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 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 12.0 years at March 31, 2018 and 11.7 years at December 31, 2017. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives (1)



	As of March 31, 2018					As of December 31, 2017
Asset Type	Net Par Outstanding		Net Fair Value			Net Par Outstanding		Net Fair Value
	(in millions)
Pooled infrastructure	$	1,577	$	(41	)	$	1,561	$	(42	)
U.S. RMBS	886		(28		)	916		(53		)
Pooled corporate obligations (TruPS collateralized debt obligations (CDOs))	767		(75		)	878		(72		)
Infrastructure finance	544		(26		)	572		(36		)
Other (2)	1,841		(66		)	2,280		(66		)
Total	$	5,615	$	(236	)	$	6,207	$	(269	)

____________________

(1) Expected loss to be recovered were $6 million as of March 31, 2018 and $14 million as of December 31, 2017.


(2)	This comprises numerous transactions across various asset classes, such as regulated utilities, health care, municipal utilities, and consumer receivables.

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. Due to the fact that the debt is subordinated,TruPS CDOs were typically structured with higher levels of embedded credit enhancement which allowed the Company to mitigate the risks associated with TruPS CDOs.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of March 31, 2018				As of December 31, 2017
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	2,137	38.1	%	$	2,144	34.6	%
AA	1,053		18.7		1,170		18.8
A	1,203		21.4		1,517		24.5
BBB	964		17.2		1,038		16.7
BIG	258		4.6		338		5.4
Credit derivative net par outstanding	$	5,615	100.0	%	$	6,207	100.0	%

Fair Value of Credit Derivatives

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



	First Quarter
	2018			2017
	(in millions)
Realized gains on credit derivatives	$	2		$	5
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	0			10
Realized gains (losses) and other settlements	2			15
Net unrealized gains (losses):
Pooled infrastructure	1			6
U.S. RMBS	26			9
Pooled corporate obligations	(3		)	20
Infrastructure finance	10			1
Other	(2		)	3
Net unrealized gains (losses)	32			39
Net change in fair value of credit derivatives	$	34		$	54

During First Quarter 2018, unrealized fair value gains were generated primarily as a result of the increase in credit given to the primary insurer on one of the Company's second-to-pay CDS policies, the paydown of CDS par, CDS terminations, and price improvements on the underlying collateral of the Company’s CDS. The increase in the credit given to the primary insurer on one of the Company’s second-to-pay CDS policies was the primary driver of the unrealized fair value gain in the U.S. RMBS sector. The unrealized fair value gains were partially offset by unrealized fair value losses related to the decreased cost to buy protection in AGC’s and AGM’s name as the market cost of AGC’s and AGM’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 and AGM decreased, the implied spreads that the Company would expect to receive on these transactions increased.

During First Quarter 2017, unrealized fair value gains were generated primarily as a result of CDS terminations and tighter implied spreads. During the quarter the Company agreed to terminate several CDS transactions, which was the primary driver of the unrealized fair value gains in the pooled corporate obligations, and U.S. RMBS sectors. The tighter implied spreads were primarily a result of price improvements on the underlying collateral of the Company’s CDS and the increased cost to buy protection in AGC’s and AGM’s name as the market cost of AGC’s and AGM’s credit protection increased 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 increased, the implied spreads that the Company would expect to receive on these transactions decreased.

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 March 31, 2018	As of December 31, 2017	As of March 31, 2017	As of December 31, 2016
Five-year CDS spread:
AGC	121	163	173	158
AGM	109	145	181	158
One-year CDS spread
AGC	25	70	31	35
AGM	22	28	31	29

Fair Value of Credit Derivatives Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads



	As of March 31, 2018			As of December 31, 2017
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(499	)	$	(555	)
Plus: Effect of AGC and AGM credit spreads	263			286
Net fair value of credit derivatives	$	(236	)	$	(269	)

The fair value of CDS contracts at March 31, 2018, 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, pooled infrastructure and infrastructure finance securities, as well as 2005-2007 vintages of Alt-A, option adjustable-rate mortgages (Option ARM) and subprime RMBS transactions. 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 TruPS CDO, and pooled infrastructure markets as well as continuing market concerns over the 2005-2007 vintages of RMBS.

Collateral Posting for Certain Credit Derivative Contracts

The transaction documentation for $333 million of the CDS insured by AGC requires AGC to post collateral, subject to a 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. The table below summarizes AGC’s CDS collateral posting requirements as of March 31, 2018 and December 31, 2017.

AGC Insured CDS Collateral Posting Requirements



	As of March 31, 2018		As of December 31, 2017
	(in millions)
Gross par of CDS with collateral posting requirement	$	333	$	497
Maximum posting requirement	300		464
Collateral posted	1		18

In First Quarter 2018, the Company terminated all of the CDS contracts with a counterparty as to which it had collateral posting obligations, and the collateral that the Company had been posting to that counterparty was all returned to the Company.