American International Group Inc. — which originates and insures mortgages, and is also a major investor in mortgage-backed securities — says the downturn in U.S. housing markets is hurting its business, but that the company’s exposure to subprime investments is limited.

In a Securities and Exchange Commission filing Thursday, AIG reported net income for the quarter was up 34 percent to $4.28 billion. That’s despite a 63 percent decline in profits from consumer finance, including mortgage lending, and a $255 million loss in capital markets.

AIG and its subsidiaries are involved in four aspects of mortgage lending. The company makes mortgage loans through its subsidiary American General Finance Inc., and provides mortgage guaranty insurance through another subsidiary, United Guaranty Corp.

In addition, AIG’s insurance and financial services subsidiaries are heavily invested in mortgage-backed securities (MBS) and collateralized debt obligations (CDOs — securities that often rely on mortgage loans for income).

AIG also provides credit default swaps — credit protections packaged into CDOs — through subsidiaries AIG Financial Products Corp. and AIG Trading Group Inc. and their subsidiaries.

AIG said its U.S. mortgage lending and guaranty operations “have been and are likely to continue to be adversely affected by” deterioration in the credit quality of loans originated to nonprime and subprime borrowers.

But the company said the downward cycle in the U.S. housing market is not expected to have a material effect on its other operations, investment portfolio and overall financial position, because of AIG’s “disciplined underwriting and active risk management.”

The company said the few investments it holds that are collateralized by subprime and nonprime mortgages have high credit ratings, and that it is protected against loss through the senior position it holds in its housing-related investments.

Mortgage lending

Operating income in AIG’s domestic consumer finance operations, which include mortgage lending, fell by $127 million for the quarter, or 68 percent, compared to the same quarter a year ago. Part of the decline was attributed to a $178 million agreement to settle charges that AIG’s subprime mortgage lending subsidiaries charged excessive broker and lender fees.

AIG said it took a $128 million charge during the first quarter and a $50 million charge during the second quarter to cover the cost of implementing the agreement with the Office of Thrift Supervision.

The agreement requires AIG subsidiaries AIG Federal Savings Bank and American General Finance Inc. to provide assistance to borrowers who are at risk of losing their homes to foreclosure, in many cases by providing more affordable loans. Borrowers who took out mortgage loans between July 2003 and May 2006 are advised to contact AIG FSB customer service.

AIG said AGF Inc. boosted provisions to cover obligations to repurchase loans sold to investors by $11 million during the quarter and $36 million for the first six months of the year. The 60-day delinquency rate on AGF’s $19.2 billion in real estate loans stood at 1.95 percent at the end of the quarter, while charge-offs on all loans increased from .86 percent last year to 1.02 percent.

Mortgage insurance

With $25.9 billion of mortgage insurance in force in the U.S., AIG subsidiary UGC saw 60-day delinquency ratios rise to 2.5 percent during the quarter. The mortgage guaranty business produced an $81 million loss for the quarter, compared with $107 million in operating income at the same time last year.

AIG blamed the “significant decline” in mortgage guaranty operating income for the quarter on losses in the U.S. first- and second-lien guaranty businesses and continued softening in the U.S. housing market

Second-lien loans originated by third parties were performing so poorly that UGC stopped accepting new business on such loans in the fourth quarter. The loss ratio on second-lien loans previously insured climbed to 111.5 for the first six months of the 2007, compared with 31.8 during the same period last year.

MBS investments

Through its insurance operations, AIG held about $94 billion in MBS, with 91 percent rated AAA and another 7 percent AA. About $400 million in AIG’s MBS investments were rated BBB or below, but as of Aug. 6 none of the company’s MBS with subprime collateral had been downgraded by ratings agencies. AIG reports holding another $3.6 billion in CDOs that include “some level of subprime exposure.”

Credit default swaps

AIGFP’s credit derivative portfolio totaled $465 billion at the end of June, including $64 billion from transactions with mixed collateral that include U.S. subprime mortgages. The company has written “super senior” protection through credit default swaps since 1998, but stopped offering such protection for CDOs that included subprime collateral in December 2005.

AIG said was able to cut operating loss on its capital markets business (which includes the credit derivative portfolio) from $1.4 billion in the first six months of 2006 to $187 million for the same period this year.

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