AIG 2007 Annual Report Download - page 176

American International Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
by AIGFP for each transaction to provide that the likelihood of any not required to make any payments as part of these terminations
payment obligation by AIGFP under each transaction is remote, and in certain cases was paid a fee upon termination. In light of
even in severe recessionary market scenarios. The underwriting this experience to date and after other comprehensive analyses,
process for these derivatives included assumptions of severely AIG did not recognize an unrealized market valuation adjustment
stressed recessionary market scenarios to minimize the likelihood for this regulatory capital relief portfolio for the year ended
of realized losses under these obligations. December 31, 2007. AIG will continue to assess the valuation of
In certain cases, the credit risk associated with a designated this portfolio and monitor developments in the marketplace. There
portfolio is tranched into different layers of risk, which are then can be no assurance that AIG will not recognize unrealized market
analyzed and rated by the credit rating agencies. Typically, there valuation losses from this portfolio in future periods. In addition
will be an equity layer covering the first credit losses in respect of to writing credit protection on the super senior risk layer on
the portfolio up to a specified percentage of the total portfolio, designated portfolios of loans or debt securities, AIGFP also wrote
and then successive layers ranging from generally a BBB-rated protection on tranches below the super senior risk layer. At
layer to one or more AAA-rated layers. In transactions that are December 31, 2007 the notional amount of the credit default
rated with respect to the risk layer or tranche that is immediately swaps in the regulatory capital relief portfolio written on tranches
junior to the threshold level above which AIGFP’s payment below the super senior risk layer was $5.8 billion, with an
obligation would generally arise, a significant majority are rated estimated fair value of $(25) million.
AAA by the rating agencies. In transactions that are not rated, AIGFP has also written credit protection on the super senior
AIGFP applies the same risk criteria for setting the threshold level risk layer of diversified por tfolios of investment grade corporate
for its payment obligations. Therefore, the risk layer assumed by debt, collateralized loan obligations (CLOs) and multi-sector CDOs.
AIGFP with respect to the designated portfolio in these transac- AIGFP is at risk only on the super senior portion related to a
tions is often called the ‘‘super senior’’ risk layer, defined as the diversified portfolio referenced to loans or debt securities. The
layer of credit risk senior to a risk layer that has been rated AAA super senior risk portion is the last tranche to suffer losses after
by the credit rating agencies, or if the transaction is not rated, significant subordination. Credit losses would have to erode all
equivalent thereto. tranches junior to the super senior tranche before AIGFP would
suffer any realized losses. The subordination level required for
At December 31, 2007 the notional amounts and unrealized market each transaction is determined based on internal modeling and
valuation loss of the super senior credit default swap portfolio by analysis of the pool of underlying assets and is not dependent on
asset classes were as follows: ratings determined by the rating agencies. While the credit default
swaps written on corporate debt obligations are cash settled, the
Notional Unrealized Market
Amount Valuation Loss majority of the credit default swaps written on CDOs and CLOs
(in billions) (in millions) require physical settlement. Under a physical settlement arrange-
Corporate loans(a) $230 $ — ment, AIGFP would be required to purchase the referenced super
Prime residential mortgages(a) 149 — senior security at par in the event of a non-payment on that
Corporate Debt/CLOs 70 226 security.
Multi-sector CDO(b) 78 11,246 Certain of these credit derivatives are subject to collateral
Total $527 $11,472 posting provisions. These provisions differ among counterparties
and asset classes. In the case of most of the multi-sector CDO
(a) Predominantly represent transactions written to facilitate regulatory
capital relief. transactions, the amount of collateral required is determined
(b) Approximately $61.4 billion in notional amount of the multi-sector CDO based on the change in value of the underlying cash security that
pools include some exposure to U.S. subprime mortgages. represents the super senior risk layer subject to credit protection,
Approximately $379 billion (consisting of the corporate loans and not the change in value of the super senior credit derivative.
and prime residential mortgages) of the $527 billion in notional AIGFP is indirectly exposed to U.S. residential mortgage
exposure of AIGFP’s super senior credit default swap portfolio as subprime collateral in the CDO portfolios, the majority of which is
of December 31, 2007 represents derivatives written for financial from 2004 and 2005 vintages. However, certain of the CDOs on
institutions, principally in Europe, for the purpose of providing which AIGFP provided credit protection permit the collateral
them with regulatory capital relief rather than risk mitigation. In manager to substitute collateral during the reinvestment period,
exchange for a minimum guaranteed fee, the counterparties subject to certain restrictions. As a result, in certain transactions,
receive credit protection in respect of diversified loan portfolios U.S. residential mortgage subprime collateral of 2006 and 2007
they own, thus improving their regulatory capital position. These vintages has been added to the collateral pools. At December 31,
derivatives are generally expected to terminate at no additional 2007, U.S. residential mortgage subprime collateral of 2006 and
cost to the counterparty upon the counterparty’s adoption of 2007 vintages comprised approximately 4.9 percent of the total
models compliant with the Basel II Accord. AIG expects that the collateral pools underlying the entire portfolio of CDOs with credit
majority of these transactions will be terminated within the next protection.
12 to 18 months by AIGFP’s counterparties as they implement AIGFP has written 2a-7 Puts in connection with certain multi-
models compliant with the new Basel II Accord. As of Febru- sector CDOs that allow the holders of the securities to treat the
ary 26, 2008, $54 billion in notional exposures have either been securities as eligible short-term 2a-7 investments under the
terminated or are in the process of being terminated. AIGFP was
122 AIG 2007 Form 10-K