Consolidation of Variable Interest Entities

3 Months Ended

Mar. 31, 2012

Consolidation of Variable Interest Entities

Consolidation of Variable Interest Entities

7. Consolidation of Variable Interest Entities

The Company provides financial guaranties with respect to debt obligations of special purpose entities, including VIEs. AGC and AGM do not sponsor any VIEs when underwriting third party financial guaranty insurance or credit derivative transactions, nor has either of them acted as the servicer or collateral manager for any VIE obligations that it insures. The transaction structure generally provides certain financial protections to the Company. This financial protection can take several forms, the most common of which are overcollateralization, first loss protection (or subordination) and excess spread. In the case of overcollateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by the Company), the structure allows defaults of the securitized assets before a default is experienced on the structured finance obligation guaranteed by the Company. In the case of first loss, the financial guaranty insurance policy only covers a senior layer of losses experienced by multiple obligations issued by special purpose entities, including VIEs. The first loss exposure with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate cash flows that are in excess of the interest payments on the debt issued by the special purpose entity. Such excess spread is typically distributed through the transaction’s cash flow waterfall and may be used to create additional credit enhancement, applied to redeem debt issued by the special purpose entities, including VIEs (thereby, creating additional overcollateralization), or distributed to equity or other investors in the transaction.

AGC and AGM are not primarily liable for the debt obligations issued by the VIEs they insure and would only be required to make payments on these debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due. AGL’s and its Subsidiaries’ creditors do not have any rights with regard to the assets of the VIEs. Proceeds from sales, maturities, prepayments and interest from VIE assets may only be used to pay debt service on VIE liabilities. Net fair value gains and losses on FG VIEs are expected to reverse to zero at maturity of the VIE debt, except for claim payments paid by AGC or AGM under the financial guaranty insurance contract. The Company’s estimate of expected loss to be paid for FG VIEs is included in Note 4, Financial Guaranty Insurance Contracts.

Consolidated FG VIEs

During First Quarter 2012, two additional VIEs were consolidated. This resulted in a net loss on consolidation of $6.1 million, which was included in “fair value gains (losses) on FG VIEs” in the consolidated statement of operations.  As a result, there were a total of 35 consolidated FG VIEs at March 31, 2012, compared to 33 FG VIEs at December 31, 2011.

The total unpaid principal balance for the FG VIEs’ assets that were over 90 days or more past due was approximately $1,048.1 million. The difference between the aggregate unpaid principal and aggregate fair value of the FG VIEs’ assets was approximately $3,121.8 million at March 31, 2012. The change in the instrument-specific credit risk of the FG VIEs’ assets for the First Quarter ended March 31, 2012 was a gain of approximately $85.9 million. The gain in instrument-specific credit risk was determined by calculating the change in credit impairment for the Company’s VIE assets during the period, which are provided by a third party pricing source.

The aggregate unpaid principal balance was approximately $2,498.7 million less than the aggregate fair value of the FG VIEs’ liabilities as of March 31, 2012.

The trustee reports of the consolidated FG VIEs are prepared by outside parties and are not available within the time constraints that the Company requires to ensure the financial accuracy of the operating results. As such, the financial results of the FG VIEs are consolidated on a lag; however, the Company adjusts the financial statements for the effects of material events occurring from the lag period until the balance sheet date. Interest income and interest expense are derived from the trustee reports and included in “fair value gains (losses) on FG VIEs” in the consolidated statement of operations. The Company has elected the fair value option for assets and liabilities classified as FG VIEs’ assets and liabilities. Upon consolidation of FG VIEs, the Company elected the fair value option because the carrying amount transition method was not practical.

The table below shows the carrying value of the consolidated FG VIEs’ assets and liabilities in the consolidated financial statements, segregated by the types of assets that collateralize their respective debt obligations.

Consolidated FG VIEs

By Type of Collateral

	As of March 31, 2012					As of December 31, 2011
	Number of FG VIEs	Assets		Liabilities		Number of FG VIEs	Assets		Liabilities
	(dollars in millions)
With recourse:
HELOCs	8	$	572.2	$	898.7	8	$	572.9	$	907.9
First liens:
Alt-A first lien	3	117.8		104.4		3	118.0		106.1
Option ARM	2	43.0		230.3		2	49.7		244.7
Subprime	7	399.7		499.0		5	386.8		472.7
Closed-end second lien	10	184.3		207.7		10	184.6		219.9
Automobile loans	4	126.9		126.9		4	155.8		155.8
Life insurance	1	298.2		298.2		1	289.8		289.8
Total with recourse	35	1,742.1		2,365.2		33	1,757.6		2,396.9
Without recourse		1,085.6		1,085.6			1,061.5		1,061.5
Total		$	2,827.7	$	3,450.8		$	2,819.1	$	3,458.4

Gross Par Outstanding for FG VIEs’ Liabilities

With Recourse

	As of March 31, 2012		As of December 31, 2011
	(in millions)
Gross par outstanding for FG VIEs’ liabilities with recourse	$	3,674.8	$	3,796.4

Contractual Maturity Schedule of FG VIE Liabilities with Recourse

Contractual Maturity	As of March 31, 2012
	(in millions)
2012	$	—
2013	11.8
2014	114.1
2015	—
2016	—
Thereafter	3,548.9
Total	$	3,674.8

The consolidation of FG VIEs has a significant effect on net income and shareholder’s equity due to (1) changes in fair value gains (losses) on FG VIE assets and liabilities, (2) the eliminations of premiums and losses related to the AGC and AGM insured FG VIE liabilities and (3) the elimination of investment balances related to the Company’s purchase of AGC and AGM insured FG VIE debt. Upon consolidation of a FG VIE, the related insurance and, if applicable, the related investment balances, are considered intercompany transactions and therefore eliminated. Such eliminations are included in the table below to present the full effect of consolidating FG VIEs.

Effect of Consolidating FG VIEs on Net Income

and Shareholders’ Equity(1)

	First Quarter
	2012			2011
	(in millions)
Net earned premiums	$	(17.0	)	$	(19.1	)
Net investment income	(3.2		)	(0.3		)
Net realized investment gains (losses)	1.4			0.3
Fair value gains (losses) on FG VIEs	(36.6		)	119.6
Loss and LAE	3.2			50.7
Total pretax effect on net income	(52.2		)	151.2
Less: tax provision (benefit)	(18.3		)	53.0
Total effect on net income (loss)	$	(33.9	)	$	98.2

	As of March 31, 2012			As of December 31, 2011
	(in millions)
Total (decrease) increase on shareholders’ equity	$	(438.7	)	$	(405.2	)

(1)Includes the effect of eliminating insurance balances related to the financial guaranty insurance contracts.

Non-Consolidated VIEs

To date, the Company’s analyses have indicated that it does not have a controlling financial interest in any other VIEs and, as a result, they are not consolidated in the consolidated financial statements. The Company’s exposure provided through its financial guaranties with respect to debt obligations of special purpose entities is included within net par outstanding in Note 3, Outstanding Exposure.