10 DERIVATIVE INSTRUMENTS

The following tables summarize the location and fair values of individual derivative instruments reported in the Consolidated Balance Sheets as of December 31, 2011 and 2010. Amounts are presented gross of the effect of offsetting balances even where a legal right of offset exists.

Fair Values of Derivative Instruments


	Derivative Asset			Derivative Liability
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair value
*December 31, 2011:*
Derivatives held for trading
Credit derivatives	Derivative assets	$	—	Derivative liabilities	$	190,653
Interest rate swaps	Derivative assets		411,652	Derivative liabilities		251,303
	Derivative liabilities		30,859	Derivative assets		242,500
Currency swaps	Derivative assets		—	Derivative liabilities		2,423
Futures contracts	Derivative assets		—	Derivative liabilities		627
Other contracts	Derivative assets		—	Derivative liabilities		361

Total derivatives held for trading			442,511			687,867

Call options on long-term debt	Derivative assets		6,055	Derivative liabilities		—

Total derivatives		$	448,566		$	687,867

Variable Interest Entities
Credit derivatives	VIE—Derivative assets	$	—	VIE—Derivative liabilities	$	—
Currency swaps	VIE—Derivative liabilities		27,779	VIE—Derivative liabilities		90,857
Interest rate swaps	VIE—Derivative liabilities		—	VIE—Derivative liabilities		2,023,974

		$	27,779		$	2,114,831

*December 31, 2010:*
Derivatives held for trading
Credit derivatives	Derivative assets	$	—	Derivative liabilities	$	221,684
Interest rate swaps	Derivative assets		408,299	Derivative liabilities		124,932
	Derivative liabilities		4,756	Derivative assets		129,185
Currency swaps	Derivative assets		—	Derivative liabilities		6,699
Futures contracts	Derivative assets		11,185	Derivative liabilities		—
Other contracts	Derivative assets		—	Derivative liabilities		232

Total derivatives held for trading			424,240			482,732

Call options on long-term debt	Derivative assets		—	Derivative liabilities		—

Total derivatives		$	424,240		$	482,732

Variable Interest Entities
Credit derivatives	VIE—Derivative assets	$	4,511	VIE—Derivative liabilities	$	—
Currency swaps	VIE—Derivative liabilities		26,577	VIE—Derivative liabilities		105,037
Interest rate swaps	VIE—Derivative liabilities		2,203	VIE—Derivative liabilities		1,503,863

		$	33,291		$	1,608,900

Amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral are not offset against fair value amounts recognized for derivative instruments on the Consolidated Balance Sheets. The amounts representing the right to reclaim cash collateral and posted margin, recorded in "Other assets" were $47,421 and $281 as of December 31, 2011 and 2010, respectively. The amounts representing the obligation to return cash collateral, recorded in "Other liabilities" were $0 and $7,005 as of December 31, 2011 and 2010, respectively.

The following tables summarize the location and amount of gains and losses of derivative contracts in the Consolidated Statement of Operations for the years ended December 31, 2011 and 2010:


	Location of Gain or (Loss) Recognized in Consolidated Statement of Operations	Amount of Gain or (Loss) Recognized in Consolidated Statement of Operations
		2011			2010
Financial Guarantee:
Credit derivatives	Net change in fair value of credit derivatives	$	48,032		$	60,183
Financial Services derivatives products:
Interest rate swaps	Derivative products		(259,941	)		205
Currency swaps	Derivative products		30			(70,552	)
Futures contracts	Derivative products		(20,496	)		(37,393	)
Other derivatives	Derivative products		(411	)		1,175

Total Financial Services derivative products			(280,818	)		(106,565	)


Call options on long-term debt	Other income		6,055			—

Variable Interest Entities:
Credit derivatives	Loss on variable interest entities		(4,511	)		(653	)
Currency swaps	Loss on variable interest entities		15,382			(78,460	)
Interest rate swaps	Loss on variable interest entities		(841,768	)		(1,003,527	)

Total Variable Interest Entities			(830,897	)		(1,082,640	)


Total derivative contracts		($	1,057,628	)	($	1,129,022	)

Financial Guarantee Credit Derivatives:

Credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation. Upon a credit event, Ambac is generally required to make payments equal to the difference between the scheduled debt service payment and the actual payment made by the issuer. The majority of our credit derivatives are written on a "pay-as-you-go" basis. Similar to an insurance policy execution, pay-as-you-go provides that Ambac pays interest shortfalls on the referenced transaction as they are incurred on each scheduled payment date, but only pays principal shortfalls upon the earlier of (i) the date on which the assets designated to fund the referenced obligation have been disposed of and (ii) the legal final maturity date of the referenced obligation.

In a small number of transactions, Ambac is required to (i) make a payment equal to the difference between the par value and market value of the underlying obligation or (ii) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation. There are 12 transactions, which are not "pay-as-you-go", with a combined notional of approximately $490,625 and a net liability fair value of $4,196 as of December 31, 2011. These transactions are primarily in the form of CLOs written between 2002 and 2005.

Substantially all of Ambac's credit derivative contracts relate to structured finance transactions. Credit derivatives issued are insured by Ambac Assurance. None of our outstanding credit derivative transactions at December 31, 2011 include ratings based collateral-posting triggers or otherwise require Ambac to post collateral regardless of Ambac's ratings or the size of the mark to market exposure to Ambac.

Ambac maintains internal credit ratings on its guaranteed obligations, including credit derivative contracts, solely to indicate management's view of the underlying credit quality of the guaranteed obligations. Independent rating agencies may have assigned different ratings on the credits in Ambac's portfolio than Ambac's internal ratings. The following tables summarize the net par outstanding for CDS contracts, by Ambac rating, for each major category as of December 31, 2011 and 2010:


*December 31, 2011*
Ambac Rating	CLO		Other		Total
AAA	$	297,741	$	913,857	$	1,211,598
AA		6,193,522		1,248,584		7,442,106
A		1,737,314		2,967,445		4,704,759
BBB⁽¹⁾		—		518,142		518,142
Below investment grade⁽²⁾		—		290,007		290,007

	$	8,228,577	$	5,938,035	$	14,166,612


*December 31, 2010*
Ambac Rating	CLO		Other		Total
AAA	$	282,294	$	2,209,540	$	2,491,834
AA		8,323,435		1,237,993		9,561,428
A		2,955,030		2,851,213		5,806,243
BBB⁽¹⁾		31,938		627,021		658,959
Below investment grade⁽²⁾		—		247,890		247,890

	$	11,592,697	$	7,173,657	$	18,766,354

(1)

BBB internal rating reflects bonds which are of medium grade credit quality with adequate capacity to pay interest and repay principal. Certain protective elements and margins may weaken under adverse economic conditions and changing circumstances. These bonds are more likely than higher rated bonds to exhibit unreliable protection levels over all cycles.

(2)	Below investment grade ("BIG") internal ratings reflect bonds which are of speculative grade credit quality with the adequacy of future margin levels for payment of interest and repayment of principal potentially adversely affected by major ongoing uncertainties or exposure to adverse conditions.

The tables below summarize information by major category as of December 31, 2011 and 2010:


	CLO			Other			Total
*December 31, 2011*
Number of CDS transactions		44			24			68
Remaining expected weighted-average life of obligations (in years)		2.7			6.0			4.1
Gross principal notional outstanding	$	8,228,577		$	5,938,035		$	14,166,612
Net derivative liabilities at fair value	$	(54,320	)	$	(136,333	)	$	(190,653	)


	CLO			Other			Total
*December 31, 2010*
Number of CDS transactions		59			30			89
Remaining expected weighted-average life of obligations (in years)		3.4			4.4			3.8
Gross principal notional outstanding	$	11,592,697		$	7,173,657		$	18,766,354
Net derivative liabilities at fair value	$	(70,467	)	$	(151,217	)	$	(221,684	)

The maximum potential amount of future payments under Ambac's credit derivative contracts written on a "pay-as-you-go" basis is generally the gross principal notional outstanding amount included in the above table plus future interest payments payable by the derivative reference obligations. For contracts that are not written with pay-as-you-go terms, the maximum potential future payment is represented by the principal notional only. Since Ambac's credit derivatives typically reference obligations of or assets held by SPEs that meet the definition of a VIE, the amount of maximum potential future payments for credit derivatives is included in the table in Note 3, Special Purpose Entities Including Variable Interest Entities.

Changes in fair value of Ambac's credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under ASC Topic 815. Changes in fair value are recorded in "Net change in fair value of credit derivatives" on the Consolidated Statements of Operations. The "Realized gains and losses and other settlements" component of this income statement line includes (i) premiums received and accrued on written credit derivative contracts, (ii) premiums paid and accrued on purchased credit derivative contracts, (iii) losses paid and payable on written credit derivative contracts and (iv) paid losses recovered and recoverable on purchased credit derivative contracts for the appropriate accounting period. All remaining purchased credit derivative contracts were terminated in 2010. Losses paid and payable and losses recovered and recoverable reported in "Realized gains and losses and other settlements" include those arising after a credit event that requires a payment under the contract terms or in connection with a negotiated termination of a contract. There were no paid losses on credit derivative contracts during the year ended December 31, 2011 compared to $2,789,037 for the year ended December 31, 2010. The "Unrealized gains (losses)" component of this income statement line includes all other changes in fair value, including reductions in the fair value of liabilities as they are paid or settled. Refer to Note 8 for a detailed description of the components of our credit derivative contracts' fair value.

Although CDS contracts are accounted for at fair value, they are surveilled similar to non-derivative financial guarantee contracts. As with financial guarantee insurance policies, Ambac's surveillance group tracks credit migration of CDS contracts' reference obligations from period to period. Adversely classified credits are assigned risk classifications by the surveillance group using the guidelines described in Note 2. As of December 31, 2011, there are four CDS contracts on Ambac's adversely classified credit listing, with a net derivative liability fair value of $46,056 and total notional principal outstanding of $290,007. As of December 31, 2010, there were three CDS contracts on Ambac's adversely classified credit listing, with a net derivative liability fair value of $23,148 and a total notional principal outstanding of $247,890.

Financial Services Derivative Products:

Ambac, through its subsidiary Ambac Financial Services ("AFS"), provided interest rate and currency swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. AFS manages its interest rate swaps business with the goal of being market neutral to changes in benchmark interest rates while retaining some basis risk and excess interest rate sensitivity as an economic hedge against the effects of rising interest rates elsewhere in the Company, including on Ambac's financial guarantee exposures. Basis risk in the portfolio arises primarily from (i) variability in the ratio of benchmark tax-exempt to taxable interest rates, (ii) potential changes in the counterparty bond issuers' bond-specific variable rates relative to taxable interest rates, and (iii) variability between Treasury and swap rates. The derivative portfolio also includes an unhedged Sterling-denominated exposure to Consumer Price Inflation in the United Kingdom. As of December 31, 2011 and 2010 the notional amounts of AFS's trading derivative products are as follows:


	Notional December 31,
Type of derivative	2011		2010
Interest rate swaps—receive-fixed/pay-variable	$	1,370,995	$	1,798,704
Interest rate swaps—pay-fixed/receive-variable		3,798,305		3,802,086
Interest rate swaps—basis swaps		175,835		231,250
Currency swaps		13,559		35,971
Futures contracts		53,500		290,000
Other contracts		118,930		154,045

Interest rate and currency swaps had been used to manage specified risks of changes in fair value or cash flows caused by variations in interest rates and foreign currency exchange rates. There were no designated hedges in effect during 2011 or 2010. Additionally, the remaining derivative contracts that were not designated hedges under ASC Topic 815, but were considered by management to be for non-trading and hedging purposes, expired during 2010. Net gains (losses) recognized on such contracts recognized as part of net mark-to-market gains (losses) on non-trading derivative contracts was $0 and ($14,295) for the years ended December 31, 2011 and 2010, respectively.

Derivatives of Consolidated Variable Interest Entities

Certain VIEs consolidated under ASC Topic 810 entered into derivative contracts to meet specified purposes within the securitization structure. The notional for VIE derivatives outstanding as of December 31, 2011 and December 31, 2010 are as follows:


Type of VIE derivative	Notional
Type of VIE derivative	December 31, 2011		December 31, 2010
Interest rate swaps—receive-fixed/pay-variable	$	1,702,113	$	1,711,881
Interest rate swaps—pay-fixed/receive-variable		4,535,626		6,291,763
Currency swaps		721,168		725,307
Credit derivatives		20,934		21,976

Call Option on Long-Term Debt

Ambac Assurance has certain contractual options to repurchase its surplus notes at a discount to their par value, which are considered stand-alone derivatives. The surplus notes were issued in connection with a settlement agreement with certain counterparties to credit default swaps in June 2010 and are classified under Long-term debt on the Consolidated Balance Sheets. The amount of surplus notes that may be repurchased under these stand-alone options is $500,000 at December 31, 2011 and 2010. The fair value of the options was $6,055 and $0 as of December 31, 2011 and 2010, respectively. Gains of $6,055 and $0 from the change in fair value of the call options were recognized within Other income (loss) in the Consolidated Statements of Operations for the years ended December 31, 2011 and 2010, respectively.

Contingent Features in Derivatives Related to Ambac Credit Risk

Ambac's interest rate swaps with professional swap-dealer counterparties and certain front-end counterparties are generally executed under standardized derivative documents including collateral support and master netting agreements. Under these agreements, Ambac is required to post collateral in the event net unrealized losses exceed predetermined threshold levels. Additionally, given that Ambac Assurance is no longer rated by an independent rating agency, counterparties have the right to terminate the swap positions.

As of December 31, 2011 and 2010, the aggregate fair value of all derivative instruments with contingent features linked to Ambac's own credit risk that are in a net liability position after considering legal rights of offset was $266,626 and $31,739, respectively, related to which Ambac had posted assets as collateral with a fair value of $263,530 and $123,519, respectively. All such ratings-based contingent features have been triggered as of December 31, 2011, requiring maximum collateral levels to be posted by Ambac while preserving counterparties' rights to terminate the contracts. Assuming all contracts terminated on December 31, 2011, settlement of collateral balances and net derivative liabilities would result in a net receipt of cash and/or securities by Ambac. If counterparties elect to exercise their right to terminate, the actual termination payment amounts will be determined in accordance with derivative contract terms, which may result in amounts that differ from market values as reported in Ambac's financial statements.