Financial Guaranty 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).

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, 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 estimated remaining weighted average life of credit derivatives was 5.1 years at September 30, 2016 and 5.4 years at December 31, 2015. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives

Subordination and Ratings



	As of September 30, 2016							As of December 31, 2015
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	$	2,583	29.2	%	45.3	%	AAA	$	5,873	30.9	%	42.3	%	AAA
Synthetic investment grade pooled corporate	7,920		22.2		19.9		AAA	7,108		21.7		19.4		AAA
TruPS CDOs	1,771		42.2		41.6		BBB	3,429		45.8		42.6		A-
Market value CDOs of corporate obligations	—		—		—		--	1,113		17.0		30.1		AAA
Total pooled corporate obligations	12,274		26.6		28.4		AAA	17,523		29.2		32.3		AAA
U.S. RMBS:
Option ARM and Alt-A first lien	277		9.4		12.7		AA-	351		10.5		12.7		AA-
Subprime first lien	891		27.8		45.0		AA	981		27.7		45.2		AA
Prime first lien	—		—		—		--	177		10.9		0.0		BB
Closed-end second lien	14		—		—		BB	17		—		—		CCC
Total U.S. RMBS	1,182		25.1		40.3		AA	1,526		24.1		37.4		A+
CMBS	159		56.9		78.9		AAA	530		44.8		52.6		AAA
Other	6,344		—		—		A	6,015		—		—		A
Total(2)	$	19,959					AA	$	25,594					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.


(2)	The September 30, 2016 total amount includes $2.3 million net par outstanding of credit derivatives acquired from CIFG.

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 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, real estate investment trusts 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 $1.6 billion of exposure to one pooled infrastructure transaction 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 AAA levels at origination. The remaining $4.7 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.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of September 30, 2016				As of December 31, 2015
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	10,778	54.0	%	$	14,808	57.9	%
AA	4,025		20.2		4,821		18.8
A	2,037		10.2		2,144		8.4
BBB	2,040		10.2		2,212		8.6
BIG	1,079		5.4		1,609		6.3
Credit derivative net par outstanding	$	19,959	100.0	%	$	25,594	100.0	%

Fair Value of Credit Derivatives

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



	Third Quarter						Nine Months
	2016			2015			2016			2015
	(in millions)
Realized gains on credit derivatives	$	11		$	14		$	39		$	52
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	4			(8		)	8			(17		)
Realized gains (losses) and other settlements	15			6			47			35
Net unrealized gains (losses):
Pooled corporate obligations	3			(24		)	(37		)	0
U.S. RMBS	(12		)	11			0			148
CMBS	0			(3		)	0			1
Other	15			96			14			116
Net unrealized gains (losses)	6			80			(23		)	265
Net change in fair value of credit derivatives	$	21		$	86		$	24		$	300

Net Par and Realized Gains

from Terminations and Settlements of Credit Derivative Contracts



	Third Quarter				Nine Months
	2016		2015		2016		2015
	(in millions)
Net par of terminated credit derivative contracts	$	1,071	$	405	$	3,507	$	969
Realized gains on credit derivatives	3		0		11		13
Net unrealized gains (losses) on credit derivatives	11		99		81		98

During Third Quarter 2016, unrealized fair value gains were generated primarily as a result of CDS terminations in the pooled corporate and other sectors and price improvements on the underlying collateral of the Company’s CDS. This was the primary driver of the unrealized fair value gains in the pooled corporate CLO, and other sectors. The unrealized fair value gains were partially offset by unrealized losses resulting from wider implied net spreads across all sectors. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, particularly for the one year CDS spread, as the market cost of AGC’s and AGM’s credit protection decreased significantly during the period. These transactions were pricing at or 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 and AGM, which management refers to as the CDS spread on AGC and AGM, decreased the implied spreads that the Company would expect to receive on these transactions increased.

During Nine Months 2016, unrealized fair value losses were generated primarily in the trust preferred sector, due to wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, particularly for the one year and five year CDS spread, as the market cost of AGC’s and AGM’s credit protection decreased during the period. These transactions were pricing at or above their floor levels, therefore when the cost of purchasing CDS protection on AGC and AGM decreased, the implied spreads that the Company would expect to receive on these transactions increased. The unrealized fair value losses were partially offset by unrealized fair value gains which resulted from the terminations of several CDS transactions during the period. The majority of the CDS transactions were terminated as a result of settlement agreements with several CDS counterparties.

During Third Quarter 2015, unrealized fair value gains were driven primarily by the termination of a Triple-X life-securitization transaction in the other sector. These unrealized gains were partially offset by wider implied net spreads in the Company’s pooled corporate CLO sector. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, particularly for the one year and five year CDS spreads, as the market cost of AGC’s and AGM’s credit protection decreased during the period. For those CDS transactions that were pricing above their floor levels, when the cost of purchasing CDS protection on AGC and AGM decreased, the implied spreads that the Company would expect to receive on these transactions increased.

During Nine Months 2015, unrealized fair value gains were generated primarily in the U.S. RMBS prime first lien and Option ARM and subprime sectors, due to tighter implied net spreads. The tighter implied net spreads were primarily a result of the increased cost to buy protection in AGC’s and AGM’s name, particularly for the one year CDS spread, as the market cost of AGC’s and AGM’s credit protection increased during the period. For those CDS transactions that were pricing above their floor levels, 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. The unrealized fair value gains in the other sector were a result of the termination of a Triple-X life-securitization transaction, referenced above. In addition, during Nine Months 2015 there was a refinement in methodology to address an instance in a U.S. RMBS transaction that changed from an expected loss to an expected recovery position. This refinement resulted in approximately $49 million in fair value gains in Nine Months 2015.

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.

CDS Spread on AGC and AGM

Quoted price of CDS contract (in basis points)



	As of September 30, 2016	As of June 30, 2016	As of December 31, 2015	As of September 30, 2015	As of June 30, 2015	As of December 31, 2014
Five-year CDS spread:
AGC	170	265	376	331	390	323
AGM	170	265	366	337	410	325
One-year CDS spread
AGC	31	45	139	112	120	80
AGM	31	47	131	104	125	85

Fair Value of Credit Derivatives Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads



	As of September 30, 2016			As of December 31, 2015
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(1,020	)	$	(1,448	)
Plus: Effect of AGC and AGM credit spreads	539			1,083
Net fair value of credit derivatives	$	(481	)	$	(365	)

The fair value of CDS contracts at September 30, 2016, 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 TruPS and pooled corporate securities as well as 2005-2007 vintages of prime first lien, Alt-A, Option ARM and subprime RMBS deals. The mark to market benefit between September 30, 2016, and December 31, 2015, resulted primarily from several CDS terminations and a narrowing of credit spreads related to the Company's TruPS obligations.

Management believes that the trading level of AGC’s and AGM’s credit spreads over the past several years has been due to the correlation between AGC’s and AGM’s risk profile and the current risk profile of the broader financial markets, 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, TruPS CDO, and CLO markets as well as continuing market concerns over the 2005-2007 vintages of 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 5) 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						Expected Loss to be (Paid) Recovered
Asset Type	As of September 30, 2016			As of December 31, 2015			As of September 30, 2016			As of December 31, 2015
	(in millions)
Pooled corporate obligations	$	(126	)	$	(82	)	$	(4	)	$	(5	)
U.S. RMBS	(97		)	(98		)	(27		)	(38		)
Other	(258		)	(185		)	26			27
Total	$	(481	)	$	(365	)	$	(5	)	$	(16	)

Ratings Sensitivities of Credit Derivative Contracts

Within the Company's insured CDS portfolio, the transaction documentation for approximately $0.7 billion in CDS gross par insured as of September 30, 2016 requires AGC to post eligible collateral to secure its obligations to make payments under such contracts. This constitutes a reduction of approximately $3.1 billion from the $3.8 billion subject to such a requirement as of December 31, 2015, primarily due to an agreement reached in May 2016 with a CDS counterparty reducing the collateral posting requirement with respect to that counterparty to zero. 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.

•

For approximately $0.6 billion gross par of such contracts, AGC has negotiated caps such that 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 an aggregate of more than $500 million, although the value of the collateral posted may exceed such fixed amount depending on the advance rate agreed with the counterparty for the particular type of collateral posted.


•	For the remaining approximately $178 million gross par of such contracts, AGC could be required from time to time to post additional collateral without such cap based on movements in the mark-to-market valuation of the underlying exposure.

As of September 30, 2016, the Company was posting approximately $130 million to secure its obligations under CDS, of which approximately $17 million related to the $178 million of gross par described above, as to which the obligation to collateralize is not capped. As of December 31, 2015, the Company was posting approximately $305 million to secure its obligations under CDS, of which approximately $23 million related to $221 million of gross par as to which the obligation to collateralize was not capped. The obligation to post collateral could impair the Company's liquidity and results of operations.

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 September 30, 2016



Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(978	)	$	(497	)
50% widening in spreads	(730		)	(249		)
25% widening in spreads	(606		)	(125		)
10% widening in spreads	(531		)	(50		)
Base Scenario	(481		)	—
10% narrowing in spreads	(435		)	46
25% narrowing in spreads	(365		)	116
50% narrowing in spreads	(251		)	230

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