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 on occasion 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 4.1 years at September 30, 2013 and 3.7 years at December 31, 2012. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives Net Par Outstanding



	As of September 30, 2013							As of December 31, 2012
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	$	20,858	32.4	%	34.2	%	AAA	$	29,142	32.8	%	33.3	%	AAA
Synthetic investment grade pooled corporate	9,716		21.6		19.7		AAA	9,658		21.6		19.7		AAA
Synthetic high yield pooled corporate	2,690		47.2		41.1		AAA	3,626		35.0		30.3		AAA
TruPS CDOs	3,673		45.9		33.6		BB+	4,099		46.5		32.7		BB
Market value CDOs of corporate obligations	3,113		31.2		31.9		AAA	3,595		30.1		32.0		AAA
Total pooled corporate obligations	40,050		31.9		30.9		AAA	50,120		31.7		30.4		AAA
U.S. RMBS:
Option ARM and Alt-A first lien	2,995		19.8		8.0		BB	3,381		20.2		10.4		B+
Subprime first lien	3,067		30.2		50.8		AA-	3,494		29.8		52.6		A+
Prime first lien	278		10.9		3.2		B	333		10.9		5.2		B
Closed end second lien and HELOCs	25		—		—		CCC	49		—		—		B-
Total U.S. RMBS	6,365		24.3		28.3		BBB	7,257		24.2		30.4		BBB
CMBS	3,781		33.3		42.0		AAA	4,094		33.3		41.8		AAA
Other	8,913		—		—		A	9,310		—		—		A-
Total	$	59,109					AA+	$	70,781					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 AAA levels at origination. The remaining $5.7 billion of exposure in “Other” CDS contracts comprises numerous deals across various asset classes, such as commercial receivables, international RMBS, infrastructure, regulated utilities and consumer receivables. Of the total net par outstanding in the "Other" sector, $0.5 million is rated BIG.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of September 30, 2013				As of December 31, 2012
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	41,753	70.6	%	$	50,918	71.9	%
AA	3,660		6.2		3,083		4.4
A	3,592		6.1		5,487		7.8
BBB	5,125		8.7		4,584		6.4
BIG	4,979		8.4		6,709		9.5
Total credit derivative net par outstanding	$	59,109	100.0	%	$	70,781	100.0	%

Net Change in Fair Value of Credit Derivatives

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



	Third Quarter					Nine Months
	2013		2012			2013			2012
	(in millions)
Net credit derivative premiums received and receivable	$	24	$	33		$	92		$	96
Net ceding commissions (paid and payable) received and receivable	0		0			1			0
Realized gains on credit derivatives	24		33			93			96
Terminations	—		—			—			(1		)
Net credit derivative losses (paid and payable) recovered and recoverable	0		(31		)	(137		)	(173		)
Total realized gains (losses) and other settlements on credit derivatives	24		2			(44		)	(78		)
Net unrealized gains (losses) on credit derivatives	330		(38		)	(120		)	(388		)
Net change in fair value of credit derivatives	$	354	$	(36	)	$	(164	)	$	(466	)

In Third Quarter 2013 and 2012, CDS contracts totaling $0.3 billion and $0.3 billion in net par were terminated, resulting in accelerations of credit derivative revenues of $0.1 million in Third Quarter 2013 and $0.4 million in Third Quarter 2012. In Nine Months 2013 and 2012, CDS contracts totaling $3.3 billion and $1.1 billion in net par were terminated, resulting in accelerations of credit derivative revenues of $15 million in Nine Months 2013 and $1 million in Nine Months 2012. In Nine Months 2013, in addition to the CDS terminations mentioned above, the Company terminated a film securitization CDS for a payment of $120 million which was recorded in realized gains (losses) and other settlements on credit derivatives, with a corresponding release of the unrealized loss recorded in unrealized gains (losses) on credit derivatives of $127 million for a net change in fair value of credit derivatives of $7 million.

Changes in the fair value of credit derivatives occur primarily because of changes in interest rates, credit spreads, notional amounts, credit ratings of the referenced entities, expected terms, realized gains (losses) and other settlements, and the issuing company’s own credit rating, credit spreads and other market factors. Except for net estimated credit impairments (i.e., net expected loss to be paid as discussed in Note 5), 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



	Third Quarter					Nine Months
Asset Type	2013		2012			2013			2012
	(in millions)
Pooled corporate obligations	$	96	$	32		$	(43	)	$	62
U.S. RMBS	195		(78		)	(248		)	(457		)
CMBS	3		—			(1		)	—
Other	36		8			172			7
Total	$	330	$	(38	)	$	(120	)	$	(388	)

During Third Quarter 2013, unrealized fair value gains were generated primarily in the U.S. RMBS prime first lien, Alt-A, Option ARM and subprime sectors, as well as pooled corporate obligations, due to tighter implied net spreads. The tighter 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 significantly during the period. These transactions were pricing at or 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 Third Quarter 2013, but did not lead to significant fair value gains, as a significant portion of AGM policies continue to price at floor levels.

During Nine Months 2013, U.S. RMBS unrealized fair value losses were generated primarily in the prime first lien, Alt-A, Option ARM and subprime RMBS sectors primarily as 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; therefore when the cost of purchasing CDS protection 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 Nine Months 2013, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels. These unrealized fair value losses were partially offset by unrealized fair value gains in the Other sector driven primarily by the termination of a film securitization transaction and price improvement on a XXX life securitization transaction.

In Third Quarter 2012, U.S. RMBS unrealized fair value losses were generated primarily in the Alt-A, Option ARM 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 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.

During Nine Months 2012, the cost to buy protection on AGC's name declined. This led to U.S. RMBS unrealized fair value losses which were generated primarily in the prime first lien, Alt-A and Option ARM 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; therefore when the cost of purchasing CDS protection 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 Nine Months 2012, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels. In addition, Nine Months 2012 included an $85 million unrealized gain relating to R&W benefits from the agreement with Deutsche Bank.

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 September 30, 2013	As of June 30, 2013	As of December 31, 2012	As of September 30, 2012	As of June 30, 2012	As of December 31, 2011
Quoted price of CDS contract (in basis points):
AGC	465	343	678	780	904	1,140
AGM	502	365	536	638	652	778

One-Year CDS Spread on AGC and AGM



	As of September 30, 2013	As of June 30, 2013	As of December 31, 2012	As of September 30, 2012	As of June 30, 2012	As of December 31, 2011
Quoted price of CDS contract (in basis points):
AGC	185	57	270	458	629	965
AGM	215	72	257	333	416	538



	As of September 30, 2013			As of December 31, 2012
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(3,955	)	$	(4,809	)
Plus: Effect of AGC and AGM credit spreads	2,034			3,016
Net fair value of credit derivatives	$	(1,921	)	$	(1,793	)

The fair value of CDS contracts at September 30, 2013, 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 2005-2007 vintages of prime first lien, Alt-A, Option ARM, subprime RMBS deals as well as trust-preferred and pooled corporate securities. Comparing September 30, 2013 with December 31, 2012, there was a narrowing of spreads primarily related to Alt-A first lien, Option ARM, and subprime RMBS transactions, as well as the Company's pooled corporate obligations. This narrowing of spreads combined with the run-off of par outstanding and termination of securities, resulted in a gain of approximately $854 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 over the past several years has been 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, TruPS CDO, and CLO markets as well as continuing market concerns over the most recent vintages of RMBS.

The following table presents the fair value and the present value of expected claim payments or recoveries (i.e. net expected loss to be paid as described in Note 5) 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 of September 30, 2013			As of December 31, 2012			As of September 30, 2013			As of December 31, 2012
	(in millions)
Pooled corporate obligations	$	(40	)	$	6		$	(33	)	$	(16	)
U.S. RMBS	(1,487		)	(1,237		)	(175		)	(181		)
CMBS	(3		)	(2		)	—			—
Other	(391		)	(560		)	44			(85		)
Total	$	(1,921	)	$	(1,793	)	$	(164	)	$	(282	)

____________________


(1)	Represents amount in excess of the present value of future installment fees to be received of $41 million as of September 30, 2013 and $43 million as of December 31, 2012. Includes R&W benefit of $174 million as of September 30, 2013 and $237 million as of December 31, 2012.

Ratings Sensitivities of Credit Derivative Contracts

Within the Company’s insured CDS portfolio, the transaction documentation for approximately $1.7 billion in CDS gross par insured as of September 30, 2013 provides that a downgrade of AGC's financial strength rating below BBB- or Baa3 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, AGC could be required to make a termination payment (or may be entitled to receive a termination payment from the CDS counterparty). The Company does not believe that it can accurately estimate the termination payments AGC could be required to make if, as a result of any such downgrade, the CDS counterparty terminated the affected transactions. These payments could have an adverse effect on the Company’s liquidity and financial condition.

The transaction documentation for approximately $11.2 billion in CDS gross par insured as of September 30, 2013 requires certain of the Company's insurance subsidiaries 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 approximately $10.8 billion of such contracts, AGC has negotiated caps such that the posting requirement cannot exceed a certain fixed amount, regardless of the mark-to-market valuation of the exposure or the financial strength ratings of AGC. For such contracts, AGC need not post on a cash basis more than $675 million, which amount is already being posted by AGC and is part of the approximately $681 million posted by the Company's insurance subsidiaries. For the remaining approximately $373 million of such contracts, the Company could be required from time to time to post additional collateral based on movements in the mark-to-market valuation of the underlying exposure. Of the $681 million being posted by the Company's insurance subsidiaries, approximately $64 million relate to such $373 million of notional.

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 September 30, 2013



Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(3,885	)	$	(1,964	)
50% widening in spreads	(2,901		)	(980		)
25% widening in spreads	(2,410		)	(489		)
10% widening in spreads	(2,115		)	(194		)
Base Scenario	(1,921		)	—
10% narrowing in spreads	(1,770		)	151
25% narrowing in spreads	(1,544		)	377
50% narrowing in spreads	(1,168		)	753

____________________


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