Note 9: Derivative Instruments

Overview

MBIA has entered into derivative transactions through its financial guarantee of CDS and for purposes of hedging risks associated with existing assets and liabilities and forecasted transactions. CDS are also entered into in the asset/liability products business to replicate investments in cash assets consistent with the Company’s risk objectives and credit guidelines for its asset management business. The Company accounts for derivative transactions in accordance with the accounting principles for derivative and hedging activities, which requires that all such transactions be recorded on the balance sheet at fair value. Refer to “Note 6: Fair Value of Financial Instruments” for the definition of fair value of derivative instruments.

Changes in the fair value of derivatives, excluding insured derivatives, are recorded each period in current earnings within “Net gains (losses) on financial instruments at fair value and foreign exchange.” Changes in the fair value of insured derivatives are recorded each period in current earnings within “Net change in fair value of insured derivatives.” The net change in the fair value of the Company’s insured derivatives has two primary components: (i) realized gains (losses) and other settlements on insured derivatives and (ii) unrealized gains (losses) on insured derivatives. “Realized gains (losses) and other settlements on insured derivatives” include (i) premiums received and receivable on written CDS contracts, (ii) premiums paid and payable to reinsurers in respect to CDS contracts, (iii) net amounts received or paid on reinsurance commutations, (iv) losses paid and payable to CDS contract counterparties due to the occurrence of a credit event or settlement agreement, (v) losses recovered and recoverable on purchased CDS contracts due to the occurrence of a credit event or settlement agreement and (vi) fees relating to CDS contracts. The “Unrealized gains (losses) on insured derivatives” include all other changes in fair value of the insured derivative contracts.

U.S. Public Finance Insurance

The Company’s derivative exposure within its U.S. public finance insurance operations primarily consists of insured interest rate and inflation-linked swaps related to insured U.S. public finance debt issues. These derivatives do not qualify for the financial guarantee scope exception. The Company has also purchased certain investments containing embedded derivatives. All derivatives are recorded at fair value on the Company’s consolidated balance sheets with the changes in fair value recorded on the Company’s consolidated statements of operations within “Unrealized gains (losses) on insured derivatives,” for the insured derivatives, or “Net gains (losses) on financial instruments at fair value and foreign exchange” for the embedded derivatives.

Structured Finance and International Insurance

The Company entered into derivative transactions that it viewed as an extension of its core financial guarantee business but which do not qualify for the financial guarantee scope exception and, therefore, must be recorded at fair value on the balance sheet. The Company’s structured finance and international insurance operations, which insured the majority of the Company’s notional derivative exposure, have insured CDS contracts, primarily referencing corporate, asset-backed, residential mortgage-backed, commercial mortgage-backed, CRE loans, and CDO securities that the Company intends to hold for the entire term of the contract absent a negotiated settlement with the counterparty.

Variable Interest Entities

VIEs consolidated by the Company have entered into derivative transactions primarily consisting of interest rate swaps. Interest rate swaps are entered into to hedge the risks associated with fluctuations in interest rates or fair values of certain contracts.

Asset/Liability Products

The Company’s asset/liability products business has entered into derivative transactions primarily consisting of interest rate swaps, cross currency swaps, and CDS contracts. Interest rate swaps are entered into to hedge the risks associated with fluctuations in interest rates or fair values of certain contracts. Cross currency swaps are entered into to hedge the variability in cash flows resulting from fluctuations in foreign currency rates. CDS contracts are entered into to hedge credit risk or to replicate investments in cash assets consistent with the Company’s risk objectives and credit guidelines for its asset management business.

Certain interest rate swaps qualify as fair value hedges. The fair value hedges are used to protect against changes in the market value of the hedged assets or liabilities. The gains and losses relating to the fair value hedges are recorded directly in earnings. Fair value hedges are hedging existing assets, liabilities or forecasted transactions.

Credit Derivatives Sold

The following table presents information about credit derivatives sold by the Company’s insurance operations that were outstanding as of June 30, 2012. Credit ratings represent the lower of underlying ratings currently assigned by Moody’s, S&P or MBIA.


In millions			Notional Value
Credit Derivatives Sold	Weighted Average Remaining Expected Maturity		AAA		AA		A		BBB		Below Investment Grade		Total Notional		Fair Value Asset (Liability)
Insured credit default swaps		5.4 Years	$	10,519	$	5,895	$	5,179	$	5,989	$	21,298	$	48,880	$	(3,206)
Insured swaps		20.0 Years		-		185		3,918		2,008		71		6,182		(9)
All others		2.3 Years		-		-		-		-		195		195		(87)

Total notional			$	10,519	$	6,080	$	9,097	$	7,997	$	21,564	$	55,257

Total fair value			$	(33)	$	(78)	$	(144)	$	(436)	$	(2,611)			$	(3,302)

The following table presents information about credit derivatives sold by the Company’s insurance operations that were outstanding as of December 31, 2011. Credit ratings represent the lower of underlying ratings currently assigned by Moody’s, S&P or MBIA.


In millions			Notional Value
Credit Derivatives Sold	Weighted Average Remaining Expected Maturity		AAA		AA		A		BBB		Below Investment Grade		Total Notional		Fair Value Asset (Liability)
Insured credit default swaps		5.6 Years	$	15,475	$	12,065	$	6,336	$	14,042	$	17,639	$	65,557	$	(4,716)
Non-insured credit default swaps-VIE		3.6 Years		-		-		-		-		643		643		(527)
Insured swaps		19.7 Years		-		164		4,270		2,589		133		7,156		(9)
All others		2.8 Years		-		-		-		-		195		195		(91)

Total notional			$	15,475	$	12,229	$	10,606	$	16,631	$	18,610	$	73,551

Total fair value			$	(114)	$	(116)	$	(205)	$	(1,355)	$	(3,553)			$	(5,343)

Referenced credit ratings assigned by MBIA to insured credit derivatives are derived by the Company’s surveillance group. In assigning an internal rating, current status reports from issuers and trustees, as well as publicly available transaction-specific information, are reviewed. Also, where appropriate, cash flow analyses and collateral valuations are considered. The maximum potential amount of future payments (undiscounted) on CDS contracts are estimated as the notional value plus any additional debt service costs, such as interest or other amounts owing on CDS contracts. The maximum amount of future payments that MBIA may be required to make under these guarantees is $53.1 billion. This amount is net of $527 million of insured derivatives ceded under reinsurance agreements in which MBIA economically hedges a portion of the credit and market risk associated with its insured derivatives and offsetting agreements with a counterparty. The maximum potential amount of future payments (undiscounted) on insured swaps are estimated as the notional value of such contracts.

MBIA may hold recourse provisions with third parties in derivative transactions through both reinsurance and subrogation rights. MBIA’s reinsurance arrangements provide that in the event MBIA pays a claim under a guarantee of a derivative contract, MBIA has the right to collect amounts from any reinsurers that have reinsured the guarantee on either a proportional or non-proportional basis, depending upon the underlying reinsurance agreement. MBIA may also have recourse through subrogation rights whereby if MBIA makes a claim payment, it is entitled to any rights of the insured counterparty, including the right to any assets held as collateral.

Financial Statement Impact

The fair value of amounts recognized for eligible derivative contracts executed with the same counterparty under a master netting agreement, including any cash collateral that may have been received or posted by the Company, is presented on a net basis in accordance with accounting guidance for the offsetting of fair value amounts related to derivative instruments.

As of June 30, 2012, the total fair value of the Company’s derivative assets, after counterparty netting, was $13 million, of which $5 million was reported within “Other assets” and “Derivative assets-VIEs” on the Company’s consolidated balance sheets, and the total fair value of the Company’s derivative liabilities, after counterparty netting and posting of cash collateral, was $3.5 billion, which was reported within “Derivative liabilities” and “Derivative liabilities-VIEs” on the Company’s consolidated balance sheets.

As of June 30, 2012, the total fair value of the Company’s derivative assets, before counterparty netting, was $111 million and the total fair value of the Company’s derivative liabilities, before counterparty netting and posting of cash collateral, was $4.0 billion. The following table presents the total fair value of the Company’s derivative assets and liabilities by instrument and balance sheet location, before counterparty netting and posting of cash collateral, as of June 30, 2012:


In millions			Derivative Assets ⁽¹⁾			Derivative Liabilities ⁽¹⁾
Derivative Instruments	Notional Amount Outstanding		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Designated as hedging instruments:
Interest rate swaps	$	97	Other Assets	$	11	Derivative liabilities	$	(8)

Total designated	$	97		$	11		$	(8)
Not designated as hedging instruments:
Insured credit default swaps	$	49,198	Other Assets	$	3	Derivative liabilities	$	(3,206)
Insured swaps		6,182	Other Assets		-	Derivative liabilities		(9)
Non-insured credit default swaps		10	Other Assets		-	Derivative liabilities		-
Interest rate swaps		2,585	Other Assets		88	Derivative liabilities		(443)
Interest rate swaps-VIE		3,239	Derivative assets- VIE		-	Derivative liabilities-VIE		(165)
Interest rate swaps-embedded		469	Medium-term notes		8	Medium-term notes		(23)
Currency swaps		38	Other Assets		-	Derivative liabilities		(1)
Currency swaps-VIE		116	Derivative assets- VIE		-	Derivative liabilities-VIE		(21)
All other		195	Other Assets		-	Derivative liabilities		(87)
All other-VIE		310	Derivative assets- VIE		1	Derivative liabilities-VIE		-
All other-embedded		20	Other investments		-	Other investments		(1)

Total non-designated	$	62,362		$	100		$	(3,956)

Total derivatives	$	62,459		$	111		$	(3,964)

(1) - In accordance with the accounting guidance for derivative instruments and hedging activities, the balance sheet location of the Company’s embedded derivative instruments is determined by the location of the related host contract.

As of December 31, 2011, the total fair value of the Company’s derivative assets, after counterparty netting, was $459 million, of which $452 million was reported within “Other assets” and “Derivative assets-VIEs” on the Company’s consolidated balance sheets, and the total fair value of the Company’s derivative liabilities, after counterparty netting, was $6.0 billion which was reported within “Derivative liabilities” and “Derivative liabilities-VIEs” on the Company’s consolidated balance sheets.

As of December 31, 2011, the total fair value of the Company’s derivative assets, before counterparty netting, was $552 million and the total fair value of the Company’s derivative liabilities, before counterparty netting, was $6.1 billion. The following table presents the total fair value of the Company’s derivative assets and liabilities by instrument and balance sheet location, before counterparty netting, as of December 31, 2011:


In millions			Derivative Assets⁽¹⁾			Derivative Liabilities⁽¹⁾
Derivative Instruments	Notional Amount Outstanding		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Designated as hedging instruments:
Interest rate swaps	$	241	Other Assets	$	10	Derivative liabilities	$	(44)

Total designated	$	241		$	10		$	(44)
Not designated as hedging instruments:
Insured credit default swaps	$	66,851	Other Assets	$	-	Derivative liabilities	$	(4,708)
Insured swaps		7,156	Other Assets		-	Derivative liabilities		(9)
Non-insured credit default swaps		30	Other Assets		1	Derivative liabilities		-
Non-insured credit default swaps-VIE		1,272	Derivative assets-VIE		447	Derivative liabilities-VIE		(527)
Interest rate swaps		2,706	Other Assets		84	Derivative liabilities		(401)
Interest rate swaps-VIE		4,878	Derivative assets-VIE		-	Derivative liabilities-VIE		(281)
Interest rate swaps-embedded		480	Medium-term notes		7	Medium-term notes		(14)
Currency swaps		62	Other Assets		-	Derivative liabilities		(4)
Currency swaps-VIE		123	Derivative assets-VIE		-	Derivative liabilities-VIE		(17)
All other		3,465	Other Assets		-	Derivative liabilities		(91)
All other-VIE		472	Derivative assets-VIE		3	Derivative liabilities-VIE		-
All other-embedded		121	Other investments		-	Other investments		(12)

Total non-designated	$	87,616		$	542		$	(6,064)

Total derivatives	$	87,857		$	552		$	(6,108)

The following tables present the effect of derivative instruments on the consolidated statements of operations for the three months ended June 30, 2012:


In millions
Derivatives in Fair Value Hedging Relationships	Location of Gain (Loss) Recognized in Income on Derivative	Gain (Loss) Recognized in Income on Derivative		Gain (Loss) Recognized in Income on Hedged Item		Net Gain (Loss) Recognized in Income
Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange	$	10	$	(10)	$	-
Interest rate swaps	Interest income (expense)		-		-		(1)

Total		$	10	$	(10)	$	(1)


In millions
Derivatives Not Designated as Hedging Instruments	Location of Gain (Loss) Recognized in Income on Derivative	Net Gain (Loss) Recognized in Income


Insured credit default swaps	Unrealized gains (losses) on insured derivatives	$	1,202
Insured credit default swaps	Realized gains (losses) and other settlements on insured derivatives		(428)
Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(60)
Interest rate swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		10
Currency swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		2
Currency swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(2)
All other	Unrealized gains (losses) on insured derivatives		1
All other-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(1)

Total		$	724

The following tables present the effect of derivative instruments on the consolidated statements of operations for the three months ended June 30, 2011:


In millions		Gain (Loss) Recognized in Income on Derivative		Gain (Loss) Recognized in Income on Hedged Item		Net Gain (Loss) Recognized in Income
Derivatives in Fair Value Hedging Relationships	Location of Gain (Loss) Recognized in Income on Derivative


Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange	$	8	$	(8)	$	-
Interest rate swaps	Interest income (expense)		-		-		(3)

Total		$	8	$	(8)	$	(3)


In millions
Derivatives Not Designated as Hedging Instruments	Location of Gain (Loss) Recognized in Income on Derivative	Net Gain (Loss) Recognized in Income
Derivatives Not Designated as Hedging Instruments		Net Gain (Loss) Recognized in Income
Insured credit default swaps	Unrealized gains (losses) on insured derivatives	$	140
Insured credit default swaps	Realized gains (losses) and other settlements on insured derivatives		(191)
Non-insured credit default swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(1)
Non-insured credit default swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		7
Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(53)
Interest rate swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(22)
Currency swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(2)
Currency swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(4)
All other	Unrealized gains (losses) on insured derivatives		(24)
All other	Net gains (losses) on financial instruments at fair value and foreign exchange		1
All other-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		1

Total		$	(148)

The following tables present the effect of derivative instruments on the consolidated statements of operations for the six months ended June 30, 2012:


In millions
Derivatives in Fair Value Hedging Relationships	Location of Gain (Loss) Recognized in Income on Derivative	Gain (Loss) Recognized in Income on Derivative		Gain (Loss) Recognized in Income on Hedged Item		Net Gain (Loss) Recognized in Income


Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange	$	37	$	(37)	$	-
Interest rate swaps	Interest income (expense)		-		-		(2)

Total		$	37	$	(37)	$	(2)


In millions
Derivatives Not Designated as Hedging Instruments	Location of Gain (Loss) Recognized in Income on Derivative	Net Gain Loss) Recognized in Income
Insured credit default swaps	Unrealized gains (losses) on insured derivatives	$	1,502
Insured credit default swaps	Realized gains (losses) and other settlements on insured derivatives		(432)
Insured swaps	Unrealized gains (losses) on insured derivatives		1
Non-insured credit default swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(1)
Non-insured credit default swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(1)
Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(50)
Interest rate swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		31
Currency swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(3)
All other	Unrealized gains (losses) on insured derivatives		3
All other	Net gains (losses) on financial instruments at fair value and foreign exchange		11
All other-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(2)

Total		$	1,059

The following tables present the effect of derivative instruments on the consolidated statements of operations for the six months ended June 30, 2011:


In millions
Derivatives in Fair Value Hedging Relationships	Location of Gain (Loss) Recognized in Income on Derivative	Gain (Loss) Recognized in Income on Derivative		Gain (Loss) Recognized in Income on Hedged Item		Net Gain (Loss) Recognized in Income
Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange	$	2	$	(2)	$	-
Interest rate swaps	Interest income (expense)		-		-		(5)
Currency swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		2		(2)		-

Total		$	4	$	(4)	$	(5)


In millions
Derivatives Not Designated as Hedging Instruments	Location of Gain (Loss) Recognized in Income on Derivative	Net Gain (Loss) Recognized in Income
Insured credit default swaps	Unrealized gains (losses) on insured derivatives	$	(1,272)
Insured credit default swaps	Realized gains (losses) and other settlements on insured derivatives		(546)
Non-insured credit default swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(2)
Non-insured credit default swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(150)
Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(51)
Interest rate swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		49
Currency swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		(7)
Currency swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(2)
All other	Unrealized gains (losses) on insured derivatives		(35)
All other-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		(1)

Total		$	(2,017)

Counterparty Credit Risk

The Company manages counterparty credit risk on an individual counterparty basis through master netting agreements covering derivative transactions in the asset/liability products segment. These agreements allow the Company to contractually net amounts due from a counterparty with those amounts due to such counterparty when certain triggering events occur. The Company only executes swaps under master netting agreements, which typically contain mutual credit downgrade provisions that generally provide the ability to require assignment or termination in the event either MBIA or the counterparty is downgraded below a specified credit rating.

Under these arrangements, the Company may receive or provide U.S. Treasury and other highly rated securities or cash to secure counterparties’ exposure to the Company or its exposure to counterparties, respectively. Such collateral is available to the holder to pay for replacing the counterparty in the event that the counterparty defaults. As of June 30, 2012, the Company did not hold cash collateral to derivative counterparties but posted cash collateral to derivative counterparties of $327 million. This amount is in derivative liability. As of December 31, 2011, the Company did not hold or post cash collateral to derivative counterparties. As of June 30, 2012 and December 31, 2011, the Company had securities with a fair value of $141 million and $470 million, respectively, posted to derivative counterparties.

As of June 30, 2012 and December 31, 2011, the fair value on one positive Credit Support Annex (“CSA”) was $2 million. This CSA governs collateral posting requirements between MBIA and its derivative counterparties. The Company did not receive collateral due to the Company’s credit rating, which was below the CSA minimum credit ratings level for holding counterparty collateral. As of June 30, 2012 and December 31, 2011, the counterparty was rated A and A+, respectively, by S&P and A2 and Aa3, respectively, by Moody’s.