AIG 2010 Annual Report Download - page 269

American International Group, Inc., and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Regulatory capital portfolio: In the case of credit default swaps written to facilitate regulatory capital relief, AIG
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 continues to reassess
the expected maturity of the portfolio. 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 Basel I. In December 2010, the Basel Committee on Banking
Supervision finalized Basel III, which, when fully implemented, may reduce or eliminate the regulatory benefits to
certain counterparties and thus my impact the period of time that such counterparties are expected to hold the
positions. In assessing the fair value of the regulatory capital CDS transactions, AIG also considers other market
data, to the extent relevant and available. For further discussion, see Note 12 herein.
Multi-sector CDO portfolios: AIG uses a modified version of the Binomial Expansion Technique (BET) model to
value AIGFP’s credit default swap portfolio written on super senior tranches of multi-sector collateralized debt
obligations (CDOs) of ABS, including maturity-shortening puts that allow the holders of the securities issued by
certain CDOs to treat the securities as short-term 2a-7 eligible 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 remains widely used.
AIG 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. CDO collateral managers provided market prices for 58.0 percent of the
underlying securities used in the valuation at December 31, 2010. When a price for an individual security is not
provided by a CDO collateral manager, AIG 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
employs a Monte Carlo simulation 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, AIG 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, AIG uses a consistent process that 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.
Corporate debt/Collateralized loan obligation (CLO) portfolios: In the case of credit default swaps written on
portfolios of investment-grade corporate debt, AIG uses a mathematical model that produces results that are
AIG 2010 Form 10-K 253