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Oifice Of Thrift Supervision
Department of the Treasury
.Northeast Region
llarborside l 1iik1llcial Center .Plaza hve, Suite 1600 jersey City, Nj 07311
Telephone: (20 1) 413-1000 ·l;ax (20 1) 413-7543
October ii, 2008
American International G-roup, Inc.
70 Pine Street
1-~ew
York,
1-~-n.{
10270
Members of the Board or their Representative:
Pursuant to Section 10 of the Home 0\vners' Loan A. ct,
\Ve
performed a risk-focused targeted review·
of A1nerican International G-roup's residential1nortgage-related securities.
Information, comments and conclusions contained in this report are based on ±!lings made with the
Office of Thrift Supervision and the books and records of the holding company and its subsidiaries.
OTS prepared this report tor supervisory purposes, and you should not consider it an audit report
OTS prepared this report for supervisory purposes and furnishes this document to the holding
con1pany, subject to prohibition of disclosure or release, for its confidential use.
Please review the report in its entirety and advise us of what action you took, or will take, regarding
each recommendation discussed in this report. Please reply within 45 days rrom the date of this
letter.
OTSA!G-EF!LES 0000078426
TARGETED REVIEW
. t\.merican
.
International Group, Inc. (.t\IG)
70 Pine Street
New York, NY
Docket Number:
Subject of Review:
Start Date:
End Date:
H2984
Residential Mortgage-Related Securities
February 11, 2008
July 9, 2008
ABBREVIATIONS USE.[)
AIG
ATGFP
BAIG
CP
CRC
ceo
ERM
!AD
PwC
RMBS
American International Group, Inc.
ATG Financial Products . Inc
Banque AIG
Counter Party
Credit Risk Committee
Chief Credit Ofiicer
Enterprise Risk Management
Internal ,Audit Department
Price WaterhouseCoopers
Residential Mortgage-Backed Securities
SCOPE
A target exanHnat1on of AIG Insurance CuuifJCtny, Inc. (AIG 01 the Cu1upany) conHnenced on
September 2, 2008. The examination focused on a top down review of the Company's super senior
credit default SV·iaps v..1ritten to facilitate regulatory capital relief for certain European Union financial
institutions (reguiatory capitai CDS). AlG subsidiary AlG Financiai Products inc. (AiGFP) entered
into these transactions through its French regulated subsidiary, Banque AIG (BAIG).
The
examination \vas conducted through discussions vvith lAJG, _i\.IGFP, and Bi\.IG management and other
personnel, the review of public records, internal financial records and other internal reports, and
reports prepared for the examiners The examination commenced and concluded with onsite work at
AIG's offices in 1'~e\v York City, 1'~e\v York Onsite \Vork at I3AIG's office in London, United
Kingdom began on September 8, 2008, and was completed on September 12, 2008. Financial data
and information in the report is as of June 30, 2008, unless othenvise noted.
The examination included an assessment of the potential for catastrophic market losses resulting from
regulator; capital CDS exposure a11d the i1npact such losses \vould have on the Co1npany's liquidity
and consoiidated capitai position. The examination included a review of vaiuation methodoiogies.
The review considered how the Company monitors and evaluates its counterparty termination
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OTSA!G-EF!LES 0000078427
expectations. The rev1ew considered V-lhether the Con1pany conducted scenano analyses in
preparation for the possibility that counterparties do not terminate the transactions as the Company
expects, a.11d \·vhether the Company has in place a plan to value these transactions under such
scenanos. The review considered how the Company monitors and assesses the performance of the
underlying portfolios and the broader residential and corporate loan markets. The review focused on
existing risk controls and governance matters. ,h.~ small sample of transaction files -.,vas reviewed.
CONCLUSIONS
The regulatory capital CDS porttolio represents a significant concentration of risk to AIG. Despite
declining by $72 billion since the beginning of 2008, the notional amount of this portfolio totaled
$307 billion or 394 percent of capital as of june 30, 2008. The regulatory capital CDS transactions
remain subject to the correlated risks such as a European and Worldwide recession, accounting
volatility brought on by risk aversion, a rapid change in regulators vie\VS of Basel II Capital models,
and long-dated legal maturities during which facts, circumstances, and conditions could change for
the worse. In addition, the Company has not conducted a comprehensive. holistic analysis of the
notional exposure subject to collateral calls, the conditions required for posting of collateral, w~d the
impact collateral calls would have on the Company's liquidity.
The regulatory capital CDS portfolio is valued at zero as of June 30, 2008. rv1anagetr,ent conducted a
comprehensive accounting analysis to support this valuation. Management concluded that the
counterparties are motivated by economic capital relief and that the value of the credit risk transfer
componem or rnese transactions cominues to be nominaL AIG believes that the most compeiling
data supporting this conclusion is the termination of $/II billion of net notional exposures in 2008 at
no cost to
i~JG.
Ho\vever, facts, circulnstailces, a.11d conditions supporting these conclusions could
change rapidly. AIG does not have an alternative valuation methodology in place should these
changes occur and the credit risk transfer component of these transaction increases in value.
The Company performs fundamental credit analysis and Worst Case Value-at-Risk (WVAR)"
analysis of the portfolios of loans underlying each regulatory capital CDS transactions. The WVA.R_
analysis 1nay not be appropriate for a poi1folio of this size because the analysis is designed to protect
against the vast majority of statistically derived, expected outcomes, not stress. AIG should therefore
focus on fundmnental credit analysis and not place too much reliance on the WVAll analysis.
~
Defined later in this document
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OTSA!G-EF!LES 0000078428
RiSK MANAGEMENT PRACTiCES
Risk Concentration
The regulatory capital CDS portfolio represents a significant concentration of risk to AlG due to the
significant size of the notional exposure and the correlated risks. Despite declining hy $72 hill ion
since the beginning of2008, the notional atr,ount of this portfolio totaled $307 billion or 394 percent
of shareholders equity capital as of June 30, 2008. The exposure increases to $313 billion when
considering the $5.8 billion in credit derivatives \Vritten by the Company on !ranches below· super
senior on certain of the regulatory capital CDS transactions. The regulatory capital CDS transactions
remain subject to the following correlated risks:
1. A European and Worldwide recession would impact the quality of the underlying protected
portfolios of mortgage an.d corporate loan.s;
2. A continuation or deterioration of the global credit markets disruption, brought on by risk
aversion, \vould result in further volatility and flight to safety in Europe, as has occurred in
the United Sates. These two risks may shift counterparties' motivations away from
regulatory capital relief toward credit risk protection, ret1ecting Increases in the value of the
credit risk transfer component of these instruments;
3. The current economic malaise could lead European Regulators to suspend or change the
capital reduction benefits afforded to these instmments by Basel II
This change could
appear rapidly, before counterparties receive approval of their Basel II capital models from
their local regulators and before the c.ounterpa.rties terminate the transactions at no c.ost to
AI G.
4. The legal maturities of the regulatory capital CDS transactions are long dated. f'v'!ost of the
regulatory capital CDS transactions written on portfolios of residential loans mature in excess
of30 years, and some mature in excess of 50 years. Therefore, even if the value ofthe credit
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OTSA!G-EF!LES 0000078429
risk transfer component is currenily nominal and the risk of any payment obligation, or actual
credit loss is currently remote, a long period of time exists during which facts, circumstances,
and conditions could go very wrong. These changes could impact CDS valuations and resuit
in credit losses.
These risks are mitigated m several respects. The regulatory capital CDS protected portfolios of
loans are diversified by country and each CDS tran.saction is diversified by many obligors.
AIGFP/BAIG underwrote each CDS transactions at attachment points designed to ensure, based on
historical loss data, a remote risk of loss The credit protection fee is typically fixed or tied to a
slowly amortizing schedule. This iT1akes the credit protection fee relatively n-,ore costly to the
counterparty on declining portfolios of loans. There are fundamental differences between the U.S.
and European loan origination models, at least \vith respect to the residential mortgage markets,
However, ihe secunlizaiion morivaied super semor CDS portfolio of mulii-secior CDOs were
mitigated by some of these same factors
The Company expects the majority of regulatory capital CDS counterparties to terminate their
contracts with the Company by the end of first quarter of 2009. Management contacts the
counterparties each quarter now to determine if their intensions to terminate have changed. They use
this information to estimate the expected call dates. At this point, the Company has not identified
concerns that counterparties won't terminate as COlTilnunicated to Company. However, as noted
above, the facts, ~,;In.;uinslam.:es, and ~,;unditiuns providing IllOlivahon to the counterparhes could
change rapidly. AJG should continue to monitor cowJteqJarty motivations re[<ctrdin[< termination,
establish concentration reduction targets, and prudentially reduce the size of this portj.fJ!io.
Some of the regulatory capital CDS transactions are subject to collateral positing requirements.
~,1anagement states that the collateral postings vary by counterparty.
Tlu: Company has not
wnducted a comprehensn'e, holistic analysis of the notional exposure subJect to collateral calls, the
conditions required for posting of collateral, and the impact collateral calls would have on the
Company's liquidity. ll;e Company should conduct this analysis promptly.
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OTSA!G-EF!LES 0000078430
SUMMARY OF FINDINGS AND CONCLUSIONS
Reporting
Our reviev·J found 1nanage1nent reporting to be insufficiently co1nprehensive or robust. It reasonably
reflects the level of AlGI's RL'viBS exposure and related risk management practices. rtowever, fli\.J
does not perform fundamental portfolio analysis and reporting of underlying mortgage characteristics
to include, inter alia, sub-types, periods to next reset, 1oan-to-va1ues (L TVs), credit scores, tnortgage
originators, geographic location, and credit surveiiiance results. Stratified risk measurement and
reporting of these risk factors would provide a more complete representation of the Company's
exposure to the residential mortgage market and further promote sound risk management.
Oversight and Risk Management
VVe note concerns with oversight of the risk 1nanage1nent ofRlvfBS. Prior to the recent U.S. hous1ng
market and credit markets downturn, AIG' s corporate risk management did not provide active
oversight other than annual portfolio revie\VS and delegations of credit authority. rv!anagers
responsible for acquiring RMBS currently conduct the portfolio performance reviews and underlying
credit analysis with little independent confirmation.
We were unable to identify risk tolerance levels, risk adjusted return objectives, and performance
metrics for the RMBS portfolio. The credit surveillance processes employed by the portfolio
managers should be validated and strengthened with more rigorous screening and migration analysis.
The improved processes could he used for internal risk rating, thereby reducing reliance placed on
external ratings.
While we conclude that management has designed and executed reasonable risk management
controls for R1'.1BS portfolio pricing and detennining OTT!, the independent oversight of the pricing
processes was performed by the accounting group on an interim basis. Corporate management is
currently transferring oversight of the pricing processes to Global and Regional Pricing Committees.
Validation of the pncmg processes \vi1l be performed by Enterprise Risk
~v1anagement's (ER~v1's)
Valuation Group.
Capital Adequacy
We are concerned with the s1ze of the Company's exposure to the U.S. residential real estate and
structured credit 1narkets and its potential impact on capitaL A. s of 1v!arch 31, 2008, AlG reported
cumulative realized and unrealized losses of $49 billion thai are attributed to the continuing U.S.
housing market deterioration and global credit markets disruption. The remaining potential exposure
is significant and will be the subject of ongoing supervisory attention for the foreseeable future. V/e
note management's recent capital augmentation and efforts to strengthen the Company's capital
structure.
!2-
OTSA!G-EF!LES 0000078436
@FedFRASER