Consolidation of Variable Interest Entities

The Company provides financial guaranties with respect to debt obligations of special purpose entities, including VIEs. AGC and AGM do not sponsor any VIEs when underwriting third party financial guaranty insurance or credit derivative transactions, nor has either of them acted as the servicer or collateral manager for any VIE obligations that it insures. The transaction structure generally provides certain financial protections to the Company. This financial protection can take several forms, the most common of which are overcollateralization, first loss protection (or subordination) and excess spread. In the case of overcollateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by the Company), the structure allows defaults of the securitized assets before a default is experienced on the structured finance obligation guaranteed by the Company. In the case of first loss, the financial guaranty insurance policy only covers a senior layer of losses experienced by multiple obligations issued by special purpose entities, including VIEs. The first loss exposure with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate cash flows that are in excess of the interest payments on the debt issued by the special purpose entity. Such excess spread is typically distributed through the transaction’s cash flow waterfall and may be used to create additional credit enhancement, applied to redeem debt issued by the special purpose entities, including VIEs (thereby, creating additional overcollateralization), or distributed to equity or other investors in the transaction.

As a condition to issuing a financial guaranty contract in respect of certain of a VIE's debt obligations, the Company obtains certain protective rights with respect to the VIE that are triggered by the occurrence of certain events, such as failure to be in compliance with a covenant due to poor transaction performance or a deterioration in a servicer or collateral manager’s financial condition. At the inception of a transaction, the Company typically is not deemed to control a VIE; however, once a trigger event occurs, the Company’s control of the VIE typically increases. The Company continuously evaluates its power to direct the activities that most significantly impact the economic performance of VIEs that have debt obligations insured by the Company, such as its ability to unilaterally terminate and replace the servicer upon the occurrence of certain triggering events and, accordingly, where the Company is obligated to absorb VIE losses that could potentially be significant to the VIE. The protective rights that the Company obtains under its insurance contract for a particular transaction give the Company additional controls over a VIE if there is either deterioration in the performance of the transaction or in the financial health of the servicer or collateral manager. The Company is deemed to be the control party for financial reporting purposes, typically when its protective rights give it the power to both terminate and replace the servicer or collateral manager, which are rights typically given to a financial guaranty insurer. If the Company’s protective rights that could make it the control party have not been triggered, then it does not consolidate the VIE. As of September 30, 2012, the Company had issued financial guaranty contracts for approximately 1,200 VIEs that it did not consolidate.

AGC and AGM are not primarily liable for the debt obligations issued by the VIEs they insure and would only be required to make payments on these debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due. AGL’s and its Subsidiaries’ creditors do not have any rights with regard to the assets of the VIEs. Proceeds from sales, maturities, prepayments and interest from VIE assets may only be used to pay debt service on VIE liabilities. Net fair value gains and losses on FG VIEs are expected to reverse to zero at maturity of the VIE debt, except for net premiums received and claims paid by AGC or AGM under the financial guaranty insurance contract. The Company’s estimate of expected loss to be paid for FG VIEs is included in Note 4, Financial Guaranty Insurance Contracts.

Consolidated FG VIEs

During Third Quarter 2012, the Company determined that, based on the assessment of its control rights over servicer or collateral manager replacement, given that servicing/managing collateral were deemed to be the FG VIEs' most significant activities, no additional VIEs required consolidation. There were a total of 34 consolidated FG VIEs at September 30, 2012, compared to 33 FG VIEs at December 31, 2011.

The total unpaid principal balance for the FG VIEs’ assets that were over 90 days or more past due was approximately $955 million. The aggregate unpaid principal of the FG VIEs’ assets was approximately $2,846 million greater than the aggregate fair value at September 30, 2012. The change in the instrument-specific credit risk of the FG VIEs’ assets for Third Quarter 2012 and Nine Months 2012 were gains of $65 million and $235 million, respectively. The change in the instrument-specific credit risk of the FG VIEs’ assets for the Third Quarter 2011 and Nine Months 2011 were losses of $178 million and $657 million, respectively.

The aggregate unpaid principal balance was approximately $2,321 million greater than the aggregate fair value of the FG VIEs’ liabilities as of September 30, 2012.

The Company has limited contractual rights to obtain the financial records of its consolidated FG VIEs. The FG VIEs do not prepare separate GAAP financial statements; therefore, the Company compiles GAAP financial information for them based on trustee reports prepared by and received from third parties. Such trustee reports are not available to the Company until approximately 30 days after the end of any given period. The time required to perform adequate reconciliations and analyses of the information in these trustee reports results in a one quarter lag in reporting the FG VIEs' activities. The Company records the fair value of FG VIE assets and liabilities based on modeled prices. The Company updates the model assumptions each reporting period for the most recent available information, which incorporates the impact of material events that may have occurred since the quarter lag date. Interest income and interest expense are derived from the trustee reports and included in “fair value gains (losses) on FG VIEs” in the consolidated statement of operations. The Company has elected the fair value option for assets and liabilities classified as FG VIEs’ assets and liabilities because the carrying amount transition method was not practical.

The table below shows the carrying value of the consolidated FG VIEs’ assets and liabilities in the consolidated financial statements, segregated by the types of assets that collateralize their respective debt obligations.

Consolidated FG VIEs

By Type of Collateral



	As of September 30, 2012					As of December 31, 2011
	Number of FG VIEs	Assets		Liabilities		Number of FG VIEs	Assets		Liabilities
	(dollars in millions)
With recourse:
HELOCs	8	$	541	$	822	8	$	573	$	908
First liens:
Alt-A first lien	3	115		94		3	118		106
Option ARM	2	38		181		2	50		245
Subprime	7	395		495		5	387		473
Closed-end second lien	10	207		198		10	184		219
Automobile loans	3	70		70		4	156		156
Life insurance	1	309		309		1	290		290
Total with recourse	34	1,675		2,169		33	1,758		2,397
Without recourse	—	1,018		1,018		—	1,061		1,061
Total	34	$	2,693	$	3,187	33	$	2,819	$	3,458

Gross Unpaid Principal for FG VIEs’ Liabilities

with Recourse



	As of September 30, 2012		As of December 31, 2011
	(in millions)
Gross unpaid principal for FG VIEs’ liabilities with recourse	$	3,395	$	3,796

Contractual Maturity Schedule of FG VIE Liabilities with Recourse



Contractual Maturity	As of September 30, 2012
	(in millions)
2012	$	—
2013	—
2014	69
2015	—
2016	—
Thereafter	3,326
Total	$	3,395

The consolidation of FG VIEs has a significant effect on net income and shareholder’s equity due to (1) changes in fair value gains (losses) on FG VIE assets and liabilities, (2) the elimination of premiums and losses related to the AGC and AGM insured FG VIE liabilities and (3) the elimination of investment balances related to the Company’s purchase of AGC and AGM insured FG VIE debt. Upon consolidation of a FG VIE, the related insurance and, if applicable, the related investment balances, are considered intercompany transactions and therefore eliminated. Such eliminations are included in the table below to present the full effect of consolidating FG VIEs.

Effect of Consolidating FG VIEs on Net Income

and Shareholders’ Equity(1)



	Third Quarter						Nine Months
	2012			2011			2012			2011
	(in millions)
Net earned premiums	$	(17	)	$	(20	)	$	(50	)	$	(57	)
Net investment income	(3		)	(4		)	(9		)	(5		)
Net realized investment gains (losses)	0			7			4			7
Fair value gains (losses) on FG VIEs	38			(99		)	174			(154		)
Loss and LAE	(2		)	38			1			106
Total pretax effect on net income	16			(78		)	120			(103		)
Less: tax provision (benefit)	5			(27		)	42			(36		)
Total effect on net income (loss)	$	11		$	(51	)	$	78		$	(67	)



	As of September 30, 2012			As of December 31, 2011
	(in millions)
Total (decrease) increase on shareholders’ equity	$	(335	)	$	(405	)

____________________


(1)	Includes the effect of eliminating insurance balances related to the financial guaranty insurance contracts.

Fair value gains (losses) on FG VIEs represent the net change in fair value on the consolidated FG VIEs’ assets and liabilities. During Third Quarter 2012, the Company recorded a pre-tax net fair value gain of consolidated FG VIEs of $38 million. While prices appreciated slightly during the period on the Company's FG VIE assets and liabilities, the gain for Third Quarter 2012 was primarily driven by large principal paydowns made on the Company's FG VIE assets. For Nine Months 2012, the Company recorded a pre-tax net fair value gain on consolidated FG VIEs of $174 million. The majority of this gain, $163 million, is a result of a R&W settlement with Deutsche Bank that closed during second quarter 2012.

A pre-tax fair value loss of approximately $99 million was recorded on the consolidated FG VIEs during Third Quarter 2011 and was primarily driven by deterioration on several HELOC transactions. During the period, long term conditional default rates increased on these transactions, which caused the prices for these HELOCs to decline. The prices for the corresponding liability for these transactions remained relatively consistent with the prior quarter. This was also the primary driver of the $154 million pre-tax net unrealized loss in the fair value of consolidated FG VIEs during Nine Months 2011. Nine Months 2011 amount was also driven by the unrealized loss on consolidation of eight new VIEs, as well as two existing transactions in which the fair value of the underlying collateral depreciated, while the price of the wrapped senior bonds was largely unchanged from the prior quarter.

Non-Consolidated VIEs

To date, the Company’s analyses have indicated that it does not have a controlling financial interest in any other VIEs and, as a result, they are not consolidated in the consolidated financial statements. The Company’s exposure provided through its financial guaranties with respect to debt obligations of special purpose entities is included within net par outstanding in Note 3, Outstanding Exposure.