Contracts Accounted for as Credit Derivatives

9 Months Ended

Sep. 30, 2020

Derivative Instruments and Hedging Activities Disclosure [Abstract]

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 September 30, 2020 and December 31, 2019, respectively.

Credit Derivatives (1)


	As of September 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	$	2,075	$	(66)	$	1,942	$	(83)
Non-U.S. public finance	2,409		(31)		2,676		(39)
U.S. structured finance	1,045		(58)		1,206		(58)
Non-U.S. structured finance	129		(4)		132		(5)
Total	$	5,658	$	(159)	$	5,956	$	(185)

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(1) Expected recoveries were $13 million as of September 30, 2020 and $4 million as of December 31, 2019.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating


	As of September 30, 2020				As of December 31, 2019
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	1,613	28.5	%	$	1,730	29.0	%
AA	1,699		30.0		1,695		28.5
A	767		13.5		1,110		18.6
BBB	1,457		25.8		1,292		21.7
BIG (1)	122		2.2		129		2.2
Credit derivative net par outstanding	$	5,658	100.0	%	$	5,956	100.0	%

____________________

(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)


	Third Quarter				Nine Months
	2020		2019		2020		2019
	(in millions)
Realized gains on credit derivatives	$	1	$	2	$	4	$	6
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(6)		(5)		(9)		(30)
Realized gains (losses) and other settlements	(5)		(3)		(5)		(24)
Net unrealized gains (losses)	2		8		25		(1)
Net change in fair value of credit derivatives	$	(3)	$	5	$	20	$	(25)

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 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 Nine 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 Third Quarter 2019, unrealized 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. These unrealized losses were offset by price improvements and the final maturity paydown of a CDS contract.

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 September 30, 2020	As of June 30, 2020	As of December 31, 2019	As of September 30, 2019	As of June 30, 2019	As of December 31, 2018
Five-year CDS spread	140	159	41	56	56	110
One-year CDS spread	27	32	9	14	13	22

Fair Value of Credit Derivative Assets (Liabilities)

and Effect of AGC

Credit Spread


	As of
	September 30, 2020		December 31, 2019
	(in millions)
Fair value of credit derivatives before effect of AGC credit spread	$	(356)	$	(261)
Plus: Effect of AGC credit spread	197		76
Net fair value of credit derivatives	$	(159)	$	(185)

The fair value of CDS contracts at September 30, 2020, before considering the benefit applicable to AGC’s credit spread, 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 $123 million in CDS net par insured by the Company requires the Company to post collateral, subject to a $123 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 September 30, 2020, AGC did not need to post collateral to satisfy these requirements.