Assured Guaranty Ltd. (AGO) Q2 2014 Earnings Report, Transcript and Summary

Good morning, and welcome to the Assured Guaranty Ltd. Second Quarter 2014 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. Now I would like to turn the conference over to Robert Tucker. Mr. Tucker, please go ahead.

Thank you, operator, and thank you, all, for joining Assured Guaranty for our second quarter 2014 financial results conference call. Today's presentation is made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The presentation may contain forward-looking statements about our new business and credit outlooks, market conditions, credit spreads, financial ratings, loss reserves, financial results, future rep and warranty settlement agreements or other items that may affect our future results. These statements are subject to change due to new information or future events. Therefore, you should not place undue reliance on them as we do not undertake any obligation to publicly update or revise them, except as required by law. If you're listening to the replay of this call or if you're reading the transcript of the call, please note that our statements made today may have been updated since this call. Please refer to the Investor Information section of our website for our recent presentations, SEC filings, most current financial filings and for the risk factors. And turning to the presentation, our speakers today are Dominic Frederico, President and Chief Executive Officer of Assured Guaranty Ltd.; and Rob Bailenson, our Chief Financial Officer. After their remarks, we will open the call to your questions. [Operator Instructions] I will now turn the call over to Dominic.

Thank you, Robert, and welcome to everyone joining today's second quarter 2014 earnings call. Assured Guaranty produced solid results in the second quarter and first half of 2014. In addition to recording $233 million of operating income year-to-date, we generated $58 million of PV premiums, which is 71% ahead of where we were at this point last year. Additionally, we continue to successfully execute our capital management strategies. In particular, we took further steps towards optimizing our capital mix, which included a very successful $500 million debt offering and additional share repurchases. From January 1, 2013, through August 1 of this year, we repurchased over 26.6 million shares, which is equivalent to 14% of our January 1, 2013, share count. Rob will give you more detail about the debt issue and our current share buyback activity. Of course, as we think about buying back shares, it's important to remember that the maintenance of our strong financial strength ratings is critical. Right now, we have more available capital than we can put to work, given the low interest rate environment. And that excess capital keeps growing through the amortization of our existing portfolio. We can, therefore, continue to buy back shares while still maintaining a very high level of capital protection for our insured portfolio. In fact, in S&P's July 2 full annual report on Assured Guaranty, the rating agency showed our capital adequacy cushion to be $1.45 billion to $1.55 billion at year end 2013, up from $450 million to $500 million a year earlier. The capital adequacy cushion is the amount of capital we would have at the end of their simulated AAA Depression test. S&P repeated that the $1.45 billion to $1.55 billion range in its July 14 Frequently Asked Questions about bond insurers' exposure in Puerto Rico, and which should also make clear that this cushion means, in S&P's exact words, "These cushions are additional losses, actual or theoretical, beyond what we already assessed in our analysis of each bond insurers' exposure to issuers in Puerto Rico." That means that insurer could, in current, still retain their current ratings. As we said in the past, our obligation is to pay debt service only as it comes due on the original schedule, thus, allowing to maintain our strong liquidity position. Assuming that Puerto Rico's recovery act survives the constitutional challenge, it will be applicable only to certain public corporations. As of July 31, we have $772 million of insured net par exposure to the Puerto Rico Electric Power Authority or PREPA and $1.7 billion of additional net par that is subject to the act. Our total exposure to credits under of the act is spread across 5 different credits with distinct revenue streams, which should contribute to strong recovery rates that we end up making debt service on any -- debt service payments on any of these credits. In looking specifically at PREPA, while they're considered the weakest credit of the group, we would be looking at an average annual debt service of about $64 million over the next 10 years, with $12 billion of claims paying resources across our group and the approximate $400 million of investment income we generate each year from our $11.6 billion investment portfolio, even 100% severity loss would obviously be manageable. That logic also applies to the other 4 exposures subject to the act, which together, have an aggregate net principal interest requirement of approximately $130 million per year over the next 10 years. Detroit is another credit that continues to draw a lot of attention. As I discussed on our last call, we have a tendered settlement regarding the unlimited tax general obligation bonds. The company continues to participate in courtroom mediation with respect to the proposed treatment of the Detroit Water and Sewer bonds in the plan of adjustment. As always, we will continue to pursue our strong legal rights in this matter to prevent any impairment of the DWSD coupons or their call protections. It is important to keep in mind that the default of Jefferson County, Alabama; Harrisburg, Pennsylvania; and Stockton, California, our eventual outcomes were better than many had anticipated when the news first broke and significantly above what we were initially offered by the issuers. Without minimizing the challenges Puerto Rico and Detroit faced, we are well positioned to negotiate forcefully for fair outcomes that acknowledge and respect our legal rights. The silver lining in occasional distress situations like Detroit and Puerto Rico, is that they reinforce the value of our product. Value not only from the protection of principal and interest in case of default, but also value from additional benefits, such as our role in lifting the burden of work-out negotiations from investors, and importantly, the greater liquidity and price stability that our insured bonds have exhibited relative to uninsured bonds of the same issuer. We think the market's growing appreciation of the value of our insurance, along with S&P's upgrade of our financial strength rating to AA with a stable outlook on March 18, is contributing to an increase in demand for our product. Turning to Moody's. On July 15, Moody's published a request for comment on proposed revisions to the rating criteria for bond insurers. Moody's said they do not expect any ratings to change if these revisions are implemented as proposed. However, under the proposed criteria, it's hard to conceive how a bond insurer could ever achieve a AA Moody's rating. In one subcategory, for instance, no bond insurer could be rated AA unless the industry writes $250 billion of new bond insurance per year, equivalent to 80% of all municipal bonds issued in 2013. This aim is designed to be an impossible hurdle. Just consider the fact that about 16% of the par issued in 2013 was AAA and another 48% was in the AA category. The reality is that our target market of A and BAA-rated credits was only 30% of the market, representing $95 billion of the 2013 volume. To put a standard for AA of 80% seems specifically designed to be unachievable. In the same proposal, Moody's would significantly reduce the importance of a financial guarantor company's insured portfolio quality and capital adequacy in the new criteria. Yet recent industry experience has clearly shown that the quality of an insurers guaranteed risk and the adequacy of its capital are the 2 most important components of its financial strength and the key factors that provide protection to investors in insured bonds. We think it's very important that the market participants take the opportunity to read this proposal and provide their feedback to Moody's by the September 15 deadline. Turning to production, we have seen a positive trend in U.S. municipal-insured volume with year-to-date insured par sold in the primary market up 30% for the industry, despite a 16% decline in overall new issuance. Insurance penetration was 5.5% of par sold during the second quarter, the highest quarterly level since third quarter 2011. That 5.5% penetration compares to the 4.6% in the first quarter this year and 3.9% in last year's second quarter. Looking at just single-A transactions, which represents a significant portion of our target market, more than half of the second quarter 2014 transactions were insured and represented 21% of the A par sold in the second quarter. But keep in mind, demand for bond insurers is still limited by the interest rates that are materially below historical norms and credit spreads that remain tight. Hopefully, we will start to see some upward movement in interest rates now that the Fed seems to be on course to end its quantitative easing program by October. Higher interest rates should make insurance more affordable. As for our municipal production, during the second quarter, the $2.5 billion of new U.S. municipal issues sold with AGM or MAC insurance is $1 billion more than in the first quarter, a 72% increase. We guaranteed 54% of the insurer par sold in the primary market during the quarter. Additionally, we insured $311 million of U.S. municipal bonds in the secondary market during the second quarter, bringing our total secondary market par insured to $492 million for the half, an 83% increase over first half 2013. And this brings our total first half of U.S. municipal par insured to $4.4 billion. Taking a closer look at the second quarter production, our $2.45 billion of U.S. municipal par insured are written at an average rating in the A category and generated $16 million of PV premium. This clearly reflects our pricing discipline when you consider that our only other active competitor reported $1.87 billion par -- dollars of par, similar business written, but generated only $5.3 million of PV premiums. Therefore, our competitor's premium-to-par ratio was approximately 30 basis points compared with 65 basis points for Assured Guaranty. I'm also pleased to say that a year after its launch, our U.S. municipal-only subsidiary, MAC, is now licensed in 48 states and the District of Columbia, having received its California license in July. In structured finance in the second quarter, we closed 4 transactions. These included a $200 million diversified payment rights future flow transaction issued by Garanti, Turkey's second largest private bank, in a private capital relief transaction. In summary, we continue to manage our capital to optimize shareholder value through share repurchases, while maintaining our strong financial condition. We continue to find opportunities to mitigate losses as our legacy troubled exposures amortize. Demand for our municipal bond insurance has increased, and we have promising structured finance and international opportunities. As always, I look forward to updating you on our activities during the second half of the year. Now I'll turn the call over to Rob.

Thank you, Dominic, and good morning to everyone on the call. As Dominic mentioned, we accessed the capital markets in the second quarter, and I am very pleased to report that we issued $500 million of 10-year senior notes with a 5% coupon. Market support for this transaction was excellent, with bids from over 130 individual investors generating a $2.4 billion book for the offering. Our initial target was an offering of $300 million over the book that was 8x oversubscribed. We decided to increase the issuance to $500 million. This offering will lead to a reduced overall cost of capital and is another step towards achieving an optimal capital mix for our company. We also continued to repurchase common shares throughout the second quarter and into July. We repurchased 7.1 million shares in the second quarter of 2014 and an additional 5.7 million shares since June 30. This brings our total repurchases since January 2013 to 26.6 million shares for a total of $609 million. The average cost per share was $22.91. This week, our board authorized an additional $400 million of share repurchases, which brings our total current authorization to $455 million. Stock buybacks are contingent on our available free cash flow, capital position, maintenance of our ratings and other factors. Turning to our operating results. We had $101 million of operating income in the second quarter of 2014 or $0.56 per share compared with $98 million or $0.52 per share in the second quarter of 2013. The increase in operating income per share was primarily attributable to share repurchases. Operating income was up slightly and included a few notable variances in premiums and losses. Premiums earned in credit derivative revenues included $25 million of accelerations in the second quarter of 2014 compared with $60 million in the second quarter of 2013. Scheduled net earned premiums were also lower, due mainly to the amortization of structured finance par. Loss expense in the second quarter of 2014 for the U.S. RMBS and other structured finance sector was $52 million lower than in the second quarter of 2013, due primarily to the continued improvement in the performance of the underlying RMBS exposures. Loss expense in the public finance sector was relatively flat compared with second quarter of 2013. Public finance loss expense for the second quarter of 2014 included an increase in Puerto Rico losses, while the second quarter of 2013 included losses on Detroit. Both second quarter of 2014 and second quarter of 2013 included an R&W benefit with various counterparties. For the second quarter of 2014, economic loss development was $23 million, which included $137 million of economic loss development on various credits, primarily additions to our Puerto Rico reserves, offset in part by positive economic development of $140 million, primarily attributable to improvements in the RMBS portfolio. Operating shareholders' equity per share has been steadily increasing over the last several years and has hit $35.31 as of June 30, 2014. While adjusted book value per share rose to $50.82 per share, primarily as a result of our share repurchase program. I'll now turn the call over to our operator to give you the instructions for the question-and-answer period. Thank you.

[Operator Instructions] And the first question comes from Sean Dargan with Macquarie.

I have a question about some of the assumptions baked into your economic loss development. Yesterday, a competitor indicated that in their probability weighted analysis, the range they are looking at for PREPA losses -- for PREPA losses severity was between 10% and 35%. Directionally, is that kind of how you're thinking about PREPA?

I'll answer that. We don't really give out that kind of information in our reserve analysis as per the GAAP requirements. You do these scenario assessments. I will say, there is a range of potential outcomes that go from a fairly optimistic, realistic, and they go into the pessimistic. So you have a wide range and I don't feel comfortable in giving you our exact percentages.

Are you in the pessimistic range now?

Remember, each of them gets a probably weighting so it really depends on how much weight we give to each of those specific additions. I think our reserve, as we've said, we added to the reserve in the current quarter as we continue to monitor the activity there. And we think it's incredibly reasonable at this time relative to all the facts that we can ascertain for the continuing developments in Puerto Rico.

Okay. And one follow-up. In regards to how you're thinking about deploying capital in the near future. I think there is a block of FG business that may be on the market that has its own Puerto Rico liabilities. I'm just wondering your thoughts on adding portfolios and what kind of return hurdles you would need to do so.

Well, as you know, our goal is to, in effect, consolidate the industry once we determine that, a, the transaction makes sense from a return point of view, and two, we're comfortable with the existing portfolio of the specific company. If there are troubled credits, obviously, in any portfolio, we would analyze. We would either set aside or attempt to get paid or set up some other vehicle to handle those specific exposures, especially in light that we believe we've got enough exposure to a given name, that's just part of a troubled credit analysis. As we look at it though, and your point is which is the better transaction, I think, you're getting at a buyback or acquisition, we'd say you've got to be cognizant of both. Remember, buyback is always going to be limited to the amount of free cash and the amount of dividend capacity coming out of the operating entities. We still believe that will leave us with excess capital within the operating groups. And this does give us an opportunity to put that capital to work at very high returns and especially given the fact that, that capital for the current period of time is still going to be retained by that specific operating entity.

And the next question comes from Geoffrey Dunn with Dowling & Partners. Geoffrey M. Dunn - Dowling & Partners Securities, LLC: Rob, first, could you update us on holding company liquidity as well as the U.S. holdco liquidity, please.

Sure. As of June 30, Jeff, we had $585 million at the U.S. holding companies, and we have about $46 million at AGO. Also the unencumbered assets at AG Re is sitting at about $217 million. Geoffrey M. Dunn - Dowling & Partners Securities, LLC: Okay. And then Dominic, on the municipal business, you highlighted the PVP to par ratio was 65 bps. We saw that ratio fall to a similar number a year ago, and it's solidly below kind of that 100-plus threshold that we tend to look for. What is it about last year or this year -- I think last year the answer was credit spreads, but what is it about what's going on in the second quarter business profile that, that ratio fell off so much?

Well, Geoff, a, I don't think it fell off that much. I think I've looked at it for quarter-to-quarter, it was fairly flat. I'll have to go back and look at my notes for the prior year. There always is the issue of mix of business. And I'm trying to remember last year second quarter, I don't know whether the Jeff Co sewer bond rewrite enters into that, but there will be, on especially some of these workout [indiscernible], some aberrational kind of results that will blow up in number in any given quarter. I think as we look at the 66, we think it's more than reasonable relative to spreads and interest rates and still provides an adequate return on the capital. And remember, when we look at our capital allocation, we charge each deal with capital to legal term. And obviously, in most cases, you wind up having the capital refunded to you at the call, because of the bonds are called. So we typically understate our return. And as I said at the 66, I thought it was basis point average, we were quite pleased with the return scenario. Remember, we're writing typically Category 1, Category 2, the low cap, low charge S&P risk. So it's disproportionate to a certain extent relative to a more diversified book. As we said, we averaged in A rating this quarter across the entire portfolio of new business written. And so that mix also will contribute to it as well, Geoff. Geoffrey M. Dunn - Dowling & Partners Securities, LLC: So borrowing workouts and the material change in mix, you think this is a good proxy for current market conditions?

Yes, I think we maintained discipline. I would like it to be higher and I think interest rates would move higher with wide spreads, and therefore, provide us better opportunities. But I am not just pleased at the current level of activity in the quarter, and especially in light of facing rather steep pricing competition from the competitor in the market that was literally half our premium rate.

[Operator Instructions] And we have a question from Ted Wachtell from Millennium.

I wanted to ask you about your disclosure on the Puerto Rico exposure, could you show them net versus gross and net. MBIA shows them in a gross fashion. So, a, how come you don't give us gross exposures? And b, is there any additional exposure over the net to Puerto Rico via entities that you reinsured with, who could be less than quality counterparties that we should be aware of?

Okay. So first, we do show total gross par for our Puerto Rico. We don't show it by the entities, you're right. And obviously, we can easily add that to the disclosure. More importantly, to your real question, is as we look at our reinsurance, we are very, very comfortable with the strength of the reinsurance. And specifically, to your question, at approximately $1.2 billion of reinsurance, there's $20 million of reinsurance to a seating company that I would consider -- assuming company rather, that I would consider potentially an issue. And it's $20 million part of $1.2 billion, therefore, we don't consider it significant, that's why we look at it net. Because all the people in our reinsurance battles are all very well capable of fully paying their share of losses.

Okay. You just mentioned that you could easily break that out. I would love to see you break that out going forward, the way MBIA does.

Duly noted.

And the next question comes from Larry Vitale with Moore Capital.

So I just wanted to get confirmation that the unencumbrance of the contingency reserves at both AGC and AGM took place in July.

Larry we did have a bet on whether this question was going to be asked by you. Rob won.

I said it was going to be your first question. And it's a good one. We're actively discussing this with our regulators, and we're confident that it's going to be done very shortly.

Okay. And can you remind us of the amounts? It was $125 million at AGC and $133 million at AGM?

Yes, it's going to be roughly $244 million when we get the release.

Larry, just to give you further clarification, New York sent us an email yesterday approving it, we're still waiting for the letter. So -- and we would expect that Maryland follow it, because they seem to be all working together.

We really expect it to happen very shortly, Larry. [indiscernible].

All right, that's helpful. And then I just wanted to go through the various categories of cash burn going forward with the new debt. So holdco expenses are, what, $8 million a quarter or thereabouts?

Yes, roughly.

Okay. Because that's what you've guided us to in the past. And you're paying, what, about $19 million a quarter in dividends? And then the new run rate on interest expense is $26.25 million?

I think that I'd have to check those numbers, but I think those are fairly close.

And we have a job in our Treasury Department, if you want it.

But Rob, you said -- and Dominic, you may have mentioned this as well. You said the words optimal capital structure. What is your optimal capital structure, and that's my last question.

We knew that, that question was coming, too. So you've got to look at it from a who's giving us the requirements. So obviously, the one we've pay most attention to is our own and then secondarily, S&P. When you look at S&P, we think [indiscernible] of that capital. So we think the optimal mix is 70-30, 70 equity or stat and 30 of other items, including debt, reinsurance, soft capital facilities, et cetera.

And as there are no more questions at the present time, I would like to turn the call back to management for any closing comments.

Great. Thank you, operator. I'd like to thank everyone for joining us on today's call. If you have additional questions, please feel free to give us a call. Thank you.

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. Have a nice day.