AIG 2009 Annual Report Download - page 157

American International Group, Inc., and Subsidiaries
require payment of the full difference between the cash price of the underlying tranches of the referenced securities
portfolio and the net notional amount specified in the credit default swap.
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 CDOs of ABS, including the 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.
AIG selected the BET model for the following reasons:
• it is known and utilized by other institutions;
• it has been studied extensively, documented and enhanced over many years;
• it is transparent and relatively simple to apply;
• the parameters required to run the BET model are generally observable; and
• it can easily be modified to use probabilities of default and expected losses derived from the underlying
collateral securities market prices instead of using rating-based historical probabilities of default.
The BET model has certain limitations. A well known limitation of the BET model is that it can understate the
expected losses for super senior tranches when default correlations are high. The model uses correlations implied
from diversity scores which do not capture the tendency for correlations to increase as defaults increase. Recognizing
this concern, AIG tested the sensitivity of the valuations to the diversity scores. The results of the testing
demonstrated that the valuations are not very sensitive to the diversity scores because the expected losses generated
from the prices of the collateral pool securities are currently high, breaching the attachment point in most
transactions. Once the attachment point is breached by a sufficient amount, the diversity scores, and their implied
correlations, are no longer a significant driver of the valuation of a super senior tranche.
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 price 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. These data are then aggregated and used to estimate the expected cash flows of the super senior
tranche of the CDO.
The application of the modified BET model involves the following steps for each individual super senior tranche of
a CDO in the portfolio:
1) Calculation of the cash flow pattern that matches the weighted average life for each underlying security of
the CDO;
2) Calculation of an implied credit spread for each security from the price and cash flow pattern determined in
step 1. This is an arithmetic process which converts prices to yields (similar to the conversion of Department
of the Treasury security prices to yields), and then subtracts LIBOR-based interest rates to determine the
credit spreads;
3) Conversion of the credit spread into its implied probability of default. This also is an arithmetic process that
determines the assumed level of default on the security that would equate the present value of the expected
cash flows discounted at a risk-free rate with the present value of the contractual cash flows discounted using
LIBOR-based interest rates plus the credit spreads;
4) Generation of expected losses for each underlying security using the probability of default and recovery rate;
5) Aggregation of the cash flows for all securities to create a cash flow profile of the entire collateral pool
within the CDO;
149 AIG 2009 Form 10-K