2007 Annual Report - AIG.com

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American International Group, Inc. and Subsidiaries Management’s Discussion and Analysis of Financial Condition and Results of Operations Continued AIG’s Consumer Finance operations in North America are principally conducted through AGF. AGF derives a substantial portion of its revenues from finance charges assessed on outstanding real estate loans, secured and unsecured non-real estate loans and retail sales finance receivables and credit-related insurance. AGF’s finance receivables are primarily sourced through its branches, although many of AGF’s real estate loans are sourced through its centralized real estate operations, which include AGF’s mortgage banking activities. The majority of the real estate loans originated by AGF’s mortgage banking subsidiary are originated through broker relationships and are sold to investors on a servicing-released basis. Beginning in July 2003, AGF’s mortgage banking subsidiaries originated and sold loans through a services arrangement with AIG Federal Savings Bank (AIG Bank), a federally chartered thrift and non-subsidiary of AGF. The services relationship was terminated in the first quarter of 2006. Since terminating the services relationship with AIG Bank, AGF’s mortgage banking subsidiaries have originated these non-conforming real estate loans using their own state licenses. On June 7, 2007, AIG’s domestic consumer finance operations, consisting of AIG Bank, AGF’s mortgage banking subsidiary Wilmington Finance, Inc. (WFI) and AGF, entered into a Supervisory Agreement with the OTS. The Supervisory Agreement per- tains to certain mortgage loans originated in the name of AIG Bank from July 2003 through early May 2006 pursuant to the services agreement between WFI and AIG Bank, which was terminated in the first quarter of 2006. Pursuant to the terms of the Supervisory Agreement, AIG Bank, WFI and AGF have implemented a financial remediation program whereby certain borrowers may be provided loans on more affordable terms and/or reimbursed for certain fees. Pursuant to the requirements of the Supervisory Agreement, the services of an external consultant have been engaged to monitor, evaluate and periodi- cally report to the OTS on compliance with the remediation program. The Supervisory Agreement will remain in effect until terminated, modified, or suspended in writing by the OTS. Failure to comply with the terms of the Agreement could result in the initiation of formal enforcement action by the OTS. Separately, the domestic consumer finance operations also committed to donate $15 million over a three-year period to certain not-for-profit organizations to support their efforts to promote financial literacy and credit counseling. Management’s best estimate of the cost of implementing the financial remediation plan contemplated by the Supervisory Agreement, including the $15 million donation, was $178 million which was recorded in 2007. The actual cost of implementing the financial remediation plan may differ from this estimate. AIG’s foreign consumer finance operations are principally conducted through AIG Consumer Finance Group, Inc. (AIGCFG). AIGCFG operates primarily in emerging and developing markets. period charge of $223 million related to the remediation of the material weakness in internal control over accounting for certain derivative transactions under FAS 133. The net loss also reflects the effect of increases in U.S. interest rates and a weakening of the U.S. dollar on derivatives hedging AIGFP’s assets and liabilities. Financial market conditions in 2007 were characterized by increases in global interest rates, widening of credit spreads, higher equity valuations and a slightly weaker U.S. dollar. The most significant component of Capital Markets operating expenses is compensation, which was approximately $423 million, $544 million and $481 million in 2007, 2006 and 2005, respectively. The amount of compensation was not affected by gains and losses arising from derivatives not qualifying for hedge accounting treatment under FAS 133. In light of the unrealized market valuation loss related to the AIGFP super senior credit default swap portfolio, to retain and motivate the affected AIGFP employees, a special incentive plan relating to 2007 was established. Under this plan, certain AIGFP employees were granted cash awards vesting over two years and payable in 2013. The expense related to these awards will be recognized ratably over the vesting period, beginning in 2008. AIG elected to early adopt FAS 155, ‘‘Accounting for Certain Hybrid Financial Instruments’’ (FAS 155) in 2006. AIGFP elected to apply the fair value option permitted by FAS 155 to its structured notes and other financial liabilities containing embedded derivatives outstanding as of January 1, 2006. The cumula- tive effect of the adoption of FAS 155 on these instruments at January 1, 2006 was a pre-tax loss of $29 million. AIGFP recognized a loss of $351 million in 2007 and a loss of $287 million in 2006 on hybrid financial instruments for which it applied the fair value option under FAS 155. These amounts were largely offset by gains and losses on economic hedge positions also reflected in AIGFP’s operating income or loss. 2006 and 2005 Comparison Capital Markets reported an operating loss in 2006 compared to operating income in 2005. Improved results, primarily from increased transaction flow in AIGFP’s credit, commodity index, energy and equity products, were more than offset by the loss resulting from the effect of derivatives not qualifying for hedge accounting treatment under FAS 133. This loss was $1.82 billion in 2006 compared to a gain of $2.01 billion in 2005, a decrease of $3.83 billion. A large part of the net loss on AIGFP’s derivatives recognized in 2006 was due to the weakening of the U.S. dollar, primarily against the British Pound and Euro, resulting in a decrease in the fair value of the foreign currency derivatives hedging AIGFP’s available for sale securities. The majority of the net gain on AIGFP’s derivatives in 2005 was due to the strengthening of the U.S. dollar, primarily against the British Pound and Euro, which increased the fair value of the foreign currency derivatives hedging available for sale securities. To a lesser extent, the net gain in 2005 was due to the decrease in long-term U.S. interest rates, which increased the fair value of derivatives hedging AIGFP’s assets and liabilities. Financial market conditions in 2006 were characterized by a general flattening of interest rate yield curves across fixed income markets globally, tightening of credit spreads, higher equity valuations and a weaker U.S. dollar. Consumer Finance 84 AIG 2007 Form 10-K
American International Group, Inc. and Subsidiaries AIGCFG has operations in Argentina, China, Hong Kong, Mexico, AGF’s net finance receivables totaled $25.5 billion at Decem- Philippines, Poland, Taiwan and Thailand and began operations in ber 31, 2007, an increase of approximately $1.2 billion compared India in 2007 through the acquisition of a majority interest in a to December 31, 2006, including $19.5 billion of real estate sales finance lending operation and the acquisition of a mortgage secured loans, most of which were underwritten with full income lending operation. In addition, in 2007, AIGCFG expanded its verification. The increase in the net finance receivables resulted in distribution channels in Thailand by acquiring an 80 percent a similar increase in revenues generated from these assets. interest in a company with a network of over 130 branches for Although real estate loan originations declined in 2007, the secured consumer lending. AIGCFG is continuously exploring softening of home price appreciation (reducing the equity customexpansion opportunities in its existing operations as well as new ers may be able to extract from their homes by refinancing) geographic locations throughout the world. contributed to an increase in non-real estate loans of 11 percent Certain of the AIGCFG operations are partly or wholly owned by at December 31, 2007 compared to December 31, 2006. Retail life insurance subsidiaries of AIG. Accordingly, the financial results sales finance receivables also increased 13 percent compared to of those companies are allocated between Financial Services and December 31, 2006 due to increased marketing efforts and Life Insurance & Retirement Services according to their ownership customer demand. AGF’s centralized real estate operations fipercentages. While products vary by market, the businesses nance receivables were essentially unchanged while branch generally provide credit cards, unsecured and secured non-real business segment finance receivables increased by 8 percent estate loans, term deposits, savings accounts, retail sales finance during 2007. and real estate loans. AIGCFG originates finance receivables AGF’s allowance for finance receivable losses as a percentage through its branches and direct solicitation. AIGCFG also of outstanding receivables was 2.36 percent at December 31, originates finance receivables indirectly through relationships with 2007 compared to 2.01 percent at December 31, 2006. retailers, auto dealers, and independent agents. Revenues from the foreign consumer finance operations increased by 29 percent in 2007 compared to 2006. Loan growth, Consumer Finance Results particularly in Poland, Thailand and Latin America, was the 2007 and 2006 Comparison primary driver of the increased revenues. The increase in revenues was more than offset by higher expenses associated Consumer Finance operating income decreased in 2007 compared with branch expansions, acquisition activities and product promoto 2006. Operating income from the domestic consumer finance tion campaigns. Operating income in 2006 reflects AIGCFG’s operations, which include the operations of AGF and AIG Bank, $47 million share of the allowance for losses related to industrydecreased by $509 million, or 77 percent, in 2007 compared to wide credit deterioration in the Taiwan credit card market. 2006. In 2007, domestic results were adversely affected by the weakening housing market and tighter underwriting guidelines, 2006 and 2005 Comparison which resulted in lower originations of real estate loans as well as the $178 million charge discussed above. Consumer Finance operating income decreased in 2006 compared AGF’s revenues decreased $95 million or 3 percent during to 2005. Operating income from domestic consumer finance 2007 compared to 2006. Revenues from AGF’s mortgage banking operations declined by $193 million, or 23 percent as a result of activities decreased $389 million during 2007 compared to 2006, decreased originations and purchases of real estate loans and which includes the charges relating to the Supervisory Agreement. margin compression resulting from increased interest rates and The decrease in revenues also reflects a significantly reduced flattened yield curves. The foreign operations operating income origination volume, lower yields based on market conditions, decreased primarily due to the credit deterioration in the Taiwan tighter underwriting guidelines, reduced margins on loans sold credit card market. and higher warranty reserves, which cover obligations to repur- Domestically, the U.S. housing market deteriorated throughout chase loans sold to third-party investors should there be a first 2006 and as a result, the real estate loan portfolio decreased payment default or breach of representations and warranties. slightly during 2006 due to lower refinancing activity. This lower AGF’s revenues in 2007 also included a recovery of $65 million refinancing activity also caused a significant decrease in originafrom a favorable out of court settlement. tions and whole loan sales in AGF’s mortgage banking operation, AGF’s operating income decreased in 2007 compared to 2006, which resulted in a substantial reduction of revenue and operating due to reduced residential mortgage origination volumes, lower income compared to the prior year. However, softening home revenues from its mortgage banking activities and increases in prices (reducing the equity customers are able to extract from the provision for finance receivable losses. AGF’s interest expense their homes when refinancing) and higher mortgage rates contrib- increased by $81 million or seven percent as its borrowing rate uted to customers utilizing non-real estate loans, which increased increased in 2007 compared to 2006. During 2007, AGF recorded 10 percent compared to 2005. Retail sales finance receivables a net loss of $28 million on its derivatives that did not qualify for also increased 23 percent due to increased marketing efforts and hedge accounting under FAS 133, including the related foreign customer demand. Higher revenue resulting from portfolio growth exchange losses, compared to a net loss of $89 million in 2006. was more than offset by higher interest expense. AGF’s short- Commencing in the second quarter of 2007, AGF began applying term borrowing rates were 5.14 percent in 2006 compared to hedge accounting. 3.58 percent in 2005. AGF’s long-term borrowing rates were 5.05 percent in 2006 compared to 4.41 percent in 2005. During AIG 2007 Form 10-K 85
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AMERICAN INTERNATIONAL GROUP, INC.
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FINANCIAL HIGHLIGHTS (in millions,
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overall financial condition, althou
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Group Executive Committee We are ad
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AIG’s life insurance network is t
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We have also begun to address the e
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WHAT WE SEE The ability to see and
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The Major Accounts Practice within
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Around the world, the middle class
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WE SEE GROWTH OPPORTUNITIES IN EMER
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To grow the strength of the AIG glo
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Since 2003, the AIG Disaster Relief
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RESPECT Respect encompasses how we
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Life Insurance & Retirement Service
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Domestic Brokerage Group— Gross P
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In the summer of 2007, widespread f
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in gross premiums written. It launc
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It grew new business premiums from
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emerging markets for its services,
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ILFC—Revenues by Region Total = $
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AIG Investments acquired a 94 perce
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and changing interest rates, as wel
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American International Group, Inc.
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UNITED STATES SECURITIES AND EXCHAN
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Index of Notes to Consolidated Fina
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SHAREHOLDER INFORMATION Corporate H
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