AIG warns of potential losses in CDS portfolio

AIG could be exposed to further losses on the super-senior credit default swap (CDS) portfolio held by its subsidiary AIG Financial Products (AIG FP) should credit markets continue to deteriorate, according to a filing the company made to the US Securities and Exchange Commission on June 29.

The insurer noted that such a hit to AIG FP's CDS portfolio "could have a material adverse effect" on the whole of the company's financial standing. Credit markets have plummeted since the credit crisis began in mid-2007. Data from the US Federal Reserve shows delinquency rates for commercial loans jumping from 1.64% on June 30, 2007, to 6.40% on March 31 this year. Speculative-grade commercial loans are expected to see a 14.5% default rate by the fourth quarter, predicted credit rating agency Moody's.

In its filing, AIG revealed that $192.6 billion (made up of corporate loans and prime residential mortgages) of the super-senior CDS portfolio of AIG FP represented derivatives positions entered into with European financial institutions as of March 31. The fair value of these derivatives positions totalled $393 million at the end of the first quarter.

The beleaguered insurer also emphasised the significance of when its counterparties choose to terminate the contracts, as the longer the positions are held, the longer AIG FP remains exposed to the risk of credit markets deteriorating. AIG highlighted counterparties held these derivatives positions as a result of the regulatory capital benefits the transactions afforded them under Basel I. Institutions are in the transition stage between Basel I and Basel II, and – bar a few exceptions – will not benefit from regulatory capital relief on the derivatives positions from 2010 onwards. Consequently, the insurer expects the majority of counterparties to terminate transactions within the next year.

Due to the current performance of the underlying loans, AIG stated it believes AIG FP will not have to make payments to counterparties under the transactions for regulatory capital relief. However, the insurer underlined the fair value of the CDS portfolio was dependent on the overall credit environment. Consequently, it could not give any "assurance that AIG will not recognise unrealised market valuation losses from this portfolio in future periods".

AIG sustained a net loss of $99.3 billion in 2008, and required a variety of substantial government bail-outs just to stay afloat. AIG FP played a major role in the company's problems: its super-senior CDS portfolio registered an unrealised market valuation loss of $28.6 billion for 2008, having written $400 billion worth of credit protection to clients across the globe through its CDS business. During the fourth quarter of 2008, AIG, the US Treasury and the New York Federal Reserve Bank terminated $62 billion of CDS written by AIG FP.

In its first quarter results, AIG showed a net loss of $4.4 billion, while the unrealised market valuation loss of AIG FP's super-senior CDS portfolio was $452 billion.

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