AIG Swaps May Take Decades to Expire Leaving a 'Toxic Pool'

By Hugh Son and James Sterngold
Bloomberg News
July 17, 2009

July 17 (Bloomberg) -- American International Group Inc.'s trading partners may force the insurer to bear the risk of losses on corporate loans and mortgages for years beyond the company's expectations, complicating U.S. efforts to stabilize the firm, analysts said.

European banks including Societe Generale SA and BNP Paribas SA hold almost $200 billion in guarantees sold by New York-based AIG allowing the lenders to reduce the capital required for loss reserves. The firms may keep the contracts to hedge against declining assets rather than canceling them as AIG said it expects the banks to do, according to David Havens, managing director at investment bank Hexagon Securities LLC.

"For counterparties to voluntarily terminate those contracts makes no sense," Havens said in an interview. "There's no question that asset values have soured on a global basis. With the faith and credit of the U.S. government backing those guarantees, why would they give that up?"

The falling value of holdings backed by the swaps may force AIG to post more collateral, pressuring the insurer's liquidity and credit ratings in a repeat of the cycle that caused the firm's near collapse in September, Citigroup Inc. analyst Joshua Shanker said last week. The insurer needed a U.S. bailout valued at $182.5 billion after handing over collateral on a different book of swaps backing U.S. subprime mortgages.

The average weighted duration of the European swaps protecting residential loans is more than 25 years, while the span tied to corporate loans is about 6 years, AIG said in a regulatory filing. Contracts covering corporate loans in the Netherlands extend almost 45 years, and the swaps on mortgages in Denmark, France and Germany mature in more than 30 years.

'Theoretical Argument'

The portfolio shrank by about half in 15 months to $192.6 billion on March 31 and AIG's models show banks will abandon more contracts, said Mark Herr, a spokesman for the insurer. AIG said in a filing last month it expects the banks to cancel "the vast majority" of the contracts in the next year as regulatory changes reduce the benefits of the derivatives for lenders.

"We think we're right because we're basing our analysis on actual behavior," said Herr. "The inarguable fact is that half of the portfolio had been unwound at no cost to us as of March 31." The contention that the swaps will last beyond a year is a "theoretical argument that is debunked" by banks' actions, he said.

Last month, AIG said in a regulatory filing that it may be at risk for losses for "significantly longer than anticipated" if the banks don't terminate their swaps.

'Plea for Help'

"Given the size of the credit exposure, a decline in the fair value of this portfolio could have a material adverse effect on AIG's consolidated results," the company said in the June 29 filing.

The Securities and Exchange Commission asked for AIG to add the disclosure to the insurer's "risk factors," Herr said. The action wasn't prompted by any change in the securities backed by the swaps, he said.

Royal Bank of Scotland Group Plc, Banco Santander SA, Danske Bank A/S, Rabobank Group NV and Credit Agricole SA's Calyon are also among banks which purchased the swaps, AIG said in a presentation in February pleading for its latest bailout. The banks could be forced to raise $10 billion in capital if AIG were allowed to fail, according to the document.

Santander said through a spokesperson that the bank's risk of an AIG failure is insignificant and fully collateralized. Calyon declined to comment. Representatives of the other lenders didn't immediately return messages seeking comment.

Counterparties terminated or allowed to expire $27.8 billion in the so-called regulatory relief swaps in the first quarter, and AIG got notice for another $16.6 billion in terminations through April 30, the firm said. Some of the remaining swaps have suffered losses, and AIG posted $1.2 billion in collateral as of the first quarter.

'Toxic Pool'

"You'll have an increasingly toxic pool of credit-default swaps every quarter" as the least risky swaps are terminated, said Donn Vickrey, analyst at research firm Gradient Analytics Inc. "Swaps that are being held are done so for two reasons, either for regulatory relief or because they're 'in the money'" which means they are valuable hedges against asset declines.

AIG has recognized that some of the swaps are no longer being held for regulatory relief. The insurer reclassified $3 billion in swaps through March 31 that are likely to be kept after the regulatory benefit expires, AIG said. The firm had a $393 million liability on those swaps.

Gerry Pasciucco, hired in November to clean up the Financial Products unit that sold the swaps, said in an interview in December that the European swaps would mature over time without loss and faced very little risk. Pasciucco said in April that future losses will be limited.

Prime Mortgages

The $192.6 billion figure for the swaps includes $99.4 billion tied to corporate loans and $90.2 billion linked to prime residential mortgages, the insurer said.

"The sheer size of the portfolio and the 'black box' nature of its underlying loans and assets do little to calm fears of further CDS losses," Shanker said in the July 8 research note. "Potential markdowns in the regulatory CDS portfolio may result in collateral calls that would again put pressure on AIG's liquidity."

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