more evenly over time, as we earn that over the life of the contract that we insure. In many cases we're insuring 20-and 30-year securities so the production or AGP is a future indicator, as you added, to the production -- the past production, which is that store house of future revenues. So earned premiums currently growing at 22%, and that store house was of future earnings is growing by roughly that same rate which would at least give you an indication where the future is.

Is the store house a discounted number?

No. That an actual number, a nominal number. You know, if we were to give other numbers in terms of adjusted book value. But that's the actual nominal must be that we either will collect or already have in house.

And that number does not appear anywhere in the financial statements?

In the financial statements? That's correct. The only thing that you will see is on our balance sheet, there's something called unearned premium reserve which totals about a billion seven today. That is on our balance sheet. What you don't see is the present value of installed premiums, or the nominal value of installed premiums which is about a billion six as well, a billion six, a billion seven, and that we report on supplemental information. It's on our website and such. We can't report that because -- in our GAAP statements because it's not a GAAP concept but it's certainly contractually due to us.

OK, thanks

)) Operator: Next question is from Marco Pinzal with Solomon Smith Barney.

Yeah, if I can just get back to the CDO's for a moment. I'm trying to understand this better. If I'm calculating it right, in excess of half a billion dollars of that portfolio is non-investment grade at this point. And presumably parks good chunk of that, if not all of that, are falling angels of sorts, given your underwriting philosophy and guidelines and focus on investment grade securities. Why shouldn't we be a little bit more concerned about some of those investment-grade contracts turning into more material losses?

Let's put it in perspective. We have roughly one deal that accounts for about $300 million of par that I've talked about. That is a very small problem and it has not deteriorated since we talked last year, or last quarter.In the area of five to $10 million I have talked about. And that has held up very, very well. The whole portfolio has held up. That relates. To a five to 10 million-dollar loss relates to a 300 million-dollar notional. So we haven't seen a lot of fallen angels. We have seen this one. But we don't have fallen angels in any material way in our book. And the book has held up extremely well to what has gone on. As I have said, 89% of the book is double-A or better. We haven't experienced that fallen angel syndrome. We have one deal that did and we have told you about it and it's actually holding its own pretty well.

OK. And then maybe more generally, on the watch list, you mentioned that it has grown a bit from period to period. Now, does that relate to individual credits or does that relate to the par value outstanding in the watch list or can you give us a sense as to what the par value looks like right now and how that relates to, let's say, a year ago?

The non-investment grade, and we don't publish our classified list for obvious reasons. But you can look at our non-investment grade list, which are fallen angels that we do publish, because that is more of public record. And I think the point to be made there is that it's about 1% of our book. It hasn't changed dramatically. Actually two or three years ago, it was a lot higher. You know, it did dip down during a little period of over, say, a year or two ago and now it's back up a little bit. That certainly natural in this environment. You know, this is an environment where, you know, credits have deteriorated, and we have seen downgrades across the board. So there's nothing material here. In fact, several creditors, as we said earlier, did come off and there were some additions as well. In terms of par value, you know, there's a modest increase period on period, but it's very modest and containable.

OK. And just one more question on investment income; there any thought to shortening the duration on new investments so that you have more flexibility when rates start to add up or what is your thinking there?

)) You know, we have traditionally not been someone that goes extremely far out the curve with our investment strategy. Association you know, the duration of our portfolio is still relatively short, particularly in a taxable area where we tend to be, you know, short or -- our duration is about six 1/2 years or so, and actually, you know, two years ago, that was a bit longer. So we have shortened it. But, again, we are investing mainly in the municipal market, where, you know, that -- where interest rate volatility is dampened by the fact it's not as volatile as the corporate market.

OK. Thank you very much.

Your next question comes from James Easterling with Oak Value Capital Management.

Good morning. Really good quarter there, frank.

Thanks.

The question I had on the schedule here for the book value, the book value to adjusted book value, it shows a pretty big increase in what is called unrealized loss on the investment agreement liabilities.

Yeah.

Is that your your mark to market on the CDO's you've been talking about?

No. Let me explain what it is. We have about a 6 billion-dollar investment agreement book which is actually grossed up on our balance sheet, meaning that we have the assets on our -- they're very high quality assets that sit on our investment side of our asset sheet, and then we have the liabilities which are the contractural obligations typically to municipalities for an offset balance of $6 million. The Taz 15 requires you to mark to market the assets but not to mark to market the liabilities. So our book value and adjusted book value has been impacted by the increased value of our Invest,emt portfolio but has not been offset by amounts equal to the liability. And we thought, and we've done this consistently since we're in the business, that if you're producing an adjusted book value number, you should adjust out for that increase or decrease in value because net-net, you're effectively hedged, and that would be somewhat misrepresentative. I know that gets a little complicated, but it's our attempt to normalize or to mark to market in effect the liability associated with that asset.

OK. Thank you.

)) Operator: At this time there are no further questions. I'm sorry. We do have a question now from Josh Shanker with Falot and Partners.

How are you guys doing?

Great.

I'm calling because -- two questions. First one involves the great growth in terms of the growth par written in the structure book. Is there any way to get a handle on how that industry grows? I know that issuance is down for corporations so you guys are insuring a lot more on the structure side. How is that sort of developing in terms of what does that mean for the gross premiums written going forward?

Yeah, I think -- I think first of all, I think I kind of listed what is in that area. There's such a hodgepodge of things in that area, including a big part of it are acid backed securities and such. But there's all different types of structured finance obligations that go into that, which actually helps us, you know, in most marks because we have diversity of deal origination. So that is great. But it really is hard to predict in terms of what is going on. The thing I want to make sure that I clarify is that we don't ensure corporate obligation. And I know corporate obligation is down. I happened to read that the other day. But that is not indicative of our business. If you want to look at anything that is indicative, you should look to the structure mark or acid backed market and look at those markets for better indication of what the deal flow could possibly be for us. But it was a very robust period for us. It has been. And greater demand for our product as well. So, you know, the combination of those two areas has helped us.

Terrific. And the second question I have, I also notice you changed the presentation of the balance sheet and added on the asset and liability side a derivatives tally.

Great catch. It actually got to the point where it was large enough for us to break out, and particularly in this area of environment of transparent see much we want to make sure our investors knew exactly what was in our balance sheet. And we therefore list and gross up, which has always been there, but it's just been in something called other assets and other liabilities, the derivative components there. So we have the -- so for example if we do an interest rate swap for a client in the market, we will book the market to market on that and say an the asset side of the balance sheet and the liability side of the balance sheet, we will have a hedge, which should be equal and offsetting.

And for each of the -- for each of the assets on the side, is there also a liabilities side derivative written and there's a corresponding one on each one that you're working on?

With the exception of credit derivatives where, if you will, we take one side of that equation. We don't hedge out our derivative risk. Where we use derivatives with respect to interest rates, currency, anything of that nature, where we use -- where we hedge it out, you're going to see an asset and liability where we're just straight writing derivatives on synthetic CDO's, that's one-sided. We don't hedge it out generally so you're going to see that as one-sided.

Terrific. Well, thank you guys very much.

Great.

At this time, sir, there are no further questions.

Well, that's great Amanda. We will call it quits now and we're here to answer anyone's calls, if you have any, and look forward to talking to you.