Chicago-based Fitch Ratings, reacting to a negative audit report related to American International Group's credit default swaps, said it was putting the insurer on Rating Watch Negative.

By 2 p.m., the company's shares on the New York Stock Exchange, which had closed on Friday at $50.68, were down to $44.84 a share.

Fitch said its action followed AIG's report in an 8K filing with the Securities and Exchange Commission today that its independent auditor, PricewaterhouseCoopers, believed that the company had a material weakness in internal controls related to the valuation of AIG Financial Products Corp. super-senior credit default swap (SS-CDS) portfolio as of Dec. 31, 2007.

In a statement the company said, “AIG continues to believe that the mark-to-market unrealized losses on the super senior credit default swap portfolio of AIG Financial Products Corp. are not indicative of the losses AIGFP may realize over time. Based upon its most current analyses, AIG believes that any losses AIGFP may realize over time as a result of meeting its obligations under these derivatives will not be material to AIG.”

Fitch said the Watch affected the insurer's Issuer Default Rating, holding company ratings and subsidiary debt ratings, including International Lease Finance and American General Finance.

Fitch said it believes this material weakness with current market conditions contributes to uncertainty regarding the valuation of AIG FP's super senior credit portfolio prior to the publication of Dec. 31, 2007 audited financial statements.

AIG's announcement, Fitch said, indicates that it believes it has compensating controls and procedures to appropriately determine the fair value of AIG FP's portfolio. Resolution of Fitch's Rating Watch, the firm said, will include an assessment of these procedures. AIG FP's obligations are guaranteed by AIG.

AIG, said Fitch, has relatively large exposure to the current U.S. residential mortgage crisis. The firm said it believes the area of AIG most exposed to further deterioration in this market is the credit derivative portfolio within AIG FP, with its large net notional exposure of $505 billion at Sept. 30, 2007.

Included in this total is $62.4 billion of collateralized debt obligations (CDOS) backed by structured finance (SF) collateral–mainly subprime U.S. residential mortgage-backed securities (RMBS).

Fitch has stated that it believes AIG will not be immune to potential losses from the U.S. residential mortgage crisis, although at the present time the agency said it believes these losses should be absorbed by the existing capital base and future earnings stream.

Today's announcement brings additional uncertainty to the potential impact on the financial statements, Fitch found.

The rating firm said it expects to resolve the Rating Watch after:

o Reviewing the 2007 audited financial statements.

o Assessing how the material weakness in internal controls affects its view of AIG FP's exposures.

o Gaining additional clarification on steps AIG plans to take to remediate the material weakness.

o Further review of the AIG FP portfolio.

Fitch said it will evaluate the valuation of credit derivatives, as well as assess the potential for economic losses on the SF CDO portfolio.

While Fitch noted that this asset class has been under considerable credit deterioration in the past few months, the firm said it is currently comforted by the fact that AIG FP's SF CDO portfolio was almost entirely underwritten before 2006.

While under considerable stress, collateral from pre-2006 U.S. RMBS vintages is generally expected to perform better than 2006-2007 vintages, according to Fitch

If weakness at AIG FP leads to a rating downgrade at the holding company, Fitch said it believes the magnitude would be limited to one notch. Fitch currently has unusually narrow notching between AIG's insurer financial strength (IFS) ratings (“AA plus”) and holding company ratings (“AA” senior debt).

The firm said this reflects the organization's “very strong financial flexibility, modest financial leverage and significant cash flow from diverse regulated and non-regulated subsidiaries.”

Fitch said it would expect to maintain the current notching between the holding company and the Finance subsidiaries.

This article updated Feb. 12, 9:32 a.m.

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Fitch Puts AIG Rating On Watch

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