Contracts Accounted for as Credit Derivatives

3 Months Ended

Mar. 31, 2019

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Contracts Accounted for as Credit Derivatives

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 derivative portfolio also includes interest rate swaps.

Credit derivative transactions are governed by International Swaps and Derivative Association, Inc. documentation and have certain characteristics that differ 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 components of the Company’s credit derivative net par outstanding are presented in the table below. The estimated remaining weighted average life of credit derivatives was 11.6 years as of both March 31, 2019 and at December 31, 2018.

Credit Derivatives (1)

	As of March 31, 2019					As of December 31, 2018
Asset Type	Net Par Outstanding		Net Fair Value			Net Par Outstanding		Net Fair Value
	(in millions)
Pooled infrastructure	$	1,403	$	(41	)	$	1,373	$	(34	)
Infrastructure finance	1,294		(87		)	1,300		(63		)
Regulated utilities	1,115		(10		)	1,096		(11		)
TruPS collateralized debt obligations (CDOs)	606		(22		)	642		(28		)
U.S. RMBS	588		(30		)	641		(31		)
Other (2)	1,114		(38		)	1,130		(40		)
Total	$	6,120	$	(228	)	$	6,182	$	(207	)

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(1)    Expected recoveries were $6 million as of March 31, 2019 and $2 million as of December 31, 2018.

(2) This represents numerous transactions across various asset classes, such as health care revenue, municipal utilities and consumer receivables.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating

	As of March 31, 2019				As of December 31, 2018
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	1,795	29.3	%	$	1,813	29.4	%
AA	1,665		27.2		1,690		27.3
A	1,180		19.3		1,171		18.9
BBB	1,327		21.7		1,351		21.9
BIG (1)	153		2.5		157		2.5
Credit derivative net par outstanding	$	6,120	100.0	%	$	6,182	100.0	%

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(1) BIG relates to U.S. RMBS.

Fair Value of Credit Derivatives

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

	First Quarter
	2019			2018
	(in millions)
Realized gains on credit derivatives	$	3		$	2
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(4		)	—
Realized gains (losses) and other settlements	(1		)	2
Net unrealized gains (losses)	(21		)	32
Net change in fair value of credit derivatives	$	(22	)	$	34

     During First Quarter 2019, unrealized fair value losses were generated primarily as a result of wider implied net spreads driven by the decreased cost to buy protection in AGC’s name, as the market cost of AGC’s credit protection decreased during the period. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC, which management refers to as the CDS spread on AGC, decreased, the implied spreads that the Company would expect to receive on these transactions increased.

During First Quarter 2018, unrealized fair value gains were generated primarily as a result of the increase in credit given to the primary insurer on one of the Company's second-to-pay CDS policies related to certain U.S. RMBS exposure, the paydown of CDS par, CDS terminations, and price improvements on the underlying collateral of the Company’s CDS. The unrealized fair value gains were partially offset by unrealized fair value losses related to 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.

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 bps)

 

	As of March 31, 2019	As of December 31, 2018	As of March 31, 2018	As of December 31, 2017
Five-year CDS spread:
AGC	74	110	121	163
AGM	72	116	109	145
One-year CDS spread
AGC	20	22	25	70
AGM	13	24	22	28

Fair Value of Credit Derivative Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads

	As of March 31, 2019			As of December 31, 2018
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(370	)	$	(407	)
Plus: Effect of AGC and AGM credit spreads	142			200
Net fair value of credit derivatives	$	(228	)	$	(207	)

The fair value of CDS contracts at March 31, 2019, 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 the low rating of certain credits. Offsetting the benefit attributable to AGC’s credit spread were wide credit spreads in the fixed income security markets. The wide credit spreads in the fixed income security market are due to the lack of liquidity in the TruPS CDO, pooled infrastructure, and infrastructure finance markets as well as continuing market concerns over the 2005-2007 vintages of RMBS.

Collateral Posting for Certain Credit Derivative Contracts

The transaction documentation with one counterparty for $221 million in CDS net par insured by AGC requires AGC to post collateral, subject to a $221 million cap, 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. The table below summarizes AGC’s CDS collateral posting requirements as of March 31, 2019 and December 31, 2018.

AGC Insured CDS Collateral Posting Requirements

	As of March 31, 2019		As of December 31, 2018
	(in millions)
Gross par of CDS with collateral posting requirement	$	221	$	250
Maximum posting requirement	221		250
Collateral posted	1		1