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Fair Value Measurements | 12 Months Ended
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Dec. 31, 2012
Fair Value Measurements |
7. | FAIR VALUE MEASUREMENTS
ASC Topic 820, Fair Value Measurements and Disclosures, establishes a framework for measuring fair value and disclosures about fair value measurements. Fair value Hierarchy: ASC Topic 820 specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company-based assumptions. In accordance with ASC Topic 820, the fair value hierarchy prioritizes model inputs into three broad levels as follows:
• Level 1 |  | – |  | Quoted prices for identical instruments in active markets. Assets and liabilities classified as Level 1 include US Treasury securities, exchange traded futures contracts, variable rate demand obligations, money market funds and mutual funds.
• Level 2 |  | – |  | Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Assets and liabilities classified as Level 2 generally include direct investments in fixed income securities representing municipal, asset-backed and corporate obligations, financial services derivatives (including certain interest rate and currency swap derivatives), and most long-term debt of variable interest entities consolidated under ASC Topic 810.
• Level 3 |  | – |  | Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. This hierarchy requires the use of observable market data when available. Assets and liabilities classified as Level 3 include credit derivative contracts written as part of the financial guarantee business, certain financial services interest rate swap contracts, call options on long-term debt, equity interests in Ambac sponsored special purpose entities and certain investments in fixed income securities. Additionally, Level 3 assets and liabilities generally include fixed income securities, loan receivables, and certain long-term debt of variable interest entities consolidated under ASC Topic 810.
The following table sets forth the carrying amount and fair value of Ambac’s financial assets and liabilities as of December 31, 2012 and December 31, 2011, including the level within the fair value hierarchy at which fair value measurements are categorized. As required by ASC Topic 820, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
|  | Carrying Amount |  |  | Total Fair Value |  |  | Fair Value Measurements Categorized as: |
|  |  | Level 1 |  |  | Level 2 |  |  | Level 3 |
December 31, 2012 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Financial assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 1,814,730 |  |  | $ | 1,814,730 |  |  | $ | — |  |  | $ | 1,814,730 |  |  | $ | — |
Corporate obligations |  |  | 1,112,174 |  |  |  | 1,112,174 |  |  |  | — |  |  |  | 1,108,518 |  |  |  | 3,656 |
Foreign obligations |  |  | 70,112 |  |  |  | 70,112 |  |  |  | — |  |  |  | 70,112 |  |  |  | — |
U.S. government obligations |  |  | 127,283 |  |  |  | 127,283 |  |  |  | 127,283 |  |  |  | — |  |  |  | — |
U.S. agency obligations |  |  | 82,535 |  |  |  | 82,535 |  |  |  | — |  |  |  | 82,535 |  |  |  | — |
Residential mortgage-backed securities |  |  | 1,455,582 |  |  |  | 1,455,582 |  |  |  | — |  |  |  | 1,455,582 |  |  |  | — |
Collateralized debt obligations |  |  | 33,342 |  |  |  | 33,342 |  |  |  | — |  |  |  | 26,860 |  |  |  | 6,482 |
Other asset-backed securities |  |  | 706,637 |  |  |  | 706,637 |  |  |  | — |  |  |  | 656,373 |  |  |  | 50,264 |
Short term investments |  |  | 661,658 |  |  |  | 661,658 |  |  |  | 657,886 |  |  |  | 3,772 |  |  |  | — |
Other investments |  |  | 100 |  |  |  | 100 |  |  |  | — |  |  |  | — |  |  |  | 100 |
Fixed income securities, pledged as collateral: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
U.S. government obligations |  |  | 265,779 |  |  |  | 265,779 |  |  |  | 265,779 |  |  |  | — |  |  |  | — |
Residential mortgage-backed securities |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Cash |  |  | 43,837 |  |  |  | 43,837 |  |  |  | 43,837 |  |  |  | — |  |  |  | — |
Restricted cash |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Loans |  |  | 9,203 |  |  |  | 7,387 |  |  |  | — |  |  |  | — |  |  |  | 7,387 |
Derivative assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest rate swaps—asset position |  |  | 46,752 |  |  |  | 46,752 |  |  |  | — |  |  |  | 46,752 |  |  |  | — |
Interest rate swaps—liability position |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Future contracts |  |  | 1,253 |  |  |  | 1,253 |  |  |  | 1,253 |  |  |  | — |  |  |  | — |
Other assets |  |  | 14,557 |  |  |  | 14,557 |  |  |  | — |  |  |  | — |  |  |  | 14,557 |
Variable interest entity assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Corporate obligations |  |  | 2,261,294 |  |  |  | 2,261,294 |  |  |  | — |  |  |  | — |  |  |  | 2,261,294 |
Restricted cash |  |  | 2,290 |  |  |  | 2,290 |  |  |  | 2,290 |  |  |  | — |  |  |  | — |
Loans |  |  | 15,568,711 |  |  |  | 15,560,051 |  |  |  | — |  |  |  | 200,978 |  |  |  | 15,359,073 |
Total financial assets |  | $ | 24,277,829 |  |  | $ | 24,267,353 |  |  | $ | 1,098,328 |  |  | $ | 5,466,212 |  |  | $ | 17,702,813 |
Financial liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Obligations under investment and repurchase agreements |  | $ | 362,017 |  |  | $ | 361,905 |  |  | $ | — |  |  | $ | — |  |  | $ | 361,905 |
Liabilities subject to compromise |  |  | 1,622,189 |  |  |  | 434,823 |  |  |  | — |  |  |  | 434,823 |  |  |  | — |
Long term debt, including accrued interest |  |  | 377,524 |  |  |  | 801,277 |  |  |  | — |  |  |  | — |  |  |  | 801,277 |
Derivative liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Credit derivatives |  |  | 213,585 |  |  |  | 213,585 |  |  |  | — |  |  |  | — |  |  |  | 213,585 |
Interest rate swaps—asset position |  |  | (151,365 | ) |  |  | (151,365 | ) |  |  | — |  |  |  | (151,365 | ) |  |  | — |
Interest rate swaps—liability position |  |  | 390,774 |  |  |  | 390,774 |  |  |  | — |  |  |  | 282,022 |  |  |  | 108,752 |
Future contracts |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Currency swaps |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Other contracts |  |  | 220 |  |  |  | 220 |  |  |  | — |  |  |  | 220 |  |  |  | — |
Liabilities for net financial guarantees written |  |  | 7,074,808 |  |  |  | 3,091,257 |  |  |  | — |  |  |  | — |  |  |  | 3,091,257 |
Variable interest entity liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Long-term debt |  |  | 15,436,008 |  |  |  | 15,414,233 |  |  |  | — |  |  |  | 12,457,732 |  |  |  | 2,956,501 |
Derivative liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest rate swaps—liability position |  |  | 2,131,315 |  |  |  | 2,131,315 |  |  |  | — |  |  |  | 2,131,315 |  |  |  | — |
Currency swaps—asset position |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Currency swaps—liability position |  |  | 90,466 |  |  |  | 90,466 |  |  |  | — |  |  |  | 90,466 |  |  |  | — |
Total financial liabilities |  | $ | 27,547,541 |  |  | $ | 22,778,490 |  |  | $ | — |  |  | $ | 15,245,213 |  |  | $ | 7,533,277 |
|  | Carrying Amount |  |  | Total Fair Value |  |  | Fair Value Measurements Categorized as: |
|  |  | Level 1 |  |  | Level 2 |  |  | Level 3 |
December 31, 2011 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Financial assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 2,002,999 |  |  | $ | 2,002,999 |  |  | $ | — |  |  | $ | 2,002,999 |  |  | $ | — |
Corporate obligations |  |  | 1,127,500 |  |  |  | 1,127,500 |  |  |  | — |  |  |  | 1,119,570 |  |  |  | 7,930 |
Foreign obligations |  |  | 94,795 |  |  |  | 94,795 |  |  |  | — |  |  |  | 94,795 |  |  |  | — |
U.S. government obligations |  |  | 111,562 |  |  |  | 111,562 |  |  |  | 111,562 |  |  |  | — |  |  |  | — |
U.S. agency obligations |  |  | 86,871 |  |  |  | 86,871 |  |  |  | — |  |  |  | 85,647 |  |  |  | 1,224 |
Residential mortgage-backed securities |  |  | 1,412,517 |  |  |  | 1,412,517 |  |  |  | — |  |  |  | 1,412,517 |  |  |  | — |
Collateralized debt obligations |  |  | 46,237 |  |  |  | 46,237 |  |  |  | — |  |  |  | 33,755 |  |  |  | 12,482 |
Other asset-backed securities |  |  | 947,808 |  |  |  | 947,808 |  |  |  | — |  |  |  | 871,922 |  |  |  | 75,886 |
Short term investments |  |  | 783,071 |  |  |  | 783,071 |  |  |  | 769,204 |  |  |  | 13,867 |  |  |  | — |
Other investments |  |  | 100 |  |  |  | 100 |  |  |  | — |  |  |  | — |  |  |  | 100 |
Fixed income securities, pledged as collateral: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
U.S. government obligations |  |  | 260,802 |  |  |  | 260,802 |  |  |  | 260,802 |  |  |  | — |  |  |  | — |
Residential mortgage-backed securities |  |  | 2,728 |  |  |  | 2,728 |  |  |  | — |  |  |  | 2,728 |  |  |  | — |
Cash |  |  | 15,999 |  |  |  | 15,999 |  |  |  | 15,999 |  |  |  | — |  |  |  | — |
Restricted cash |  |  | 2,500 |  |  |  | 2,500 |  |  |  | 2,500 |  |  |  | — |  |  |  | — |
Loans |  |  | 18,996 |  |  |  | 16,934 |  |  |  | — |  |  |  | — |  |  |  | 16,934 |
Derivative assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest rate swaps—asset position |  |  | 411,652 |  |  |  | 411,652 |  |  |  | — |  |  |  | 260,851 |  |  |  | 150,801 |
Interest rate swaps—liability position |  |  | (242,500 | ) |  |  | (242,500 | ) |  |  | — |  |  |  | (53 | ) |  |  | (242,447 | )
Future contracts |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Call options on long-term debt |  |  | 6,055 |  |  |  | 6,055 |  |  |  | — |  |  |  | — |  |  |  | 6,055 |
Other assets |  |  | 16,779 |  |  |  | 16,779 |  |  |  | — |  |  |  | — |  |  |  | 16,779 |
Variable interest entity assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Corporate obligations |  |  | 2,199,338 |  |  |  | 2,199,338 |  |  |  | — |  |  |  | — |  |  |  | 2,199,338 |
Restricted cash |  |  | 2,140 |  |  |  | 2,140 |  |  |  | 2,140 |  |  |  | — |  |  |  | — |
Loans |  |  | 14,329,515 |  |  |  | 14,309,134 |  |  |  | — |  |  |  | 182,140 |  |  |  | 14,126,994 |
Total financial assets |  | $ | 23,637,464 |  |  | $ | 23,615,021 |  |  | $ | 1,162,207 |  |  | $ | 6,080,738 |  |  | $ | 16,372,076 |
Financial liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Obligations under investment and repurchase agreements |  | $ | 546,546 |  |  | $ | 549,043 |  |  | $ | — |  |  | $ | — |  |  | $ | 549,043 |
Liabilities subject to compromise |  |  | 1,622,189 |  |  |  | 112,233 |  |  |  | — |  |  |  | 112,233 |  |  |  | — |
Long term debt, including accrued interest |  |  | 391,372 |  |  |  | 562,043 |  |  |  | — |  |  |  | — |  |  |  | 562,043 |
Derivative liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Credit derivatives |  |  | 190,653 |  |  |  | 190,653 |  |  |  | — |  |  |  | — |  |  |  | 190,653 |
Interest rate swaps—asset position |  |  | (30,859 | ) |  |  | (30,859 | ) |  |  | — |  |  |  | — |  |  |  | (30,859 | )
Interest rate swaps—liability position |  |  | 251,303 |  |  |  | 251,303 |  |  |  | — |  |  |  | 9,913 |  |  |  | 241,390 |
Futures contracts |  |  | 627 |  |  |  | 627 |  |  |  | 627 |  |  |  | — |  |  |  | — |
Currency swaps |  |  | 2,423 |  |  |  | 2,423 |  |  |  | — |  |  |  | 2,423 |  |  |  | — |
Other contracts |  |  | 361 |  |  |  | 361 |  |  |  | — |  |  |  | 361 |  |  |  | — |
Liabilities for net financial guarantees written |  |  | 7,547,288 |  |  |  | 2,642,795 |  |  |  | — |  |  |  | — |  |  |  | 2,642,795 |
Variable interest entity liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Long-term debt |  |  | 14,288,540 |  |  |  | 14,255,452 |  |  |  | — |  |  |  | 12,320,810 |  |  |  | 1,934,642 |
Derivative liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest rate swaps—liability position |  |  | 2,023,974 |  |  |  | 2,023,974 |  |  |  | — |  |  |  | 2,023,974 |  |  |  | — |
Currency swaps—asset position |  |  | (27,779 | ) |  |  | (27,779 | ) |  |  | — |  |  |  | (27,779 | ) |  |  | — |
Currency swaps—liability position |  |  | 90,857 |  |  |  | 90,857 |  |  |  | — |  |  |  | 90,857 |  |  |  | — |
Total financial liabilities |  | $ | 26,897,495 |  |  | $ | 20,623,126 |  |  | $ | 627 |  |  | $ | 14,532,792 |  |  | $ | 6,089,707 |
Determination of Fair Value: When available, the Company generally uses quoted active market prices specific to the financial instrument to determine fair value, and classifies such items within Level 1. Because many fixed income securities do not trade on a daily basis, pricing sources apply available information through processes such as matrix pricing to calculate fair value. In those cases the items are classified within Level 2. If quoted market prices are not available, fair value is based upon models that use, where possible, current market-based or independently-sourced market parameters. Items valued using valuation models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be significant inputs that are readily observable. The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. We believe the potential for differences in third-party pricing levels is particularly significant with respect to residential mortgage-backed and certain other asset-backed securities held in our investment portfolio and referenced in our credit derivative portfolio, due to the low levels of trading activity for such securities. In addition, the use of internal valuation models may require assumptions about hypothetical or inactive markets. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position by Ambac, may be significantly different from its recorded fair value. Ambac’s financial instruments carried at fair value are mainly comprised of investments in fixed income securities, derivative instruments, most variable interest entity assets and liabilities and equity interests in Ambac sponsored special purpose entities. Valuation of financial instruments is performed by Ambac’s Finance group using methods approved by senior financial management with consultation from risk management and portfolio managers as appropriate. Preliminary valuation results are discussed with portfolio managers quarterly to assess consistency with market transactions and trends as applicable. Market transactions such as trades or negotiated settlements of similar positions, if any, are reviewed quarterly to validate fair value model results. However many of the financial instruments valued using significant unobservable inputs have very little or no observable market activity. Methods and significant inputs and assumptions used to determine fair values across portfolios are reviewed quarterly by senior financial management. Additionally, changes to fair value methods and assumptions are reviewed with the CEO and audit committee when such changes may be material to the company’s financial position or results. Other valuation control procedures specific to particular portfolios are described further below. We reflect Ambac’s own creditworthiness in the fair value of financial liabilities by including a credit valuation adjustment (“CVA”) in the determination of fair value. A decline (increase) in Ambac’s creditworthiness as perceived by market participants will generally result in a higher (lower) CVA, thereby lowering (increasing) the fair value of Ambac’s financial liabilities as reported. Fixed Income Securities: The fair values of fixed income investment securities held by Ambac and its operating subsidiaries are based primarily on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and yield curves for asset-type and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. Longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value. Generally, lower credit ratings or longer expected maturities will be accompanied by higher yields used to value a security. At December 31, 2012, approximately 10%, 89%, and 1% of the investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively. At December 31, 2011, approximately 8%, 91%, and 1% of the investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively. Ambac performs various review and validation procedures to quoted and modeled prices for fixed income securities, including price variance analyses, missing and static price reviews, overall valuation analyses by senior traders and finance managers and reviews associated with our ongoing impairment analysis. Unusual prices identified through these procedures will be evaluated further against separate broker quotes (if available) or internally modeled prices, and the pricing source values will be challenged as necessary. Price challenges generally result in the use of the pricing source’s quote as originally provided or as revised by the source following their internal diligence process. A price challenge may result in a determination that the pricing source cannot provide a reasonable value for a security or cannot adequately support a quote, in which case Ambac would resort to using either other quotes or internal models. Results of price challenges are reviewed and approved by senior traders and finance managers. Third party quotes represent the only input to the reported fair value of Level 2 fixed income securities. Information about the valuation inputs for fixed income securities classified as Level 3 is included below: Corporate obligations: These securities represent interest only strips of investment grade corporate obligations. The fair value of such securities classified as Level 3 was $3,656 and $7,930 at December 31, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with the discount rate determined from the yields of corporate bonds from the same issuers. Significant inputs for the interest only strips valuation at December 31, 2012 and December 31, 2011 include the following weighted averages: December 31, 2012
| a. | Coupon rate: 0.345%
| b. | Maturity: 21.14 years
| c. | Yield: 6.08%
December 31, 2011
| a. | Coupon rate: 0.60%
| b. | Maturity: 21.44 years
| c. | Yield: 7.20%
U.S. agency obligations: These notes are secured by separate lease rental agreements with the U.S. Government acting through the General Services Administration. There were no U.S. agency obligations classified as Level 3 at December 31, 2012. The fair value of such securities classified as Level 3 was $1,224 at December 31, 2011. Fair value was calculated using a discounted cash flow approach with the yield based on comparable U.S. agency securities. Significant inputs for the valuation at December 31, 2011 include the following weighted averages: December 31, 2011
| a. | Coupon rate: 6.91%
| b. | Maturity: 1.33 years
| c. | Yield: 2.13%
Collateralized debt obligations (“CDO”): Securities are floating rate senior notes where the underlying securities of the CDO consist of subordinated bank perpetual preferred securities. The fair value of such securities classified as Level 3 was $6,482 and $12,482 at December 31, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at December 31, 2012 and December 31, 2011 include the following weighted averages: December 31, 2012
| a. | Coupon rate: 1.05%
| b. | Maturity: 1.51 years
| c. | Yield: 5.92%
December 31, 2011
| a. | Coupon rate: 0.86%
| b. | Maturity: 1.55 years
| c. | Yield: 11.79%
Other asset-backed securities: These securities are floating rate investment grade notes collateralized by various asset types. The fair value of such securities classified as Level 3 was $50,264 and $75,886 at December 31, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at December 31, 2012 and December 31, 2011 include the following weighted averages: December 31, 2012
| a. | Coupon rate: 0.71%
| b. | Maturity: 7.86 years
| c. | Yield: 7.50%
December 31, 2011
| a. | Coupon rate: 1.41%
| b. | Maturity: 3.00 years
| c. | Yield: 4.50%
Derivative Instruments: Ambac’s derivative instruments primarily comprise interest rate and credit default swaps, exchange traded futures contracts and call options to repurchase Ambac Assurance surplus notes. All call options to repurchase surplus notes were exercised or expired in June 2012. Fair value is determined based upon market quotes from independent sources, when available. When independent quotes are not available, fair value is determined using valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads and ratings on underlying referenced obligations, yield curves and tax-exempt interest ratios. The valuation of certain interest rate and currency swaps as well as all credit derivative contracts also require the use of data inputs and assumptions that are determined by management and are not readily observable in the market. Under ASC Topic 820, Ambac is required to consider its own credit risk when measuring the fair value of derivative and other liabilities. The fair value of credit derivative liabilities was reduced by $261,203 at December 31, 2012 and $572,523 at December 31, 2011, as a result of incorporating a CVA on Ambac Assurance into the valuation model for these transactions. Interest rate swaps and other derivative liabilities may also require an adjustment to fair value to reflect Ambac Assurance’s credit risk. Factors considered in estimating the amount of any Ambac CVA on such contracts include collateral posting provisions, right of set-off with the counterparty, the period of time remaining on the derivatives and the pricing of recent terminations and amendments. Derivative liabilities were reduced by $121,928 at December 31, 2012 and $166,868 at December 31, 2011, as a result of Ambac CVA adjustments to derivative contracts other than credit derivatives. As described further below, certain valuation models require other inputs that are not readily observable in the market. The selection of a model to value a derivative depends on the contractual terms of, and specific risks inherent in the instrument as well as the availability of pricing information in the market. For derivatives that are less complex and trade in liquid markets or may be valued primarily by reference to interest rates and yield curves that are observable and regularly quoted, such as interest rate swaps, we utilize vendor-developed models. These models provide the net present value of the derivatives based on contractual terms and observable market data. Downgrades of Ambac Assurance, as guarantor of the financial services derivatives, have increased collateral requirements and triggered termination provisions in certain interest rate swaps. Increased termination activity since the initial rating downgrades of Ambac Assurance provided additional information about the replacement and/or exit value of certain financial services derivatives, which has been incorporated into the fair value of these derivatives as appropriate. Generally, the need for counterparty (or Ambac) CVAs is mitigated by the existence of collateral posting agreements under which adequate collateral has been posted. Derivative contracts entered into with financial guarantee customers are not typically subject to collateral posting agreements. Counterparty credit risk related to such customer derivative assets is included in our fair value adjustments. For derivatives that do not trade, or trade in less liquid markets such as credit derivatives, a proprietary model is used because such instruments tend to be unique, contain complex or heavily modified and negotiated terms, and pricing information is not readily available in the market. Derivative fair value models and the related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in modeling techniques. Ambac has not made any significant changes to its modeling techniques or related model inputs for the periods presented. Credit Derivatives (“CDS”): Fair value of Ambac’s CDS is determined using internal valuation models and represents the net present value of the difference between the fees Ambac originally charged for the credit protection and our estimate of what a financial guarantor of comparable credit worthiness would hypothetically charge to provide the same protection at the balance sheet date. Ambac competed in the financial guarantee market, which differs from the credit markets where Ambac-insured obligations may trade. As a financial guarantor, Ambac assumes only credit risk; we do not assume other risks and costs inherent in direct ownership of the underlying reference securities. Additionally, as a result of having the ability to influence our CDS counterparty in certain investor decisions, financial guarantors generally have the ability to actively remediate the credit, potentially reducing the loss given a default. Financial guarantee contracts, including CDS, issued by Ambac and its competitors are typically priced to capture some portion of the spread that would be observed in the capital markets for the underlying (insured) obligation, with minimum pricing constrained by objective estimates of expected loss and financial guarantor required rates of return. Such pricing was well established by historical financial guarantee fees relative to capital market spreads as observed and executed in competitive markets, including in financial guarantee reinsurance and secondary market transactions. Because of this relationship and in the absence of severe credit deterioration, changes in the fair value of our credit default swaps will generally be less than changes in the fair value of the underlying reference obligations. Key variables used in our valuation of substantially all of our credit derivatives include the balance of unpaid notional, expected term, fair values of the underlying reference obligations, reference obligation credit ratings, assumptions about current financial guarantee CDS fee levels relative to reference obligation spreads and the CVA applied against Ambac Assurance liabilities by market participants. Notional balances, expected remaining term and reference obligation credit ratings are monitored and determined by Ambac’s Risk Group. Fair values of the underlying reference obligations are obtained from broker quotes when available, or are derived from other market indications such as new issuance spreads and quoted values for similar transactions. Implicit in the fair values we obtain on the underlying reference obligations are the market’s assumptions about default probabilities, default timing, correlation, recovery rates and collateral values. Broker quotes on the reference obligations named in our CDS contracts represent an input to determine the estimated fair value of the CDS contract. Broker quotes are indicative values for the reference obligation and generally do not represent a bid or doing-business quote for the reference instrument. Such quotes follow methodologies that are generally consistent with those used to value similar assets on the quote providers’ own books. Methodologies may differ among brokers but are understood to reflect observable trading activity (when available) and modeling that relies on empirical data and reasonable assumptions. For certain CDS contracts referencing unsecuritized pools of assets, we will obtain counterparty quotes on the credit derivative itself. Such quotes are adjusted to reflect Ambac’s own credit risk when determining the fair value of credit derivative liabilities. Third party reference obligation values or specific credit derivative quotes were used in the determination of CDS fair values related to transactions representing 81% of CDS gross par outstanding and 79% of the CDS derivative liability as of December 31, 2012. When broker quotes for reference obligations are not available, reference obligation prices used in the valuation model are estimated internally based on averages of the quoted prices for other transactions of the same bond type and Ambac rating as well as changes in published credit spreads for securities with similar collateral and ratings characteristics. When price quotes of a similar bond type vary significantly or the number of similar transactions is small, management will consider additional factors, such as specific collateral composition and performance and contractual subordination, to identify similar transactions. Reference obligation prices derived internally as described above were used in the determination of CDS fair values related to transactions representing 19% of CDS gross par outstanding and 21% of the CDS derivative liability as of December 31, 2012. Ambac’s CDS fair value calculations are adjusted for changes in our estimates of expected loss on the reference obligations and observable changes in financial guarantee market pricing. If no adjustment is considered necessary, Ambac maintains the same percentage of the credit spread (over LIBOR) demanded in the market for the reference obligation as existed at the inception of the CDS. Therefore, absent changes in expected loss on the reference obligations or financial guarantee CDS market pricing, the financial guarantee CDS fee used for a particular contract in Ambac’s fair value calculations represent a consistent percentage, period to period, of the credit spread determinable from the reference obligation value at the balance sheet date. This results in a CDS fair value balance that fluctuates in proportion with the reference obligation value. The amount of expected loss on a reference obligation is a function of the probability that the obligation will default and severity of loss in the event of default. Ambac’s CDS transactions were all originally underwritten with extremely low expected losses. Both the reference obligation spreads and Ambac’s CDS fees at the inception of these transactions reflect these low expected losses. When reference obligations experience credit deterioration, there is an increase in the probability of default on the obligation and, therefore, an increase in expected loss. Ambac reflects the effects of changes in expected loss on the fair value of its CDS contracts by increasing the percentage of the reference obligation spread (over LIBOR) which would be captured as a CDS fee (“relative change ratio”) at the valuation date, resulting in a higher mark-to-market loss on our CDS relative to any price decline on the reference obligation. The fundamental assumption is that financial guarantee CDS fees will increase relative to reference obligation spreads as the underlying credit quality of the reference obligation deteriorates and approaches payment default. For example, if the credit spread of an underlying reference obligation was 80 basis points at the inception of a transaction and Ambac received a 20 basis point fee for issuing a CDS on that obligation, the relative change ratio, which represents the CDS fee to cash market spread Ambac would utilize in its valuation calculation, would be 25%. If the reference obligation spread increased to 100 basis points in the current reporting period, absent any observable changes in financial guarantee CDS market pricing or credit deterioration, Ambac’s current period CDS fee would be computed by multiplying the current reference obligation spread of 100 basis points by the relative change ratio of 25%, resulting in a 25 basis point fee. Thus, the model indicates we would need to receive an additional 5 basis points (25 basis points currently less the 20 basis points contractually received) for issuing a CDS in the current reporting period for this reference obligation. We would then discount the product of the notional amount of the CDS and the 5 basis point hypothetical CDS fee increase, over the weighted average life of the reference obligation to compute the current period mark-to-market loss. Using the same example, if the reference obligation spread increased to 100 basis points and there was credit deterioration as evidenced by an internal rating downgrade which increased the relative change ratio from 25% to 35%, we would estimate a 15 basis point CDS fee increase in our model (35% of 100 basis points reference obligation spread, or 35 basis points currently, less the 20 basis points contractually received). Therefore, we would record a higher mark-to-market loss based on the computations described above absent any observable changes in financial guarantee CDS market pricing. We do not adjust the relative change ratio until an actual internal rating downgrade has occurred unless we observe new pricing on financial guarantee CDS contracts. However, because we have active surveillance procedures in place for our entire CDS portfolio, particularly for transactions at or near a below investment grade threshold, we believe it is unlikely that an internal downgrade would lag the actual credit deterioration of a transaction for any meaningful time period. The factors used to increase the relative change ratio are based on rating agency probability of default percentages determined by management to be appropriate for the relevant bond type. That is, the probability of default associated with the respective tenor and internal rating of each CDS transaction is utilized in the computation of the relative change ratio in our CDS valuation model. The new relative change ratio in the event of an internal downgrade of the reference obligation is calculated as the weighted average of: (i) a given transaction’s inception relative change ratio and (ii) a ratio of 100%. The weight given to the inception relative change ratio is 100% minus the current probability of default (the probability of non-default) and the weight given to using a 100% relative change ratio is the probability of default. For example, assume a transaction having an inception relative change ratio of 33% is downgraded to B- during the period, at which time it has an estimated remaining life of 8 years. If the estimated probability of default for an 8 year, B- rated credit of this type is 60% then the revised relative change ratio will be 73.2%. The revised relative change ratio can be calculated as 33% x (100%-60%) + 100% x 60% = 73.2%. As noted above, reference obligation spreads incorporate market perceptions of default probability and loss severity, as well as liquidity risk and other factors. Loss severities are generally correlated to default probabilities during periods of economic stress. By increasing the relative change ratio in our calculations proportionally to default probabilities, Ambac incorporates into its CDS fair value the higher expected loss on the reference obligation (probability of default x loss severity), by increasing the portion of reference obligation spread that should be paid to the CDS provider. Ambac incorporates its own credit risk into the valuation of its CDS liabilities by applying a CVA to the calculations described above. Under our methodology, determination of the CDS fair value requires estimating hypothetical financial guarantee CDS fees for a given credit at the valuation date and estimating the present value of those fees. Our approach begins with pricing in the risk of default of the reference obligation using that obligation’s credit spread. The widening of the reference obligation spread results in a mark-to-market loss to Ambac, as the credit protection seller, and a gain to the credit protection buyer because the cost of credit protection on the reference obligation (ignoring CDS counterparty credit risk) will be greater than the amount of the actual contractual CDS fees. The Ambac CVA is a percentage applied to the estimated CDS liability fair value otherwise calculated as described above. The Ambac CVA is estimated using relevant data points, including quoted prices of securities guaranteed by Ambac Assurance which indicate the value placed by market participants on Ambac Assurance’s insurance obligations and the fair value of Ambac Assurance surplus notes. The resulting Ambac CVA percentage used in the valuation of CDS liabilities was 55% and 75% as of December 31, 2012 and December 31, 2011, respectively. In instances where narrower reference obligation spreads result in a CDS asset to Ambac, those hypothetical future CDS fees are discounted at a rate which incorporates our counterparty’s credit spread (i.e. the discount rate used is LIBOR plus the current credit spread of the counterparty). In addition, when there are sufficient numbers of new observable transactions, negotiated settlements or other market indications of a general change in market pricing trends for CDS on a given bond type, management will adjust its assumptions about the percentage of reference obligation spreads captured as CDS fees to match the current market. No such adjustments were made during the periods presented. Ambac is not transacting CDS business currently and other guarantors have stated they have exited this product. Additionally, there have been no negotiated settlements of CDS contracts during the periods presented. Key variables which impact the “Realized gains and losses and other settlements” component of “Net change in fair value of credit derivatives” in the Consolidated Statements of Total Comprehensive Income are the most readily observable variables since they are based solely on the CDS contractual terms and cash settlements. Those variables include premiums received and accrued and losses paid and payable on written credit derivative contracts for the appropriate accounting period. Losses paid and payable reported in “Realized gains and losses and other settlements” include those arising after a credit event that requires a payment under the contract terms has occurred or in connection with a negotiated termination of a contract. The remaining key variables described above impact the “Unrealized gains (losses)” component of “Net change in fair value of credit derivatives.” The net notional outstanding of Ambac’s CDS contracts were $11,281,777 and $14,166,612 at December 31, 2012 and December 31, 2011, respectively. Credit derivative liabilities at December 31, 2012 and 2011 had a combined fair value of $213,585 and $190,653, respectively, and related to underlying reference obligations that are classified as either CLOs or Other. Information about the above described model inputs used to determine the fair value of each class of credit derivatives as of December 31, 2012 and 2011 is summarized below: As of December 31, 2012
|  | CLOs |  |  | Other(1) |
Notional outstanding |  | $ | 6,155,767 |  |  | $ | 3,701,387 |
Weighted average reference obligation price |  |  | 96.5 |  |  |  | 86.9 |
Weighted average life (WAL) in years |  |  | 2.2 |  |  |  | 4.2 |
Weighted average credit rating |  |  | AA- |  |  |  | A |
Weighted average relative change ratio |  |  | 34.4 | % |  |  | 38.2 | %
CVA percentage |  |  | 55 | % |  |  | 55 | %
Fair value of derivative liabilities |  | $ | (34,645 | ) |  | $ | (116,086 | )
As of December 31, 2011
|  | CLOs |  |  | Other(1) |
Notional outstanding |  | $ | 8,228,577 |  |  | $ | 4,099,766 |
Weighted average reference obligation price |  |  | 92.5 |  |  |  | 84.3 |
Weighted average life (WAL) in years |  |  | 2.7 |  |  |  | 4.7 |
Weighted average credit rating |  |  | AA- |  |  |  | A |
Weighted average relative change ratio |  |  | 34.4 | % |  |  | 38.5 | %
CVA percentage |  |  | 75 | % |  |  | 75 | %
Fair value of derivative liabilities |  | $ | (54,320 | ) |  | $ | (86,526 | )
(1) | Excludes contracts for which fair values are based on credit derivative quotes rather than reference obligation quotes. Such contracts have a combined notional outstanding of $1,424,623, WAL of 7.9 years and liability fair value of ($62,854) as of December 31, 2012. Other inputs to the valuation of these transactions at December 31, 2012 include weighted average quotes of 10% of notional, weighted average rating of A and Ambac CVA percentage of 55%. As of December 31, 2011, these contracts had a combined notional outstanding of $1,838,269, WAL of 9.0 years and liability fair value of ($49,807). Other inputs to the valuation of these transactions at December 31, 2011 include weighted average quotes of 11% of notional, weighted average rating of A+ and Ambac CVA percentage of 75%.
Significant unobservable inputs for credit derivatives include WAL, internal credit rating, relative change ratio and CVA percentage. A longer (shorter) WAL, lower (higher) reference obligation credit rating, higher (lower) relative change ratio or lower (higher) CVA percentage, in isolation, would result in an increase (decrease) in the fair value liability measurement. A change in an internal credit rating of a reference obligation in our model will generally result in a directionally opposite change in the relative change ratio. Also, a shorter (longer) WAL will generally correspond with a lower (higher) CVA percentage. Call options on long-term debt: The fair value of Ambac Assurance’s options to repurchase Ambac Assurance surplus notes at a discount to par was estimated based on a combination of internal discounted cash flow analysis and market observations. The discounted cash flow analysis uses multiple discount rate scenarios to determine the present value of the surplus notes assuming exercise and non-exercise of the options, with the difference representing the option value under that scenario. The results are probability weighted to determine the recorded option value. All options to repurchase Ambac Assurance surplus notes that were stand-alone derivatives and reported at fair value on the Consolidated Balance Sheets were exercised in June 2012. The weighted average discount rate used to value such options was 36.57% at December 31, 2011. Financial Guarantees: Fair value of net financial guarantees written represents our estimate of the cost to Ambac to completely transfer its insurance obligation to another market participant of comparable credit worthiness. In theory, this amount should be the same amount that another market participant of comparable credit worthiness would hypothetically charge in the market place, on a present value basis, to provide the same protection as of the balance sheet date. This fair value estimate of financial guarantees is presented on a net basis and includes direct and assumed contracts written, net of ceded reinsurance contracts. In preparation for Ambac’s eventual bankruptcy emergence, which will require us to adjust the assets and liabilities on our balance sheet to fair value in accordance with fresh-start accounting rules, we have continued to refine the fair value model for financial guarantees. For 2011, the fair value estimate of financial guarantees was calculated using aggregate (portfolio level) balances. Specifically, the fair value estimate of direct and assumed contracts written was based on the sum of the present values of aggregate (i) unearned premium reserves; and (ii) loss and loss expense reserves, including unpaid claims recorded. The fair value estimate of ceded reinsurance contracts was based on the sum of the present values of aggregate (i) deferred ceded premiums, net of ceding commissions; and (ii) reinsurance recoverables on paid and unpaid losses. Key portfolio-level variables used were par amounts outstanding (including future periods for the calculation of future installment premiums), expected term, discount rate, and expected net loss and loss expense payments. U.S. GAAP requires that the nonperformance risk of a financial liability be included in the estimation of fair value, which includes considering Ambac Assurance’s own credit risk. As a result, because the aggregate balances related to direct contracts written and assumed were in a net liability (cash outflow) position, we included an Ambac CVA of 75% in the fair value estimate to reflect Ambac’s credit risk, consistent with that used for credit derivative contracts guaranteed by Ambac Assurance. Refer to “Credit Derivatives” above for additional information on the determination of the CVA. The aggregate balances related to ceded reinsurance contracts were in a net asset (cash inflow) position and therefore we included adjustments in the discount rate to reflect reinsurer counterparty credit risk. For 2012, the fair value estimate of financial guarantees was refined by utilizing cash flows calculated at the policy level. For direct and assumed contracts, projected net cash flows for each policy included: (i) installment premium receipts, (ii) estimated gross claim payments, and (iii) subrogation receipts. For ceded reinsurance contracts, projected net cash flows for each policy included: (i) installment ceded premium payments, (ii) ceding commission receipts, (iii) ceded claim receipts, and iv) ceded subrogation payments. For each individual direct, assumed contract, and ceded reinsurance contract, the respective undiscounted cash flow components are aggregated to determine if we are in a net asset or net liability position. For each contract in a net liability position, we estimate the fair value using internally developed discount rates that incorporate Ambac’s own credit risk and subsequently apply a 20% profit margin. This profit margin represents what another market participant would require to assume the financial guarantee contracts. Given the unique nature of financial guarantees and current inactive state of the industry there is a lack of observable market information to make this estimate. A profit margin of 20% was developed based on discussions with the third-party institutions with valuation expertise, discussions with industry participants and yields on Ambac Assurance surplus notes. The discount rates used for contracts in a net liability position are derived from the rates implicit in the fair value of surplus notes and guaranteed securities with future cash flows that are highly dependent upon Ambac financial guarantee payments. For each contract in a net asset position, we estimate the fair value using a discount rate that is commensurate with a market participant’s cost of capital. Refer to Note 5 for additional information on factors which influence our estimate of loss and loss expenses. There are a number of factors that limit our ability to accurately estimate the fair value of our financial guarantees. The first limitation is the lack of observable pricing data points as a result of Ambac no longer writing new financial guarantee business. Additionally, although the fair value accounting guidance for liabilities requires a company to consider the cost to completely transfer its obligation to another party of comparable credit worthiness, our primary insurance obligation is irrevocable and thus there is no established active market for transferring such obligations. Further refinements to this model could result in a significant difference between the financial guarantee fair value estimate disclosed in this Note at December 31, 2012 and the aggregate fair value of the insurance assets and liabilities to be reported on our balance sheet at Ambac’s bankruptcy emergence date. Liabilities Subject to Compromise: The fair value of Ambac’s debt included in Liabilities Subject to Compromise is based on quoted market prices. Long-term Debt: The fair value of surplus notes issued by Ambac Assurance and classified as long-term debt is internally estimated considering market transactions when available and internally developed discounted cash flow models. Surplus notes were initially recorded at fair value at the date of issuance. In subsequent periods, surplus notes are carried at their face value less unamortized discount. Other Financial Assets and Liabilities: The fair values of Ambac’s equity interest in Ambac sponsored special purpose entities (included in Other assets), Loans, and Obligations under investment and repurchase agreements are estimated based upon internal valuation models that discount expected cash flows using discount rates consistent with the credit quality of the obligor after considering collateralization. Variable Interest Entity Assets and Liabilities: The financial assets and liabilities of VIEs consolidated under ASC Topic 810 consist primarily of fixed income securities, loans, and derivative and debt instruments and are generally carried at fair value. These consolidated VIEs are securitization entities which have liabilities and/or assets guaranteed by Ambac Assurance. The fair values of VIE debt instruments are determined using the same methodologies used to value Ambac’s fixed income securities in its investment portfolio as described above. VIE debt fair value is based on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes are considered Level 2 and generally consider a variety of factors, including recent trades of the same and similar securities. For those VIE debt instruments where quotes were not available, the debt instrument fair values are considered Level 3 and are based on internal discounted cash flow models. Comparable to the sensitivities of investments in fixed income securities described above, longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value liability measurement for VIE debt. VIE debt instruments considered Level 3 include fixed rate, floating rate and zero coupon notes secured by various asset types, primarily European ABS. Information about the valuation inputs for the various VIE debt categories classified as Level 3 is as follows: European ABS transactions: The fair value of such obligations classified as Level 3 was $2,956,501 and $1,934,642 at December 31, 2012 and December 31, 2011, respectively. Fair values were calculated by using a discounted cash flow approach. The discount rates used were based on the rates implied from the third party quoted values (Level 2) for comparable notes from the same securitization. Significant inputs for the valuation at December 31, 2012 and December 31, 2011 include the following weighted averages: December 31, 2012
| a. | Coupon rate: 1.64%
| b. | Maturity: 12.34 years
| c. | Yield: 4.02%
December 31, 2011
| a. | Coupon rate: 1.56%
| b. | Maturity: 11.99 years
| c. | Yield: 3.90%
VIE derivative asset and liability fair values are determined using valuation models. When specific derivative contractual terms are available and may be valued primarily by reference to interest rates, foreign exchange rates and yield curves that are observable and regularly quoted the derivatives are valued using vendor-developed models. Other derivatives within the VIEs that include significant unobservable valuation inputs are valued using internally developed models. VIE derivative fair value balances at December 31, 2012 and December 31, 2011 were developed using vendor-developed models and do not use significant unobservable inputs. The fair value of VIE assets are obtained from market quotes when available. Typically the asset fair values are not readily available from market quotes and are estimated internally. The consolidated VIEs are securitization entities in which net cash flows from assets and derivatives (after adjusting for financial guarantor cash flows and other expenses) will be paid out to note holders or equity interests. Our valuation of VIE assets (fixed income securities or loans), therefore, are derived from the fair value of notes and derivatives, as described above, adjusted for the fair value of cash flows from Ambac’s financial guarantee. The fair value of financial guarantee cash flows include: (i) estimated future premiums discounted at a rate consistent with that implicit in the fair value of the VIE’s liabilities and (ii) internal estimates of future loss payments by Ambac discounted at a rate that includes Ambac’s own credit risk. Estimated future premium payments to be paid by the VIEs were discounted at a weighted average rate of 7.6% and 8.4% at December 31, 2012 and 2011, respectively. The value of future loss payments to be paid by Ambac to the VIEs was adjusted to include an Ambac CVA appropriate for the term of expected Ambac claim payments. Additional Fair Value Information: The following tables present the changes in the Level 3 fair value category for the years ended December 31, 2012 and 2011. Ambac classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs. Level-3 financial assets and liabilities accounted for at fair value
|  |  |  |  |  |  |  |  |  |  | VIE Assets and Liabilities |  |  |  |
2012 |  | Investments |  |  | Other assets |  |  | Derivatives |  |  | Investments |  |  | Loans |  |  | Derivatives |  |  | Long-term debt |  |  | Total |
Balance, beginning of period |  | $ | 97,522 |  |  | $ | 16,779 |  |  | $ | (486,775 | ) |  | $ | 2,199,338 |  |  | $ | 14,126,994 |  |  | $ | — |  |  | $ | (1,934,642 | ) |  | $ | 14,019,216 |
Additions of VIEs consolidated |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  |  | (3 | ) |  |  | (2,222 | ) |  |  | 21,076 |  |  |  | (41,289 | ) |  |  | 952,463 |  |  |  | — |  |  |  | (208,678 | ) |  |  | 721,347 |
Included in other comprehensive income |  |  | 7,485 |  |  |  | — |  |  |  | — |  |  |  | 103,245 |  |  |  | 637,954 |  |  |  | — |  |  |  | (98,311 | ) |  |  | 650,373 |
Purchases |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Issuances |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (162,460 | ) |  |  | (162,460 | )
Sales |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Settlements |  |  | (97,206 | ) |  |  | — |  |  |  | (48,886 | ) |  |  | — |  |  |  | (358,338 | ) |  |  | — |  |  |  | 64,781 |  |  |  | (439,649 | )
Transfers in Level 3 |  |  | 58,905 |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (1,875,121 | ) |  |  | (1,816,216 | )
Transfers out of Level 3 |  |  | (6,301 | ) |  |  | — |  |  |  | 192,248 |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 1,257,930 |  |  |  | 1,443,877 |
Deconsolidation of VIEs |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Balance, end of period |  | $ | 60,402 |  |  | $ | 14,557 |  |  | $ | (322,337 | ) |  | $ | 2,261,294 |  |  | $ | 15,359,073 |  |  | $ | — |  |  | $ | (2,956,501 | ) |  | $ | 14,416,488 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | (2,222 | ) |  | $ | (113,836 | ) |  | $ | (41,289 | ) |  | $ | 952,944 |  |  | $ | — |  |  | $ | (208,678 | ) |  | $ | 587,983 |
|  |  |  |  |  |  |  |  |  |  | VIE Assets and Liabilities |  |  |  |
2011 |  | Investments |  |  | Other assets |  |  | Derivatives |  |  | Investments |  |  | Loans |  |  | Derivatives |  |  | Long-term debt |  |  | Total |
Balance, beginning of period |  | $ | 199,172 |  |  | $ | 17,909 |  |  | $ | (195,933 | ) |  | $ | 1,904,361 |  |  | $ | 15,800,918 |  |  | $ | 4,511 |  |  | $ | (1,856,366 | ) |  | $ | 15,874,572 |
Additions of VIEs consolidated |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (350,624 | ) |  |  | (350,624 | )
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  |  | (3,467 | ) |  |  | (1,130 | ) |  |  | (335,633 | ) |  |  | 311,842 |  |  |  | 664,823 |  |  |  | (4,511 | ) |  |  | (118,048 | ) |  |  | 513,876 |
Included in other comprehensive income |  |  | (124 | ) |  |  | — |  |  |  | — |  |  |  | (16,865 | ) |  |  | (14,881 | ) |  |  | — |  |  |  | 11,240 |  |  |  | (20,630 | )
Purchases |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Issuances |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Sales |  |  | (16,600 | ) |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (16,600 | )
Settlements |  |  | (6,446 | ) |  |  | — |  |  |  | 44,791 |  |  |  | — |  |  |  | (428,899 | ) |  |  | — |  |  |  | 35,241 |  |  |  | (355,313 | )
Transfers in Level 3 |  |  | 469 |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (905,664 | ) |  |  | (905,195 | )
Transfers out of Level 3 |  |  | (75,482 | ) |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 955,636 |  |  |  | 880,154 |
Deconsolidation of VIEs |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (1,894,967 | ) |  |  | — |  |  |  | 293,943 |  |  |  | (1,601,024 | )
Balance, end of period |  | $ | 97,522 |  |  | $ | 16,779 |  |  | $ | (486,775 | ) |  | $ | 2,199,338 |  |  | $ | 14,126,994 |  |  | $ | — |  |  | $ | (1,934,642 | ) |  | $ | 14,019,216 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | (1,130 | ) |  | $ | (340,674 | ) |  | $ | 311,842 |  |  | $ | 664,823 |  |  | $ | (4,511 | ) |  | $ | (118,063 | ) |  | $ | 512,287 |
The tables below provide roll-forward information by class of investments and derivatives measured using significant unobservable inputs. This information is provided for the year ended December 31, 2012 as required by amendments to ASC Topic 820 effective January 1, 2011. Level-3 Investments by class
Year ended December 31, 2012 |  | Collateralized Debt Obligations |  |  | Other Asset Backed Securities |  |  | Corporate Obligations |  |  | U.S. Agency Obligations |  |  | Total Investments |
Balance, beginning of period |  | $ | 12,482 |  |  | $ | 75,886 |  |  | $ | 7,930 |  |  | $ | 1,224 |  |  | $ | 97,522 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  |  | (5 | ) |  |  | — |  |  |  | 4 |  |  |  | (2 | ) |  |  | (3 | )
Included in other comprehensive income |  |  | 646 |  |  |  | 7,051 |  |  |  | (203 | ) |  |  | (9 | ) |  |  | 7,485 |
Purchases |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Issuances |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Sales |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Settlements |  |  | (6,641 | ) |  |  | (85,741 | ) |  |  | (4,075 | ) |  |  | (749 | ) |  |  | (97,206 | )
Transfers in Level 3 |  |  | — |  |  |  | 53,068 |  |  |  | 5,837 |  |  |  | — |  |  |  | 58,905 |
Transfers out of Level 3 |  |  | — |  |  |  | — |  |  |  | (5,837 | ) |  |  | (464 | ) |  |  | (6,301 | )
Balance, end of period |  | $ | 6,482 |  |  | $ | 50,264 |  |  | $ | 3,656 |  |  | $ | — |  |  | $ | 60,402 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |
Level-3 Investments by class
Year ended December 31, 2011 |  | Collateralized Debt Obligations |  |  | Other Asset Backed Securities |  |  | Corporate Obligations |  |  | U.S. Agency Obligations |  |  | Total Investments |
Balance, beginning of period |  | $ | 30,433 |  |  | $ | 159,473 |  |  | $ | 8,069 |  |  | $ | 1,197 |  |  | $ | 199,172 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  |  | (3,286 | ) |  |  | — |  |  |  | (177 | ) |  |  | (4 | ) |  |  | (3,467 | )
Included in other comprehensive income |  |  | 6,454 |  |  |  | (6,612 | ) |  |  | 38 |  |  |  | (4 | ) |  |  | (124 | )
Purchases |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Issuances |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Sales |  |  | (16,600 | ) |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (16,600 | )
Settlements |  |  | (4,519 | ) |  |  | (1,493 | ) |  |  | — |  |  |  | (434 | ) |  |  | (6,446 | )
Transfers in Level 3 |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 469 |  |  |  | 469 |
Transfers out of Level 3 |  |  | — |  |  |  | (75,482 | ) |  |  | — |  |  |  | — |  |  |  | (75,482 | )
Balance, end of period |  | $ | 12,482 |  |  | $ | 75,886 |  |  | $ | 7,930 |  |  | $ | 1,224 |  |  | $ | 97,522 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |
Level-3 Derivatives by class
Year ended December 31, 2012 |  | Interest Rate Swaps |  |  | Credit Derivatives |  |  | Call Options on Long-term debt |  |  | Total Derivatives |
Balance, beginning of period |  | $ | (302,177 | ) |  | $ | (190,653 | ) |  | $ | 6,055 |  |  | $ | (486,775 | )
Additions of VIEs consolidated |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  |  | (70,415 | ) |  |  | (9,219 | ) |  |  | 100,710 |  |  |  | 21,076 |
Included in other comprehensive income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Purchases |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Issuances |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Sales |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Settlements |  |  | 71,592 |  |  |  | (13,713 | ) |  |  | (106,765 | ) |  |  | (48,886 | )
Transfers in Level 3 |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Transfers out of Level 3 |  |  | 192,248 |  |  |  | — |  |  |  | — |  |  |  | 192,248 |
Deconsolidation of VIEs |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Balance, end of period |  | $ | (108,752 | ) |  | $ | (213,585 | ) |  | $ | — |  |  | $ | (322,337 | )
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | (78,505 | ) |  | $ | (35,331 | ) |  | $ | — |  |  | $ | (113,836 | )
Level-3 Derivatives by class
Year ended December 31, 2011 |  | Interest Rate Swaps |  |  | Credit Derivatives |  |  | Call Options on Long-term debt |  |  | Total Derivatives |
Balance, beginning of period |  | $ | 25,751 |  |  | $ | (221,684 | ) |  | $ | — |  |  | $ | (195,933 | )
Additions of VIEs consolidated |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  |  | (389,720 | ) |  |  | 48,032 |  |  |  | 6,055 |  |  |  | (335,633 | )
Included in other comprehensive income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Purchases |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Issuances |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Sales |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Settlements |  |  | 61,792 |  |  |  | (17,001 | ) |  |  | — |  |  |  | 44,791 |
Transfers in Level 3 |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Transfers out of Level 3 |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Deconsolidation of VIEs |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Balance, end of period |  | $ | (302,177 | ) |  | $ | (190,653 | ) |  | $ | 6,055 |  |  | $ | (486,775 | )
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | (356,354 | ) |  | $ | 9,625 |  |  | $ | 6,055 |  |  | $ | (340,674 | )
Invested assets and VIE long-term debt are transferred into Level 3 when internal valuation models that include significant unobservable inputs are used to estimate fair value. All such securities that have internally modeled fair values have been classified as Level 3 as of December 31, 2012 and December 31, 2011. Derivative instruments are transferred into Level 3 when the use of unobservable inputs becomes significant to the overall valuation. Certain interest rate swaps were transferred out of Level 3 in 2012 when appropriate observable market discount rates replaced internal estimates of such rates in the determination of fair value. All transfers into and out of Level 3 represent transfers between Level 3 and Level 2. There were no transfers between Level 1 and Level 2 for the periods presented. All transfers between fair value hierarchy Levels 1, 2, and 3 are recognized at the beginning of each accounting period. Gains and losses (realized and unrealized) relating to Level 3 assets and liabilities included in earnings for years ended December 31, 2012 and 2011 are reported as follows:
|  | Net investment income |  |  | Realized gains or (losses) and other settlements on credit derivative contracts |  |  | Unrealized gains or (losses) on credit derivative contracts |  |  | Derivative products revenues (interest rate swaps) |  |  | Income (loss) on variable interest entities |  |  | Other income |
2012 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Total gains or losses included in earnings for the period |  | $ | (3 | ) |  | $ | 13,713 |  |  | $ | (22,932 | ) |  | $ | (70,415 | ) |  | $ | 702,496 |  |  | $ | 98,488 |
Changes in unrealized gains or losses relating to the assets and liabilities still held at the reporting date |  |  | — |  |  |  | — |  |  |  | (35,331 | ) |  |  | (78,505 | ) |  |  | 702,977 |  |  |  | (2,222 | )
2011 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Total gains or losses included in earnings for the period |  | $ | (3,467 | ) |  | $ | 17,001 |  |  | $ | 31,031 |  |  | $ | (389,720 | ) |  | $ | 854,106 |  |  | $ | 4,925 |
Changes in unrealized gains or losses relating to the assets and liabilities still held at the reporting date |  |  | — |  |  |  | — |  |  |  | 9,625 |  |  |  | (356,354 | ) |  |  | 854,091 |  |  |  | 4,925 |

X
- Definition The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information. + References Reference 1: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 16 -URI http://asc.fasb.org/extlink&oid=7491637&loc=d3e13504-108611 Reference 2: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 107 -Paragraph 15C, 15D -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 3: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 133 -Paragraph 44A, 44B -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 4: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 107 -Paragraph 15A -Subparagraph a-d -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 5: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 107 -Paragraph 3, 10, 14, 15 -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 6: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 10 -URI http://asc.fasb.org/extlink&oid=7491637&loc=d3e13433-108611 Reference 7: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 159 -Paragraph 17-22, 27, 28 -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 8: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 21 -URI http://asc.fasb.org/extlink&oid=7491637&loc=d3e13537-108611 Reference 9: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 107 -Paragraph 15B -Subparagraph a, b -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 10: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 157 -Paragraph 32, 33, 34 -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 11: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 820 -SubTopic 10 -Section 50 -Paragraph 2 -URI http://asc.fasb.org/extlink&oid=7578670&loc=d3e19207-110258 Reference 12: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 28 -URI http://asc.fasb.org/extlink&oid=6957238&loc=d3e14064-108612 Reference 13: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 30 -URI http://asc.fasb.org/extlink&oid=6957238&loc=d3e14172-108612 + Details
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