Financial Guaranty Contracts Accounted for as Credit Derivatives

Accounting Policy

Credit derivatives are recorded at fair value. Changes in fair value are recorded in “net change in fair value of credit derivatives” on the consolidated statement of operations. Realized gains and other settlements on credit derivatives include credit derivative premiums received and receivable for credit protection the Company has sold under its insured CDS contracts, premiums paid and payable for credit protection the Company has purchased, contractual claims paid and payable and received and receivable related to insured credit events under these contracts, ceding commissions expense or income and realized gains or losses related to their early termination. Net unrealized gains and losses on credit derivatives represent the adjustments for changes in fair value in excess of realized gains and other settlements. Fair value of credit derivatives is reflected as either net assets or net liabilities determined on a contract by contract basis in the Company's consolidated balance sheets. See Note 8, Fair Value Measurement, for a discussion on the fair value methodology for credit derivatives.

Credit Derivatives

The Company has a portfolio of financial guaranty contracts that meet the definition of a derivative in accordance with GAAP (primarily CDS). Until the Company ceased selling credit protection through credit derivative contracts in the beginning of 2009, following the issuance of regulatory guidelines that limited the terms under which the credit protection could be sold, management considered these agreements to be a normal part of its financial guaranty business. The potential capital or margin requirements that may apply under the Dodd-Frank Wall Street Reform and Consumer Protection Act contributed to the decision of the Company not to sell new credit protection through CDS in the foreseeable future.

Credit derivative transactions are governed by ISDA documentation and have different characteristics 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, while the Company’s exposure under credit derivatives, like the Company’s exposure under financial guaranty insurance contracts, has been generally for as long as the reference obligation remains outstanding, unlike financial guaranty contracts, a credit derivative may be terminated for a breach of the ISDA documentation or other specific events. A loss payment is made only upon the occurrence of one or more defined credit events with respect to the referenced securities or loans. A credit event may be a non-payment event such as a failure to pay, bankruptcy or restructuring, as negotiated by the parties to the credit derivative transactions. 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. The Company may be required to make a termination payment to its swap counterparty upon such termination. 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 estimated remaining weighted average life of credit derivatives was 3.7 years at December 31, 2012 and 4.3 years at December 31, 2011. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives Net Par Outstanding



	As of December 31, 2012							As of December 31, 2011
Asset Type	Net Par Outstanding		Original Subordination(1)		Current Subordination(1)		Weighted Average Credit Rating	Net Par Outstanding		Original Subordination(1)		Current Subordination(1)		Weighted Average Credit Rating
	(dollars in millions)
Pooled corporate obligations:
Collateralized loan obligation/collateral bond obligations	$	29,142	32.8	%	33.3	%	AAA	$	34,567	32.6	%	32.0	%	AAA
Synthetic investment grade pooled corporate	9,658		21.6		19.7		AAA	12,393		20.4		18.7		AAA
Synthetic high yield pooled corporate	3,626		35.0		30.3		AAA	5,049		35.7		30.3		AA+
TruPS CDOs	4,099		46.5		32.7		BB	4,518		46.6		31.9		BB
Market value CDOs of corporate obligations	3,595		30.1		32.0		AAA	4,546		30.6		28.9		AAA
Total pooled corporate obligations	50,120		31.7		30.4		AAA	61,073		31.2		28.9		AAA
U.S. RMBS:
Option ARM and Alt-A first lien	3,381		20.2		10.4		B+	4,060		19.6		13.6		BB-
Subprime first lien	3,494		29.8		52.6		A+	4,012		30.1		53.9		A+
Prime first lien	333		10.9		5.2		B	398		10.9		8.4		B
Closed end second lien and HELOCs	49		—		—		B-	62		—		—		B
Total U.S. RMBS	7,257		24.2		30.4		BBB	8,532		24.1		32.2		BBB
CMBS	4,094		33.3		41.8		AAA	4,612		32.6		38.9		AAA
Other	9,310						A-	10,830		—		—		A
Total	$	70,781					AA+	$	85,047					AA+

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(1)	Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses.

Except for TruPS CDOs, the Company’s exposure to pooled corporate obligations is highly diversified in terms of obligors and industries. Most pooled corporate transactions are structured to limit exposure to any given obligor and industry. The majority of the Company’s pooled corporate exposure consists of collateralized loan obligation (“CLO”) or synthetic pooled corporate obligations. Most of these CLOs have an average obligor size of less than 1% of the total transaction and typically restrict the maximum exposure to any one industry to approximately 10%. The Company’s exposure also benefits from embedded credit enhancement in the transactions which allows a transaction to sustain a certain level of losses in the underlying collateral, further insulating the Company from industry specific concentrations of credit risk on these deals.

The Company’s TruPS CDO asset pools are generally less diversified by obligors and industries than the typical CLO asset pool. Also, the underlying collateral in TruPS CDOs consists primarily of subordinated debt instruments such as TruPS issued by bank holding companies and similar instruments issued by insurance companies, REITs and other real estate related issuers while CLOs typically contain primarily senior secured obligations. However, to mitigate these risks TruPS CDOs were typically structured with higher levels of embedded credit enhancement than typical CLOs.

The Company’s exposure to “Other” CDS contracts is also highly diversified. It includes $3.2 billion of exposure to three pooled infrastructure transactions comprising diversified pools of international infrastructure project transactions and loans to regulated utilities. These pools were all structured with underlying credit enhancement sufficient for the Company to attach at super senior AAA levels at origination. The remaining $6.1 billion of exposure in “Other” CDS contracts comprises numerous deals across various asset classes, such as commercial receivables, international RMBS, infrastructure, regulated utilities and consumer receivables. Of the total net par outstanding in the "Other" sector, $983 million is rated BIG.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of December 31, 2012				As of December 31, 2011
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
Super Senior	$	18,908	26.7	%	$	21,802	25.6	%
AAA	32,010		45.2		40,240		47.3
AA	3,083		4.4		4,342		5.1
A	5,487		7.8		5,830		6.9
BBB	4,584		6.4		5,030		5.9
BIG	6,709		9.5		7,803		9.2
Total credit derivative net par outstanding	$	70,781	100.0	%	$	85,047	100.0	%

Credit Derivative

U.S. Residential Mortgage-Backed Securities



	As of December 31, 2012							Net Change in Unrealized Gain (Loss)
Vintage	Net Par Outstanding		Original Subordination(1)		Current Subordination(1)		Weighted Average Credit Rating	Year Ended December 31, 2012
	(in millions)							(in millions)
2004 and Prior	$	124	6.4	%	19.2	%	BBB+	$	3
2005	2,036		31.2		66.3		AA+	12
2006	1,572		29.4		34.5		A-	(63		)
2007	3,525		18.5		8.2		B	(503		)
Total	$	7,257	24.2	%	30.4	%	BBB	$	(551	)

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(1)	Represents the sum of subordinate tranches and overcollateralization and does not include any benefit from excess interest collections that may be used to absorb losses.

Net Change in Fair Value of Credit Derivatives

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



	Year Ended December 31,
	2012			2011			2010
	(in millions)
Net credit derivative premiums received and receivable	$	127		$	185		$	207
Net ceding commissions (paid and payable) received and receivable	1			3			3
Realized gains on credit derivatives	128			188			210
Terminations	(1		)	(23		)	—
Net credit derivative losses (paid and payable) recovered and recoverable	(235		)	(159		)	(57		)
Total realized gains (losses) and other settlements on credit derivatives	(108		)	6			153
Net unrealized gains (losses) on credit derivatives	(477		)	554			(155		)
Net change in fair value of credit derivatives	$	(585	)	$	560		$	(2	)

In years ended December 31, 2012 and 2011, CDS contracts totaling $2.3 billion and $11.5 billion in net par were terminated, resulting in accelerations of credit derivative revenue of $3 million in 2012 and $25 million in 2011.

Changes in the fair value of credit derivatives occur primarily because of changes in interest rates, credit spreads, notional amounts, credit ratings of the referenced entities, expected terms, realized gains (losses) and other settlements, and the issuing company’s own credit rating, credit spreads and other market factors. Except for net estimated credit impairments (i.e., net expected loss to be paid as discussed in Note 6), the unrealized gains and losses on credit derivatives are expected to reduce to zero as the exposure approaches its maturity date. With considerable volatility continuing in the market, unrealized gains (losses) on credit derivatives may fluctuate significantly in future periods.

Net Change in Unrealized Gains (Losses) on Credit Derivatives By Sector



	Year Ended December 31,
Asset Type	2012			2011			2010
	(in millions)

Pooled corporate obligations:
CLOs/Collateral bond obligations	$	6		$	10		$	2
Synthetic investment grade pooled corporate	18			16			(2		)
Synthetic high yield pooled corporate	21			(1		)	11
TruPS CDOs	15			14			59
Market value CDOs of corporate obligations	(1		)	0			0
Total pooled corporate obligations	59			39			70
U.S. RMBS:
Option ARMs and Alt-A first lien	(447		)	300			(281		)
Subprime first lien	(55		)	24			(10		)
Prime first lien	(54		)	47			(8		)
Closed end second lien and HELOCs	5			10			(2		)
Total U.S. RMBS	(551		)	381			(301		)
CMBS	2			11			10
Other	13			123			66
Total	$	(477	)	$	554		$	(155	)

During 2012, U.S. RMBS unrealized fair value losses were generated primarily in the prime first lien, Alt-A, Option ARM and subprime RMBS sectors primarily as a result of the decreased cost to buy protection in AGC's name as the market cost of AGC's credit protection decreased. These transactions were pricing above their floor levels (or the minimum rate at which the Company would consider assuming these risks based on historical experience); therefore 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. The cost of AGM's credit protection also decreased during 2012, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels.

In 2011, U.S. RMBS unrealized fair value gains were generated primarily in the Option ARM, Alt-A, prime first lien and subprime sectors primarily as a result of the increased cost to buy protection in AGC's name as the market cost of AGC's credit protection increased. These transactions were pricing above their floor levels; therefore when the cost of purchasing CDS protection on AGC, increased the implied, spreads that the Company would expect to receive on these transactions decreased. The unrealized fair value gain in "other" primarily resulted from tighter implied net spreads on a XXX life securitization transaction and a film securitization, which also resulted from the increased cost to buy protection in AGC's name, referenced above. The cost of AGM's credit protection also increased during the year, but did not lead to significant fair value gains, as the majority of AGM policies continue to price at floor levels.

In 2010, U.S. RMBS unrealized fair value losses were generated primarily in the Option ARM and Alt-A first lien sector due to internal ratings downgrades on several of these Option ARM and Alt-A first lien policies. The unrealized fair value gain within the TruPS CDO and Other asset classes resulted from tighter implied spreads. These transactions were pricing above their floor levels; therefore when the cost of purchasing CDS protection on AGC and AGM increased, the implied spreads that the Company would expect to receive on these transactions decreased. During 2010, AGC's and AGM's spreads widened. However, gains due to the widening of the Company's own CDS spreads were offset by declines in fair value resulting from price changes and the internal downgrades of several U.S. RMBS policies referenced above.

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. Generally, a widening of the CDS prices traded on AGC and AGM has an effect of offsetting unrealized losses that result from widening general market credit spreads, while a narrowing of the CDS prices traded on AGC and AGM has an effect of offsetting unrealized gains that result from narrowing general market credit spreads.

Five-Year CDS Spread on AGC and AGM



	As of December 31, 2012	As of December 31, 2011	As of December 31, 2010
Quoted price of CDS contract (in basis points):
AGC	678	1,140	804
AGM	536	778	650

Components of Credit Derivative Assets (Liabilities)



	As of December 31, 2012			As of December 31, 2011
	(in millions)
Credit derivative assets	$	141		$	153
Credit derivative liabilities	(1,934		)	(1,457		)
Net fair value of credit derivatives	$	(1,793	)	$	(1,304	)



	As of December 31, 2012			As of December 31, 2011
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(4,809	)	$	(5,596	)
Plus: Effect of AGC and AGM credit spreads	3,016			4,292
Net fair value of credit derivatives	$	(1,793	)	$	(1,304	)

The fair value of CDS contracts at December 31, 2012, 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 ratings downgrades. The asset classes that remain most affected are recent vintages of prime first lien, Alt-A, Option ARM, subprime RMBS deals as well as trust-preferred securities. Comparing December 31, 2012 with December 31, 2011, there was a narrowing of spreads primarily related to Alt-A first lien and subprime RMBS transactions. This narrowing of spreads resulted in a gain of approximately $787 million, before taking into account AGC’s or AGM’s credit spreads.

Management believes that the trading level of AGC’s and AGM’s credit spreads are due to the correlation between AGC’s and AGM’s risk profile and the current risk profile of the broader financial markets and to increased demand for credit protection against AGC and AGM as the result of its financial guaranty volume, as well as the overall lack of liquidity in the CDS market. Offsetting the benefit attributable to AGC’s and AGM’s credit spread were higher credit spreads in the fixed income security markets. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the high yield CDO, Trust- Preferred CDO, and CLO markets as well as continuing market concerns over the most recent vintages of subprime RMBS.

The following table presents the fair value and the present value of expected claim payments or recoveries (i.e. net expected loss to be paid as described in Note 6) for contracts accounted for as derivatives.

Net Fair Value and Expected Losses of Credit Derivatives by Sector



	Fair Value of Credit Derivative Asset (Liability), net						Present Value of Expected Claim (Payments) Recoveries(1)
Asset Type	As of December 31, 2012			As of December 31, 2011			As of December 31, 2012			As of December 31, 2011
	(in millions)
Pooled corporate obligations:
CLOs/ Collateralized bond obligations	$	3		$	(1	)	$	—		$	—
Synthetic investment grade pooled corporate	(5		)	(24		)	—			—
Synthetic high-yield pooled corporate	3			(16		)	—			(5		)
TruPS CDOs	3			(12		)	(16		)	(40		)
Market value CDOs of corporate obligations	2			3			—			—
Total pooled corporate obligations	6			(50		)	(16		)	(45		)
U.S. RMBS:
Option ARM and Alt-A first lien	(1,076		)	(596		)	(121		)	(191		)
Subprime first lien	(52		)	(23		)	(70		)	(95		)
Prime first lien	(99		)	(44		)	—			—
Closed-end second lien and HELOCs	(10		)	(15		)	10			7
Total U.S. RMBS	(1,237		)	(678		)	(181		)	(279		)
CMBS	(2		)	(5		)	—			—
Other	(560		)	(571		)	(85		)	(95		)
Total	$	(1,793	)	$	(1,304	)	$	(282	)	$	(419	)

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(1)	Represents amount in excess of the present value of future installment fees to be received of $43 million as of December 31, 2012 and $47 million as of December 31, 2011. Includes R&W benefit of $237 million as of December 31, 2012 and $215 million as of December 31, 2011.

Ratings Sensitivities of Credit Derivative Contracts

Within the Company’s insured CDS portfolio, the transaction documentation for approximately $2.0 billion in CDS gross par insured as of December 31, 2012 provides that a downgrade of AGC's financial strength rating below BBB- or Baa3 would constitute a termination event that would allow the relevant CDS counterparty to terminate the affected transactions. If the CDS counterparty elected to terminate the affected transactions, AGC could be required to make a termination payment (or may be entitled to receive a termination payment from the CDS counterparty). Of the transactions described above, for one of the CDS counterparties, a downgrade of AGC's financial strength rating below A- or A3 (but not below BBB- or Baa3) would constitute a termination event for which the Company has the right to cure by posting collateral, assigning its rights and obligations in respect of the transactions to a third party, or seeking a third party guaranty of its obligations. No counterparty had a right to terminate any transactions as a result of the January 2013 Moody's downgrade of AGC. The Company does not believe that it can accurately estimate the termination payments AGC could be required to make if, as a result of any such downgrade, a CDS counterparty terminated the affected transactions. These payments could have a material adverse effect on the Company’s liquidity and financial condition.

The transaction documentation for approximately $13.2 billion in CDS gross par insured as of December 31, 2012 requires certain of the Company's insurance subsidiaries to post eligible collateral to secure its obligation to make payments under such contracts based on (i) the mark-to-market valuation of the underlying exposure and (ii) in some cases, the financial strength ratings of such subsidiaries. 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 a result of the January 2013 Moody's downgrade of AGC's financial strength rating, AGC was required under such transaction documentation to post approximately $70 million of additional collateral, for a total amount posted by the Company's insurance subsidiaries of approximately $728 million (which amount reflects some of the eligible collateral being valued at a discount to the face amount).

•

For approximately $12.8 billion of such contracts, AGC has negotiated caps such that, after giving effect to the January 2013 Moody's downgrade of AGC, the posting requirement cannot exceed a certain fixed amount, regardless of the mark-to-market valuation of the exposure or the financial strength ratings of AGC. For such contracts, AGC need not post on a cash basis more than $675 million, which amount is already being posted by AGC and is part of the approximately $728 million posted by the Company's insurance subsidiaries.


•	For the remaining approximately $400 million of such contracts, AGC could be required from time to time to post additional collateral based on movements in the mark-to-market valuation of the underlying exposure. Of the $728 million being posted by the Company's insurance subsidiaries, approximately $68 million relate to such $400 million of notional.

Sensitivity to Changes in Credit Spread

The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming immediate parallel shifts in credit spreads on AGC and AGM and on the risks that they both assume.

Effect of Changes in Credit Spread

As of December 31, 2012



Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(3,765	)	$	(1,972	)
50% widening in spreads	(2,777		)	(984		)
25% widening in spreads	(2,283		)	(490		)
10% widening in spreads	(1,987		)	(194		)
Base Scenario	(1,793		)	—
10% narrowing in spreads	(1,634		)	159
25% narrowing in spreads	(1,402		)	391
50% narrowing in spreads	(1,028		)	765

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(1)	Includes the effects of spreads on both the underlying asset classes and the Company’s own credit spread.