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). The credit derivatives portfolio also includes interest rate swaps and hedges on other financial guarantors.

Accounting Policy

Credit derivatives are recorded at fair value. Changes in fair value are recorded in “net change in fair value of credit derivatives” on the consolidated statement of operations. Realized gains (losses) and other settlements on credit derivatives include credit derivative premiums received and receivable for credit protection the Company has sold under its insured CDS contracts, premiums paid and payable for credit protection the Company has purchased, claims paid and payable and received and receivable related to insured credit events under these contracts, ceding commission expense or income and realized gains or losses related to their early termination. Fair value of credit derivatives is reflected as either net assets or net liabilities determined on a contract by contract basis in the Company's consolidated balance sheets. See Note 7, Fair Value Measurement, for a discussion on the fair value methodology for credit derivatives.

Credit Derivative Net Par Outstanding by Sector

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. Absent such an event of default or termination event, 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.

The estimated remaining weighted average life of credit derivatives was 5.3 years at December 31, 2016 and 5.4 years at December 31, 2015. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives



	As of December 31, 2016			As of December 31, 2015
Asset Type	Net Par Outstanding		Weighted Average Credit Rating	Net Par Outstanding		Weighted Average Credit Rating
	(dollars in millions)
Pooled corporate obligations:
Collateralized loan obligations (CLO) /collateralized bond obligations	$	2,022	AAA	$	5,873	AAA
Synthetic investment grade pooled corporate	7,224		AAA	7,108		AAA
TruPS CDOs	1,179		BBB+	3,429		A-
Market value CDOs of corporate obligations	—		--	1,113		AAA
Total pooled corporate obligations	10,425		AAA	17,523		AAA
U.S. RMBS	1,142		AA-	1,526		A+
CMBS	—		--	530		AAA
Other	5,430		A+	6,015		A
Total(1)	$	16,997	AA+	$	25,594	AA+

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(1)	The December 31, 2016 total amount includes $1.7 billion net par outstanding of credit derivatives from CIFG Acquisition.

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, real estate investment trusts 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 $1.5 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 $3.9 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 December 31, 2016				As of December 31, 2015
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	10,967	64.6	%	$	14,808	57.9	%
AA	2,167		12.7		4,821		18.8
A	1,499		8.8		2,144		8.4
BBB	1,391		8.2		2,212		8.6
BIG	973		5.7		1,609		6.3
Credit derivative net par outstanding	$	16,997	100.0	%	$	25,594	100.0	%

Fair Value of Credit Derivatives

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



	Year Ended December 31,
	2016			2015			2014
	(in millions)
Realized gains on credit derivatives	$	56		$	63		$	73
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(27		)	(81		)	(50		)
Realized gains (losses) and other settlements	29			(18		)	23
Net unrealized gains (losses):
Pooled corporate obligations	(16		)	147			(18		)
U.S. RMBS	22			396			814
CMBS	0			42			2
Other	63			161			2
Net unrealized gains (losses)	69			746			800
Net change in fair value of credit derivatives	$	98		$	728		$	823

Terminations and Settlements

of Direct Credit Derivative Contracts



	Year Ended December 31,
	2016		2015			2014
	(in millions)
Net par of terminated credit derivative contracts	$	3,811	$	2,777		$	3,591
Realized gains on credit derivatives	20		13			1
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	—		(116		)	(26		)
Net unrealized gains (losses) on credit derivatives	103		465			546

During 2016, unrealized fair value gains were generated primarily as a result of CDS terminations in the U.S. RMBS and other sectors, run-off of CDS par and price improvements on the underlying collateral of the Company’s CDS. The majority of the CDS transactions were terminated as a result of settlement agreements with several CDS counterparties. The unrealized fair value gains were partially offset by unrealized losses resulting from wider implied net spreads across all sectors. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, as the market cost of AGC’s and AGM’s credit protection decreased 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 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 2015, unrealized fair value gains were generated primarily as a result of CDS terminations. The Company reached a settlement agreement with one CDS counterparty to terminate five Alt-A first lien CDS transactions resulting in unrealized fair value gains of $213 million and was the primary driver of the unrealized fair value gains in the U.S. RMBS sector. The Company also terminated a CMBS transaction, a Triple-X life insurance securitization transaction, and a distressed middle market CLO securitization during the period and recognized unrealized fair value gains of $41 million, $99 million and $99 million, respectively. These were the primary drivers of the unrealized fair value gains in the CMBS, Other, and pooled corporate CLO sectors, respectively, during the period. The remainder of the fair value gains for the period were a result of tighter implied net spreads across all sectors. 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. 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. Finally, during 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 2015.

During 2014, unrealized fair value gains were generated primarily in the U.S. RMBS prime first lien, Option ARM and subprime sectors. This is primarily due to a significant unrealized fair value gain in the Option ARM and Alt-A first lien sector of approximately $543 million, as a result of the terminations of three large Alt-A first lien resecuritization transactions and one Option ARM first lien transaction during the period. In addition, there was an unrealized gain of approximately $346 million related to the change in index used to determine fair value during the fourth quarter of 2014. In the fourth quarter of 2014, new market indices were published on Option ARM and Alt-A first lien securitizations. As part of the Company’s normal review process the Company reviewed these indices and based upon the collateral make-up, collateral vintage, and collateral loss experience, determined it to be a better market indication for the Company’s Option ARM and Alt-A first lien securitizations. The unrealized fair value gains were partially offset by unrealized fair value losses generated by wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, 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 decreased, the implied spreads that the Company would expect to receive on these transactions increased.

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.

CDS Spread on AGC and AGM

Quoted price of CDS contract (in basis points)



	As of December 31, 2016	As of December 31, 2015	As of December 31, 2014
Five-year CDS spread:
AGC	158	376	323
AGM	158	366	325

One-year CDS spread:
AGC	35	139	80
AGM	29	131	85

Fair Value of Credit Derivatives Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads



	As of December 31, 2016			As of December 31, 2015
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(811	)	$	(1,448	)
Plus: Effect of AGC and AGM credit spreads	422			1,083
Net fair value of credit derivatives	$	(389	)	$	(365	)

The fair value of CDS contracts at December 31, 2016, 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 TruPS and pooled corporate securities as well as 2005-2007 vintages of Alt-A, Option ARM and subprime RMBS deals. The mark to market benefit between December 31, 2016, and December 31, 2015, resulted primarily from several CDS terminations and a narrowing of credit spreads related to the Company's TruPS and U.S. RMBS obligations.

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, 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 5) for contracts accounted for as derivatives.

Net Fair Value and Expected Losses

of Credit Derivatives



	As of December 31, 2016			As of December 31, 2015
	(in millions)
Fair value of credit derivative asset (liability), net	$	(389	)	$	(365	)
Expected loss to be (paid) recovered	(10		)	(16		)

Ratings Sensitivities of Credit Derivative Contracts

Within the Company’s insured CDS portfolio, the transaction documentation for approximately $0.7 billion in CDS gross par insured as of December 31, 2016 requires AGC to post eligible collateral to secure its obligations to make payments under such contracts. This constitutes a reduction of approximately $3.1 billion from the $3.8 billion subject to such a requirement as of December 31, 2015, primarily due to an agreement reached in May 2016 with a CDS counterparty reducing the collateral posting requirement with respect to that counterparty to zero. 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 $516 million gross par 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 an aggregate of more than $500 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 $174 million gross par 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 December 31, 2016, the Company was posting approximately $116 million to secure its obligations under CDS, of which approximately $16 million related to the $174 million of gross par described above, as to which the obligation to collateralize is not capped. As of December 31, 2015, the Company was posting approximately $305 million to secure its obligations under CDS, of which approximately $23 million related to $221 million of gross par as to which the obligation to collateralize was not capped. In February 2017, the Company terminated all of its remaining CDS contracts with one of its counterparties as to which it had a posting requirement (subject to a cap); the CDS contracts related to approximately $183 million gross par and $73 million of collateral posted, as December 31, 2016; and all the collateral is being returned to the Company.

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 December 31, 2016



Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(791	)	$	(402	)
50% widening in spreads	(590		)	(201		)
25% widening in spreads	(490		)	(101		)
10% widening in spreads	(430		)	(41		)
Base Scenario	(389		)	—
10% narrowing in spreads	(351		)	38
25% narrowing in spreads	(295		)	94
50% narrowing in spreads	(203		)	186

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