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European Debt Crisis Could Touch AIG

Source: NY Times

Posted on 25 May 2010

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The waves of financial trouble across Europe could ripple out to American International Group (AIG).

AIG has sought to unwind its derivatives business, which gave it a big exposure to Europe.

After an outcry over details disclosed last year about how the government's bailout helped a number of European banks, the company intended to rid itself of the derivatives it sold to those institutions to help them comply with their capital requirements.

But its latest quarterly filing with regulators shows that the insurance behemoth still has significant exposure to those banks. AIG listed the total notional value of these derivatives, credit-default swaps, as $109 billion at the end of March. That means if events in Europe turned sharply against AIG, its maximum possible loss on these derivatives would be $109 billion.

No one is suggesting that is likely. Still, it would be a sore spot if AIG once again had to make good on a European bank’s investment losses, even on a small scale. A spokesman for AIG, Mark Herr, declined to name the European banks that bought its swaps to shore up their capital.

AIG’s stock has also fallen in recent days amid uncertainty over whether the continuing European debt crisis could set back an important, $35.5 billion asset sale. AIG’s chief executive, Robert Benmosche, announced in March that the company would sell its big Asian life insurance business to Prudential of Britain, raising money to pay back part of its rescue loans.

The transaction needs the approval of 75 percent of Prudential’s shareholders.

Shares of AIG fell seven consecutive trading days to close at $34.81 on Thursday. That was a drop of 23 percent since May 11. The shares recovered slightly on Friday, closing at $35.96.

AIG's swaps work something like bond insurance. The European banks that bought them could keep riskier assets on their books without running afoul of their capital requirements, because the insurer promised to make the banks whole if the assets soured. The contracts call for AIG’s financial products unit to pay in cases of bankruptcy, payment shortfalls or asset write-downs.

AIG is also required to post collateral to the European banks under certain circumstances, but the company said it could not forecast how much.

It was the collateral provisions of a separate portfolio of credit-default swaps that caused AIG's near collapse in September 2008. Those swaps were tied to complex assets whose values were hard to track.

The European bank assets now in question consist mostly of pooled corporate loans and residential mortgages. AIG has said they are easier to evaluate and therefore less risky.

AIG had hoped these swaps would become obsolete at the end of 2009, when European banking was to have completed its adoption of a detailed new set of capital adequacy rules, known as Basel II. Since AIG’s swaps were designed to help banks comply with the more simplistic previous regime, the insurer thought they would serve no useful purpose after the changeover and could be terminated without incident.

But international bank regulators have yet to fully adopt Basel II. AIG’s first-quarter report said “it remains to be seen” which capital adequacy rules would be used in different parts of Europe. Mr. Herr said AIG could not comment beyond the information already filed with regulators. In its first-quarter report, the insurer said the banks were holding the loans and mortgages in blind pools, making it hard to know how they would weather Europe’s storm. Some pools have fallen below investment grade.

AIG said the pools of loans and mortgages were not generally concentrated in any industry or country. They have an expected average maturity, over all, of a little less than two years. The company said it was getting regular reports on the blind pools and losses so far had been modest.