Interest Rate Roundup

Monday, February 11, 2008

AIG says "Oops, my bad"

Yes, that's a tongue-in-cheek reference to the movie Clueless. Unfortunately, the subject matter isn't quite so funny. Global insurance giant American International Group announced in an 8-K filing earlier today that it is having some issues related to the value of its portfolio of certain derivatives. The language in the filing is extremely complex (see the excerpt below about such everyday, household items as the "Binomial Expansion Technique" model).

But the impact of the announcement is significant on the market -- AIG shares were recently down more than 11% and the long bond futures are flying -- up a full point on this news. And it's not like the credit markets were stable coming into today's U.S. session anyway.

"In connection with the preparation of its 2007 financial reports, American International Group, Inc. ("AIG") has recently concluded that AIG should clarify and expand its prior disclosures relating to the methodology and data inputs used to determine the fair values of the super senior credit default swap portfolio in respect of multi-sector collateralized debt obligations ("CDOs") of AIG Financial Products Corp. and AIG Trading Group Inc., including their respective subsidiaries (collectively, "AIGFP"). As disclosed in AIG's Quarterly Report on Form 10-Q for the quarter ended September 30, 2007 (the "Form 10-Q"), AIGFP values its super senior credit default swaps using internal methodologies that utilize available market observable information and incorporate management estimates and judgments when information is not available. In doing so, it employs a modified Binomial Expansion Technique ("BET") model that currently utilizes, among other data inputs, market prices obtained from independent sources, from which it derives credit spreads for the securities constituting the collateral pools underlying the related CDOs. The modified BET model derives default probabilities and expected losses from market prices, not credit ratings. The initial implementation of the BET model did not adequately quantify, and thus did not give effect to, the benefit of certain structural mitigants, such as triggers that accelerate amortization of the more senior CDO tranches."

Later on in the filing, AIG also notes the following:

"The fair value of the super senior credit default swap portfolio for the year ended December 31, 2007 will reflect continuing refinements, if any, of AIG's valuation methodologies and additional market data. AIG has been advised by its independent auditors, PricewaterhouseCoopers LLC, that they have concluded that at December 31, 2007, AIG had a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the AIGFP super senior credit default swap portfolio. AIG's assessment of its internal controls relating to the fair value valuation of the AIGFP super senior credit default swap portfolio is ongoing, but AIG believes that it currently has in place the necessary compensating controls and procedures to appropriately determine the fair value of AIGFP's super senior credit default swap portfolio for purposes of AIG's year-end financial statements."


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