AIG 2007 Annual Report Download - page 177

American International Group, Inc. and Subsidiaries
Investment Company Act of 1940. Holders of securities are AIGFP obtained prices on these securities from the CDO collateral
permitted, in certain circumstances, to tender their securities to managers.
the issuers at par. If an issuer’s remarketing agent is unable to The BET model also utilizes diversity scores, weighted average
resell the securities so tendered, AIGFP must purchase the lives, recovery rates and discount rates. The determination of
securities at par as long as the security has not experienced a some of these inputs require the use of judgment and estimates,
default. During 2007, AIGFP repurchased securities with a princi- particularly in the absence of market observable data. AIGFP also
pal amount of approximately $754 million pursuant to these employed a Monte Carlo simulation to assist in quantifying the
obligations. In certain transactions, AIGFP has contracted with effect on valuation of the CDO of the unique features of the
third parties to provide liquidity for the securities if they are put to CDO’s structure such as triggers that divert cash flows to the
AIGFP for up to a three-year period. Such liquidity facilities totaled most senior level of the capital structure.
approximately $3 billion at December 31, 2007. As of Febru- The credit default swaps written by AIGFP cover only the failure
ary 26, 2008, AIGFP has not utilized these liquidity facilities. At of payment on the super senior CDO security. AIGFP does not own
December 31, 2007, AIGFP had approximately $6.5 billion of the securities in the CDO collateral pool. The credit spreads
notional exposure on 2a-7 Puts, included as part of the multi- implied from the market prices of the securities in the CDO
sector CDO portfolio discussed herein. collateral pool incorporate the risk of default (credit risk), the
As of January 31, 2008, a significant majority of AIGFP’s super market’s price for liquidity risk and in distressed markets, the risk
senior exposures continued to have tranches below AIGFP’s aversion costs. Spreads on credit derivatives tend to be narrower
attachment point that have been explicitly rated AAA or, in AIGFP’s because, unlike in the case of investing in a bond, there is no
judgment, would have been rated AAA had they been rated. need to fund the position (except when an actual credit event
AIGFP’s portfolio of credit default swaps undergoes regular occurs). In times of illiquidity, the difference between spreads on
monitoring, modeling and analysis and contains protection through cash securities and derivative instruments (the ‘‘negative basis’’)
collateral subordination. may be even wider for high quality assets. AIGFP was unable to
AIGFP accounts for its credit default swaps in accordance with reliably verify this negative basis due to the accelerating severe
FAS 133 ‘‘Accounting For Derivative Instruments and Hedging dislocation, illiquidity and lack of trading in the asset backed
Activities’’ and Emerging Issues Task Force 02-3, ‘‘Issues Involved securities market during the fourth quarter of 2007 and early
in Accounting for Derivative Contracts Held for Trading Purposes 2008. The valuations produced by the BET model therefore
and Contracts Involved in Energy Trading and Risk Management represent the valuations of the underlying super senior CDO cash
Activities’’ (EITF 02-3). In accordance with EITF 02-3, AIGFP does securities with no recognition of the effect of the basis differential
not recognize income in earnings at the inception of each on that valuation.
transaction because the inputs to value these instruments are not AIGFP also considered the valuation of the super senior CDO
derivable from observable market data. securities provided by third parties, including counterparties to
The valuation of the super senior credit derivatives has these transactions, and made adjustments as necessary.
become increasingly challenging given the limitation on the As described above, AIGFP uses numerous assumptions in
availability of market observable information due to the lack of determining its best estimate of the fair value of the super senior
trading and price transparency in the structured finance market, credit default swap portfolio. The most significant assumption
particularly in the fourth quarter of 2007. These market condi- utilized in developing the estimate is the pricing of the securities
tions have increased the reliance on management estimates and within the CDO collateral pools. If the actual pricing of the
judgments in arriving at an estimate of fair value for financial securities within the collateral pools differs from the pricing used
reporting purposes. Further, disparities in the valuation methodol- in estimating the fair value of the super senior credit default swap
ogies employed by market participants and the varying judgments portfolio, there is potential for significant variation in the fair value
reached by such participants when assessing volatile markets has estimate. A decrease by five points (for example, from 87 cents
increased the likelihood that the various parties to these per dollar to 82 cents per dollar) in the aggregate price of the
instruments may arrive at significantly different estimates as to securities would cause an additional unrealized market valuation
their fair values. loss of approximately $3.7 billion, while an increase in the
AIGFP’s valuation methodologies for the super senior credit aggregate price of the securities by five points (for example, from
default swap portfolio have evolved in response to the deteriorat- 90 cents per dollar to 95 cents per dollar) would reduce the
ing market conditions and the lack of sufficient market observable unrealized market valuation loss by approximately $3 billion. The
information. AIG has sought to calibrate the model to market effect on the unrealized market valuation loss is not proportional
information and to review the assumptions of the model on a to the change in the aggregate price of the securities.
regular basis. In the case of credit default swaps written on investment grade
AIGFP employs a modified version of the BET model to value its corporate debt and CLOs, AIGFP estimated the value of its
super senior credit default swap portfolio, including the 2a-7 Puts. obligations by reference to the relevant market indices or third
The BET model utilizes default probabilities derived from credit party quotes on the underlying super senior tranches where
spreads implied from market prices for the individual securities available.
included in the underlying collateral pools securing the CDOs. AIGFP monitors the underlying portfolios to determine whether
the credit loss experience for any particular portfolio has caused
AIG 2007 Form 10-K 123