Financial Guaranty Contracts Accounted for as Credit Derivatives

3 Months Ended

Mar. 31, 2011

Financial Guaranty Contracts Accounted for as Credit Derivatives

Financial Guaranty Contracts Accounted for as Credit Derivatives

7. Financial Guaranty Contracts Accounted for as Credit Derivatives

Credit Derivatives

The Company has a portfolio of financial guaranty contracts accounted for as derivatives (primarily CDS) that meet the definition of a derivative in accordance with GAAP. Management has considered these agreements to be a normal part of its financial guaranty business. A loss payment is made only upon the occurrence of one or more defined credit events with respect to the referenced securities or loans. A credit event may be a non-payment event such as a failure to pay, bankruptcy or restructuring, as negotiated by the parties to the credit derivative transactions. Credit derivative transactions are governed by ISDA documentation and have some different characteristics from financial guaranty contracts accounted for as insurance. For example, the Company’s control rights with respect to a reference obligation under a credit derivative may be more limited than when the Company issues a financial guaranty contract accounted for as insurance. In addition, while the Company’s exposure under credit derivatives, like the Company’s exposure under financial guaranty contracts accounted for as insurance, has been generally for as long as the reference obligation remains outstanding, unlike financial guaranty contracts, a credit derivative may be terminated for a breach of the ISDA documentation or other specific events. If events of default or termination events specified in the credit derivative documentation were to occur, the non-defaulting or the non-affected party, which may be either the Company or the counterparty, depending upon the circumstances, may decide to terminate a credit derivative prior to maturity. The Company may be required to make a termination payment to its swap counterparty upon such termination.

Credit Derivative Net Par Outstanding by Sector

The estimated remaining weighted average life of credit derivatives was 4.8 years at March 31, 2011 and 4.9 years at December 31, 2010. The components of the Company’s credit derivative net par outstanding as of March 31, 2011 and December 31, 2010 are:

Net Par Outstanding on Credit Derivatives

	As of March 31, 2011							As of December 31, 2010
Asset Type	Original Subordination(1)		Current Subordination(1)		Net Par Outstanding		Weighted Average Credit Rating	Original Subordination(1)		Current Subordination(1)		Net Par Outstanding		Weighted Average Credit Rating
	(dollars in millions)
Pooled corporate obligations:
Collateralized loan obligations/Collateralized bond obligations	32.4	%	31.1	%	$	44,393	AAA	32.2	%	30.4	%	$	45,953	AAA
Synthetic investment grade pooled corporate(2)	19.2		17.5		15,164		AAA	19.2		17.6		14,905		AAA
Synthetic high yield pooled corporate	39.6		34.6		6,605		AAA	39.4		34.6		7,316		AAA
Trust preferred securities collateralized debt obligations	46.7		31.9		5,737		BB+	46.8		32.0		5,757		BB+
Market value collateralized debt obligations of corporate obligations	34.9		42.0		4,926		AAA	36.0		42.9		5,069		AAA
Total pooled corporate obligations	31.6		29.5		76,825		AAA	31.7		29.3		79,000		AAA
U.S. RMBS:
Option ARMs and Alt-A first lien	19.6		16.1		4,607		B	19.7		17.0		4,767		B+
Subprime first lien (including net interest margin)	30.0		53.9		4,307		A+	27.9		50.4		4,460		A+
Prime first lien	10.9		10.1		446		B	10.9		10.3		468		B
Closed end second lien and HELOCs(3)	—		—		71		B	—		—		81		B
Total U.S. RMBS	23.9		32.9		9,431		BBB-	23.1		32.4		9,776		BBB-
CMBS	30.8		34.9		6,534		AAA	29.8		31.3		6,751		AAA
Other	—		—		13,623		A	—		—		14,244		A+
Total					$	106,413	AA+					$	109,771	AA+

(1) Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses.

(2) Increase in net par outstanding in the synthetic investment grade pooled corporate sector is due principally to the reassumption of a previously ceded book of business.

(3) Many of the closed end second lien transactions insured by the Company have unique structures whereby the collateral may be written down for losses without a corresponding write-down of the obligations insured by the Company. Many of these transactions are currently under-collateralized, with the principal amount of collateral being less than the principal amount of the obligation insured by the Company. The Company is not required to pay principal shortfalls until legal maturity (rather than making timely principal payments), and takes the under- collateralization into account when estimating expected losses for these transactions.

The Company’s exposure to pooled corporate obligations is highly diversified in terms of obligors and, except in the case of collateralized debt obligations backed by trust preferred securities (“TruPS CDOs”), industries. Most pooled corporate transactions are structured to limit exposure to any given obligor and industry. The majority of the Company’s pooled corporate exposure consists of collateralized loan obligations (“CLOs”) or synthetic pooled corporate obligations. Most of these CLOs have an average obligor size of less than 1% of the total transaction and typically restrict the maximum exposure to any one industry to approximately 10%. The Company’s exposure also benefits from embedded credit enhancement in the transactions which allows a transaction to sustain a certain level of losses in the underlying collateral, further insulating the Company from industry specific concentrations of credit risk on these deals.

The Company’s TruPS CDO asset pools are generally less diversified by obligors and industries than the typical CLO asset pool. Also, the underlying collateral in TruPS CDOs consists primarily of subordinated debt instruments such as TruPS CDOs issued by banks, real estate investment trusts and insurance companies, while CLOs typically contain primarily senior secured obligations. Finally, TruPS CDOs typically contain interest rate hedges that may complicate the cash flows. However, to mitigate these risks TruPS CDOs were typically structured with higher levels of embedded credit enhancement than typical CLOs.

The Company’s exposure to “Other” CDS contracts is also highly diversified. It includes $3.5 billion of exposure to three pooled infrastructure transactions comprised of diversified pools of international infrastructure project transactions and loans to regulated utilities. These pools were all structured with underlying credit enhancement sufficient for the Company to attach at super senior AAA levels. The remaining $10.1 billion of exposure in “Other” CDS contracts is comprised of numerous deals typically structured with significant underlying credit enhancement and spread across various asset classes, such as commercial receivables, international RMBS securities, infrastructure, regulated utilities and consumer receivables.

The following table summarizes net par outstanding by rating of the Company’s credit derivatives portfolio as of March 31, 2011 and December 31, 2010.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating

	March 31, 2011				December 31, 2010
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
Super Senior	$	29,947	28.1	%	$	29,344	26.7	%
AAA	46,921		44.1		50,214		45.7
AA	7,763		7.3		8,138		7.4
A	6,823		6.4		7,405		6.7
BBB	6,127		5.8		6,312		5.8
BIG	8,832		8.3		8,358		7.7
Total credit derivative net par outstanding	$	106,413	100.0	%	$	109,771	100.0	%

The following tables present details about the Company’s U.S. RMBS CDS by vintage.

U.S. Residential Mortgage-Backed Securities

	March 31, 2011							First Quarter
Vintage	Original Subordination(1)		Current Subordination(1)		Net Par Outstanding (in millions)		Weighted Average Credit Internal Rating	2011 Net Change in Unrealized Gain (Loss) (in millions)
								(restated)
2004 and Prior	6.2	%	19.8	%	$	160	A-	$	(3.3	)
2005	30.3		63.6		2,790		AA	(19.1		)
2006	29.0		35.4		1,720		BBB	(40.7		)
2007	18.6		13.7		4,761		B	(227.7		)
Total	23.9	%	32.9	%	$	9,431	BBB-	$	(290.8	)

(1) Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses.

The following table presents additional details about the Company’s CMBS transactions by vintage:

Commercial Mortgage-Backed Securities

	March 31, 2011							First Quarter
Vintage	Original Subordination(1)		Current Subordination(1)		Net Par Outstanding (in millions)		Weighted Average Credit Internal Rating	2011 Net Change in Unrealized Gain (Loss) (in millions)
2004 and Prior	29.2	%	45.6	%	$	307	AAA	$	(0.1	)
2005	17.8		26.5		678		AAA	—
2006	29.0		32.6		4,134		AAA	0.6
2007	42.6		43.4		1,415		AAA	0.2
Total	30.8	%	34.9	%	$	6,534	AAA	$	0.7

(1) Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses.

Net Change in Fair Value of Credit Derivatives

The following table disaggregates the components of net change in fair value of credit derivatives.

Net Change in Fair Value of Credit Derivatives Gain (Loss)

	First Quarter
	2011			2010
	(in millions)
	(restated)
Net credit derivative premiums received and receivable	$	59.6		$	53.7
Net ceding commissions (paid and payable) received and receivable	1.4			1.0
Realized gains on credit derivatives	61.0			54.7
Net credit derivative losses (paid and payable) recovered and recoverable	(25.6		)	(28.0		)
Total realized gains and other settlements on credit derivatives	35.4			26.7
Total unrealized gains (losses) on credit derivatives	(271.6		)	252.1
Net change in fair value of credit derivatives	$	(236.2	)	$	278.8

In First Quarter 2011, CDS contracts totaling $2.6 billion in net par were terminated for total net payments to the Company of $15.5 million. Changes in the fair value of credit derivatives occur primarily because of changes in interest rates, credit spreads, credit ratings of the referenced entities, realized gains and other settlements, and the issuing company’s own credit rating, credit spreads and other market factors. Except for estimated credit impairments (i.e., net expected payments), the unrealized gains and losses on credit derivatives is expected to reduce to zero as the exposure approaches its maturity date. During First Quarter 2011 and 2010, the Company made $13.0 million and $28.0 million in claim payments on credit derivatives, respectively. With considerable volatility continuing in the market, unrealized gains (losses) on credit derivatives may fluctuate significantly in future periods.

Net Change in Unrealized Gains (Losses) on Credit Derivatives

By Sector

	First Quarter
Asset Type	2011			2010
	(in millions)
	(restated)
Financial Guaranty:
Pooled corporate obligations:
CLOs/Collateralized bond obligations	$	2.0		$	1.5
Synthetic investment grade pooled corporate	10.5			(7.6		)
Synthetic high yield pooled corporate	(2.8		)	20.4
TruPS CDOs	(20.8		)	29.7
Market value CDOs of corporate obligations	(0.1		)	0.4
Total pooled corporate obligations	(11.2		)	44.4
U.S. RMBS:
Option ARMs and Alt-A first lien	(267.6		)	150.9
Subprime first lien (including net interest margin)	(24.1		)	0.6
Prime first lien	0.6			14.2
Closed end second lien and HELOCs	0.3			8.4
Total U.S. RMBS	(290.8		)	174.1
CMBS	0.7			9.5
Other(1)	29.7			24.1
Total financial guaranty	$	(271.6	)	$	252.1

(1) “Other” includes all other U.S. and international asset classes, such as commercial receivables, international infrastructure, international RMBS securities, and pooled infrastructure securities.

Net Position of Credit Derivatives by Sector

As of March 31, 2011

Asset Type	Credit Derivative Asset (Liability), net			Present Value of Expected Claim Payments
	(in millions)
	(restated)
Pooled corporate obligations:
CLOs/ Collateralized bond obligations	$	(9.8	)	$	—
Synthetic investment grade pooled corporate	(29.1		)	—
Synthetic high yield pooled corporate	(18.7		)	(9.4		)
TruPS CDOs	(46.8		)	(65.0		)
Market value CDOs of corporate obligations	3.1			—
Total pooled corporate obligations	(101.3		)	(74.4		)
U.S. RMBS:
Option ARMs and Alt-A first lien	(1,182.9		)	(275.3		)
Subprime first lien (including net interest margin)	(51.8		)	(139.5		)
Prime first lien	(90.6		)	—
Closed end second lien and HELOCs	(25.2		)	1.3
Total U.S. RMBS	(1,350.5		)	(413.5		)
CMBS	(14.3		)	—
Other(1)	(673.9		)	(87.4		)
Total	$	(2,140.0	)	$	(575.3	)

(1) “Other” includes all other U.S. and international asset classes, such as commercial receivables, international infrastructure, international RMBS securities, and pooled infrastructure securities.

One of the key assumptions of the Company’s internally developed model is gross spread and how that gross spread is allocated.

Gross spread is the difference between the yield of a security paid by an issuer on an insured versus uninsured basis or, in the case of a CDS transaction, the difference between the yield and an index such as the London Interbank Offered Rate (“LIBOR”). Such pricing is well established by historical financial guaranty fees relative to capital market spreads as observed and executed in competitive markets, including in financial guaranty reinsurance and secondary market transactions. Gross spread on a financial guaranty accounted for as CDS is allocated among:

1. the profit the originator, usually an investment bank, realizes for putting the deal together and funding the transaction (“bank profit”);

2. premiums paid to the Company for the Company’s credit protection provided (“net spread”); and

3. the cost of CDS protection purchased on the Company by the originator to hedge their counterparty credit risk exposure to the Company (“hedge cost”).

The premium the Company receives is referred to as the “net spread.” The Company’s own credit risk is factored into the determination of net spread based on the impact of changes in the quoted market price for credit protection bought on the Company, as reflected by quoted market prices on CDS referencing AGC or AGM. The cost to acquire CDS protection referencing AGC or AGM affects the amount of spread on CDS deals that the Company retains and, hence, their fair value. As the cost to acquire CDS protection referencing AGC or AGM increases, the amount of premium the Company retains on a deal generally decreases. As the cost to acquire CDS protection referencing AGC or AGM decreases, the amount of premium the Company retains on a deal generally increases. In the Company’s valuation model, the premium the Company captures is not permitted to go below the minimum rate that the Company would currently charge to assume similar risks. This assumption can have the effect of mitigating the amount of unrealized gains that are recognized on certain CDS contracts.

The Company determines the fair value of its CDS contracts by applying the difference between the current net spread and the contractual net spread for the remaining duration of each contract to the notional value of its CDS contracts. To the extent available, actual transactions executed in the market during the accounting period are used to validate the model results and to explain the correlation between various market indices and indicative CDS market prices.

The Company’s fair value model inputs are gross spread, credit spreads on risks assumed and credit spreads on the Company’s name. Gross spread is an input into the Company’s fair value model that is used to ultimately determine the net spread a comparable financial guarantor would charge the Company to transfer risk at the reporting date. The Company’s estimate of the fair value represents the difference between the estimated present value of premiums that a comparable financial guarantor would accept to assume the risk from the Company on the current reporting date, on terms identical to the original contracts written by the Company and the contractual premium for each individual credit derivative contract. Gross spread was an observable input that the Company historically obtained for deals it had closed or bid on in the market place prior to the credit crisis. The Company uses these historical gross spreads as a reference point to estimate fair value in current reporting periods.

The Company’s model does not permit the premium to go below the minimum amount the Company would currently charge to assume similar risks. Given the current market conditions and the Company’s own credit spreads, the fair value of the Company’s CDS contracts are calculated using this minimum premium.

With respect to CDS transactions for which there is an expected claim payment within the next twelve months, the allocation of gross spreads was revised in First Quarter 2011 to reflect a higher allocation to the cost of credit rather than the bank profit component. In the current market, it is assumed that a bank would be willing to accept a lower profit on distressed transactions in order to remove these transactions from its financial statements. The effect of this refinement in assumptions was an increase in fair value losses of $260.4 million and was concentrated in the Alt-A first lien and Option ARMs.

In First Quarter 2011, U.S. RMBS unrealized fair value losses were generated primarily in the Option ARM, Alt-A first lien, and Subprime RMBS sectors due to wider implied net spreads. The wider implied net spreads were a result of price deterioration as well as the decreased cost to buy protection in AGC’s name as the market cost of AGC’s credit protection declined. These transactions were pricing above their floor levels (or the minimum rate at which the Company would consider assuming these risks based on historical experience); therefore when the cost of purchasing CDS protection on AGC declined, which management refers to as the CDS spread on AGC, the implied spreads that the Company would expect to receive on these transactions increased. The cost of AGM’s credit protection remained relatively flat during the quarter. The unrealized fair value gain within the Other asset class resulted from price improvement on a XXX life-securitization policy within the quarter.

The First Quarter 2010 unrealized gain on credit derivatives was primarily due to the increased cost to buy protection in AGC’s name as the market cost of AGC’s credit protection increased. This led to lower implied premiums on several Subprime RMBS and TruPS transactions.

The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structural terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative contracts also reflects the change in the Company’s own credit cost based on the price to purchase credit protection on AGC and AGM. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date. Generally, a widening of the CDS prices traded on AGC and AGM has an effect of offsetting unrealized losses that result from widening general market credit spreads, while a narrowing of the CDS prices traded on AGC and AGM has an effect of offsetting unrealized gains that result from narrowing general market credit spreads. An overall narrowing of spreads generally results in an unrealized gain on credit derivatives for the Company and an overall widening of spreads generally results in an unrealized loss for the Company.

Effect of the Company’s Credit Spread on Credit Derivatives Fair Value

	As of March 31, 2011			As of December 31, 2010			As of March 31, 2010			As of December 31, 2009
	(dollars in millions)
	(restated)			(restated)
Quoted price of CDS contract (in basis points):
AGC	724			804			734			634
AGM	660			650			468			541
Fair value gain (loss) of credit derivatives:
Before considering implication of the Company’s credit spreads	$	(5,578.8	)	$	(5,539.3	)	$	(5,253.5	)	$	(5,830.8	)
After considering implication of the Company’s credit spreads	$	(2,140.0	)	$	(1,869.9	)	$	(1,284.9	)	$	(1,542.1	)

Components of Credit Derivative Assets (Liabilities)

	As of March 31, 2011			As of December 31, 2010
	(in millions)
	(restated)			(restated)
Credit derivative assets	$	619.3		$	592.9
Credit derivative liabilities	(2,759.3		)	(2,462.8		)
Net fair value of credit derivatives	$	(2,140.0	)	$	(1,869.9	)

The $5.6 billion liability as of March 31, 2011, which represents the fair value of CDS contracts before considering the implications of AGC’s and AGM’s credit spreads, is a direct result of continued wide credit spreads in the fixed income security markets, and ratings downgrades. The asset classes that remain most affected are recent vintages of Subprime RMBS and Alt-A first lien deals, as well as trust-preferred securities. When looking at March 31, 2011 compared to December 31, 2010, there was a widening of spreads relating to the Company’s Alt-A first lien and Subprime RMBS transactions, which was substantially offset by a narrowing of spreads in the Company’s pooled corporate obligation asset classes as well as for policies guaranteeing XXX life securitization transactions included in the Company’s Other asset class. These price movements during the quarter resulted in a loss of approximately $39.5 million before taking into account AGC or AGM’s credit spreads.

Management believes that the trading level of AGC’s and AGM’s credit spreads are due to the correlation between AGC’s and AGM’s risk profile and that experienced currently by the broader financial markets and increased demand for credit protection against AGC and AGM as the result of its financial guaranty volume as well as the overall lack of liquidity in the CDS market. Offsetting the benefit attributable to AGC’s and AGM’s credit spread were declines in fixed income security market prices primarily attributable to widening spreads in certain markets as a result of the continued deterioration in credit markets and some credit rating downgrades. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the high yield CDO and CLO markets as well as continuing market concerns over the most recent vintages of subprime RMBS.

Ratings Sensitivities of Credit Derivative Contracts

The Company has $2.8 billion in CDS par insured that have rating triggers that allow the CDS counterparty to terminate in the case of a rating downgrade. If the ratings of AGC were reduced below certain levels and the Company’s counterparty elected to terminate the CDS, the Company could be required to make a termination payment on certain of its credit derivative contracts, as determined under the relevant documentation. Under certain documents, the Company may have the right to cure the termination event by posting collateral, assigning its rights and obligations in respect of the transactions to a third party or seeking a third party guaranty of the obligations of the Company. The Company currently has three ISDA master agreements under which the applicable counterparty could elect to terminate transactions upon a rating downgrade of AGC: if AGC’s ratings were downgraded to BBB- or Baa3, $89 million in par insured could be terminated by one counterparty; and if AGC’s ratings were downgraded to BB+ or Ba1, approximately $2.7 billion in par insured could be terminated by the other two counterparties. The Company does not believe that it can accurately estimate the termination payments it could be required to make if, as a result of any such downgrade, a CDS counterparty terminated its CDS contracts with the Company. These payments could have a material adverse effect on the Company’s liquidity and financial condition.

Under a limited number of other CDS contracts, the Company may be required to post eligible securities as collateral—generally cash or U.S. government or agency securities. For certain of such contracts, this requirement is based on a mark-to-market valuation, as determined under the relevant documentation, in excess of contractual thresholds that decline or are eliminated if the ratings of certain of the Company’s insurance subsidiaries decline. Under other contracts, the Company has negotiated caps such that the posting requirement cannot exceed a certain amount. As of March 31, 2011, and without giving effect to thresholds that apply at current ratings, the amount of par that is subject to collateral posting is approximately $18.2 billion, for which the Company has agreed to post approximately $765.6 million of collateral. The Company may be required to post additional collateral from time to time, depending on its ratings and on the market values of the transactions subject to the collateral posting. Counterparties have agreed that for approximately $17.6 billion of that $18.2 billion, the maximum amount that the Company could be required to post is capped at $635 million at current rating levels (which amount is included in the $765.6 million as to which the Company has agreed to post). Such cap increases by $50 million to $685 million in the event AGC’s ratings are downgraded to A+ or A3.