AIG 2009 Annual Report Download - page 158

American International Group, Inc., and Subsidiaries
6) Division of the collateral pool into a number of hypothetical independent identical securities based on the
CDO’s diversity score so that the cash flow effects of the portfolio can be mathematically aggregated
properly. The purpose of dividing the collateral pool into hypothetical securities is a simplifying assumption
used in all BET models as part of a statistical technique that aggregates large amounts of homogeneous data;
7) Simulation of the default behavior of the hypothetical securities using a Monte Carlo simulation and
aggregation of the results to derive the effect of the expected losses on the cash flow pattern of the super
senior tranche taking into account the cash flow diversion mechanism of the CDO;
8) Discounting of the expected cash flows determined in step 7 using LIBOR-based interest rates to estimate
the value of the super senior tranche of the CDO; and
9) Adjustment of the model value for the super senior multi-sector CDO credit default swap for the effect of
the risk of non-performance by AIG using the credit spreads of AIG available in the marketplace and
considering the effects of collateral and master netting arrangements.
AIGFP employs a Monte Carlo simulation in step 7 above to assist in quantifying the effect on the valuation of the
CDO of the unique aspects of the CDO’s structure such as triggers that divert cash flows to the most senior part of the
capital structure. The Monte Carlo simulation is used to determine whether an underlying security defaults in a given
simulation scenario and, if it does, the security’s implied random default time and expected loss. This information is
used to project cash flow streams and to determine the expected losses of the portfolio.
In addition to calculating an estimate of the fair value of the super senior CDO security referenced in the credit
default swaps using its internal model, AIGFP also considers the price estimates for the super senior CDO securities
provided by third parties, including counterparties to these transactions, to validate the results of the model and to
determine the best available estimate of fair value. In determining the fair value of the super senior CDO security
referenced in the credit default swaps, AIGFP uses a consistent process which considers all available pricing data
points and eliminates the use of outlying data points. When pricing data points are within a reasonable range, an
averaging technique is applied.
The following table presents the net notional amount and fair value of derivative liability of the multi-sector super
senior credit default swap portfolio using AIGFP’s fair value methodology:
Net Notional Amount Fair Value Derivative Liability
At December 31,
(in millions) 2009 2008 2009 2008
BET model $ 2,186 $ 2,545 $ 1,092 $ 1,370
Third party price 2,466 2,951 1,883 1,753
Average of BET model and third party price 193 3,218 145 1,568
European RMBS 3,081 3,842 1,298 1,215
Total $ 7,926 $ 12,556 $ 4,418 $ 5,906
The fair value of derivative liability of $4.4 billion recorded on AIGFP’s super senior multi-sector CDO credit
default swap portfolio, represents the cumulative change in fair value of the outstanding derivatives, which represents
AIG’s best estimate of the amount it would need to pay to a willing, able and knowledgeable third-party to assume the
obligations under AIGFP’s super senior multi-sector credit default swap portfolio at December 31, 2009.
Arbitrage Portfolio — Corporate Debt/CLOs
The valuation of credit default swaps written on portfolios of investment-grade corporate debt and CLOs is less
complex than the valuation of super senior multi-sector CDO credit default swaps and the valuation inputs are more
transparent and readily available.
During the third quarter of 2009, AIGFP enhanced its valuation methodology for credit default swaps written on
portfolios of investment-grade corporate debt. This new methodology uses a mathematical model that produces
results that are more closely aligned with prices received from third-parties, rather than relying on market indices.
AIG 2009 Form 10-K 150