AIG 2011 Annual Report Download - page 263

American International Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
employed by market participants and the varying judgments reached by such participants when assessing volatile
markets have increased the likelihood that the various parties to these instruments may arrive at significantly
different estimates as to their fair values.
AIG’s valuation methodologies for the super senior credit default swap portfolio have evolved over time in
response to market conditions and the availability of market observable information. AIG has sought to calibrate
the methodologies to available market information and to review the assumptions of the methodologies on a
regular basis.
Regulatory capital portfolio: In the case of credit default swaps written to facilitate regulatory capital relief, AIG
estimates the fair value of these derivatives by considering observable market transactions. The transactions with
the most observability are the early terminations of these transactions by counterparties. AIG continues to reassess
the expected maturity of the portfolio. AIGFP has not been required to make any payments as part of
terminations of super senior regulatory capital CDSs initiated by counterparties. However, during the second
quarter of 2011, AIGFP terminated mezzanine tranches related to certain terminated super senior regulatory
capital trades and made payments which approximated their fair values at the time of termination.
The regulatory benefit of these transactions for AIGFP’s financial institution counterparties is generally derived
from the capital regulations promulgated by the Basel Committee on Banking Supervision, known as Basel I. In
December 2010, the Basel Committee on Banking Supervision finalized a new framework for international capital
and liquidity standards known as Basel III, which, when fully implemented, may reduce or eliminate the regulatory
benefits to certain counterparties and thus may impact the period of time that such counterparties are expected to
hold the positions. In assessing the fair value of the regulatory capital CDS transactions, AIG also considers other
market data, to the extent relevant and available. For further discussion, see Note 12 herein.
Multi-sector CDO portfolios: AIG uses a modified version of the Binomial Expansion Technique (BET) model
to value AIGFP’s credit default swap portfolio written on super senior tranches of multi-sector CDOs of ABS.
The BET model was developed in 1996 by a major rating agency to generate expected loss estimates for CDO
tranches and derive a credit rating for those tranches, and remains widely used.
AIG has adapted the BET model to estimate the price of the super senior risk layer or tranche of the CDO.
AIG modified the BET model to imply default probabilities from market prices for the underlying securities and
not from rating agency assumptions. To generate the estimate, the model uses the price estimates for the securities
comprising the portfolio of a CDO as an input and converts those estimates to credit spreads over current
LIBOR-based interest rates. These credit spreads are used to determine implied probabilities of default and
expected losses on the underlying securities. This data is then aggregated and used to estimate the expected cash
flows of the super senior tranche of the CDO.
Prices for the individual securities held by a CDO are obtained in most cases from the CDO collateral
managers, to the extent available. CDO collateral managers provided market prices for 61.7 percent of the
underlying securities used in the valuation at December 31, 2011. When a price for an individual security is not
provided by a CDO collateral manager, AIG derives the price through a pricing matrix using prices from CDO
collateral managers for similar securities. Matrix pricing is a mathematical technique used principally to value debt
securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the
relationship of the security to other benchmark quoted securities. Substantially all of the CDO collateral managers
who provided prices used dealer prices for all or part of the underlying securities, in some cases supplemented by
third-party pricing services.
The BET model also uses diversity scores, weighted average lives, recovery rates and discount rates. AIG
employs a Monte Carlo simulation to assist in quantifying the effect on the valuation of the CDO of the unique
aspects of the CDO’s structure such as triggers that divert cash flows to the most senior part of the capital
structure. The Monte Carlo simulation is used to determine whether an underlying security defaults in a given
AIG 2011 Form 10-K 249