The exposure stems from investments in mortgage and corporate debt assets, and may make it more difficult for the battered insurer to repay the Federal Government for its bailout package.
AIG spokesman Nick Ashooh confirmed the company's exposure Wednesday, after The Wall Street Journal reported the trades may be the first sign that the New York-based insurer has been gambling with its own capital.
The company also said the Journal incorrectly reported on Wednesday that the $10 billion in trades was a previously undisclosed obligation to AIG counterparties.
Ashooh said the trades in question were not speculative bets but "credit protection instruments." The swaps on these synthetic securities are also referred to as "cash settlement" or "Pay As You Go" swaps because they are settled in cash as and when losses are taken, the company said.
"These are not debts that we owe, but yes, they are an exposure for us," Ashooh said.
He said the exposure has been fully disclosed in regulatory filings and comprises about $9.8 billion of AIG's $71.6 billion exposure to derivative contracts on collateralized debt obligations.
CDOs are securities backed by pools of mortgages or other assets. They have plummeted in value since the credit crisis erupted a year ago. Credit default swaps are essentially contracts that insure against the default of bonds and corporate debt such as CDOs. Sellers of swaps are on the hook to repay customers if the value of the underlying bonds or debt declines.
"The majority of the multi-sector CDS swaps were written as 'physical settlement' swaps, where AIG is required to physically buy the underlying CDO bond in the event of a CDO credit event," AIG said in a statement.
The $9.8 billion notional amount does not represent a loss to AIG or a debt it owes to counterparties, the company said, because there are no underlying assets the company is obligated to buy. Instead "Pay As You Go" swaps mean AIG must pay losses on that tranche as and when they occur, the company said.
"It sounds like AIG is saying this is yesterday's news and they are acknowledging they have various problems in derivatives and these are among the problems they've had," Donald Light, a senior analyst at Celent, a Boston-based financial research and consulting firm. "How they are going to fix that problem, we'll have to see."
Last month, the government said it would provide a $150 billion rescue package to AIG to help it remain in business amid the worsening credit crisis. That rescue package came just two months after AIG was extended an $85 billion loan from the Federal Reserve. The original loan was replaced by the $150 billion package as it became apparent the insurer needed more funds, and AIG must repay the loan. The government rescue of the insurer also left taxpayers holding about 80 percent of the company's shares.
Like other insurers, AIG has been slammed by deterioration in the credit markets amid concerns that complex, structured investments it insures will increasingly default.
Problems at AIG did not come from its traditional insurance subsidiaries, but instead from its financial services operations, and primarily its insurance of mortgage-backed securities and other risky debt against default.
"We are working on resolving the trades, as we are with the rest of the CDS portfolio, but these will require a different approach because there is no CDO to buy," said Joseph Norton, another AIG spokesman.
Under the $150 billion government rescue package, many of AIG's derivatives can be unwound or settled, because a government fund is buying the debt that AIG had guaranteed for banks and other parties. But the $9.8 billion in additional exposure in question is not eligible to be covered by the government bailout funds.
And that raises questions about how AIG will cover its exposure.
"They took a bet and they lost," said Russell Walker, a risk management professor at the Kellogg School of Management at Northwestern University. "If the government isn't responsible, then the shareholders of AIG are."
In October, AIG said it would sell off a number of business units to pay off its initial $85 billion loan from the government. The company has not disclosed the assets it would sell or the expected transaction values. As of Dec. 5, AIG had already sold interests in three businesses.
Shares of AIG fell 17 cents, or 8.8 percent, to $1.76 in afternoon trading.
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Weather Outlook for Wednesday, Nov. 22