| RADIAN GROUP INC Item 1A Risk Factors |
| Risks Affecting Our Company Deterioration in general economic factors may increase our loss experience and decrease demand for mortgage insurance and financial guaranties |
| Our business tends to be cyclical and tends to track general economic and market conditions |
| Our loss experience on the mortgage and financial guaranty insurance we write is subject to general economic factors that are beyond our control, many of which we cannot anticipate, including extended national economic recessions, interest-rate changes or volatility, business failures, the impact of terrorist attacks or acts of war, or changes in investor perceptions regarding the strength of private mortgage insurers or financial guaranty providers and the policies or guaranties they offer |
| Deterioration of general economic conditions, such as increasing unemployment rates, negatively affects our mortgage insurance business by increasing the likelihood that borrowers will not pay their mortgages |
| Personal factors affecting individual borrowers, such as divorce or illness, also impact the ability of borrowers to continue to pay their mortgages |
| Depreciation of home prices also is a leading indication of an increase in our future losses |
| Our financial guaranty business also is impacted by adverse economic conditions due to the impact or perceived impact these conditions may have on the credit quality of municipalities and corporations |
| The same events that increase our loss experience in each business also generally lead to decreased activity in the market for mortgages and financial obligations, leading to decreased demand for our mortgage insurance or financial guaranties |
| An increase in our loss experience or a decrease in demand for our products due to adverse economic factors could have a material adverse effect on our business, financial condition and operating results |
| Deterioration in regional economic factors could increase our losses or reduce demand for our insurance |
| We could be affected by weakening economic conditions, catastrophic events, or acts of terrorism in specific regions of the United States where our business is concentrated |
| A majority of our primary mortgage insurance in force is concentrated in ten states, with the highest percentage being in Florida, California, Texas and New York |
| A large percentage of our second-lien mortgage insurance in force is concentrated in California and Florida |
| Our financial guaranty business also has a significant portion of its insurance in force concentrated in a small number of states, principally including California, New York, Texas, Pennsylvania and Florida |
| A continued and prolonged weakening of economic conditions, declines in home-price appreciation or catastrophic events or acts of terrorism in the states where our business is concentrated could have an adverse effect on our financial condition and results of operations |
| Downgrade or potential downgrade of our credit ratings or the insurance financial strength ratings assigned to any of our operating subsidiaries could weaken our competitive position and affect our financial condition |
| The insurance financial strength ratings assigned to our subsidiaries may be downgraded by one or more of S&P, Moody’s or Fitch if they believe that we or the applicable subsidiary has experienced adverse developments in our business, financial condition or operating results |
| These ratings are important to our ability to market our products and to maintain our competitive position and customer confidence in our products |
| A downgrade in these ratings, or the announcement of a potential for a downgrade, could have a material adverse effect on our business, financial condition and operating results |
| Our principal operating subsidiaries had been assigned the following ratings as of the date of this report: MOODY’S MOODY’S OUTLOOK S&P S&P OUTLOOK FITCH FITCH OUTLOOK Radian Guaranty Aa3 Stable AA Stable AA Stable Radian Insurance Aa3 Stable AA Stable AA Stable Amerin Guaranty Aa3 Stable AA Stable AA Stable Radian Asset Assurance Aa3 Stable AA Negative AA Negative Radian Asset Assurance Limited — — AA Negative AA Negative 57 ______________________________________________________________________ [99]Table of Contents If the financial strength ratings assigned to any of our mortgage insurance subsidiaries were to fall below “Aa3” from Moody’s or the “AA” level from S&P and Fitch, then national mortgage lenders and a large segment of the mortgage securitization market, including Fannie Mae and Freddie Mac, generally would not purchase mortgages or mortgage-backed securities insured by that subsidiary |
| Any downgrade of the ratings assigned to our financial guaranty subsidiaries would limit the desirability of their respective direct insurance products and would reduce the value of Radian Asset Assurance’s reinsurance, even to the point where primary insurers may be unwilling to continue to cede insurance to Radian Asset Assurance at attractive rates |
| In addition, many of Radian Asset Assurance’s reinsurance agreements give the primary insurers the right to recapture business ceded to Radian Asset Assurance under these agreements, and in some cases, the right to increase commissions charged to Radian Asset Assurance if Radian Asset Assurance’s insurance financial strength rating is downgraded below specified levels |
| Accordingly, Radian Asset Assurance’s competitive position and prospects for future financial guaranty reinsurance opportunities would be damaged by a downgrade in its ratings |
| For example, downgrades that occurred in October 2002 and in May 2004 triggered these recapture rights |
| See “Ratings” in Item 1 for more information regarding these downgrades |
| We cannot be certain that the impact on our business of any future downgrades would not be worse than the impact resulting from these prior downgrades |
| In addition to the financial strength ratings assigned to our subsidiaries, we have been assigned a senior debt rating of A+ by Fitch, A by S&P and A2 by Moody’s |
| The credit ratings generally impact the interest rates that we pay on money that we borrow |
| Therefore, a downgrade in our credit ratings could increase our cost of borrowing which would have an adverse affect on our liquidity, financial condition and results of operations |
| An increase in our subsidiaries’ risk-to-capital or leverage ratios may prevent them from writing new insurance |
| Rating agencies and state insurance regulators impose capital requirements on our subsidiaries |
| These capital requirements include risk-to-capital ratios, leverage ratios and surplus requirements that limit the amount of insurance that these subsidiaries may write |
| For example, Moody’s and S&P have entered into an agreement with Radian Guaranty that obligates Radian Guaranty to maintain specified levels of capital in Radian Insurance as a condition of the issuance and maintenance of Radian Insurance’s ratings |
| A material reduction in the statutory capital and surplus of any of our subsidiaries, whether resulting from underwriting or investment losses or otherwise, or a disproportionate increase in risk in force, could increase that subsidiary’s risk-to-capital ratio or leverage ratio |
| This in turn could limit that subsidiary’s ability to write new business or require that subsidiary to lower its ratios by obtaining capital contributions from us, reinsuring existing business or reducing the amount of new business it writes, which could have a material adverse effect on our business, financial condition and operating results |
| If the estimates we use in establishing loss reserves for our mortgage insurance or financial guaranty business are incorrect, we may be required to take unexpected charges to income and our ratings may be lowered |
| We establish loss reserves in both our mortgage insurance and financial guaranty businesses to provide for the estimated cost of claims |
| However, our loss reserves may be inadequate to protect us from the full amount of claims we may have to pay |
| Setting our loss reserves involves significant reliance on estimates of the likelihood, magnitude and timing of anticipated losses |
| The models and estimates we use to establish loss reserves may prove to be inaccurate, especially during an extended economic downturn |
| Further, if our estimates are inadequate, we may be forced by insurance and other regulators or rating agencies to increase our reserves, which could result in a downgrade of the insurance financial strength ratings assigned to our operating subsidiaries |
| Failure to establish adequate reserves or a requirement that we increase our reserves could have a material adverse effect on our business, financial condition and operating results |
| In our mortgage insurance business, in accordance with GAAP, we generally do not establish reserves until we are notified that a borrower has failed to make at least two payments when due |
| Upon notification that two 58 ______________________________________________________________________ [100]Table of Contents payments have been missed, we establish a loss reserve by using historical models based on a variety of loan characteristics, including the status of the loan as reported by the servicer of the loan, economic conditions, the estimated amount recoverable by foreclosure and the estimated foreclosure period in the area where a default exists |
| These reserves are therefore based on a number of assumptions and estimates that may prove to be inaccurate |
| It is even more difficult to estimate the appropriate loss reserves for our financial guaranty business because of the nature of potential losses in that business |
| We establish both case and non-specific reserves for losses |
| We increase case reserves when we determine that a default has occurred |
| We also establish non-specific reserves to reflect deterioration of our insured credits for which we have not provided specific reserves |
| In January and February of 2005, we discussed with the SEC staff, both separately and together with other members of the financial guaranty industry, the differences in loss reserve practices followed by different financial guaranty industry participants |
| On June 8, 2005, the FASB added a project to its agenda to consider the accounting by insurers for financial guaranty insurance |
| The FASB will consider several aspects of the insurance accounting model, including claims liability recognition, premium recognition and the related amortization of deferred policy acquisition costs |
| In addition, we also understand that the FASB may expand the scope of this project to include income recognition and loss reserving methodology in the mortgage insurance industry |
| Proposed and final guidance from the FASB regarding accounting for financial guaranty insurance is expected to be issued in 2006 |
| When and if the FASB or the SEC reaches a conclusion on these issues, we and the rest of the financial guaranty and mortgage insurance industries may be required to change some aspects of our accounting policies |
| If the FASB or the SEC were to determine that we should account for our financial guaranty contracts differently, for example by requiring them to be treated solely as one or the other of short-duration or long-duration contracts under SFAS Nodtta 60, this determination could impact our accounting for loss reserves, premium revenue and deferred acquisition costs, all of which are covered by SFAS Nodtta 60 |
| Management is unable to estimate what impact, if any, the ultimate resolution of this issue will have on our financial condition or operating results |
| Our success depends on our ability to assess and manage our underwriting risks |
| Our mortgage insurance and financial guaranty premium rates may not adequately cover future losses |
| Our mortgage insurance premiums are based upon our expected risk of claims on insured loans, and take into account, among other factors, each loan’s LTV, type (eg, prime vs |
| variable payments), term, occupancy status and coverage percentage |
| Similarly, our financial guaranty premiums are based upon our expected risk of claim on the insured obligation, and take into account, among other factors, the rating and creditworthiness of the issuer of the insured obligations, the type of insured obligation, the policy term and the structure of the transaction being insured |
| In addition, our premium rates take into account expected cancellation rates, operating expenses and reinsurance costs, as well as profit and capital needs and the prices that we expect our competitors to offer |
| We generally cannot cancel or elect not to renew the mortgage insurance or financial guaranty insurance coverage we provide, and because we generally fix premium rates for the life of a policy when issued, we cannot adjust renewal premiums or otherwise adjust premiums over the life of a policy |
| If the risk underlying a particular mortgage insurance or financial guaranty coverage develops more adversely than we anticipate, or if national and regional economies undergo unanticipated stress, we generally cannot increase premium rates on in-force business, cancel coverage or elect not to renew coverage to mitigate the effects of these adverse developments |
| Despite the analytical methods we employ, our premiums earned and the associated investment income on those premiums may ultimately prove to be inadequate to compensate for the losses that we may incur |
| An increase in the amount or frequency of claims beyond the levels contemplated by our pricing assumptions could have a material adverse effect on our business, financial condition and operating results |
| 59 ______________________________________________________________________ [101]Table of Contents Our success depends, in part, on our ability to manage risks in our investment portfolio |
| Our income from our investment portfolio is one of our primary sources of cash flow to support our operations and claim payments |
| If we incorrectly calculate our policy liabilities, or if we improperly structure our investments to meet those liabilities, we could have unexpected losses, including losses resulting from forced liquidation of investments before their maturity |
| Our investments and investment policies and those of our subsidiaries are subject to state insurance laws |
| We may be forced to change our investments or investment policies depending upon regulatory, economic and market conditions and the existing or anticipated financial condition and operating requirements, including the tax position, of our business segments |
| We cannot be certain that our investment objectives will be achieved |
| Although our portfolio consists mostly of highly rated investments that comply with applicable regulatory requirements, the success of our investment activity is affected by general economic conditions, which may adversely affect the markets for interest-rate-sensitive securities, including the extent and timing of investor participation in these markets, the level and volatility of interest rates and, consequently, the value of our fixed-income securities |
| Volatility or illiquidity in the markets in which we directly or indirectly hold positions could have a material adverse effect on our business, financial condition and operating results |
| As a holding company, we depend on our subsidiaries’ ability to transfer funds to us to pay dividends and to meet our obligations |
| We act principally as a holding company for our insurance subsidiaries and do not have any significant operations of our own |
| Dividends from our subsidiaries and permitted payments to us under our expense- and tax-sharing arrangements with our subsidiaries, along with income from our investment portfolio and dividends from our affiliates (C-BASS and Sherman), are our principal sources of cash to pay stockholder dividends and to meet our obligations |
| These obligations include our operating expenses and interest and principal payments on debt |
| The payment of dividends and other distributions to us by our insurance subsidiaries is regulated by insurance laws and regulations |
| In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval |
| In addition, our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the rating agencies for us to maintain our ratings |
| If the cash we receive from our subsidiaries pursuant to dividend payment and tax-sharing arrangements is insufficient for us to fund our obligations, we may be required to seek capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all |
| The need to raise additional capital or the failure to make timely payments on our obligations could have a material adverse effect on our business, financial condition and operating results |
| Our reported earnings are subject to fluctuations based on changes in our credit derivatives that require us to adjust their fair market value as reflected on our income statement |
| Our business includes the provision of credit enhancement in the form of derivative contracts |
| The gains and losses on these derivative contracts are derived from internally generated models, which may differ from other models |
| We estimate fair value amounts using market information, to the extent available, and valuation methodologies that we deem appropriate |
| The gains and losses on assumed derivative contracts are provided by the primary insurance companies |
| Considerable judgment is required to interpret available market data to develop the estimates of fair value |
| Accordingly, our estimates are not necessarily indicative of amounts we could realize in a current market exchange, due to, among other factors, the lack of a liquid market |
| Temporary market changes as well as actual credit improvement or deterioration in these contracts are reflected in the mark-to-market gains and losses |
| Because these adjustments are reflected on our income statement, they affect our reported earnings and create earnings volatility even though they might not have a cash flow effect |
| The performance of our strategic investments could harm our financial results |
| Part of our business involves strategic investments in other companies, and we generally do not have control over the way that these companies run their day-to-day operations |
| In particular, our financial services segment 60 ______________________________________________________________________ [102]Table of Contents consists mostly of our strategic interests in C-BASS and Sherman |
| At December 31, 2005, we had investments in affiliates of dlra446dtta2 million |
| Our ability to engage in additional strategic investments is subject to the availability of capital and maintenance of our insurance financial strength ratings |
| The performance of our strategic investments could be harmed by: • the performance of our strategic partners; • changes in the financial markets generally and in the industries in which our strategic partners operate, including increased competition from new entrants in these industries; • significant litigation involving the companies in which we hold a strategic interest or other significant costs incurred by such companies in complying with regulatory or other applicable laws; or • changes in interest rates or other macroeconomic factors that might diminish the profitability of these businesses |
| C-BASS’s results could vary significantly from period to period |
| As part of its business, C-BASS securitizes non-conforming mortgages into mortgage-backed securities |
| As a result, a portion of C-BASS’s income depends on its ability to sell different tranches of its securities in the capital markets, which can be volatile, depending on interest rates, credit spreads and liquidity |
| In addition, C-BASS also owns mortgage-backed securities, some of which can be called for redemption, particularly in low interest-rate environments |
| Redemptions can result in volatility in C-BASS’s quarterly results as can the application of accounting rules that require C-BASS to mark many components of its balance sheet to market |
| Although there has been growth in the volume of non-conforming mortgage originations in recent years, growth in this industry may not continue if interest rates continue to rise or competition in the industry continues to increase |
| If C-BASS is unable to continue to successfully grow its portfolio of non-conforming mortgages, its income could be negatively affected |
| Sherman’s results could be adversely impacted by increased pricing competition for the pools of consumer assets they purchase, as well as a reduction in the success of their collection efforts due to macroeconomic or other factors |
| In addition, results of their credit card origination business are sensitive to interest-rate changes, charge-off losses and the success of their collection efforts |
| As a result of their significant amount of collection efforts, there is a risk that either C-BASS or Sherman could be subject to consumer related lawsuits and other investigations related to fair debt collection practices, which could have an adverse effect on C-BASS’s or Sherman’s income, reputation and future ability to conduct business |
| Our international operations subject us to numerous risks |
| We have committed and may in the future commit additional significant resources to expand our international operations, particularly in the UK We also are in the process of applying to commence international mortgage operations in Hong Kong |
| Accordingly, we are subject to a number of risks associated with our international business activities, including: • risks of war and civil disturbances or other events that may limit or disrupt markets; • dependence on regulatory and third-party approvals; • changes in rating or outlooks assigned to our foreign subsidiaries by rating agencies; • challenges in attracting and retaining key foreign-based employees, customers and business partners in international markets; • foreign governments’ monetary policies and regulatory requirements; • economic downturns in targeted foreign mortgage origination markets; • interest-rate volatility in a variety of countries; 61 ______________________________________________________________________ [103]Table of Contents • the burdens of complying with a wide variety of foreign regulations and laws, some of which may be materially different than the regulatory and statutory requirements we face in our domestic business, and which may change unexpectedly; • potentially adverse tax consequences; • restrictions on the repatriation of earnings; • foreign currency exchange rate fluctuations; and • the need to develop and market products appropriate to the various foreign markets |
| Any one or more of the risks listed above could limit or prohibit us from developing our international operations profitably |
| In addition, we may not be able to effectively manage new operations or successfully integrate them into our existing operations, which could have a material adverse effect on our business, financial condition or operating results |
| Our business may suffer if we are unable to meet our customers’ technological demands |
| Participants in the mortgage insurance and financial guaranty industries rely on e-commerce and other technologies to provide and expand their products and services |
| Our customers generally require that we provide aspects of our products and services electronically, and the percentage of our new insurance written and claims processing that we deliver electronically has continued to increase |
| We expect this trend to continue and, accordingly, we may be unable to satisfy our customers’ requirements if we fail to invest sufficient resources or otherwise are unable to maintain and upgrade our technological capabilities |
| This may result in a decrease in the business we receive, which could impact our profitability |
| Our information technology systems may not be configured to process information regarding new and emerging products |
| Many of our information technology systems have been in place for a number of years, and many of them originally were designed to process information regarding traditional products |
| As products such as reduced documentation or interest-only mortgages with new features emerge, or when we insure structured transactions with unique features, our systems may require modification in order to recognize these features to allow us to price or bill for our insurance of these products appropriately |
| Our systems also may not be capable of recording, or may incorrectly record, information about these products that may be important to our risk management and other functions |
| In addition, our customers may encounter similar technological issues that prevent them from sending us complete information about the products or transactions that we insure |
| Making appropriate modifications to our systems involves inherent time lags and may require us to incur significant expenses |
| The inability to make necessary modifications to our systems in a timely and cost-effective manner may have adverse effects on our business, financial condition and operating results |
| Risks Particular to Our Mortgage Insurance Business A decrease in the volume of high-LTV home mortgage originations or an increase in the volume of cancellations or non-renewals of our existing policies could have a significant effect on our revenues |
| Factors that could lead to a decrease in the volume of high-LTV home mortgage originations, and consequently, reduce the demand for our mortgage insurance products, include: • a decline in economic conditions generally or in conditions in regional and local economies; • the level of home mortgage interest rates; • adverse population trends, lower homeownership rates and the rate of household formation; and • changes in government housing policies encouraging loans to first-time homebuyers |
| 62 ______________________________________________________________________ [104]Table of Contents Most of our mortgage insurance premiums earned each month are derived from the monthly renewal of policies that we previously have written |
| As a result, a decrease in the length of time that our mortgage insurance policies remain in force reduces our revenues and could have a material adverse effect on our business, financial condition and operating results |
| Fannie Mae and Freddie Mac generally permit homeowners to cancel their mortgage insurance when the principal amount of a mortgage falls below 80prca of the home’s value |
| Factors that are likely to increase the number of cancellations or non-renewals of our mortgage insurance policies include: • falling mortgage interest rates (which tends to lead to increased refinancings and associated cancellations of mortgage insurance); • appreciating home values; and • changes in the mortgage insurance cancellation requirements applicable to mortgage lenders and homeowners |
| Because our mortgage insurance business is concentrated among relatively few major customers, our revenues could decline if we lose any significant customer |
| Our mortgage insurance business depends to a significant degree on a small number of customers |
| Our top ten mortgage insurance customers are generally responsible for approximately half of both our primary new insurance written in a given year and our direct primary risk in force |
| This concentration of business may increase as a result of mergers of those customers or other factors |
| Our master policies and related lender agreements do not, and by law cannot, require our mortgage insurance customers to do business with us |
| The loss of business from even one of our major customers could have a material adverse effect on our business, financial condition and operating results |
| A large portion of our mortgage insurance risk in force consists of loans with high-LTV ratios and loans that are non-prime, or both, which generally result in more and larger claims than loans with lower-LTV ratios and prime loans |
| We generally provide private mortgage insurance on mortgage products that have more risk than conforming mortgage products |
| A large portion of our mortgage insurance in force consists of insurance on mortgage loans with LTVs at origination of more than 90prca |
| Mortgage loans with LTVs greater than 90prca are expected to default substantially more often than those with lower LTVs |
| In addition, when we are required to pay a claim on a higher LTV loan, it is generally more difficult to recover our costs from the underlying property, especially in areas with declining property values |
| Due to competition for prime loan business from lenders offering alternative arrangements, such as simultaneous second mortgages, a large percentage of our mortgage insurance in force is written on non-prime loans, which we believe to be the largest area for growth in the private mortgage insurance industry |
| In 2005, non-prime business accounted for dlra17dtta8 billion or 41dtta7prca of our new primary mortgage insurance written (63dtta3prca of which was Alt-A), compared to dlra16dtta4 billion or 36dtta6prca in 2004 (61dtta9prca of which was Alt-A) |
| At December 31, 2005, non-prime insurance in force was dlra34dtta7 billion or 31dtta7prca of total primary insurance in force, compared to dlra35dtta7 billion or 31dtta0prca of primary insurance in force at December 31, 2004 |
| Although we historically have limited the insurance of these non-prime loans to those made by lenders with good results and servicing experience in this area, because of the lack of data regarding the performance of non-prime loans, and our relative inexperience in insuring these loans, we may fail to estimate default rates properly and may incur larger losses than we anticipate, which could have a material adverse effect on our business, financial condition and operating results |
| In general, non-prime loans are more likely to go into default and require us to pay claims |
| In addition, some of our non-prime business, in particular Alt-A loans, tends to have larger loan balances relative to our other loans |
| We cannot be certain that the increased premiums that we charge for mortgage insurance on non-prime loans will be adequate to compensate us for the losses we incur on these products |
| We use Smart Home reinsurance arrangements as a way of managing our exposure to non-prime risk |
| Under these arrangements, we cede a portion of the risk associated with a portfolio of non-prime residential mortgage 63 ______________________________________________________________________ [105]Table of Contents loans insured by us to an unaffiliated reinsurance company |
| As a consequence of these arrangements, we are able to effectively transfer a portion of the non-prime risk that we would otherwise hold to investors that are willing to hold the risk in exchange for payments of interest and premium on the credit-linked notes |
| By ceding risk in this manner, we are able to continue to take on more non-prime risk and the higher premiums associated with insuring these types of products |
| As a result, we consider Smart Home arrangements to be very important to our ability to effectively manage our risk profile and to remain competitive in the non-prime market |
| Because the Smart Home arrangement ultimately depends on the willingness of investors to invest in Smart Home securities, we cannot be certain that Smart Home will always be available to us or will be available on terms that are acceptable to us |
| If we are unable to continue to use Smart Home arrangements, our ability to participate in the non-prime mortgage market could be limited, which could have a material adverse effect on our business, financial condition and operating results |
| We offer pool mortgage insurance, which exposes us to different risks than the risks applicable to primary mortgage insurance |
| Our pool mortgage insurance products generally cover all losses in a pool of loans up to our aggregate exposure limit, which generally is between 1prca and 10prca of the initial aggregate loan balance of the entire pool of loans |
| Under pool insurance, we could be required to pay the full amount of every loan in the pool within our exposure limits that is in default and upon which a claim is made until the aggregate limit is reached, rather than a percentage of the loan amount, as is the case with traditional primary mortgage insurance |
| At December 31, 2005, dlra2dtta7 billion of our mortgage insurance risk in force was attributable to pool insurance |
| Approximately 32prca of our mortgage insurance risk in force consists of adjustable-rate mortgages or ARMs |
| Our claim frequency on ARMs has been higher then on fixed-rate loans due to monthly payment increases that occur when interest rates rise |
| We believe that claims on ARMs will continue to be substantially higher than for fixed-rate loans during prolonged periods of rising interest rates |
| In addition, we insure interest-only mortgages, where the borrower pays only the interest charge on a mortgage for a specified period of time, usually five to ten years, after which the loan payment increases to include principal payments |
| These loans may have a heightened propensity to default because of possible “payment shocks” after the initial low-payment period expires and because the borrower does not automatically build equity as payments are made |
| We also write credit insurance on non-traditional, mortgage-related assets such as second mortgages, home equity loans and mortgages with LTVs above 100prca, provide credit enhancement to mortgage-related capital market transactions such as net interest margin securities and credit default swaps, and have in the past and may again write credit insurance on manufactured housing loans |
| These types of insurance generally have higher claim payouts than traditional mortgage insurance products |
| We have less experience writing these types of insurance and less performance data on this business, which could lead to greater losses than we anticipate |
| Greater than anticipated losses could have a material adverse effect on our business, financial condition and operating results |
| An increasing concentration of servicers in the mortgage lending industry could lead to disruptions in the servicing of mortgage loans that we insure, resulting in increased delinquencies |
| A recent trend in the mortgage lending and mortgage loan servicing industry has been towards consolidation of loan servicers |
| This reduction in the number of servicers could lead to disruptions in the servicing of mortgage loans covered by our insurance policies |
| This, in turn, could contribute to a rise in delinquencies among those loans and could have a material adverse effect on our business, financial condition and operating results |
| We face the possibility of higher claims as our mortgage insurance policies age |
| Historically, most claims under private mortgage insurance policies on prime loans occur during the third through fifth year after issuance of the policies, and under policies on non-prime loans during the second through 64 ______________________________________________________________________ [106]Table of Contents fourth year after issuance of the policies |
| Low mortgage interest-rate environments tend to lead to increased refinancing of mortgage loans and to lower the average age of our mortgage insurance policies |
| On the other hand, increased interest rates tend to reduce mortgage refinancings and cause a greater percentage of our mortgage insurance risk in force to reach its anticipated highest claim frequency years |
| In addition, periods of growth in our business tend to reduce the average age of our policies |
| For example, the relatively recent growth of our non-prime mortgage insurance business means that a significant percentage of our insurance in force on non-prime loans has not yet reached its anticipated highest claim frequency years |
| A resulting increase in claims could have a material adverse effect on our business, financial condition and operating results |
| Our delegated underwriting program may subject our mortgage insurance business to unanticipated claims |
| In our mortgage insurance business, we enter into agreements with our mortgage lender customers that commit us to insure loans using pre-established underwriting guidelines |
| Once we accept a lender into our delegated underwriting program, we generally insure a loan originated by that lender even if the lender has not followed our specified underwriting guidelines |
| Under this program, a lender could commit us to insure a material number of loans with unacceptable risk profiles before we discover the problem and terminate that lender’s delegated underwriting authority |
| Even if we terminate a lender’s underwriting authority, we remain at risk for any loans previously insured on our behalf by the lender before that termination |
| The performance of loans insured through programs of delegated underwriting has not been tested over a period of extended adverse economic conditions, meaning that the program could lead to greater losses than we anticipate |
| Greater than anticipated losses could have a material adverse effect on our business, financial condition and operating results |
| We face risks associated with our contract underwriting business |
| As part of our mortgage insurance business, we provide contract underwriting services to some of our mortgage lender customers, even with respect to loans for which we are not providing mortgage insurance |
| Under the terms of our contract underwriting agreements, we agree that if we make mistakes in connection with these underwriting services, the mortgage lender may, subject to certain conditions, require us to purchase the loans or issue mortgage insurance on the loans, or to indemnify it against future loss associated with the loans |
| Accordingly, we assume some credit risk and interest-rate risk in connection with providing these services |
| In a rising interest-rate environment, the value of loans that we are required to repurchase could decrease, and consequently, our costs of those repurchases could increase |
| In 2005, we underwrote dlra4dtta1 billion in principal amount of loans through contract underwriting |
| Depending on market conditions, a significant amount of our underwriting services may be performed by independent contractors hired by us on a temporary basis |
| If these independent contractors make more mistakes than we anticipate, the resulting need to provide greater than anticipated recourse to mortgage lenders could have a material adverse effect on our business, financial condition and operating results |
| If housing values fail to appreciate or begin to decline, we may be less able to recover amounts paid on defaulted mortgages |
| The amount of loss we suffer, if any, depends in part on whether the home of a borrower who has defaulted on a mortgage can be sold for an amount that will cover unpaid principal and interest on the mortgage and expenses from the sale |
| If a borrower defaults under our standard mortgage insurance policy, generally we have the option of paying the entire loss amount and taking title to a mortgaged property or paying our coverage percentage in full satisfaction of our obligations under the policy |
| In the strong housing market of recent years, we have been able to take title to the properties underlying certain defaulted loans and to sell the properties quickly at prices that have allowed us to recover most or all of our losses |
| If housing values fail to appreciate or begin to decline, the frequency of loans going to claim and our ability to mitigate our losses on defaulted mortgages may be reduced, which could have a material adverse effect on our business, financial condition and operating results |
| 65 ______________________________________________________________________ [107]Table of Contents Our mortgage insurance business faces intense competition from other mortgage insurance providers and from alternative products |
| The United States mortgage insurance industry is highly dynamic and intensely competitive |
| Our competitors include: • other private mortgage insurers, some of which are subsidiaries of well-capitalized companies with stronger insurance financial strength ratings and greater access to capital than we have; • federal and state governmental and quasi-governmental agencies, principally the VA and the FHA, which has increased its competitive position in areas with higher home prices by streamlining its down-payment formula and reducing the premiums it charges; and • mortgage lenders that demand increased participation in revenue-sharing arrangements such as captive reinsurance arrangements |
| Governmental and quasi-governmental entities typically do not have the same capital requirements that we and other mortgage insurance companies have, and therefore, may have financial flexibility in their pricing and capacity that could put us at a competitive disadvantage |
| In the event that a government-owned or sponsored entity in one of our markets determines to reduce prices significantly or alter the terms and conditions of its mortgage insurance or other credit enhancement products in furtherance of social or other goals rather than a profit motive, we may be unable to compete in that market effectively, which could have an adverse effect on our financial condition and results of operations |
| In addition, there are an increasing number of alternatives to traditional private mortgage insurance, and new alternatives may develop, which could reduce the demand for our mortgage insurance |
| Existing alternatives include: • mortgage lenders structuring mortgage originations to avoid private mortgage insurance, mostly through “80-10-10 loans” or other forms of simultaneous second loans |
| The use of simultaneous second loans has increased significantly during recent years and is likely to continue to be a competitive alternative to private mortgage insurance, particularly in light of the following factors: • the potential lower monthly cost of simultaneous second loans compared to the cost of mortgage insurance in a low-interest-rate environment; • the tax deductibility in most cases of interest on second mortgages compared to the non-deductibility of mortgage insurance payments; and • possible negative borrower, broker and realtor perceptions about mortgage insurance |
| • investors using other forms of credit enhancement such as credit default swaps or securitizations as a partial or complete substitute for private mortgage insurance; and • mortgage lenders and other intermediaries that forego third-party insurance coverage and retain the full risk of loss on their high-LTV loans |
| Much of the competition described above is directed at prime loans, which has led us to shift more of our business to insuring riskier, non-prime loans |
| In addition, the intense competition we face in the mortgage insurance industry requires that we dedicate time and energy to the development and introduction of competitive new products and programs |
| Our inability to compete with other providers and the various alternatives to traditional mortgage insurance, including the timely introduction of profitable new products and programs, or our incurring increased losses as a result of insuring more non-prime loans could have a material adverse effect on our business, financial condition and operating results |
| Because many of the mortgage loans that we insure are sold to Fannie Mae and Freddie Mac, changes in their charters or business practices could significantly impact our mortgage insurance business |
| Fannie Mae’s and Freddie Mac’s charters generally prohibit them from purchasing any mortgage with a loan amount that exceeds 80prca of the home’s value, unless that mortgage is insured by a qualified insurer or the 66 ______________________________________________________________________ [108]Table of Contents mortgage seller retains at least a 10prca participation in the loan or agrees to repurchase the loan in the event of a default |
| As a result, high-LTV mortgages purchased by Fannie Mae or Freddie Mac generally are insured with private mortgage insurance |
| Fannie Mae and Freddie Mac are the beneficiaries of the majority of our mortgage insurance policies |
| Changes in the charters or business practices of Fannie Mae or Freddie Mac could reduce the number of mortgages they purchase that are insured by us and consequently reduce our revenues |
| Some of Fannie Mae’s and Freddie Mac’s more recent programs require less insurance coverage than they historically have required, and they have the ability to further reduce coverage requirements, which could reduce demand for mortgage insurance and have a material adverse effect on our business, financial condition and operating results |
| Fannie Mae and Freddie Mac also have the ability to implement new eligibility requirements for mortgage insurers and to alter or liberalize underwriting standards on low-down-payment mortgages they purchase |
| We cannot predict the extent to which any new requirements may be implemented or how they may affect the operations of our mortgage insurance business, our capital requirements and our products |
| Additionally, Fannie Mae and Freddie Mac could decide to treat more favorably mortgage insurance companies rated “AAA” rather than “AA” Although this has not occurred to date, such a decision could impair our “AA”-rated subsidiaries’ ability to compete with “AAA”-rated companies (of which there currently is one) and could have a material adverse effect on our business, financial condition and operating results |
| Fannie Mae’s and Freddie Mac’s business practices may be impacted by legislative or regulatory changes governing their operations and the operations of other government-sponsored enterprises |
| Fannie Mae and Freddie Mac currently are subject to ongoing investigations regarding their accounting practices, disclosures and other matters, and legislation proposing increased regulatory oversight over them is currently under consideration in the US Congress |
| The proposed legislation encompasses substantially all of the operations of Fannie Mae and Freddie Mac and is intended to be a comprehensive overhaul of the existing regulatory structure |
| Although we cannot predict whether, or in what form, this legislation will be enacted, the proposed legislation could limit the growth of Fannie Mae and Freddie Mac, which could reduce the size of the mortgage insurance market and consequently have an adverse effect on our operations, financial condition and results of operations |
| Legislation and regulatory changes and interpretations could harm our mortgage insurance business |
| Our business and legal liabilities may be affected by the application of existing federal or state consumer lending and insurance laws and regulations, or by unfavorable changes in these laws and regulations |
| For example, recent regulatory changes have reduced demand for private mortgage insurance by increasing the maximum loan amount that the FHA can insure and reducing the premiums it charges |
| Also, we have been subject to consumer lawsuits alleging violations of the provisions of the RESPA that prohibit the giving of any fee, kickback or thing of value under any agreement or understanding that real estate settlement services will be referred |
| In addition, proposed changes to the application of RESPA could harm our competitive position |
| HUD proposed an exemption under RESPA for lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all the settlement services associated with the loan, commonly referred to as “bundling |
| ” In 2003, HUD withdrew the proposed rule and submitted another rule to the Office of Management and Budget, the contents of which have not yet been made public |
| If bundling is exempted from RESPA, mortgage lenders may have increased leverage over us, and the premiums we are able to charge for mortgage insurance could be negatively affected |
| 67 ______________________________________________________________________ [109]Table of Contents Risks Particular to Our Financial Guaranty Business Our financial guaranty business may subject us to significant risks from the failure of a single company, municipality or other entity whose obligations we have insured |
| The breadth of our financial guaranty business exposes us to potential losses in a variety of our products as a result of credit problems with one counterparty |
| For example, we could be exposed to an individual corporate credit risk in multiple transactions if the credit is contained in multiple portfolios of collateralized debt obligations that we have insured, or if one counterparty (or its affiliates) acts as the originator or servicer of the underlying assets or loans backing any of the structured securities that we have insured |
| Although we track our aggregate exposure to single counterparties in our various lines of business and have established underwriting criteria to manage aggregate risk from a single counterparty, we cannot be certain that our ultimate exposure to a single counterparty will not exceed our underwriting guidelines, due to merger or otherwise, or that an event with respect to a single counterparty will not cause a significant loss in one or more of the transactions in which we face risk to such counterparty |
| In addition, because we insure and reinsure municipal obligations, we can have significant exposures to individual municipal entities, directly or indirectly through explicit or implicit support of related entities |
| Even though we believe that the risk of a complete loss on some municipal obligations generally is lower than for corporate credits because some municipal bonds are backed by taxes or other pledged revenues, a single default by a municipality could have a significant impact on our liquidity or could result in a large or even complete loss that could have a material adverse effect on our business, financial condition and operating results |
| Our financial guaranty business is concentrated among relatively few major customers, meaning that our revenues could decline if we lose any significant customer |
| Our financial guaranty business derives a significant percentage of its annual gross premiums from a small number of customers |
| A loss of business from even one of our major customers could have a material adverse effect on our business, financial condition and operating results |
| In May 2004, Moody’s downgraded the financial strength rating of Radian Reinsurance Inc, our principal financial guaranty reinsurance subsidiary |
| As a result, one of the few primary insurer customers of our financial guaranty reinsurance business exercised its right, effective February 28, 2005, to recapture significant reinsurance ceded to us |
| After giving effect to this recapture, one single customer of our financial guaranty business accounted for over 19prca of the premiums written by our financial guaranty business in 2005 |
| The May 2004 downgrade followed an earlier downgrade by S&P of the same reinsurance subsidiary in October 2002 that resulted in the recapture by another of our customers of substantially all of the financial guaranty reinsurance business it had ceded to us |
| For more information regarding these downgrades, see “Ratings” in Item 1 |
| Further downgrades could trigger similar recapture rights in our other primary insurer customers, or we may lose a customer for other reasons, which could have a material adverse effect on our business, financial condition and operating results |
| Some of our financial guaranty products are riskier than traditional guaranties of public finance obligations |
| In addition to the traditional guaranties of public finance bonds, we write guaranties involving structured finance transactions that expose us to a variety of complex credit risks and indirectly to market, political and other risks beyond those that generally apply to financial guaranties of public finance obligations |
| We issue financial guaranties connected with certain asset-backed transactions and securitizations secured by one or a few classes of assets, such as residential mortgages, auto loans and leases, credit card receivables and other consumer assets, obligations under credit default swaps, both funded and synthetic, and in the past have issued financial guaranties covering utility mortgage bonds and multi-family housing bonds |
| We also have exposure to trade credit reinsurance (which is currently in run-off), which protects sellers of goods under certain circumstances against nonpayment of their accounts receivable |
| These guaranties expose us to the risk of buyer nonpayment, which could be triggered by many factors, including the failure of a buyer’s business |
| These guaranties may 68 ______________________________________________________________________ [110]Table of Contents cover receivables where the buyer and seller are in the same country as well as cross-border receivables |
| In the case of cross-border transactions, we sometimes grant coverage that effectively provides coverage to losses that could result from political risks, such as foreign currency controls and expropriation, which could interfere with the payment from the buyer |
| Losses associated with these non-public finance financial guaranty products are difficult to predict accurately, and a failure to properly anticipate those losses could have a material adverse effect on our business, financial condition and operating results |
| We may be forced to reinsure greater risks than we desire due to adverse selection by ceding companies |
| A portion of our financial guaranty reinsurance business is written under treaties that generally give the ceding company some ability to select the risks that they cede to us within the terms of the treaty |
| There is a risk under these treaties that the ceding companies will decide to cede to us exposures that have higher rating agency capital charges or that the ceding companies expect to be less profitable, which could have a material adverse effect on our business, financial condition and operating results |
| We attempt to mitigate this risk in a number of ways, including requiring ceding companies to retain a specified minimum percentage on a pro-rata basis of the ceded business, but we cannot be certain that our mitigation attempts will succeed |
| Our financial guaranty business faces intense competition |
| The financial guaranty industry is highly competitive |
| The principal sources of direct and indirect competition are: • other financial guaranty insurance companies; • multiline insurers that have increased their participation in financial guaranty reinsurance, some of which have formed strategic alliances with some of the US primary financial guaranty insurers; • other forms of credit enhancement, including letters of credit, guaranties and credit default swaps provided in most cases by foreign and domestic banks and other financial institutions, some of which are governmental enterprises, that have been assigned the highest ratings awarded by one or more of the major rating agencies or have agreed to post collateral to support their risk position; • alternate transaction structures that permit issuers to securitize assets more cost-effectively without the need for credit enhancement of the types we provide; and • cash-rich investors seeking additional yield on their investments by foregoing credit enhancement |
| Competition in the financial guaranty reinsurance business is based on many factors, including overall financial strength, financial strength ratings, pricing and service |
| The rating agencies allow credit to a ceding company’s capital requirements and single risk limits for reinsurance that is ceded |
| The amount of this credit is in part determined by the financial strength rating of the reinsurer |
| Some of our competitors have greater financial resources than we have and are better capitalized than we are and/or have been assigned higher ratings by one or more of the major rating agencies |
| In addition, the rating agencies could change the level of credit they will allow a ceding company to take for amounts ceded to us and/or similarly rated reinsurers |
| In 2004, the laws applicable to New York-domiciled monoline financial guarantors were amended to permit them to use certain default swaps meeting applicable requirements as statutory collateral (ie, to offset their statutory single risk limits, aggregate risk limits, aggregate net liability calculations and contingency reserve requirements) |
| This regulatory change, which makes credit default swaps a more attractive alternative to traditional financial guaranty reinsurance, may result in a reduced demand for traditional monoline financial guaranty reinsurance in the future |
| An inability to compete for desirable financial guaranty business could have a material adverse effect on our business, financial condition and operating results |
| Legislation and regulatory changes and interpretations could harm our financial guaranty business |
| The laws and regulations affecting the municipal, asset-backed and trade credit debt markets, as well as other governmental regulations, could be changed in ways that subject us to additional legal liability or affect the 69 ______________________________________________________________________ [111]Table of Contents demand for the primary financial guaranty insurance and reinsurance that we provide |
| Any such change could have a material adverse effect on our business, financial condition and operating results |
| Changes in tax laws could reduce the demand for or profitability of financial guaranty insurance, which could harm our business |
| Any material change in the US tax treatment of municipal securities, or the imposition of a “flat tax” or a national sales tax in lieu of the current federal income tax structure in the United States, could adversely affect the market for municipal obligations and, consequently, reduce the demand for related financial guaranty insurance and reinsurance |
| For example, the Jobs and Growth Tax Relief Reconciliation Act of 2003, enacted in May 2003, significantly reduced the federal income tax rate for individuals on dividends and long-term capital gains |
| This tax change may reduce demand for municipal obligations and, in turn, may reduce the demand for financial guaranty insurance and reinsurance of these obligations by increasing the comparative yield on dividend-paying equity securities |
| Future potential changes in US tax laws, including current efforts to eliminate the federal income tax on dividends, might also affect demand for municipal obligations and for financial guaranty insurance and reinsurance of those obligations |
| We may be unable to develop or sustain our financial guaranty business if it cannot obtain reinsurance or other forms of capital |
| In order to comply with regulatory, rating agency and internal capital and single risk retention limits as our financial guaranty business grows, we need access to sufficient reinsurance or other capital capacity to underwrite transactions |
| The market for reinsurance recently has become more concentrated because several participants have exited the industry |
| If we are unable to obtain sufficient reinsurance or other forms of capital, we may be unable to issue new policies and grow our financial guaranty business |