Note 8: Derivative Instruments

Overview

MBIA has entered into derivative instruments through its financial guarantee of CDS and for purposes of hedging risks associated with existing assets and liabilities and forecasted transactions. The Company accounts for derivative instruments in accordance with the accounting principles for derivative and hedging activities, which requires that all such instruments be recorded on the balance sheet at fair value. Refer to “Note 6: Fair Value of Financial Instruments” for the method of determining the fair value of derivative instruments.

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 instruments 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. These insured CDS contracts, primarily referencing corporate, asset-backed, residential mortgage-backed, commercial mortgage-backed, CRE loans, and CDO securities, are intended to be held for the entire term of the contract absent a negotiated settlement with the counterparty.

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 sold 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.

Variable Interest Entities

VIEs consolidated by the Company have entered into derivative instruments primarily consisting of interest rate swaps. Interest rate swaps are entered into to mitigate 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 instruments 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.

In certain instances, the Company’s asset/liability products business purchased or issued securities that contain embedded derivatives. 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 security.

Changes in the fair value of the Company’s asset/liability products business derivatives are recorded on the Company’s consolidated statements of operations within “Net gains (losses) on financial instruments at fair value and foreign exchange”.

Credit Derivatives Sold

The following tables present information about credit derivatives sold by the Company’s insurance operations that were outstanding as of March 31, 2013 and December 31, 2012. Credit ratings represent the lower of underlying ratings assigned to the collateral by Moody’s, S&P or MBIA.


$ in millions			As of March 31, 2013
			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		4.9 Years	$	10,007	$	5,792	$	3,109	$	11,250	$	14,228	$	44,386	$	(2,960)
Insured swaps		19.2 Years		-		85		3,632		1,958		-		5,675		(8)
All others		32.6 Years		-		-		-		-		195		195		(38)

Total notional			$	10,007	$	5,877	$	6,741	$	13,208	$	14,423	$	50,256

Total fair value			$	(3)	$	(83)	$	(8)	$	(534)	$	(2,378)			$	(3,006)


$ in millions			As of December 31, 2012
			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		5.1 Years	$	10,457	$	5,862	$	5,253	$	11,571	$	13,859	$	47,002	$	(2,858)
Insured swaps		19.4 Years		-		103		3,661		1,982		71		5,817		(8)
All others		1.8 Years		-		-		-		-		195		195		(68)

Total notional			$	10,457	$	5,965	$	8,914	$	13,553	$	14,125	$	53,014

Total fair value			$	(7)	$	(70)	$	(72)	$	(732)	$	(2,053)			$	(2,934)

Internal credit ratings assigned by MBIA on the underlying collateral 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 as of March 31, 2013 is $48.5 billion. This amount is net of $392 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 instruments 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.

Counterparty Credit Risk

The Company manages counterparty credit risk on an individual counterparty basis through master netting agreements covering derivative instruments in the asset/liability products segment. There are no master netting agreements in the Structured Finance and International Insurance or the U.S. Public Finance segments. The master netting agreements in the asset/liability products segment 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 March 31, 2013, the Company did not hold cash collateral to derivative counterparties but posted cash collateral to derivative counterparties of $262 million. Of this amount, $188 million is netted within “Derivative liabilities”, $16 million is included within “Other liabilities” as cash collateral netted against accrued interest on derivative liabilities and an additional $58 million is included in “Other assets” on the Company’s consolidated balance sheets. As of December 31, 2012, the Company did not hold cash collateral to derivative counterparties but posted cash collateral to derivative counterparties of $285 million. Of this amount, $203 million is netted within “Derivative liabilities”, $16 million is included within “Other liabilities” as cash collateral netted against accrued interest on derivative liabilities and an additional $66 million is included in “Other assets” on the Company’s consolidated balance sheets. As of March 31, 2013 and December 31, 2012, the Company did not post securities to derivative counterparties.

As of March 31, 2013 and December 31, 2012, the fair value on one positive Credit Support Annex (“CSA”) was $4 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 March 31, 2013 and December 31, 2012, the counterparty was rated A2 by Moody’s and A by S&P.

Financial Statement Presentation

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. Insured CDSs and insured swaps are not subject to master netting agreements. VIE derivative assets and liabilities are not presented net of any master netting agreements.

As of March 31, 2013, the total fair value of the Company’s derivative assets, after counterparty netting of $81 million, was $12 million, of which $4 million was reported within “Other assets” and “Other assets-VIEs”. Embedded derivatives of $8 million were reported within “Medium-term notes” on the Company’s consolidated balance sheets.

As of March 31, 2013, the total fair value of the Company’s derivative liabilities, after counterparty netting of $81 million and cash collateral posted by the Company of $188 million was $3.2 billion, which was reported within “Derivative liabilities” and “Derivative liabilities-VIEs” on the Company’s consolidated balance sheets. Embedded derivatives of $37 million were reported within “Medium-term notes” on the Company’s consolidated balance sheets.

Counterparty netting of derivative assets and liabilities offsets balances in “Interest rate” and “Currency swaps” in the table below.

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 March 31, 2013:


In millions			Derivative Assets⁽¹⁾			Derivative Liabilities⁽¹⁾
Derivative Instruments	Notional Amount Outstanding		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Not designated as hedging instruments:
Insured credit default swaps	$	44,705	Other assets	$	-	Derivative liabilities	$	(2,960)
Insured swaps		5,675	Other assets		-	Derivative liabilities		(8)
Non-insured credit default swaps		5	Other assets		-	Derivative liabilities		-
Interest rate swaps		1,604	Other assets		85	Derivative liabilities		(269)
Interest rate swaps-VIE		2,728	Other assets-VIE		-	Derivative liabilities-VIE		(127)
Interest rate swaps-embedded		468	Medium-term notes		8	Medium-term notes		(37)
Currency swaps		19	Other assets		-	Derivative liabilities		-
Currency swaps-VIE		107	Other assets-VIE		-	Derivative liabilities-VIE		(23)
All other		195	Other assets		-	Derivative liabilities		(38)
All other-VIE		280	Other assets-VIE		-	Derivative liabilities-VIE		-
All other-embedded		20	Other investments		-	Other investments		-

Total non-designated derivatives	$	55,806		$	93		$	(3,462)

(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, 2012, the total fair value of the Company’s derivative assets, after counterparty netting of $90 million, was $12 million, of which $4 million was reported within “Other assets” and “Other assets-VIEs”. Embedded derivatives of $8 million were reported within “Medium-term notes” on the Company’s consolidated balance sheets.

As of December 31, 2012, the total fair value of the Company’s derivative liabilities, after counterparty netting of $90 million and cash collateral posted by the Company of $203 million, was $3.1 billion which was reported within “Derivative liabilities” and “Derivative liabilities-VIEs” on the Company’s consolidated balance sheets. Embedded derivatives of $36 million were reported within “Medium-term notes” and “Other investments” on the Company’s consolidated balance sheets.

Counterparty netting of derivative assets and liabilities offsets balances in “Interest rate swaps not designated as hedging instruments” and “Currency swaps” in the table below.


In millions			Derivative Assets⁽¹⁾			Derivative Liabilities⁽¹⁾
Derivative Instruments	Notional Amount Outstanding		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Not designated as hedging instruments:
Insured credit default swaps	$	47,320	Other assets	$	-	Derivative liabilities	$	(2,858)
Insured swaps		5,817	Other assets		-	Derivative liabilities		(8)
Non-insured credit default swaps		10	Other assets		-	Derivative liabilities		-
Interest rate swaps		1,637	Other assets		94	Derivative liabilities		(290)
Interest rate swaps-VIE		2,728	Other assets-VIE		-	Derivative liabilities-VIE		(141)
Interest rate swaps-embedded		483	Medium-term notes		8	Medium-term notes		(35)
Currency swaps		40	Other assets		-	Derivative liabilities		(3)
Currency swaps-VIE		110	Other assets-VIE		-	Derivative liabilities-VIE		(21)
All other		195	Other assets		-	Derivative liabilities		(68)
All other-VIE		280	Other assets-VIE		-	Derivative liabilities-VIE		-
All other-embedded		20	Other investments		-	Other investments		(1)

Total non-designated	$	58,640		$	102		$	(3,425)

Total derivatives	$	58,640		$	102		$	(3,425)

(1) -

The following table presents the effect of derivative instruments on the consolidated statements of operations for the three months ended March 31, 2013:


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	$	(103)
Insured credit default swaps	Realized gains (losses) and other settlements on insured derivatives		12
Interest rate swaps	Net gains (losses) on financial instruments at fair value and foreign exchange		3
Interest rate swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		13
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		(1)
All other	Unrealized gains (losses) on insured derivatives		30

Total		$	(44)

The following table presents the effect of derivative instruments on the consolidated statements of operations for the three months ended March 31, 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	$	27	$	(27)	$	-
Interest rate swaps	Interest income (expense)		-		-		(2)

Total		$	27	$	(27)	$	(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	$	301
Insured credit default swaps	Realized gains (losses) and other settlements on insured derivatives		(4)
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		10
Interest rate swaps-VIE	Net gains (losses) on financial instruments at fair value and foreign exchange-VIE		21
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		2
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		(1)

Total		$	334