Financial Guaranty Contracts Accounted for as Credit Derivatives

Credit Derivatives

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

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, there are more circumstances under which the Company may be obligated to make payments. Similar to a financial guaranty insurance contract, the Company would be obligated to pay if the obligor failed to make a scheduled payment of principal or interest in full. However, the Company may also be required to pay if the obligor becomes bankrupt or if the reference obligation were restructured if, after negotiation, those credit events are specified in the documentation for the credit derivative transactions. Furthermore, the Company may be required to make a payment due to an event that is unrelated to the performance of the obligation referenced in the credit derivative. 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. In that case, 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 5.3 years at September 30, 2015 and 4.7 years at December 31, 2014. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives

Subordination and Ratings



	As of September 30, 2015							As of December 31, 2014
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	$	7,299	31.1	%	39.6	%	AAA	$	11,688	32.0	%	36.9	%	AAA
Synthetic investment grade pooled corporate	7,119		21.7		19.4		AAA	7,640		22.6		20.6		AAA
TruPS CDOs	3,604		45.7		41.6		BBB+	3,119		45.3		35.8		BBB-
Market value CDOs of corporate obligations	1,113		17.0		10.5		AAA	1,174		19.1		20.7		AAA
Total pooled corporate obligations	19,135		29.5		30.8		AAA	23,621		30.1		30.7		AAA
U.S. RMBS:
Option ARM and Alt-A first lien	1,186		15.7		10.5		AAA	1,378		16.3		10.7		BB+
Subprime first lien	1,215		27.2		41.8		AA	1,366		31.1		50.5		A
Prime first lien	183		10.9		0.0		BB	223		10.9		0.0		B
Closed-end second lien	17		—		—		CCC	19		—		—		CCC
Total U.S. RMBS	2,601		22.6		29.6		AA	2,986		24.8		33.9		BBB
CMBS	1,127		28.4		35.8		AAA	1,952		35.3		43.6		AAA
Other	6,770		—		—		A	6,437		—		—		A
Total(2)	$	29,633					AA	$	34,996					AA+

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(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)	The September 30, 2015 total amount includes $4.3 billion net par outstanding of credit derivatives acquired from Radian Asset.

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 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 $1.9 billion of exposure to one pooled infrastructure transaction 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 $4.9 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.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of September 30, 2015				As of December 31, 2014
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	17,080	57.7	%	$	21,817	62.3	%
AA	5,785		19.5		5,398		15.4
A	2,065		7.0		1,982		5.7
BBB	2,674		9.0		2,774		8.0
BIG(1)	2,029		6.8		3,025		8.6
Credit derivative net par outstanding	$	29,633	100.0	%	$	34,996	100.0	%

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(1)	The September 30, 2015 BIG amount includes $489 million net par outstanding of credit derivatives acquired from Radian Asset.

Fair Value of Credit Derivatives

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



	Third Quarter						Nine Months
	2015			2014			2015			2014
	(in millions)
Realized gains on credit derivatives (1)	$	14		$	17		$	52		$	58
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(8		)	(31		)	(17		)	(38		)
Realized gains (losses) and other settlements on credit derivatives	6			(14		)	35			20
Net change in unrealized gains (losses) on credit derivatives:
Pooled corporate obligations	(24		)	4			0			10
U.S. RMBS	11			252			148			117
CMBS	(3		)	0			1			2
Other	96			13			116			(2		)
Net change in unrealized gains (losses) on credit derivatives	80			269			265			127
Net change in fair value of credit derivatives (2)	$	86		$	255		$	300		$	147

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(1)	Includes realized gain due to terminations of CDS contracts. CDS terminations in Nine Months 2015 also included a payment received from the resolution of a dispute related to a termination of CDS in 2008.

(2)

On October 9, 2015, the Company reached a settlement agreement with a CDS counterparty to terminate five Alt-A first lien CDS transactions. This termination agreement will generate a net fair value gain of approximately $293 million in the Company’s fourth quarter 2015 financial statements. In addition, on October 13, 2015, the Company terminated a CMBS transaction with a CDS counterparty and this termination agreement will generate a net fair value gain of approximately $34 million in the Company's fourth quarter 2015 financial statements.

Net Par and Realized Gain

from Terminations of CDS Contracts



	Third Quarter					Nine Months
	2015		2014			2015		2014
	(in millions)
Net par of terminated CDS contracts	$	405	$	1,631		$	969	$	2,931
Realized gain due to termination of CDS contracts	0.3		(0.1		)	12.9		0.6

During Third Quarter 2015, unrealized fair value gains were driven primarily by the termination of a Triple-X life-securitization transaction in the Other sector. These unrealized gains were partially offset by wider implied net spreads in the Company’s pooled corporate CLO sector. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, particularly for the one year and five year CDS spreads, as the market cost of AGC’s and AGM’s credit protection decreased 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 and AGM, which management refers to as the CDS spread on AGC and AGM, decreased the implied spreads that the Company would expect to receive on these transactions increased.

During Nine Months 2015, unrealized fair value gains were generated primarily in the U.S. RMBS prime first lien and Option ARM and subprime sectors, 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 and AGM’s name, particularly for the one year CDS spread, as the market cost of AGC’s and AGM’s credit protection increased during the period. These transactions were pricing at or above their floor levels, therefore when the cost of purchasing CDS protection on AGC and AGM increased, the implied spreads that the Company would expect to receive on these transactions decreased. The unrealized fair value gains in the other sector were a result of the termination of a Triple-X life-securitization transaction, referenced above. In addition, during Nine Months 2015 there was a refinement in methodology to address an instance in a U.S. RMBS transaction where the Company now expects recoveries. This refinement resulted in approximately $49 million in fair value gains in Nine Months 2015.

During Third Quarter 2014, unrealized fair value gains were generated primarily in the U.S. RMBS prime first lien and Option ARM and subprime sectors. This is due primarily to a significant unrealized fair value gain in the Option ARM sector as a result of the termination of a resecuritization transaction during the period. In addition, there were unrealized fair value gains 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 during the period, with the change in the one year CDS spread having the largest impact. These transactions were pricing at or above their floor levels; 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 did not change significantly during Third Quarter 2014, and did not lead to significant changes in the fair value of the Company’s CDS policies.

During Nine Months 2014, unrealized fair value gains were generated primarily in the U.S. RMBS Option ARM sector due to the termination of a resecuritization transaction. The unrealized fair value gains were partially offset by unrealized fair value losses resulting from wider implied net spreads in the prime first lien and Option ARM sectors. 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 significantly during the period. 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 2014, but did not lead to significant fair value losses, 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.

Five-Year CDS Spread

on AGC and AGM

Quoted price of CDS contract (in basis points)



	As of September 30, 2015	As of June 30, 2015	As of December 31, 2014	As of September 30, 2014	As of June 30, 2014	As of December 31, 2013
AGC	331	390	323	345	327	460
AGM	337	410	325	344	346	525

One-Year CDS Spread

on AGC and AGM

Quoted price of CDS contract (in basis points)



	As of September 30, 2015	As of June 30, 2015	As of December 31, 2014	As of September 30, 2014	As of June 30, 2014	As of December 31, 2013
AGC	112	120	80	125	85	185
AGM	104	125	85	120	115	220

Fair Value of Credit Derivatives Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads



	As of September 30, 2015			As of December 31, 2014
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(1,973	)	$	(2,029	)
Plus: Effect of AGC and AGM credit spreads	1,126			1,134
Net fair value of credit derivatives (1)	$	(847	)	$	(895	)

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(1)	September 30, 2015 amount includes $174 million of net fair value loss of credit derivatives acquired from Radian Asset.

The fair value of CDS contracts at September 30, 2015, 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 TruPS and pooled corporate securities. Comparing September 30, 2015 with December 31, 2014, there was a narrowing of spreads primarily related to the Company's pooled corporate obligations which resulted in a mark to market benefit. This benefit was partially offset by the Company's acquisition of Radian Asset Assurance’s CDS portfolio which increased the Company's mark to market liability. This narrowing of spreads combined with the acquisition of Radian Asset, resulted in a gain of approximately $56 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 2005-2007 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 6) 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						Expected Loss to be (Paid) Recovered (1)
Asset Type	As of September 30, 2015			As of December 31, 2014			As of September 30, 2015			As of December 31, 2014
	(in millions)
Pooled corporate obligations	$	(231	)	$	(49	)	$	(67	)	$	(23	)
U.S. RMBS	(346		)	(494		)	19			(73		)
CMBS	(40		)	0			(7		)	—
Other	(230		)	(352		)	28			38
Total	$	(847	)	$	(895	)	$	(27	)	$	(58	)

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(1)	Includes R&W benefit of $82 million as of September 30, 2015 and $86 million as of December 31, 2014.

Ratings Sensitivities of Credit Derivative Contracts

Within the Company's insured CDS portfolio, the transaction documentation for approximately $4.9 billion in CDS gross par insured as of September 30, 2015 requires AGC to post eligible collateral to secure its obligations 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 $4.7 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 $575 million, although the value of the collateral posted may exceed such fixed amount depending on the advance rate agreed with the counterparty for the particular type of collateral posted.


•	For the remaining approximately $235 million of such contracts, AGC could be required from time to time to post additional collateral without such cap based on movements in the mark-to-market valuation of the underlying exposure.

As of September 30, 2015, the Company posted approximately $333 million to secure obligations under its CDS exposure, of which approximately $20 million related to such $235 million of notional. As of December 31, 2014, the Company posted approximately $376 million, of which approximately $25 million related to $242 million of notional where AGC or AGRO could be required to post additional collateral based on movements in the mark-to-market valuation of the underlying exposure.

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, 2015



Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(1,723	)	$	(876	)
50% widening in spreads	(1,285		)	(438		)
25% widening in spreads	(1,067		)	(220		)
10% widening in spreads	(935		)	(88		)
Base Scenario	(847		)	—
10% narrowing in spreads	(765		)	82
25% narrowing in spreads	(643		)	204
50% narrowing in spreads	(441		)	406

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