In another example of how often arcane accounting standards can obscure reality for everyday investors, besieged monoline insurer MBIA, Inc. (MBI) reported a surprise profit of $1.7 billion, or $7.14 per share, for the second quarter; but the profit was largely the result a $3.3 pre-tax paper gain tied to a substantial widening of credit default swap spreads on MBIA itself during the second quarter. In other words, as investors bid up risk premiums on MBIA's own debt in the wake of the company's downgrade by major credit rating agencies earlier in the quarter, the value of the company’s bond guarantees was similarly lowered — and that drop in fair-value of the company’s liabilities is allowed to be booked as a gain under an accounting standard known as SFAS 157. The same accounting artifact led Ambac Financial Group Inc. (ABK) to post a surprise profit as well when it reported its Q2 results earlier this week. Operating income at MBIA, excluding the impact of the accounting quirk, was $228.9 million during the second quarter, MBIA said, or $.96 per share. "It's phantom profit, mostly," said one analyst that spoke with HW. "They were able to record paper gains off of their own trouble." Profits were also helped by the insurer's decision not to add to existing loss reserves, a move that raised eyebrows among more than a few of HW's key sources. MBIA CEO Jay Brown justified the move by arguing that while the housing market's performance continues to deteriorate, performance during the quarter was within expectations. "While the deterioration in the housing and mortgage markets continued over the past three months, it has been consistent with what we projected when we established reserves and impairments for our housing-related portfolio in the first quarter," said Brown. "As such, we did not increase our loss reserves or credit derivative impairment estimates during the second quarter beyond our normal accretion adjustments and quarterly loss reserving formula." Credit trends hurt, nonetheless Paid claims skyrocketed during Q2, despite a lack of reserving activity. MBIA absorbed $304.8 million in paid claims during the second quarter, up sharply from $107.5 million in the first quarter of 2008. It's worth noting that while MBIA claimed that operating cash flow in the first six months was positive -- meaning that total cash inflows more than covered outflows tied to cash paid claims -- operating income was a negative $27 million in the second quarter. MBIA said the negative cash result in Q2 was tied to "timing of claims," which will remain to be seen as we move through the rest of the year; some of HW's sources suggested that paid claims will likely continue to rise throughout 2008, which may further hinder operating cash flow. MBIA held $1.4 billion in cash and other short-term liquid investments at the end of Q2, it said. In June, MBIA Insurance Corporation's financial strength ratings were downgraded from AAA to AA and placed on negative watch by Standard & Poor's Ratings Services, and to A2 with a Negative Outlook by Moody's Investors Service. The downgrades triggered collateral posting and cash termination payments totaling $7.5 billion, according to company estimates; MBIA said it has sold $4.3 billion of investments during the quarter to meet such requirements, at a loss of $306 million. The monoline will continue to sell assets as it looks to improve its liquidity profile, it said. That said, the monoline remains highly exposed to the RMBS segment, with direct RMBS exposure of $36.6 billion in net par outstanding at the end of the second quarter; $8.2 billion of that total is tied to home equity lines of credit, while another $9.6 billion in tied to closed-end second liens. That's nearly $18 billion in exposure to a sector of RMBS largely expected by analysts to crater over the next year. Looking at the investor presentation, it's pretty clear why: closed-end seconds have seen defaults increase nearly 100 percent between the end of last year to March alone, and have continued climbing since then, nearing a cumulative default rate of roughly 10 percent. HELOCs have seen CDRs head north of ten percent. Not surprisingly, the insurer said it is actively looking for ways to put loans back with major issuers, and said it "continues to evaluate potential recoveries and intends to pursue the aggressively." With paid claims swamping cash flow in Q2, we'd expect some pretty aggressive putback attempts in Q3 from the monoline. Related links: investor presentation Disclosure: No positions in MBI when story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.