AIG 2008 Annual Report Download - page 241

transacted, or have been transacted, with the greatest volume or level of activity. AIG has determined that the
principal market participants, therefore, would consist of other large financial institutions who participate in
sophisticated over-the-counter derivatives markets. The specific valuation methodologies vary based on the nature
of the referenced obligations and availability of market prices.
The valuation of the super senior credit derivatives continues to be challenging given the limitation on the
availability of market observable information due to the lack of trading and price transparency in the structured
finance market, particularly during and since the second half of 2007. These market conditions have increased the
reliance on management estimates and judgments in arriving at an estimate of fair value for financial reporting
purposes. Further, disparities in the valuation methodologies employed by market participants and the varying
judgments reached by such participants when assessing volatile markets have increased the likelihood that the
various parties to these instruments may arrive at significantly different estimates as to their fair values.
AIGFP’s valuation methodologies for the super senior credit default swap portfolio have evolved in response to
the deteriorating market conditions and the lack of sufficient market observable information. AIG has sought to
calibrate the model to available market information and to review the assumptions of the model on a regular basis.
In the case of credit default swaps written to facilitate regulatory capital relief, AIGFP estimates the fair value
of these derivatives by considering observable market transactions. The transactions with the most observability are
the early terminations of these transactions by counterparties. AIG expects that the majority of these transactions
will be terminated within the next 15 months by AIGFP’s counterparties. During 2008, $99.7 billion in net notional
amount of regulatory capital super senior transactions was terminated or matured. AIGFP has also received formal
termination notices for an additional $26.5 billion in net notional amount of regulatory capital super senior CDS
transactions with effective termination dates in 2009. AIGFP has not been required to make any payments as part of
these terminations and in certain cases was paid a fee upon termination. AIGFP also considers other market data, to
the extent relevant and available.
AIGFP uses a modified version of the Binomial Expansion Technique (BET) model to value its credit default
swap portfolio written on super senior tranches of multi-sector collateralized debt obligations (CDOs) of asset-
backed securities (ABS), including maturity-shortening puts that allow the holders of the securities issued by
certain CDOs to treat the securities as short-term eligible 2a-7 investments under the Investment Company Act of
1940 (2a-7 Puts). The BET model was developed in 1996 by a major rating agency to generate expected loss
estimates for CDO tranches and derive a credit rating for those tranches, and has been widely used ever since.
AIGFP has adapted the BET model to estimate the price of the super senior risk layer or tranche of the CDO.
AIG modified the BET model to imply default probabilities from market prices for the underlying securities and not
from rating agency assumptions. To generate the estimate, the model uses the price estimates for the securities
comprising the portfolio of a CDO as an input and converts those estimates to credit spreads over current LIBOR-
based interest rates. These credit spreads are used to determine implied probabilities of default and expected losses
on the underlying securities. This data is then aggregated and used to estimate the expected cash flows of the super
senior tranche of the CDO.
Prices for the individual securities held by a CDO are obtained in most cases from the CDO collateral
managers, to the extent available. For the year ended December 31, 2008, CDO collateral managers provided
market prices for 61.2 percent of the underlying securities. When a price for an individual security is not provided
by a CDO collateral manager, AIGFP derives the price through a pricing matrix using prices from CDO collateral
managers for similar securities. Matrix pricing is a mathematical technique used principally to value debt securities
without relying exclusively on quoted prices for the specific securities, but rather by relying on the relationship of
the security to other benchmark quoted securities. Substantially all of the CDO collateral managers who provided
prices used dealer prices for all or part of the underlying securities, in some cases supplemented by third-party
pricing services.
The BET model also uses diversity scores, weighted average lives, recovery rates and discount rates.
AIG 2008 Form 10-K 235
American International Group, Inc., and Subsidiaries
Notes to Consolidated Financial Statements — (Continued)