AIG 2008 Annual Report Download - page 149

reasonably estimate the aggregate amount that it would be required to pay under the super senior credit default
swaps in the event of any further downgrade.
Certain super senior credit default swaps written for regulatory capital relief, with a net notional amount of
$161.5 billion at December 31, 2008, include triggers that require certain actions to be taken by AIG once AIG’s
rating level falls to certain levels, which, if not taken, give rise to a right of the counterparties to terminate the CDS.
Such actions include posting collateral, transferring the swap or providing a guarantee from a more highly rated
entity. In light of the rating actions taken in respect of AIG on September 15, 2008, AIGFP has implemented
collateral arrangements in a large majority of these transactions. In the event of a termination of the contract that is
caused by AIG’s rating downgrade, AIGFP is obligated to compensate the counterparty based on its “loss.” As a
result of AIGFP posting collateral, AIG eliminated the counterparties’ right to terminate under this downgrade
provision, thereby avoiding the uncertainty of determining the “loss” from an early termination of a regulatory
capital CDS.
Collateral
Most of AIGFP’s credit default swaps are subject to collateral posting provisions. These provisions differ
among counterparties and asset classes. Although AIGFP has collateral posting obligations associated with both
regulatory capital relief transactions and arbitrage transactions, the large majority of these obligations to date have
been associated with arbitrage transactions in respect of multi-sector CDOs.
The collateral arrangements in respect of the multi-sector CDO, regulatory capital and corporate arbitrage
transactions are nearly all documented under a Credit Support Annex (CSA) to an ISDA Master Agreement (Master
Agreement). The Master Agreement and CSA forms are standardized form agreements published by the ISDA,
which market participants have adopted as the primary contractual framework for various kinds of derivatives
transactions, including CDS. The Master Agreement and CSA forms are designed to be customized by counter-
parties to accommodate their particular requirements for the anticipated types of swap transactions to be entered
into. Elective provisions and modifications of the standard terms are negotiated in connection with the execution of
these documents. The Master Agreement and CSA permit any provision contained in these documents to be further
varied or overridden by the individual transaction confirmations, providing flexibility to tailor provisions to
accommodate the requirements of any particular transaction. A CSA, if agreed by the parties to a Master
Agreement, supplements and forms part of the Master Agreement and contains provisions (among others) for
the valuation of the covered transactions, the delivery and release of collateral, the types of acceptable collateral, the
grant of a security interest (in the case of a CSA governed by New York law) or the outright transfer of title (in the
case of a CSA governed by English law) in the collateral that is posted, the calculation of the amount of collateral
required, the valuation of the collateral provided, the timing of any collateral demand or return, dispute mech-
anisms, and various other rights, remedies and duties of the parties with respect to the collateral provided.
In general, each party has the right under a CSA to act as the “Valuation Agent” and initiate the calculation of
the exposure of one party to the other (Exposure) in respect of transactions covered by the CSA. The valuation
calculation may be performed daily, weekly or at some other interval, and the frequency is one of the terms
negotiated at the time the CSA is signed. The definition of Exposure under a standard CSA is the amount that would
be payable to one party by the other party upon a hypothetical termination of that transaction. This amount is
determined, in most cases, by the Valuation Agent using its estimate of mid-market quotations (i.e., the average of
hypothetical bid and ask quotations) of the amounts that would be paid for a replacement transaction. AIGFP
determines Exposure typically by reference to the mark-to-market valuation of the relevant transaction produced by
its systems and specialized models. Exposure amounts are typically determined for all transactions under a Master
Agreement (unless the parties have specifically agreed to exclude certain transactions, not to apply the CSA or to set
a specific transaction Exposure to zero). The aggregate Exposure less the value of collateral already held by the
relevant party (and following application of certain thresholds) results in a net exposure amount (Delivery Amount).
If this amount is a positive number, then the other party must deliver collateral with a value equal to the Delivery
Amount. Under the standard CSA, the party not acting as Valuation Agent for any particular Exposure calculation
may dispute the Valuation Agent’s calculation of the Delivery Amount. If the parties are unable to resolve this
dispute, the terms of the standard CSA provide that the Valuation Agent is required to recalculate Exposure using, in
substitution for the disputed Exposure amounts, the average of actual quotations at mid-market from four leading
dealers in the relevant market.
AIG 2008 Form 10-K 143
American International Group, Inc., and Subsidiaries