Financial Guaranty Contracts Accounted for as Credit Derivatives

9 Months Ended

Sep. 30, 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

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. Until the Company ceased selling credit protection through credit derivative contracts in the beginning of 2009, following the issuance of regulatory guidelines that limited the terms under which the credit protection could be sold, management considered these agreements to be a normal part of its financial guaranty business. The potential capital or margin requirements that may apply under the Dodd-Frank Wall Street Reform and Consumer Protection Act contributed to the decision of the Company not to sell new credit protection through CDS in the foreseeable future.

Credit derivative transactions are governed by ISDA documentation and have different characteristics from financial guaranty insurance contracts. 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 insurance contract. In addition, while the Company’s exposure under credit derivatives, like the Company’s exposure under financial guaranty insurance contracts, 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. 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. 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. The Company may not unilaterally terminate a CDS contract; however, the Company has mutually agreed with various counterparties to terminate certain CDS transactions. See “Net Change in Fair Value of Credit Derivatives.”

Credit Derivative Net Par Outstanding by Sector

The estimated remaining weighted average life of credit derivatives was 4.5 years at September 30, 2011 and 4.9 years at December 31, 2010. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives Net Par Outstanding

	As of September 30, 2011							As of December 31, 2010
Asset Type	Net Par Outstanding		Original Subordination (1)		Current Subordination (1)		Weighted Average Credit Rating	Net Par Outstanding		Original Subordination (1)		Current Subordination (1)		Weighted Average Credit Rating
	(dollars in millions)
Pooled corporate obligations:
Collateralized loan obligations/Collateralized bond obligations	$	36,983	32.7	%	32.1	%	AAA	$	45,953	32.2	%	30.4	%	AAA
Synthetic investment grade pooled corporate	13,379		19.8		18.4		AAA	14,905		19.2		17.6		AAA
Synthetic high-yield pooled corporate	6,027		35.6		30.5		AAA	8,249		39.4		34.6		AA+
Trust preferred securities collateralized debt obligations	4,613		46.6		31.8		BB+	5,757		46.8		32.0		BB+
Market value collateralized debt obligations of corporate obligations	5,234		32.1		25.0		AAA	5,069		36.0		42.9		AAA
Total pooled corporate obligations	66,236		31.3		28.6		AAA	79,933		31.7		29.3		AAA
U.S. RMBS:
Option ARM and Alt-A first lien	4,251		19.6		13.0		B+	4,767		19.7		17.0		B+
Subprime first lien (including net interest margin)	4,132		30.1		54.0		A+	4,460		27.9		50.4		A+
Prime first lien	410		10.9		9.1		B	468		10.9		10.3		B
Closed-end second lien and HELOCs(2)	65		—		—		B	81		—		—		B
Total U.S. RMBS	8,858		24.0		31.7		BBB-	9,776		23.1		32.4		BBB-
CMBS	4,480		33.9		40.1		AAA	6,751		29.8		31.3		AAA
Other	11,130		—		—		A	13,311		—		—		A+
Total	$	90,704					AA+	$	109,771					AA+

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

(2) 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 undercollateralized, 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 undercollateralization 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 issued by bank holding companies and similar instruments issued by insurance companies, real estate investment trusts and other real estate related issuers 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. In June 2011, approximately $837.8 million of CDS written on TruPS CDOs were converted to financial guaranty policies.

The Company’s exposure to “Other” CDS contracts is also highly diversified. It includes $3.4 billion of exposure to three pooled infrastructure transactions comprising 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 $7.7 billion of exposure in “Other” CDS contracts comprises 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 credit derivatives portfolio.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating

	September 30, 2011				December 31, 2010
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
Super Senior	$	23,744	26.2	%	$	29,344	26.7	%
AAA	43,350		47.8		50,214		45.7
AA	4,361		4.8		8,138		7.4
A	6,312		7.0		7,405		6.7
BBB	4,784		5.2		6,312		5.8
BIG	8,153		9.0		8,358		7.7
Total credit derivative net par outstanding	$	90,704	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

	September 30, 2011							Net Change inUnrealized Gain (Loss)
Vintage	Net Par Outstanding (in millions)		Original Subordination(1)		Current Subordination(1)		Weighted Average Credit Internal Rating	Third Quarter2011		Nine Months2011
								(in millions)
2004 and Prior	$	149	6.2	%	19.4	%	A-	$	2.5	$	(0.5	)
2005	2,623		30.4		64.5		AA	14.1		(3.1		)
2006	1,660		29.3		35.4		BBB+	104.0		3.0
2007	4,426		18.6		10.5		B	879.0		658.3
Total	$	8,858	24.0	%	31.7	%	BBB-	$	999.6	$	657.7

(1) Represents the sum of subordinate tranches and overcollateralization 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

	September 30, 2011							Net Change inUnrealized Gain (Loss)
Vintage	Net Par Outstanding (in millions)		Original Subordination(1)		Current Subordination(1)		Weighted Average Credit Internal Rating	Third Quarter2011			Nine Months 2011
								(in millions)
2004 and Prior	$	211	29.8	%	57.4	%	AAA	$	0.2		$	—
2005	676		17.8		31.2		AAA	(0.1		)	(0.1		)
2006	2,178		33.6		38.8		AAA	0.7			11.6
2007	1,415		42.6		43.8		AAA	(1.0		)	(1.2		)
Total	$	4,480	33.9	%	40.1	%	AAA	$	(0.2	)	$	10.3

(1) Represents the sum of subordinate tranches and overcollateralization 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)

	Third Quarter						Nine Months
	2011			2010			2011			2010
	(in millions)
Net credit derivative premiums received and receivable	$	40.6		$	49.8		$	147.8		$	154.2
Net ceding commissions (paid and payable) received and receivable	0.7			0.9			2.9			2.9
Realized gains on credit derivatives	41.3			50.7			150.7			157.1
Termination losses	—			—			(22.5		)	—
Net credit derivative losses (paid and payable) recovered and recoverable	(40.8		)	1.7			(103.1		)	(39.6		)
Total realized gains and other settlements on credit derivatives	0.5			52.4			25.1			117.5
Net unrealized gains (losses) on credit derivatives	1,155.5			(276.4		)	829.8			10.8
Net change in fair value of credit derivatives	$	1,156.0		$	(224.0	)	$	854.9		$	128.3

In Third Quarter 2011 and Nine Months 2011, CDS contracts totaling $1.8 billion and $9.5 billion, respectively, in net par were terminated. Credit derivative revenues included $2.6 million in Third Quarter 2011 and $24.2 million in Nine Months 2011, which represent the acceleration of future premium revenues for the terminated CDS and are included in the table above in the “net credit derivative premiums received and receivable” line item. In addition, the Company paid $22.5 million to terminate several CMBS CDS transactions in the Second Quarter 2011 which carried high rating agency capital charges. 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. 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

	Third Quarter						Nine Months
Asset Type	2011			2010			2011			2010
	(in millions)
Pooled corporate obligations:
CLOs/Collateralized bond obligations	$	13.1		$	(1.4	)	$	11.5		$	1.9
Synthetic investment grade pooled corporate	0.8			0.3			10.5			(3.7		)
Synthetic high-yield pooled corporate	(1.3		)	(2.9		)	(0.6		)	11.6
TruPS CDOs	82.5			(11.6		)	46.2			53.6
Market value CDOs of corporate obligations	5.1			(0.4		)	(0.2		)	(0.1		)
Total pooled corporate obligations	100.2			(16.0		)	67.4			63.3
U.S. RMBS:
Option ARM and Alt-A first lien	780.8			(205.1		)	541.3			(44.6		)
Subprime first lien (including net interest margin)	108.6			(8.1		)	17.3			(7.2		)
Prime first lien	101.9			(17.2		)	89.7			2.2
Closed-end second lien and HELOCs	8.3			1.6			9.4			(4.3		)
Total U.S. RMBS	999.6			(228.8		)	657.7			(53.9		)
CMBS	(0.2		)	0.4			10.3			10.2
Other(1)	55.9			(32.0		)	94.4			(8.8		)
Total	$	1,155.5		$	(276.4	)	$	829.8		10.8

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

Components of Credit Derivative Assets (Liabilities)

	As of September 30, 2011			As of December 31, 2010
	(in millions)
				(restated)
Credit derivative assets	$	467.2		$	592.9
Credit derivative liabilities	(1,495.3		)	(2,462.8		)
Net fair value of credit derivatives	(1,028.1		)	(1,869.9		)
Less: Effect of AGC and AGM credit spreads	4,938.6			3,669.4
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(5,966.7	)	$	(5,539.3	)

Net Fair Value and Expected Losses of Credit Derivatives by Sector

As of September 30, 2011

Asset Type	Credit Derivative Asset (Liability), net			Present Value of Expected Claim (Payments) Recoveries(2)
	(in millions)
Pooled corporate obligations:
CLOs/ Collateralized bond obligations	$	0.2		$	—
Synthetic investment grade pooled corporate	(29.0		)	—
Synthetic high-yield pooled corporate	(15.3		)	(6.1		)
TruPS CDOs	20.3			(72.6		)
Market value CDOs of corporate obligations	3.2			—
Total pooled corporate obligations	(20.6		)	(78.7		)
U.S. RMBS:
Option ARM and Alt-A first lien	(354.9		)	(219.3		)
Subprime first lien (including net interest margin)	(29.6		)	(113.8		)
Prime first lien	(1.5		)	—
Closed-end second lien and HELOCs	(16.0		)	5.7
Total U.S. RMBS	(402.0		)	(327.4		)
CMBS	(4.8		)	—
Other(1)	(600.7		)	(102.4		)
Total	$	(1,028.1	)	$	(508.5	)

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

(2) Represents amount in excess of the present value of future installment fees to be received of $37.2 million. Includes R&W on credit derivatives of $213.0 million.

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. 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.

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.

In Third Quarter 2011, U.S. RMBS unrealized fair value gains were generated primarily in the prime first lien, Alt-A, Option ARM and subprime RMBS sectors due to narrower implied net spreads. The narrower implied net spreads were primarily a result of the increased cost to buy protection in AGC’s name as the market cost of AGC’s credit protection increased. 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, which management refers to as the CDS spread on AGC, increased the implied spreads that the Company would expect to receive on these transactions decreased. The cost of AGM’s credit protection also increased during the quarter, but did not lead to significant fair value gains, as the majority of AGM policies continue to price at floor levels.

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 September 30, 2011	As of June 30, 2011	As of December 31, 2010	As of June 30, 2010	As of December 31, 2009
Quoted price of CDS contract (in basis points):
AGC	1,351	634	804	1,010	634
AGM	1,004	472	650	802	541

The fair value of CDS contracts at September 30, 2011, 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 September 30, 2011 compared with December 31, 2010, there was widening of spreads primarily relating to the Company’s Alt-A first lien and subprime RMBS transactions, as well as the Company’s trust-preferred securities. This widening of spreads resulted in a loss of approximately $439.4 million, before taking into account AGC’s 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 the current risk profile of the broader financial markets and to 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

AGC has $2.4 billion in CDS par insured that have rating triggers that allow the CDS counterparty to terminate in the case of a rating downgrade of AGC. 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 $2.4 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 September 30, 2011, and without giving effect to thresholds that apply at current ratings, the amount of par that is subject to collateral posting is approximately $15.4 billion, for which the Company has agreed to post approximately $774.3 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 $14.8 billion of that $15.4 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 $774.3 million that 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.