AIG 2007 Annual Report Download - page 219

American International Group, Inc. and Subsidiaries
may be even wider for high quality assets. AIGFP was unable to
8. Derivatives and Hedge Accounting
reliably verify this negative basis due to the accelerating severe
Continued
dislocation, illiquidity and lack of trading in the asset backed
AIGFP accounts for its credit default swaps in accordance with securities market during the fourth quarter of 2007 and early
FAS 133 ‘‘Accounting For Derivative Instruments and Hedging 2008. The valuations produced by the BET model therefore
Activities’’ and Emerging Issues Task Force 02-3, ‘‘Issues Involved represent the valuations of the underlying super senior CDO cash
in Accounting for Derivative Contracts Held for Trading Purposes securities with no recognition of the effect of the basis differential
and Contracts Involved in Energy Trading and Risk Management on that valuation.
Activities’’ (EITF 02-3). In accordance with EITF 02-3, AIGFP does AIGFP also considered the valuation of the super senior CDO
not recognize income in earnings at the inception of each securities provided by third parties, including counterparties to
transaction because the inputs to value these instruments are not these transactions, and made adjustments as necessary.
derivable from observable market data. As described above, AIGFP uses numerous assumptions in
The valuation of the super senior credit derivatives has determining its best estimate of the fair value of the super senior
become increasingly challenging given the limitation on the credit default swap portfolio. The most significant assumption
availability of market observable information due to the lack of utilized in developing the estimate is the pricing of the securities
trading and price transparency in the structured finance market, within the CDO collateral pools. If the actual pricing of the
particularly in the fourth quarter of 2007. These market condi- securities within the collateral pools differs from the pricing used
tions have increased the reliance on management estimates and in estimating the fair value of the super senior credit default swap
judgments in arriving at an estimate of fair value for financial portfolio, there is potential for significant variation in the fair value
reporting purposes. Further, disparities in the valuation methodol- estimate.
ogies employed by market participants and the varying judgments In the case of credit default swaps written on investment grade
reached by such participants when assessing volatile markets has corporate debt and CLOs, AIGFP estimated the value of its
increased the likelihood that the various parties to these obligations by reference to the relevant market indices or third
instruments may arrive at significantly different estimates as to party quotes on the underlying super senior tranches where
their fair values. available.
AIGFP’s valuation methodologies for the super senior credit AIGFP monitors the underlying portfolios to determine whether
default swap portfolio have evolved in response to the deteriorat- the credit loss experience for any particular portfolio has caused
ing market conditions and the lack of sufficient market observable the likelihood of AIGFP having a payment obligation under the
information. AIG has sought to calibrate the model to market transaction to be greater than super senior risk.
information and to review the assumptions of the model on a
regular basis. Other Derivative Users
AIGFP employs a modified version of the BET model to value its
super senior credit default swap portfolio, including the 2a-7 Puts. AIG and its subsidiaries (other than AIGFP) also use derivatives
The BET model utilizes default probabilities derived from credit and other instruments as par t of their financial risk management
spreads implied from market prices for the individual securities programs. Interest rate derivatives (such as interest rate swaps)
included in the underlying collateral pools securing the CDOs. are used to manage interest rate risk associated with investments
AIGFP obtained prices on these securities from the CDO collateral in fixed income securities, commercial paper issuances, medium-
managers. and long-term note offerings, and other interest rate sensitive
The BET model also utilizes diversity scores, weighted average assets and liabilities. In addition, foreign exchange derivatives
lives, recovery rates and discount rates. The determination of (principally cross currency swaps, forwards and options) are used
some of these inputs require the use of judgment and estimates, to economically mitigate risk associated with non-U.S. dollar
particularly in the absence of market observable data. AIGFP also denominated debt, net capital exposures and foreign exchange
employed a Monte Carlo simulation to assist in quantifying the transactions. The derivatives are effective economic hedges of the
effect on valuation of the CDO of the unique features of the exposures they are meant to offset.
CDO’s structure such as triggers that divert cash flows to the In 2007, AIG and its subsidiaries other than AIGFP designated
most senior level of the capital structure. certain derivatives as either fair value or cash flow hedges of their
The credit default swaps written by AIGFP cover only the failure debt. The fair value hedges included (i) interest rate swaps that
of payment on the super senior CDO security. AIGFP does not own were designated as hedges of the change in the fair value of fixed
the securities in the CDO collateral pool. The credit spreads rate debt attributable to changes in the benchmark interest rate
implied from the market prices of the securities in the CDO and (ii) foreign currency swaps designated as hedges of the
collateral pool incorporate the risk of default (credit risk), the change in fair value of foreign currency denominated debt
market’s price for liquidity risk and in distressed markets, the risk attributable to changes in foreign exchange rates and/or the
aversion costs. Spreads on credit derivatives tend to be narrower benchmark interest rate. With respect to the cash flow hedges,
because, unlike in the case of investing in a bond, there is no (i) interest rate swaps were designated as hedges of the changes
need to fund the position (except when an actual credit event in cash flows on floating rate debt attributable to changes in the
occurs). In times of illiquidity, the difference between spreads on benchmark interest rate, and (ii) foreign currency swaps were
cash securities and derivative instruments (the ‘‘negative basis’’) designated as hedges of changes in cash flows on foreign
AIG 2007 Form 10-K 165