Contracts Accounted for as Credit Derivatives

9 Months Ended

Sep. 30, 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 11.2 years and 11.6 years as of September 30, 2019 and December 31, 2018, respectively.

Credit Derivatives (1)

	As of September 30, 2019					As of December 31, 2018 (2)
	Net Par Outstanding		Net Fair Value			Net Par Outstanding		Net Fair Value
	(in millions)
U.S. public finance	$	2,067	$	(103	)	$	1,783	$	(65	)
Non-U.S. public finance	2,709		(46		)	2,807		(51		)
U.S. structured finance	1,266		(51		)	1,465		(85		)
Non-U.S. structured finance	123		(8		)	127		(6		)
Total	$	6,165	$	(208	)	$	6,182	$	(207	)

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(1)    Expected recoveries were $5 million as of September 30, 2019 and $2 million as of December 31, 2018.

(2)    Prior year presentation has been conformed to the current year's presentation.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating

	As of September 30, 2019				As of December 31, 2018
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	1,662	27.0	%	$	1,813	29.4	%
AA	1,748		28.4		1,690		27.3
A	1,255		20.3		1,171		18.9
BBB	1,368		22.2		1,351		21.9
BIG (1)	132		2.1		157		2.5
Credit derivative net par outstanding	$	6,165	100.0	%	$	6,182	100.0	%

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(1) All BIG credit derivatives are U.S. RMBS transactions.

Fair Value of Credit Derivatives

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

	Third Quarter						Nine Months
	2019			2018			2019			2018
	(in millions)
Realized gains on credit derivatives	$	2		$	2		$	6		$	6
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(5		)	(1		)	(30		)	(2		)
Realized gains (losses) and other settlements	(3		)	1			(24		)	4
Net unrealized gains (losses)	8			20			(1		)	99
Net change in fair value of credit derivatives	$	5		$	21		$	(25	)	$	103

     Realized losses and other settlements for Nine Months 2019 were primarily due to a final maturity paydown of a U.S. structured finance transaction, for which there was an offsetting unrealized gain.

During Third Quarter 2019, unrealized fair value gains were generated primarily as a result of price improvements on the underlying collateral of certain of the Company's public finance CDS. The unrealized fair value gains were partially offset by unrealized fair value losses related to certain structured finance CDS transactions and changes in discount rates.

During Nine Months 2019, unrealized fair value losses were generated primarily as a result of wider implied net spreads driven by the decreased market cost to buy protection in AGC’s name 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. These unrealized losses were offset by price improvements and the final maturity paydown of a CDS contract.

During Third Quarter 2018, unrealized fair value gains were generated primarily as a result of price improvements on the underlying collateral of the Company’s CDS. This was the primary driver of the unrealized fair value gains in the U.S. structured finance and U.S. public finance sectors. The unrealized fair value gains were partially offset by unrealized fair value losses related to the decreased cost to buy protection in AGC’s name as the market cost of AGC’s credit protection decreased during the period.

During Nine Months 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, 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 name as the market cost of AGC’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. 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

Quoted price of CDS contract (in bps)

 

	As of September 30, 2019	As of June 30, 2019	As of December 31, 2018	As of September 30, 2018	As of June 30, 2018	As of December 31, 2017
Five-year CDS spread	56	56	110	77	105	163
One-year CDS spread	14	13	22	15	22	70

Fair Value of Credit Derivative Assets (Liabilities)

and Effect of AGC

Credit Spreads

	As of September 30, 2019			As of December 31, 2018
	(in millions)
Fair value of credit derivatives before effect of AGC credit spread	$	(306	)	$	(407	)
Plus: Effect of AGC credit spread	98			200
Net fair value of credit derivatives	$	(208	)	$	(207	)

The fair value of CDS contracts at September 30, 2019, before considering the benefit applicable to AGC’s credit spreads, is a direct result of the relatively wide credit spreads of certain underlying credits generally due to the long tenor of these credits.

Collateral Posting for Certain Credit Derivative Contracts

The transaction documentation with one counterparty for $193 million in CDS net par insured by AGC requires AGC to post collateral, subject to a $193 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. There was no collateral posted as of September 30, 2019.