Ambac Financial Group Inc (AMBC) 2005 Q2 法說會逐字稿

Good morning, ladies and gentlemen. And welcome to the Ambac Financial Group, Inc. second quarter earnings conference call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Sean Leonard, Chief Financial Officer of Ambac Financial Group Inc. Thank you, Mr. Leonard. You may begin.

Thank you. Welcome everyone to Ambac's second quarter conference call. I'm Sean Leonard, Chief Financial Officer of Ambac. With me are Tom Gandolfo, Ambac's former CFO; Ronald Eisman, controller; and Pete Poillon, Investor Relations. This call is also broadcast on the web. Our earnings press release and quarterly supplement are our website and will be mailed to those who requested. Also note that we have included on our website this quarter a short slide presentation that summarizes the results of the quarter. Third quarter, 2005 earnings will be released on October 19 at 8:00 a.m. with conference call at 11:00 a.m. During this conference call we may make statements that would be regarded as forward-looking statements. These statements are based on management's current expectations. I refer you to our press release for factors that could change actual results.

Net income was $186.1 million, or $1.69 per diluted share, up 4% on a per-diluted basis from the second quarter of 2004. While Ambac reports net income in accordance with generally-accepted accounting principals or GAAP, research analysts make certain adjustments to net income to calculate reported estimates. Therefore, to enhance investors' understanding of our financial results, we continue to provide information on the items that analysts adjust that of GAAP net income to arrive at their current estimates. Those items are: Net after-tax gains and losses from sales of investment securities and market-to-market gains and losses on credit, total return, and non-trading derivative contracts, which in the second quarter of 2005 were net after-tax gains of $14.9 million, or $0.14 per diluted share. This compares to net gains of $5.1 million, or $0.04 per diluted share impact in the second quarter of 2004.

Some analysts also back out the after-tax effect of accelerated premiums earned on obligations that have been refunded in other accelerated premiums, such as reinsurance cancellations. Total after-tax accelerated premiums amounted to $14 million, or $0.12 per diluted share in the second quarter of 2005, which compares to $17.4 million, or $0.16 per diluted share in the second quarter of '04. Let me remind you that we had about $4.5 million after-tax of accelerated earnings, net of related accelerated deferred acquisition costs relating to the cancellation of reinsurance contracts in the second quarter of 2004.

Credit enhancement production, or CEP, which represents gross upfront premiums plus the present value of estimated installment premiums on insurance policies and structured credit derivatives issued in the period came in at $397.9 million, down 3% from the very strong $411.2 million in the comparable prior period. Public finance CEP was $170 million, down 28% from the second quarter of 2004. Muni issuance as reported by third party sources with up quarter on quarter from $103 billion in the second quarter of '04 to approximately $112 billion in the second quarter of '05, and insured penetration remains very strong at approximately 61%. The environment, however, remains somewhat challenging in that the issuance level of the highly structured transactions that we typically target has been lower than expected. The majority of issuance over the past few quarters has been in segments we classify as traditional business and market conditions have adversely affected pricing in those segments.

Having said that, it is noteworthy that Ambac's market share in the quarter, based on prior written was approximately 27%, up from 22% in the second quarter of 2004 as we opportunistically improve the overall credit quality of our public finance book by strategically using it to write high-quality business. Structured finance CEP was $141.6 million, 58% higher than the comparable prior quarter. The MBS market continues to be a challenge due to tight credit spreads and Ambac is maintaining its discipline. We only guaranteed about $2.2 billion of par during the quarter. However, Ambac was active in other asset classes within consumer asset-backed, especially auto rental and sub-prime auto securitizations, and investor-run utilities where spreads haven't narrowed as severely and where our expertise and structuring skills are highly valued.

Ambac continues to close transactions in a wide breadth of asset classes while maintaining our strict underrating and return discipline. International CEP in the second quarter came in at $86.3 million, up 3% from the second quarter of 2004. Ambac writings during the quarter demonstrate its global capabilities as transactions closed, including deals written in Australia, Japan, Italy, and the UK, as well as Brazil and Turkey in future flow execution. In terms of asset class, utility transactions were dominant.

We continue to expect international business production to be lumpy, characterized by large, complex, high-return transactions. However, we believe this market will provide good opportunity for long-term growth. Net premiums and other credit enhancements these earned, excluding refundings, increased $181.3 million, up 8% from the second quarter of 2004.

Public finance earned premiums, before accelerations, grew 8%. Structured finance grew 6%, while international grew 10%. As discussed previously, we are facing difficult market conditions and strong competition in the form of senior subordinated execution and from other financial guarantors in the MBS and CDO markets, and to a lesser degree in other structured finance markets. Runoff of our book of business in the form of refinancings, refundings, and paydowns has been significant. During this second quarter net par outstanding in MBS alone declined by $3.3 billion. For the quarter, we wrote more than $40 billion of gross par across all lines, yet our net book grew less than $5 billion.

Deferred earnings representing future earnings on premiums already collected or installments contractually due us grew to $5.4 billion. These deferred earnings will be recognized in earned premium and other credit enhancement fees in the future over the likely related exposures. Investment income, excluding VIE income, was $92.2 million, up 5%. Investment income was adversely impacted by the continued low-interest rate environment and our buy-back of nearly 2 million shares of stock during the period, costing approximately $134 million.

Loss provisioning amounted to $21.7 million, up $4.2 million from the second quarter of 2004, driven primarily by increased active credit reserves and structured finance transactions. Our loss provision was also impacted by a $5 million increase in NHK (ph) reserve. Total loss reserves at June 30, 2005 were $212.2 million. Total loss reserves include case basis reserves of $86.7 million and ACR of $125.5 million. Case basis loss reserves decreased $44.1 million in the second quarter of 2005. This decrease resulted primarily from claims payments totally approximately $50 million, partially offset by additional case reserves amounting to approximately $6 million.

Claim payments made during the quarter relate primarily to the EETC transaction we discussed last quarter. We sold four of the aircraft from that transaction and have successfully released the remaining three aircraft. There will be no other Loss Reserve activity related to that transaction. Five million of the case reserve relates to the health care credit that we discussed in previous quarters. There's been little news on the industry's Loss Reserve accounting methodology during the quarter, other than the Financial Accounting Standards Board formally agreeing to address the issue. As result, our accounting policies are subject to change in the future. I encourage all investors and other interested parties to read Ambac's accounting policy footnote and MDA discussion regarding a Loss Reserve policy, our Loss Reserve methodology and the potential for future changes. These disclosures can be found in our 2004 Form 10-K that was filed with the SEC in March.

Financial Services net revenues, excluding realizes and unrealized net gains and losses were $.2 million, compared to $12.5 million in the comparable prior period. We included a brief explanation of our Financial Services activities in our press release. As a reminder, what we do in that segment, and I think it worthwhile to repeat that here, the Financial Services segment is comprised of the investment agreement business and derivative products business. The investment agreement business is managed with the goal of matching cash flows of the investment agreement liabilities with the cash flows of the related investment portfolio. To achieve this goal in the investment agreement business, derivative contracts, what we term as non-trading derivative contracts, are used for hedging purposes. The primary activities in the derivative products business are intermediation of interest rate and currency swap transactions and taking total return swap positions on certain fixed income obligations.

Most of the swap intermediation is on a fully-hedged basis with the exception of certain municipal interest rate swaps that are not hedged for the basis difference between taxable and tax-exempt interest rates, and total return swaps, which are not hedged for credit risk. As such, changes in the relationship between taxable and tax-exempt interest rates will result in market-to-market gains or losses in this business line. The decrease in Financial Services net revenues was driven by the derivative products business. Revenues in that segment, excluding total return swaps, were negative $3.7 million in the second quarter of 2005, down from $7.4 million in the second quarter of 2004. Net revenue in this business included market-to-market adjustments, primarily resulting from the increase in the ratio of tax-exempt interest rates to taxable interest rates, amounting to losses of $6 million and gains of $4.6 million in the second quarter of 2005 and 2004, respectively.

During the quarter we recorded net securities gains of $29.6 million on a pre-tax basis. The effective tax rate on a portion of this gain is in excess of 35% due to the fact that net securities gains generated in the Financial Services segment is taxed at approximately 45% due to the inclusion of state and local income taxes. Net securities gains and losses are not part of Ambac's core business results and analysts and investors typically exclude business results and analysts and investors typically exclude them in the analysis of our results. However, I would like to describe the components that make up this amount. The largest component is an unrealized market-to-market gain on non-trading derivative contracts amounting to $47.2 million. Included within the $51.3 million of net market-to-market gain on non-trading derivative contracts line item in our income statement. The difference relates to realized amounts of approximately $4 million before tax. Realized amounts have been included in our operating results to be consistent with the prior-year presentation.

That gain is almost entirely the result of market-to-market certain interest rate hedge contracts on long-term liabilities in our investment agreement business. While these were highly effective hedges, from an economic standpoint, they did not meet the very strict technical requirements of FAS-133. As such, during the quarter we recorded the market-to-market on the hedging derivative without offsetting the market-to-market on the hedged item. $27.3 million of the gain resulted specifically from market movements on these derivatives during the second quarter of 2005. As of July 1, 2005, the hedges had been re-designated and we expect the market-to-market of the hedging derivative and the hedged investment agreements will substantially offset any income statement prospectively.

The second component of this amount is net market-to-market losses on credit and total return swaps of $17 million. That is broken out into a $12 million market-to-market loss in our CDO portfolio and a $5 million loss in the total return swap portfolio. The CDO market-to-market loss related to market conditions resulting in the extension of the weighted average life of certain transactions within our CDO portfolio. The total return swap loss resulted from spread widening on certain credits within our total return portfolio. As many of you who are familiar with our business know, unless we ultimately pay a claim on these transactions, the market-to-market will reverse back to income over time.

ROE for the second quarter was 14.3%. Our ROE results have been negatively impacted by the low interest rate environment. Ambac announced today that it's increasing its quarterly dividend by 20%, from $0.12.5 to $0.15 per share. Ambac has raised its dividend every year since going public in 1991. Just a short reminder about our policy on earnings guidance, last quarter, upon lowering our 2005 guidance, our core earnings growth-- on-core earnings growth we announced we would not be providing any further earnings guidance. In summary, Ambac had a strong quarter from the top-line production standpoint under difficult market conditions. We achieved those results mile maintaining our strict underwriting and return standards. Our primary business financial guarantee achieved a 7% earnings growth quarter-on-quarter. That concludes my prepared remarks. I would now like to open it up for questions.

Thank you. At this time, ladies and gentlemen, we will be conducting a question-and-answer session. [Operator Instructions.] Our first question is coming from Geoff Dunn of KBW. Sir, please state your question.

First, could you add a little bit more color. In your press release, you talked about building up the unallocated due to deteriorating outlook on some of the structured transactions. Can you talk a little bit, what sectors have you more concerned? Is this a run rate we should expect or should we move back down to the 17 million level we've been talking about before?

Okay, Geoff, you're talking about our active credit reserves?

Yes, the incurred loss provision.

Right. The incurred loss provision is due to two items that I mentioned. One item is due to some increases in our case reserving due to one health care credit we've talked about in the past of $5 million; and the rest is due to our active credit reserve, which is based upon our internal classified listings and our internal view of credit deterioration, kind of provided an analysis in our-- a good description in our Annual Report regarding our methodology.

Our methodology is sensitive to credit deterioration, so going forward that will be sensitive to views regarding either improving or deteriorating credit quality. So that will impact our loss provisioning going forward. Regarding the second quarter, really what happened there was there was some structured finance transactions that, while we don't necessarily talk about individual sectors within structured finance, we had some credit deterioration that we recorded, approximate increase in ACR of about $16 million.

And over the last year or two it's been in the mortgage and CDO segments. Is that a good guess as where the on-going pressures are, or can you give us any idea where you're more conservative?

Yes, we don't comment specifically on sectors, Geoff, but what I will say is on the below-investment grade, we did have-- you can kind of' take a look through that chart that we've provided in our operating supplements. There was some improvement in certain CDO's. There was a decline in our below investment grade overall. A portion of that was related to our international pooled debt obligations.

Okay, and then on the capital front, you have the S & P capital numbers out now. You bought back 2 million shares, but basically not much after the first week of May, although the stock remained down. Can you give us an update on what you might think of an excess capital position and why the Company wasn't maybe more aggressive in buying back the stock during the quarter at the depressed levels?

Yes, Geoff, on a regular basis, we do obviously assess our capital position. We consider a number of variables when we look at the level of buy-backs and other items to manage that capital position, including views on business opportunities and required capital levels. We calculate our capital three ways. The most onerous allocator of capital ever is the S & P. We do look at the trading level of the shares and adjusted book value, and from time to time when we decided it's opportunistic, we will do that, so I think it's a combination of our view on future business and our view of other acquired capital levels. While we don't want to go down to a very low level of cushion, we do consider that when we determine what level to buy back. One other item I would like to mention is we do have approximately $5 million-- 5 million shares approved under our previous Board authorization, so we will continue to look at that and make decisions, as appropriate.

All right, maybe to look at it a different way, can you tell us what end of the range that S & P provided that Ambac's capital is at right now, between the 1.4 and 1.5?

We don't discuss that, Geoff, because while we have an idea of how they calculate those numbers, they may make certain adjustments that we are not aware of in coming out with a range, so we typically, since it's their published number, we typically don't give an exact number.

Okay. Thanks.

Thank you. Our next question is coming from Mark Lane of William Blair & Company. Please state your question.

Good morning. Just as a follow-up on the capital question. Can you talk about capital at the holding company level or what capital Ambac has that wouldn't be incorporated within S & P's margin of safety calculation?

Mark, it's Tom. Actually, in our-- what we do-- because all the capital at the holding company level is available to dividend down to Ambac Assurance, it is all actually counted in the margin of safety. However, our history has been to keep very little capital at the holding company. We generally push it down to Ambac Assurance, but you should know, we do have the ability and we have the approval from our regulators to dividend up $200 million from Ambac Assurance, an additional $200 million from Ambac Assurance to Ambac Inc. as we see fit.

At any time that you want to?

Correct, subject to Board authorization, but it's an internal authorization. We have all the external approval.

Okay. And the mortgage backs business, I think you said you wrote 2.2 billion of par and the maturity was 3.3 billion? Is that the same numbers that correspond to the first quarter that you provided of $2 billion and $6 billion? Is that comparable?

Yes, I think so. The numbers that we talked about here are the net decline in the underlying business. You can kind of' see that pretty clearly from our supplement when you look at that particular sector.

What was the runoff, then? I think you said the runoff in the first quarter was $6 billion. What was the runoff in the MBS book, U.S. MBS book in the second quarter?

Second quarter?

Yes.

It was approximately 7.

7 billion, okay. And then what's going on with this health care claim? Can you give us the total exposure to that health care claim and why is that continuing to be a problem

Yes, total exposure, net par perspective, is approximately $77 million. There was-- we're continuing to work that situation from a risk mitigation standpoint and we may have more to talk about in the third and fourth quarter on that particular credit. We do have a fairly sizable case reserve established against that particular par amount outstanding.

But what is that?

I think our case reserve is approximately--

Give us one second and we'll give you the exact number.

It's approximately 56 million.

And so on the double ETC exposure to the one particular airline, you're saying that you've basically relieved yourself of your obligation to any of those aircraft. Is that basically-- completely extricated yourself from that?

That's correct. Clearly we have three of the airplanes, but the results from that will show up in our income statement as lease rentals, because we've leased those aircraft in depreciation.

That's still the exposure, so you've leased--

We've paid the claim and we're off of that exposure.

Okay. Thank you.

You're welcome.

Thank you. Our next question is coming from Ken Zerbe of Morgan Stanley. Please state your question.

Hi, good morning.

Good morning.

Can you just actually run through the numbers again, the CEP and public finance and how that relates to your market share. Obviously, your CEP was down quite a bit this quarter, but I thought I heard you say your market share went up. I'm trying to understand how that could be if the issuance and the share penetration was relatively stable quarter-over-quarter.

Yes, I did mention that, Ken. Effectively, it is true, our share was approximately 27%. That's due to the fact that we were insuring high-quality certain general obligation bonds during the quarter, generally attracts a lower premium rate, so therefore, you're seeing a high volume from a par perspective, but a lower CEP on a relative basis.

I see. Okay. That makes sense. The second question is, how sensitive is your ROE to interest rates? I see a 14.3%, looks like it's going down 30, 40 basis points per quarter. You know, especially if interest rates were to remain at current levels for the next say two quarters, where could we see ROE down to?

Ken, what's happened on the-- about a third of our revenue comes from our investment portfolio, and if you go back in history with Ambac, go back years ago, our target used to be 600 basis points over the 10-year Treasury, which was kind of the risk rate, and what we were doing is we were always consistently well in excess of that and then we migrated to the 15%, as a result of that. Our ROE, while we're still pricing business at pretty attractive returns, certainly in that 15% or better, we are getting dragged down a bit by this continued low rate environment, and we saw the 10-year at 390 again in the second quarter, which was you know, surprising, I think to everybody. So it is a drag on the ROE. So I can't really quantify for you, you know, what it will do eventually, but I think if you look at-- we still would think we'd be well in excess of 600 basis points over the-- certainly over the risk-free rate.

Okay.

And as the book of the-- insured book grows, hopefully, the premium, the pace of the premium revenue will outpace the, you know, pace of the investment revenue, so it would become less of an effect.

Yes, just additional comments on that. We did see some rate impact during the quarter in our net investment income. Our portfolio is substantially made up of tax-exempt securities, so there was a decline quarter-on-quarter relating to the rate variance, I think, was approximately $2 million.

Okay. And then just a final comment. The comments in the press release on the international earned premium seem somewhat negative, just in terms of the outlook about the runoff, the tight spreads. Is this-- obviously, you have a positive outlook on the international, but is this, are you trying to telegraph your positive use just becoming a little more negative on this business, or this area?

No, I don't think so, Ken. We're just trying to give a sense for what happened during the quarter and international, while it does not have a solid base of what I'll call "flow business," it is characterized by a large, complex transactions, and we do see opportunities in the European sector specifically relating to infrastructure, roads, hospitals, and a variety of other infrastructure projects and significant needs around in Europe. So we do see some good opportunities there, but this particular quarter you can look at our outstandings, our outstandings from quarter to quarter did decline in the asset-backed sectors. However, we had a very strong quarter in the utilities, specifically UK transactions and an Australian transaction.

All right. Thank you.

You're welcome.

Thank you. Our next question is coming from Mike Grasher of Piper Jaffray. Please state your question.

Good morning. Most of my questions have been answered, but maybe you could just give a little more detail. I think you mentioned in your opening comments, Sean, that the pricing from competition really impacting. Can you give a little more, I guess, information or a little bit more of the landscape in terms of, you know, how much is pricing, how much is change in terms and conditions?

We don't-- it's difficult to quantify the exact change in specific pricing from dealing with transactions from quarter to quarter. However, from a general perspective, we are seeing general market conditions are that there are tight credit spreads, so from a general perspective, we are seeing that. We are seeing in certain cases some loosening up of credit standards, but largely, it's hard to quantify that effect.

We're going to continue to do what we've said we're always going to do. We're going to sit on the sidelines when we see that. We won't win a deal based on aggressive credit terms. We're certainly willing to sit those particular transactions out, if it comes down to negotiating terms.

Okay. Thanks for that. And then do you care to update us on any progress in terms of new geographies or products?

Just geographies, we did have some successful transactions during the quarter in Mexico, which was a very promising transaction. We continued to look for opportunities internationally, where we are-- we have a very good presence. Europe, Australia, we've seen some transactions there. From a potential new market perspective, I guess you can look to Eastern Europe. We did mention in our script some transactions in Turkey. We did open up an office in Italy, so we do see opportunities there. Clearly, we'll meet our credit standards in countries that perhaps we look at with some [inaudible] risk, but we will continue to explore those opportunities.

Okay. And then just a final clarification. I think it goes back to Geoff's question on capital and the share repurchase. I think you said you had 5 million shares approved under the authorization. Is that 5 million remaining following this quarter?

Yes, it is. There's 5 million remaining in the authorization.

Okay. Thank you very much.

You're welcome.

Thank you. Our next question is coming from Terry Schuh (ph) of JP Morgan. Please state your question.

Hi. A clarification on the credit quality. I think in answer to Geoff Dunn's question, you said there was actually an improvement in the CDO book, a decline in below investment grade. However, then, the comment on a few structured finance transactions, some deterioration. The overall book when you look at it across all classes, is it more stressed because of the environment? And did I hear it correctly that there was an improvement in the below investment grade CDO book if you look at the supplement?

Yes, the answer to the last question is there is improvement in the CDO book from a below investment grade par standpoint.

Right, right. And the issue is just a couple of transactions or is the issue some general deterioration because it's in the macro environment?

I would characterize it more in a couple of transactions, rather than a broad movement across the entire sector.

Okay. Therefore, it's really not appropriate or not possible to extrapolate some kind of a trend. Is that right?

Yes, that is correct.

And, then, on the writings in the public finance book, you did say that you took the opportunities to improve the quality and wrote more GO business. The assumption, though, would be that the GO business also has lower returns. I think, Tom, you said that overall you're still finding transactions that meet your mid-teens-type ROE target. So from a broader standpoint that the new business has put on in the quarter, can we still say that it's meeting your mid-teens type return on equity? So when we look at the good production quarter, that overall, it's meeting in aggregate that target?

Absolutely, Terry. On average, it is. In fact, if you looked at structured finance this quarter it was a very good quarter, and that sector tends to be a higher return sector.

And on the public finance side, it's just that there aren't any more complicated deals; therefore, you didn't have a choice but to write more GO's? Is that what it is? I didn't quite understand.

Yes, that's a good question. I wouldn't say there were none. There were less health care transactions that we participated in and less structured real estate transactions that we have a specific expertise in that did not come to market at the same level as in prior periods.

Right, but the assumption is correct that it's somewhat lesser return, the GO plain vanilla, traditional business? Which is offset maybe by higher returns in the structured deals, the auto, auto/rentals--

That's right, Terry. We don't want to overplay. The business we do in public finance, we're still seeing attractive returns there, because, although those spreads have tightened, there's still on a relative basis, you can still get paid in public finance pretty well.

Okay.

So, yes, I don't want to overplay that. And just on your question on the below investment grade. The credit that probably we've talked about for, I think, two or three years, that large CDO, is about $500 million CDO that we had paid some claims on, that actually matured in May. We are off-risk on that transaction now. That's gone.

Okay, that you talked about. And one clarification, again, on the market-to-market loss-- that slowed through to your core earnings, I guess that you've computed about $0.07 or so. Is that an economic loss, the basis risk that you took that doesn't reverse? Is that correct? Whereas, the below the line stuff does, is sort of match and does reverse? Is that the correct interpretation?

Yes. I think that's a reasonable interpretation. Some of it actually, of the loss, relates to actual re-sets, where we have paid money. Some of it also relates to unrealized losses relating to the long end of the municipal versus taxable curve. So we have seen some of that reverse in the third quarter, over $2 million reversed in the third quarter to date.

So there's been-- and if you have some reversal, you get it back and it would only be a further drag if it starts going the other way again. Is that the correct interpretation?

That is correct, and-- that is correct.

Are we sort of at a limit? I mean, was it surprising, the relationship where it's reached?

We did see unusual ratios during the quarter, I think, from a short-term perspective. I think they got into the 90's, into the low 90's.

And where it is now? Back in the 80's again in?

Yes, it's actually at the one-year point,Terry, you're down to about 73 at June 30.

Okay. So are you more impacted by the longer end or the shorter end?

The market-to-market's more impacted by the longer end. What drives it a little bit is what I think-- well, what I know drove the ratio up on the long end was the very low taxable rate environment. You get the spread compression when tax get extremely low. So as rates rise, which we've seen, you tend to reverse the basis lost.

Right, right. So assuming that rates go to come-- some other level, I don't know, mid-4's or something like that, long rates, it could fully reverse, that kind of thing?

Yes.

Although, did you take some permanent loss? You said you had to pay some money or-- is that retrievable or? I guess I just want to understand the dynamics a little better.

Terry, some of it due to the resetting rates will be cash that we pay out during the quarter. That was approximately $1 million.

So not a huge amount. Okay. All right. Thanks a lot.

You're welcome.

Thank you. Our next question is coming from Rob Ryan of Merrill Lynch. Please state your question.

Good morning.

Good morning.

I'm following up on the swaps issue. Could you explain the strategic importance of that business to your overall operation, especially in light of it putting you somewhat in competition with investment banks that bring you a lot of transactions for the Financial Guarantee business?

Yes, certainly can comment on that. We look at the business as a complimentary business to our Financial Guarantee, which is clearly our core business, and you are right, there is some competition with the investment banks. That has, though, resulted in a relative decline in that municipal interest rate swap business due to that very factor. So we have seen declines over the years quarter-on-quarter of doing those types of transactions.

Rob, we're going to use that business, once again like Sean said, it's really not a business. It's probably the wrong word for it, it's more of a product that we offer where the investment banks, where our constituents there are not heavily involved, so we'll do that more on the smaller to mid-sized transactions where we can help a Financial Guarantee client and maybe it will help us also win the Financial Guarantee.

Great, thank you.

You're welcome.

Thank you. Our next question is coming from Al Copersino of Columbia Management. Please state your question.

Hi, thanks very much. This might be premature, but it just strikes me looking at a handful of measures. Financial Guarantee production was down so in the quarter, though less than the previous quarter, total Financial Guarantee expenses were up in the quarter, but less so than last quarter. Refundings are declining. This obviously hurts near-term earnings, but it's an MPB positive long-term. Again, this might be premature, but is it -- are we getting to a point where we consider the underlying things are getting better even if it takes a while for that to show up in GAAP earnings, or is it too soon to say that?

I think what you're seeing-- once again, it's hard to, and we want to be very careful not to project, but let me say this. We are up against-- you know, 2003 and 2004 were some absolutely amazing years in this industry, the best years in the history of the industry. So you are up against those comparisons now, and Sean talked about the shorter-term business running off, whether it be mortgages or CDO's, some very lucrative business that was written that has a four or five-year life. So I do think after that runoff period is over, that's going to be a positive, and we won't have to deal with those very difficult comparisons. We're being held to you know, the standard of kind of two years of nirvana, so you're looking at 13, 14% ROE's and pretty healthy net income that we generated this quarter, but it's muted a little bit because of the difficult comparison.

Yeah, and I think, also, we had a slide in our presentation that we had on the website kind of shows, kind of a summary on Page 4, the Financial Guarantee growth, and that from a quarter-on-quarter perspective was up about 7%, but it does you know, the growth rates are impacting that, certainly a decline in that par from certain asset-backed classes is hurting the growth level, as well as the investment income, the re-investment we generate substantial amount of free cash flow and we're reinvesting that at lower rates, so that's creating some stress on the growth numbers, as well as the ROE.

Great, thanks to you both.

You're welcome.

Our next question is coming from Gary Ransom of Fox-Pit and Kelton. Please state your question.

Good morning. My only other question is more of a long-term question on the credit cycle, and we've seen some spreads around the edges of the market widening in the last few months, and yet not any broad-based changes at this point, but I wonder if you could just just give us your opinion of where you think we are at this point in a broader credit cycle.

Yes, I mean, from a credit, maybe we can separate credit from pricing a little bit. From a credit perspective, I think we're looking at a good period, coming off perhaps a period, a couple years ago, when there was a lot of corporate defaults and that type of thing. So I think from a credit perspective, we're looking at a pretty healthy period. From a pricing perspective, for our product, we are looking at some competitive pressures. Market conditions, availability of capital, driving credit spreads and the appetite of investors willing to take those credit risks at perhaps lower rates.

There was an article that you probably saw, Gary, in the Journal, I think a couple days ago, on just this topic of investors, fixed-income investors, really, just having just almost disregarding risk in their drive for yields, and at some point, you would think that would have to change when there's events that you know, will wake people up.

Which argues that it's part of what we're seeing is just the demand for the insurance product generally is less than it has been in the recent past.

I think the demand is still there, as you look at insured penetration and the muni world, it's actually extremely healthy, the demand. It's just that the investor appetite to buy uninsured paper or to accept more risk in the other markets, senior sub would be a classic example in the mortgage market. You know, that's where I think you're seeing-- that's why you're seeing spread so tight in those markets.

Do you see any other indications? I know on the investor day you had some charts that seemed to point like there was a little bit of a turn in spreads in some areas. Do you see any of that on top of what you saw back in March or April, whenever that was?

Not a lot, Gary. The Ford/GM was maybe the blip that we were referring to. There was a blip, particularly in the CDO market, when Ford and GM was in the press every day, but that's been absorbed pretty well now by the market.

Okay. All right, thank you.

Thank you. Our next question is coming from Jonathan Adams of Brown Brothers Harriman. Please state your question.

Good morning. Of the 47 million market-to-market gain in derivatives that were redesignated that meet the requirements of FAS-133, will that have any impact on operating results in the third and fourth quarter since those instruments have been marked up and the hedged item has not been adjusted?

We've redesignated those particular hedging contracts with the hedged items, so we expect there to be a substantial offset, just a little bit of background. These particular investment agreements and the resulting hedge are highly tailored. What we seek to do is match all the terms of the derivative with the underlying debt instrument, so we believe those to be highly effective and we expect that to continue going forward. However, we might see some small amounts due to ineffectiveness on the particular hedges, on a go-forward basis, but we expect a substantial offset.

But the redesignation itself has no operating ramifications?

No, it does not.

Okay, thanks.

Thank you. Our next question is coming from Geoff Dunn of KBW. Please state your question.

My follow-up was answered, thanks.

Our final question is coming from Darin Arita of Deutsche Bank. Please state your question.

Hi, good morning. Just going back to the U.S. public finance commentary, I've noticed I guess at least a couple of quarters now Ambac talking about how very, I guess, a few large highly-structured transactions came to market, and just wondering, how should we think about that? Should we think about that more in terms of of that being a trend of a declining pipeline or something more similar to how the international market can be lumpy? Thanks.

No, I don't think that would be a particular trend. I mean, we are seeing opportunities in those particular sectors that you mentioned in both health care and in the structured real estate, so I would not consider that a trend. They are a bit unique transactions, in a sense, when you're talking structured real estate, so they're longer-term, more complicated, so they will-- I wouldn't necessarily call them flow business-- so that will create from time to time good quarters when we close those transactions.

At this time I'm showing no further questions in queue, sir.

Okay. Thank you very much, everyone, for attending the call. We'll be here today, myself, Tom, Pete and Rob. If there are any additional questions, we'd be happy to answer those questions, so please, give us a call. Thank you very much.

Thank you for your participation. This does conclude today's teleconference.