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.

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.

Credit Derivative Net Par Outstanding by Sector

The estimated remaining weighted average life of credit derivatives was 6.2 years at March 31, 2017 and 5.3 years at December 31, 2016. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives

As of March 31, 2017

As of December 31, 2016

Asset Type

Net Par

Outstanding

Weighted

Average

Credit

Rating

Net Par

Outstanding

Weighted

Average

Credit

Rating

(dollars in millions)

Pooled corporate obligations:

CLO/collateralized bond obligations

1,461

AAA

2,022

AAA

Synthetic investment grade pooled corporate

4,400

AAA

7,224

AAA

TruPS CDOs

999

A-

1,179

BBB+

Total pooled corporate obligations

6,860

AAA

10,425

AAA

U.S. RMBS

1,080

1,142

AA-

Pooled infrastructure

1,363

AAA

1,513

AAA

Infrastructure finance

832

BBB+

1,021

BBB+

Other(1)

2,721

A-

2,896

Total

12,856

16,997

AA+

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(1)	This comprises numerous transactions across various asset classes, such as commercial receivables, international RMBS, regulated utilities and consumer receivables.

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 transactions.

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.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of March 31, 2017				As of December 31, 2016
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	7,493	58.3	%	$	10,967	64.6	%
AA	1,900		14.8		2,167		12.7
A	1,597		12.4		1,499		8.8
BBB	1,114		8.7		1,391		8.2
BIG	752		5.8		973		5.7
Credit derivative net par outstanding	$	12,856	100.0	%	$	16,997	100.0	%

Fair Value of Credit Derivatives

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



	First Quarter
	2017		2016
	(in millions)
Realized gains on credit derivatives	$	5	$	10
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	10		(2		)
Realized gains (losses) and other settlements	15		8
Net unrealized gains (losses):
Pooled corporate obligations	20		(48		)
U.S. RMBS	9		(15		)
Pooled infrastructure	6		0
Infrastructure finance	1		0
Other	3		(5		)
Net unrealized gains (losses)	39		(68		)
Net change in fair value of credit derivatives	$	54	$	(60	)

Terminations and Settlements

of Direct Credit Derivative Contracts



	First Quarter
	2017			2016
	(in millions)
Net par of terminated credit derivative contracts	$	184		$	—
Realized gains on credit derivatives	0			0
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(12		)	—
Net unrealized gains (losses) on credit derivatives	15			11

During First Quarter 2017, unrealized fair value gains were generated primarily as a result of CDS terminations and tighter implied spreads. During the quarter the Company agreed to terminate several CDS transactions, which was the primary driver of the unrealized fair value gains in the pooled corporate CLO, and U.S. RMBS sectors. The tighter implied spreads were primarily a result of price improvements on the underlying collateral of the Company’s CDS and the increased cost to buy protection in AGC’s and AGM’s name 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.

During First Quarter 2016, unrealized fair value losses were generated primarily in the trust preferred, and U.S. RMBS prime first lien and subprime sectors, due to wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection on AGC and AGM, particularly for the one year and five year CDS spreads. 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. Unrealized fair value losses in the Other Sector were generated primarily by a price decline on a hedge the Company has against another financial guarantor. These losses were partially offset by an unrealized fair value gain on a terminated toll road securitization.

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 March 31, 2017	As of December 31, 2016	As of March 31, 2016	As of December 31, 2015
Five-year CDS spread:
AGC	173	158	307	376
AGM	181	158	309	366
One-year CDS spread
AGC	31	35	105	139
AGM	31	29	102	131

Fair Value of Credit Derivatives Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads



	As of March 31, 2017			As of December 31, 2016
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(713	)	$	(811	)
Plus: Effect of AGC and AGM credit spreads	363			422
Net fair value of credit derivatives	$	(350	)	$	(389	)

The fair value of CDS contracts at March 31, 2017, 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 transactions. The mark to market benefit between March 31, 2017 and December 31, 2016, 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 March 31, 2017			As of December 31, 2016
	(in millions)
Fair value of credit derivative asset (liability), net	$	(350	)	$	(389	)
Expected loss to be (paid) recovered	(4		)	(10		)

Collateral Posting for Certain Credit Derivative Contracts

The transaction documentation for approximately $506 million in gross par of CDS insured by AGC as of March 31, 2017 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. The collateral requirement for approximately $333 million in gross par of insured CDS is subject to a cap of $300 million, while the collateral requirement for the remaining approximately $173 million in gross par of insured CDS is not capped.

As of March 31, 2017, the Company was posting approximately $36 million of collateral to secure its obligations under insured CDS with collateral posting requirements. Approximately $27 million of that amount related to the capped collateral requirement and the remaining $9 million related to the uncapped requirement.

As of December 31, 2016, the Company was posting approximately $116 million of collateral to secure its obligations under insured CDS with collateral posting requirements. Approximately $100 million of that amount related to $516 million in gross par for which there was then a posting requirement subject to a cap, and the remaining $16 million related to $174 million in 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 in gross par and $73 million of collateral posted as of December 31, 2016, and all the collateral was 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 March 31, 2017



Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(712	)	$	(362	)
50% widening in spreads	(531		)	(181		)
25% widening in spreads	(441		)	(91		)
10% widening in spreads	(387		)	(37		)
Base Scenario	(350		)	—
10% narrowing in spreads	(316		)	34
25% narrowing in spreads	(266		)	84
50% narrowing in spreads	(182		)	168

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