Contracts Accounted for as Credit Derivatives

6 Months Ended

Jun. 30, 2020

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 Derivatives 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 11.3 years and 11.5 years as of June 30, 2020 and December 31, 2019, respectively.

Credit Derivatives (1)

	As of June 30, 2020					As of December 31, 2019
	Net Par Outstanding		Net Fair Value Asset (Liability)			Net Par Outstanding		Net Fair Value Asset (Liability)
	(in millions)
U.S. public finance	$	2,195	$	(66	)	$	1,942	$	(83	)
Non-U.S. public finance	2,327		(29		)	2,676		(39		)
U.S. structured finance	1,119		(61		)	1,206		(58		)
Non-U.S. structured finance	124		(5		)	132		(5		)
Total	$	5,765	$	(161	)	$	5,956	$	(185	)

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(1)    Expected recoveries were $14 million as of June 30, 2020 and $4 million as of December 31, 2019.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating

	As of June 30, 2020				As of December 31, 2019
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	1,594	27.6	%	$	1,730	29.0	%
AA	1,728		30.0		1,695		28.5
A	848		14.7		1,110		18.6
BBB	1,470		25.5		1,292		21.7
BIG (1)	125		2.2		129		2.2
Credit derivative net par outstanding	$	5,765	100.0	%	$	5,956	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 Gains (Losses)

	Second Quarter						Six Months
	2020			2019			2020			2019
	(in millions)
Realized gains on credit derivatives	$	1		$	1		$	3		$	4
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(1		)	(21		)	(3		)	(25		)
Realized gains (losses) and other settlements	—			(20		)	—			(21		)
Net unrealized gains (losses)	100			12			23			(9		)
Net change in fair value of credit derivatives	$	100		$	(8	)	$	23		$	(30	)

     Realized losses and other settlements for Second Quarter 2019 and Six 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 Second Quarter 2020, unrealized gains were generated primarily as a result of price improvements of the underlying collateral.  These gains were partially offset by losses due to the decreased cost to buy protection on AGC, 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 (or another comparable entity) would expect to receive on these transactions increased.

During Six Months 2020, unrealized gains were generated primarily as a result of the increased cost to buy protection on AGC, as the market cost of AGC's credit protection increased during the period. These gains were partially offset by the wider spreads of the underlying collateral and lower discount rates.

During Second Quarter 2019, unrealized gains were generated primarily as a result of a final maturity paydown of a CDS contract and price improvements. These items were partially offset by wider implied net spreads driven by the decreased market cost to buy protection in AGC’s name during the period.

During Six Months 2019, unrealized 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. These losses were partially offset by the price improvements.

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 (in bps)

	As of June 30, 2020	As of March 31, 2020	As of December 31, 2019	As of June 30, 2019	As of March 31, 2019	As of December 31, 2018
Five-year CDS spread	159	224	41	56	74	110
One-year CDS spread	32	64	9	13	20	22

Fair Value of Credit Derivative Assets (Liabilities)

and Effect of AGC

Credit Spread

	As of June 30, 2020			As of December 31, 2019
	(in millions)
Fair value of credit derivatives before effect of AGC credit spread	$	(388	)	$	(261	)
Plus: Effect of AGC credit spread	227			76
Net fair value of credit derivatives	$	(161	)	$	(185	)

The fair value of CDS contracts at June 30, 2020, 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 $148 million in CDS net par insured by the Company requires the Company to post collateral, subject to a $148 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. As of June 30, 2020, AGC did not need to post collateral to satisfy these requirements.