American International Group said it was able to terminate $16 billion in credit default swaps — taking at least a step toward correcting the CDS issue that was a root of its financial disaster.

The struggling insurance giant that has been bailed out by the federal government said that Maiden Lane III LLC (ML III), a financing entity recently created by the Federal Reserve Bank of New York, purchased $16 billion in multi-sector collateralized debt obligations. As a result, the associated swap contracts and similar instruments written by AIG Financial Products Corp. (AIGFP) have been terminated.

AIG said that ML III’s purchases of CDOs, in conjunction with the termination of related CDS instruments, have mitigated AIG’s liquidity issues in connection with its CDS and similar exposures on multi-sector CDOs. ML III has now purchased a total of $62.1 billion in CDOs.

The shadowy world of CDS involves unregulated derivatives that were supposed to offer their buyers a payout if the company against which they were written defaulted or went bankrupt. Once hailed by some as a financial wonder, however, the instruments had a notional value that soared to some $62.2 trillion in 2007 from $34.4 trillion in 2006, according to the International Swaps and Derivatives Association.

The purchase of the additional $16 billion of AIG multi-sector CDOs was funded by a net payment to counterparties of about $6.7 billion and the surrender by AIGFP of about $9.2 billion in collateral previously posted by AIGFP to CDS counterparties related to the terminated CDS instruments. Under an agreement with ML III, AIGFP received payments totaling $2.5 billion from ML III in connection with the November and December purchases of multi-sector CDOs.

AIG has provided $5 billion in equity funding, and the Federal Reserve Bank of New York has agreed to provide up to $30 billion in senior funding to ML III. Of this amount, about $24.3 billion has been funded toward purchases of CDOs.

ML III will collect cash flows from the assets it owns and pay a distribution to AIG for its equity interest once principal and interest owing to the New York Fed on the senior loan have been paid down in full. Upon payment in full of the New York Fed’s senior loan and AIG’s equity interest, all remaining amounts received by ML III will be paid 67 percent to the FRBNY and 33 percent to AIG.