2007 Annual Report - AIG.com
2007 Annual Report - AIG.com
2007 Annual Report - AIG.com
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American International Group, Inc. and Subsidiaries<br />
8. Derivatives and Hedge Accounting<br />
Continued<br />
<strong>AIG</strong>FP accounts for its credit default swaps in accordance with<br />
FAS 133 ‘‘Accounting For Derivative Instruments and Hedging<br />
Activities’’ and Emerging Issues Task Force 02-3, ‘‘Issues Involved<br />
in Accounting for Derivative Contracts Held for Trading Purposes<br />
and Contracts Involved in Energy Trading and Risk Management<br />
Activities’’ (EITF 02-3). In accordance with EITF 02-3, <strong>AIG</strong>FP does<br />
not recognize in<strong>com</strong>e in earnings at the inception of each<br />
transaction because the inputs to value these instruments are not<br />
derivable from observable market data.<br />
The valuation of the super senior credit derivatives has<br />
be<strong>com</strong>e increasingly challenging given the limitation on the<br />
availability of market observable information due to the lack of<br />
trading and price transparency in the structured finance market,<br />
particularly in the fourth quarter of <strong>2007</strong>. These market condi-<br />
tions have increased the reliance on management estimates and<br />
judgments in arriving at an estimate of fair value for financial<br />
reporting purposes. Further, disparities in the valuation methodol-<br />
ogies employed by market participants and the varying judgments<br />
reached by such participants when assessing volatile markets has<br />
increased the likelihood that the various parties to these<br />
instruments may arrive at significantly different estimates as to<br />
their fair values.<br />
<strong>AIG</strong>FP’s valuation methodologies for the super senior credit<br />
default swap portfolio have evolved in response to the deteriorat-<br />
ing market conditions and the lack of sufficient market observable<br />
information. <strong>AIG</strong> has sought to calibrate the model to market<br />
information and to review the assumptions of the model on a<br />
regular basis.<br />
<strong>AIG</strong>FP employs a modified version of the BET model to value its<br />
super senior credit default swap portfolio, including the 2a-7 Puts.<br />
The BET model utilizes default probabilities derived from credit<br />
spreads implied from market prices for the individual securities<br />
included in the underlying collateral pools securing the CDOs.<br />
<strong>AIG</strong>FP obtained prices on these securities from the CDO collateral<br />
managers.<br />
The BET model also utilizes diversity scores, weighted average<br />
lives, recovery rates and discount rates. The determination of<br />
some of these inputs require the use of judgment and estimates,<br />
particularly in the absence of market observable data. <strong>AIG</strong>FP also<br />
employed a Monte Carlo simulation to assist in quantifying the<br />
effect on valuation of the CDO of the unique features of the<br />
CDO’s structure such as triggers that divert cash flows to the<br />
most senior level of the capital structure.<br />
The credit default swaps written by <strong>AIG</strong>FP cover only the failure<br />
of payment on the super senior CDO security. <strong>AIG</strong>FP does not own<br />
the securities in the CDO collateral pool. The credit spreads<br />
implied from the market prices of the securities in the CDO<br />
collateral pool incorporate the risk of default (credit risk), the<br />
market’s price for liquidity risk and in distressed markets, the risk<br />
aversion costs. Spreads on credit derivatives tend to be narrower<br />
because, unlike in the case of investing in a bond, there is no<br />
need to fund the position (except when an actual credit event<br />
occurs). In times of illiquidity, the difference between spreads on<br />
cash securities and derivative instruments (the ‘‘negative basis’’)<br />
may be even wider for high quality assets. <strong>AIG</strong>FP was unable to<br />
reliably verify this negative basis due to the accelerating severe<br />
dislocation, illiquidity and lack of trading in the asset backed<br />
securities market during the fourth quarter of <strong>2007</strong> and early<br />
2008. The valuations produced by the BET model therefore<br />
represent the valuations of the underlying super senior CDO cash<br />
securities with no recognition of the effect of the basis differential<br />
on that valuation.<br />
<strong>AIG</strong>FP also considered the valuation of the super senior CDO<br />
securities provided by third parties, including counterparties to<br />
these transactions, and made adjustments as necessary.<br />
As described above, <strong>AIG</strong>FP uses numerous assumptions in<br />
determining its best estimate of the fair value of the super senior<br />
credit default swap portfolio. The most significant assumption<br />
utilized in developing the estimate is the pricing of the securities<br />
within the CDO collateral pools. If the actual pricing of the<br />
securities within the collateral pools differs from the pricing used<br />
in estimating the fair value of the super senior credit default swap<br />
portfolio, there is potential for significant variation in the fair value<br />
estimate.<br />
In the case of credit default swaps written on investment grade<br />
corporate debt and CLOs, <strong>AIG</strong>FP estimated the value of its<br />
obligations by reference to the relevant market indices or third<br />
party quotes on the underlying super senior tranches where<br />
available.<br />
<strong>AIG</strong>FP monitors the underlying portfolios to determine whether<br />
the credit loss experience for any particular portfolio has caused<br />
the likelihood of <strong>AIG</strong>FP having a payment obligation under the<br />
transaction to be greater than super senior risk.<br />
Other Derivative Users<br />
<strong>AIG</strong> and its subsidiaries (other than <strong>AIG</strong>FP) also use derivatives<br />
and other instruments as part of their financial risk management<br />
programs. Interest rate derivatives (such as interest rate swaps)<br />
are used to manage interest rate risk associated with investments<br />
in fixed in<strong>com</strong>e securities, <strong>com</strong>mercial paper issuances, medium-<br />
and long-term note offerings, and other interest rate sensitive<br />
assets and liabilities. In addition, foreign exchange derivatives<br />
(principally cross currency swaps, forwards and options) are used<br />
to economically mitigate risk associated with non-U.S. dollar<br />
denominated debt, net capital exposures and foreign exchange<br />
transactions. The derivatives are effective economic hedges of the<br />
exposures they are meant to offset.<br />
In <strong>2007</strong>, <strong>AIG</strong> and its subsidiaries other than <strong>AIG</strong>FP designated<br />
certain derivatives as either fair value or cash flow hedges of their<br />
debt. The fair value hedges included (i) interest rate swaps that<br />
were designated as hedges of the change in the fair value of fixed<br />
rate debt attributable to changes in the benchmark interest rate<br />
and (ii) foreign currency swaps designated as hedges of the<br />
change in fair value of foreign currency denominated debt<br />
attributable to changes in foreign exchange rates and/or the<br />
benchmark interest rate. With respect to the cash flow hedges,<br />
(i) interest rate swaps were designated as hedges of the changes<br />
in cash flows on floating rate debt attributable to changes in the<br />
benchmark interest rate, and (ii) foreign currency swaps were<br />
designated as hedges of changes in cash flows on foreign<br />
<strong>AIG</strong> <strong>2007</strong> Form 10-K 165