Financial Guaranty Contracts Accounted for as Credit Derivatives

3 Months Ended

Mar. 31, 2012

Financial Guaranty Contracts Accounted for as Credit Derivatives

Financial Guaranty Contracts Accounted for as Credit Derivatives

6. Financial Guaranty Contracts Accounted for as Credit Derivatives

The Company has a portfolio of financial guaranty contracts that meet the definition of a derivative in accordance with GAAP (primarily CDS). 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.

Credit Derivative Net Par Outstanding by Sector

The estimated remaining weighted average life of credit derivatives was 4.0 years at March 31, 2012 and 4.3 years at December 31, 2011. In First Quarter 2012, CDS contracts totaling $0.2 billion in net par were terminated. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives Net Par Outstanding

	As of March 31, 2012							As of December 31, 2011
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 obligation/collateral bond obligations	$	34,272	33.0	%	32.2	%	AAA	$	34,567	32.6	%	32.0	%	AAA
Synthetic investment grade pooled corporate	11,521		20.8		19.0		AAA	12,393		20.4		18.7		AAA
Synthetic high yield pooled corporate	5,077		35.7		29.8		AA+	5,049		35.7		30.3		AA+
TruPS CDOs	4,475		46.5		31.6		BB	4,518		46.6		31.9		BB
Market value CDOs of corporate obligations	4,122		34.9		30.1		AAA	4,546		30.6		28.9		AAA
Total pooled corporate obligations	59,467		32.0		29.3		AAA	61,073		31.2		28.9		AAA
U.S. RMBS:
Option ARM and Alt-A first lien	3,953		19.2		12.8		BB	4,060		19.6		13.6		BB-
Subprime first lien (including net interest margin)	3,925		29.4		53.6		A+	4,012		30.1		53.9		A+
Prime first lien	382		10.9		7.9		B	398		10.9		8.4		B
Closed end second lien and HELOCs	59		—		—		B	62		—		—		B
Total U.S. RMBS	8,319		23.5		31.8		BBB	8,532		24.1		32.2		BBB
CMBS	4,410		33.5		40.3		AAA	4,612		32.6		38.9		AAA
Other	10,806		—		—		A	10,830		—		—		A
Total	$	83,002					AA+	$	85,047					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.

Except for TruPS CDOs, the Company’s exposure to pooled corporate obligations is highly diversified in terms of obligors and 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 obligation (“CLO”) 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, REITs and other real estate related issuers while CLOs typically contain primarily senior secured obligations. 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 $3.2 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 at origination. The remaining $7.6 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, infrastructure, regulated utilities and consumer receivables.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating

	As of March 31, 2012				As of December 31, 2011
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
Super Senior	$	20,787	25.0	%	$	21,802	25.6	%
AAA	40,099		48.3		40,240		47.3
AA	3,617		4.4		4,084		4.8
A	5,906		7.1		5,830		6.9
BBB	5,114		6.2		5,030		5.9
BIG	7,479		9.0		8,061		9.5
Total credit derivative net par outstanding	$	83,002	100.0	%	$	85,047	100.0	%

Credit Derivative

U.S. Residential Mortgage-Backed Securities

	As of March 31, 2012							First Quarter 2012
Vintage	Net Par Outstanding (in millions)		Original Subordination(1)		Current Subordination(1)		Weighted Average Credit Rating	Unrealized Gain (Loss) (in millions)
2004 and Prior	$	140	6.4	%	19.4	%	BBB+	$	(1.5	)
2005	2,444		30.6		65.3		AA	(5.7		)
2006	1,621		29.4		35.5		A-	(33.4		)
2007	4,114		17.5		10.8		BB-	(588.8		)
Total	$	8,319	23.5	%	31.8	%	BBB	$	(629.4	)

(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.

Credit Derivative

Commercial Mortgage-Backed Securities

	As of March 31, 2012							First Quarter 2012
Vintage	Net Par Outstanding (in millions)		Original Subordination(1)		Current Subordination(1)		Weighted Average Credit Rating	Unrealized Gain (Loss) (in millions)
2004 and Prior	$	144	28.2	%	59.2	%	AAA	$	(0.1	)
2005	672		17.9		33.9		AAA	(0.1		)
2006	2,104		33.9		39.8		AAA	0.5
2007	1,490		40.5		42.2		AAA	(0.1		)
Total	$	4,410	33.5	%	40.3	%	AAA	$	0.2

(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

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

	First Quarter
	2012			2011
	(in millions)
Net credit derivative premiums received and receivable	$	28.9		$	59.6
Net ceding commissions (paid and payable) received and receivable	(0.1		)	1.4
Realized gains on credit derivatives	28.8			61.0
Net credit derivative losses (paid and payable) recovered and recoverable	(85.7		)	(25.6		)
Total realized gains (losses) and other settlements on credit derivatives	(56.9		)	35.4
Net unrealized gains (losses) on credit derivatives	(633.8		)	(271.6		)
Net change in fair value of credit derivatives	$	(690.7	)	$	(236.2	)

Net credit derivative premiums received and receivable included $0.2 million in First Quarter 2012, which represents the acceleration of future premium revenues for terminated CDS. 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. The increase in paid losses was due primarily to claims paid on an insured film securitization.

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 (losses) 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 are 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

	First Quarter
Asset Type	2012			2011
	(in millions)
Pooled corporate obligations:
CLOs/Collateral bond obligations	$	7.3		$	2.0
Synthetic investment grade pooled corporate	1.6			10.5
Synthetic high yield pooled corporate	10.8			(2.8		)
TruPS CDOs	(13.8		)	(20.8		)
Market value CDOs of corporate obligations	(0.4		)	(0.1		)
Total pooled corporate obligations	5.5			(11.2		)
U.S. RMBS:
Option ARM and Alt-A first lien	(517.7		)	(267.6		)
Subprime first lien (including net interest margin)	(26.1		)	(24.1		)
Prime first lien	(86.1		)	0.6
Closed end second lien and HELOCs	0.5			0.3
Total U.S. RMBS	(629.4		)	(290.8		)
CMBS	0.2			0.7
Other	(10.1		)	29.7
Total	$	(633.8	)	$	(271.6	)

In First Quarter 2012, U.S. RMBS unrealized fair value losses were generated primarily in the Option ARM, Alt-A, prime first lien and subprime RMBS sectors due to wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s name as the market cost of AGC’s credit protection decreased. 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, decreased the implied spreads that the Company would expect to receive on these transactions increased. The cost of AGM’s credit protection also decreased during the quarter, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels.

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; 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 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.

Five-Year CDS Spread on AGC and AGM

	As of March 31, 2012	As ofDecember 31, 2011
Quoted price of CDS contract (in basis points):
AGC	743	1,140
AGM	555	778

Components of Credit Derivative Assets (Liabilities)

	As of March 31, 2012			As of December 31, 2011
	(in millions)
Credit derivative assets	$	463.6		$	468.9
Credit derivative liabilities	(2,416.3		)	(1,772.8		)
Net fair value of credit derivatives	$	(1,952.7	)	$	(1,303.9	)

	As of March 31, 2012			As of December 31, 2011
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(4,897.7	)	$	(5,595.8	)
Less: Effect of AGC and AGM credit spreads	(2,945.0		)	(4,291.9		)
Net fair value of credit derivatives	$	(1,952.7	)	$	(1,303.9	)

The fair value of CDS contracts at First Quarter 2012 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, 2012 compared with December 31, 2011, there was tightening 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 tightening of spreads resulted in a gain of approximately $698.1 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 higher credit spreads in the fixed income security markets. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the high yield CDO, Trust- Preferred CDO, and CLO markets as well as continuing market concerns over the most recent vintages of subprime RMBS.

The following table presents the fair value and the present value of expected claim payments or recoveries for contracts accounted for as derivatives.

Net Fair Value and Expected Losses of Credit Derivatives by Sector

	Fair Value of Credit Derivative Asset (Liability), net						Present Value of Expected Claim (Payments) Recoveries(1)
Asset Type	As ofMarch 31, 2012			As ofDecember 31, 2011			As ofMarch 31, 2012			As ofDecember 31, 2011
	(in millions)
Pooled corporate obligations:
CLOs/ Collateralized bond obligations	$	6.6		$	(0.7	)	$	—		$	—
Synthetic investment grade pooled corporate	(22.6		)	(23.8		)	—			—
Synthetic high-yield pooled corporate	(4.9		)	(15.7		)	(0.6		)	(5.2		)
TruPS CDOs	(25.8		)	(11.9		)	(38.1		)	(39.3		)
Market value CDOs of corporate obligations	2.3			2.5			—			—
Total pooled corporate obligations	(44.4		)	(49.6		)	(38.7		)	(44.5		)
U.S. RMBS:
Option ARM and Alt-A first lien(2)	(1,137.2		)	(596.4		)	(159.4		)	(191.2		)
Subprime first lien (including net interest margin)	(31.6		)	(22.5		)	(94.6		)	(94.9		)
Prime first lien	(130.4		)	(44.3		)	—			—
Closed-end second lien and HELOCs	(14.4		)	(14.9		)	12.8			6.6
Total U.S. RMBS	(1,313.6		)	(678.1		)	(241.2		)	(279.5		)
CMBS	(4.6		)	(4.9		)	—			—
Other	(590.1		)	(571.3		)	(96.3		)	(94.9		)
Total	$	(1,952.7	)	$	(1,303.9	)	$	(376.2	)	$	(418.9	)

(1)Represents amount in excess of the present value of future installment fees to be received of $54.4 million as of March 31, 2012 and $47.1 million as of December 31, 2011. Includes R&W on credit derivatives of $233.4 million as of March 31, 2012 and $215.0 million as of December 31, 2011.

(2)Includes one transaction which is covered under the Bank of America Agreement.

Ratings Sensitivities of Credit Derivative Contracts

Within the Company’s insured CDS portfolio, the transaction documentation for $2.3 billion in CDS par insured provides that if the financial strength rating of AGC were downgraded past a specified level (which level varies from transaction to transaction), would constitute a termination event that would allow the CDS counterparty to terminate the affected transactions. If the CDS counterparty elected to terminate the affected transactions, under some transaction documents the Company could be required to make a termination payment (or may be entitled to receive a termination payment from the CDS counterparty) and under other transaction documents the credit protection would be cancelled and no termination payment would be owing by either party. Under certain documents, the Company has 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 financial strength 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, an additional approximately $2.2 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 collateral to secure its obligation to make payments under such contracts. Eligible collateral is generally cash or U.S. government or agency securities; eligible collateral other than cash is valued at a discount to the face amount. For certain of such contracts, the CDS counterparty has agreed to have some exposure to the Company on an unsecured basis, but as the financial strength ratings of the Company’s insurance subsidiaries decline, the amount of unsecured exposure to the Company allowed by the CDS counterparty decreases until, at a specified rating level (which level varies from transaction to transaction), the Company must collateralize all of the exposure. The amount of collateral required is based on a mark-to-market valuation of the exposure that must be secured. Under other contracts, the Company has negotiated caps such that the posting requirement cannot exceed a certain fixed amount, regardless of the financial strength ratings of the Company’s insurance subsidiaries. As of March 31, 2012 the amount of insured par that is subject to collateral posting is approximately $14.6 billion (which amount is not reduced by unsecured exposure to the Company allowed by CDS counterparties at current financial strength rating levels), for which the Company has agreed to post approximately $678.2 million of collateral (which amount reflects some of the eligible collateral being valued at a discount to the face amount). The Company may be required to post additional collateral from time to time, depending on its financial strength ratings and on the market values of the transactions subject to the collateral posting. For approximately $14.1 billion of that $14.6 billion, at the Company’s current ratings, the Company need not post on a cash basis more than $625 million, regardless of any change in the market value of the transactions, due to caps negotiated with counterparties. For the avoidance of doubt, the $625 million is already included in the $678.2 million that the Company has agreed to post. In the event AGC’s ratings are downgraded to A+ or A3, the maximum amount to be posted against the $14.1 billion increases by $50 million to $675 million.

Sensitivity to Changes in Credit Spread

The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming immediate parallel shifts in credit spreads on AGC and AGM and on the risks that they both assume.

Effect of Changes in Credit Spread

	As of March 31, 2012
Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(4,060.1	)	$	(2,107.4	)
50% widening in spreads	(3,009.8		)	(1,057.1		)
25% widening in spreads	(2,484.6		)	(531.9		)
10% widening in spreads	(2,169.5		)	(216.8		)
Base Scenario	(1,952.7		)	—
10% narrowing in spreads	(1,774.4		)	178.3
25% narrowing in spreads	(1,497.0		)	455.7
50% narrowing in spreads	(1,037.1		)	915.6

(1)Includes the effects of spreads on both the underlying asset classes and the Company’s own credit spread.