AIG 2008 Annual Report Download - page 147

• If there are reimbursements received (actual or deemed) by the CDS buyer in respect of prior triggering
events, AIGFP will be entitled to receive equivalent amounts from the counterparty to the extent AIGFP has
previously made a related payment.
Physical Settlement. For CDS transactions requiring physical settlement, AIGFP is generally required to pay
unpaid principal and accrued interest for the relevant reference obligation in return for physical delivery of such
reference obligation by the CDS buyer upon the occurrence of a credit event. After purchasing the reference
obligation, AIGFP may sell the security and recover all or a portion of the purchase price paid under the CDS, or
hold such security and be entitled to receive subsequent collections of principal and interest. AIGFP generally is
required to settle such a transaction only if the following conditions are satisfied:
• A “Credit Event” (as defined in the relevant CDS transaction confirmation) must have occurred. In all CDS
transactions subject to physical settlement, “Failure to Pay” is specified as a Credit Event and is generally
triggered if there is a failure by the issuer under the related CDO to make a payment under the reference
obligation (after the expiration of any applicable grace period and, in certain transactions, subject to a
nominal non-payment threshold having been met).
• In addition, certain of the AIGFP CDS (with an aggregate net notional amount totaling $265 million and
$8.3 billion at December 31, 2008 and 2007, respectively) provide credit protection in respect of CDOs
that require minimum amounts of collateral to be maintained to support the CDO debt, where the notional
amount of such collateral, subject to certain adjustments, is affected by among other things the ratings of
the securities and other obligations comprising such collateral. In the event that the issuer of such a CDO
fails to maintain the minimum levels of collateral, an event of default would occur, triggering a right by a
specified controlling class of CDO note holders to accelerate the payment of principal and interest on the
protected reference obligations. Under certain of the CDSs, upon acceleration of the reference obligations
underlying a CDS, AIGFP may be required to purchase such reference obligations for a purchase price
equal to unpaid principal of and accrued interest on the CDO in settlement of the CDS. As a result of this
over-collateralization feature of these CDOs, AIGFP potentially may be required to purchase such CDO
securities in settlement of the related CDS sooner than would be required if such CDOs did not have an
over-collateralization feature. One of these CDOs was accelerated in 2008, and AIGFP extinguished its
CDS obligations by purchasing the protected CDO security for $162 million, which equaled the principal
amount outstanding related to this CDS, of which $103 million was recorded in the trading securities
portfolio and $59 million was recorded in the available for sale portfolio. AIGFP had no CDS net notional
exposure with respect to CDOs that have experienced over-collateralization events of default at Feb-
ruary 18, 2009.
• In addition to subordination, cash flow diversion mechanics may provide further protection from losses
for holders of the super senior CDO securities. Following the acceleration of a CDO security, all, or a
portion of, available cash flows in a CDO could be diverted from the junior tranches to the most senior
tranches. In a CDO with such a feature, the junior tranches may not receive any cash flows until all interest
on, and principal of, the super senior tranches are paid in full. Thus, potential losses borne by the holders
of the super senior CDO securities may be mitigated as cash flows that would otherwise be payable to
junior tranches throughout the entire CDO capital structure are instead diverted directly to the most senior
tranches. Cash flow diversion mechanics also may arise in the context of over-collateralization tests. Upon
a failure by the CDO issuer to comply with certain over-collateralization tests (other than those that trigger
an indenture event of default), cash flows that would otherwise be payable to certain junior tranches
throughout the CDO capital structure may instead be diverted to more senior tranches. Consequently, the
super senior risk layer is paid down at a faster rate, effectively increasing the relative level of
subordination.
• The existence of a tranche of securities ranking pari passu with the super senior CDO securities does not
provide additional subordination that protects holders of the super senior CDO securities, as holders of
such pari passu securities are entitled to receive payments from available cash flows at the same level of
priority as holders of the super senior securities. Thus, a pari passu tranche of securities does not affect the
amount of losses that have to be absorbed by classes of CDO securities other than the super senior CDO
AIG 2008 Form 10-K 141
American International Group, Inc., and Subsidiaries