AIG 2009 Annual Report Download - page 159

American International Group, Inc., and Subsidiaries
This methodology is widely used by other market participants and uses the current market credit spreads of the names
in the portfolios along with the base correlations implied by the current market prices of comparable tranches of the
relevant market traded credit indices as inputs. Two transactions, representing two percent of the total notional
amount of the corporate arbitrage transactions, are valued using third party quotes given their unique attributes.
AIGFP estimates the fair value of its obligations resulting from credit default swaps written on CLOs to be
equivalent to the par value less the current market value of the referenced obligation. Accordingly, the value is
determined by obtaining third-party quotes on the underlying super senior tranches referenced under the credit
default swap contract.
No assurance can be given that the fair value of AIGFP’s arbitrage credit default swap portfolio would not change
materially if other market indices or pricing sources were used to estimate the fair value of the portfolio.
Regulatory Capital Portfolio
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. AIGFP continues to reassess the expected maturity of this
portfolio. As of December 31, 2009, AIGFP estimated that the weighted average expected maturity of the portfolio
was 1.35 years. AIGFP has not been required to make any payments as part of terminations initiated by
counterparties. The regulatory benefit of these transactions for AIGFP’s financial institution counterparties is
generally derived from the terms of the Capital Accord of the Basel Committee on Banking Supervision (Basel I) that
existed through the end of 2007 and which is in the process of being replaced by Basel II. It was expected that financial
institution counterparties would have transitioned from Basel I to Basel II by the end of the two-year adoption period
on December 31, 2009, after which they would have received little or no additional regulatory benefit from these CDS
transactions, except in a small number of specific instances. However, the Basel Committee recently announced that it
has agreed to keep in place the Basel I capital floors beyond the end of 2009, although it remains to be seen how this
extension will be implemented by the various European Central Banking districts. Should certain counterparties
continue to receive favorable regulatory capital benefits from these transactions, those counterparties may not
exercise their options to terminate the transactions in the expected time frame. AIGFP also considers other market
data, to the extent relevant and available.
AIGFP does not expect to make any payment under these contracts based on current portfolio conditions and stress
analyses performed. Over the contractual life of the transactions, AIGFP is owed contractual premiums over an
extended period. However, the expectation that the counterparties will be willing and able to terminate these
transactions in the very near term based on the contract provisions and market conditions significantly reduces the
expected future cash flows to be received. Consequently, the future expected cash flows validate the observable
market transactions used to price the portfolio.
In light of early termination experience to date and after other analyses, AIG determined that there was no
unrealized market valuation adjustment for this regulatory capital relief portfolio for the year ended December 31,
2009 other than (1) for transaction where AIGFP believes the counterparty is no longer using the transaction to
obtain regulatory capital relief and (2) for transactions where the counterparty has failed to terminate the transaction
early as expected and no longer has any rights to terminate early in the future. During 2009, AIGFP effected the early
termination of a CDS transaction written on a European RMBS security of $1.5 billion in net notional amount that
was reported as part of Regulatory Capital — Other at a level approximating its fair value at that time. Given its
unique structure and concentrated exposure to high loan-to-value Spanish residential mortgages, this transaction had
exposed AIGFP to a relatively higher level of liquidity and credit risk than any other regulatory capital CDS exposure,
and AIG felt it prudent to terminate the transaction to avoid further deterioration.
AIG will continue to assess the valuation of this portfolio and monitor developments in the marketplace. Given the
potential for further significant deterioration in the credit markets and the risk that AIGFP’s expectations with
respect to the termination of these transactions by its counterparties may not materialize, there can be no assurance
that AIG will not recognize unrealized market valuation losses from this portfolio in future periods. Moreover, given
151 AIG 2009 Form 10-K