AIG: The Company

American International Group Inc. (AIG or AIG parent) was a holding company, incorporated in Delaware and listed on the New York Stock Exchange. Its three major business activities were insurance, financial services, and asset management. AIG Insurance offered a broad spectrum of products ranging from general insurance (i.e., property, casualty, specialty, and reinsurance) to commercial, industrial, and life insurance, including annuities and retirement services. Financial Services included capital markets, consumer finance, insurance premium finance, derivatives, and aircraft leasing. Finally, Asset Management included AIG’s investment advisory, brokerage, and private banking activities.

Between 1983 and 2005, AIG was one of the largest, most successful, and respected publicly traded financial institutions in the world. With its triple-A credit rating, the company stood shoulder-to-shoulder with a small group of elite risk managers, such as Berkshire Hathaway, GE Capital, Syncora Guarantee, and Toyota. Maurice (Hank) Greenberg had been the company’s Chief Executive Officer (CEO) since 1968 and seemed to understand every facet of AIG’s business interests, as well as how they interacted. The company’s strategy and execution appeared to work hand-in-glove. At the end of 2007, AIG had more than $1 trillion in assets, 74 million customers in more than 130 countries and jurisdictions, 116,000 employees, net income of $6.2 billion, equity of $95.8 billion, and market capitalization of $147.5 billion.351

Between 2002 and 2005, AIG became embroiled in a series of business-related scandals resulting in SEC fines and a restatement of profits for the 2001–2005 period, by $3.5 billion. These scandals culminated in 2005, when the SEC charged Hank Greenberg with fraudulent business practices and accounting fraud misrepresentation, forcing him to leave AIG on March 14. Martin Sullivan, who had worked at AIG since he was seventeen years old, took over as CEO. Whether AIG would have fared better under Greenberg’s continued leadership is a matter of speculation, but we know that succession planning at AIG was not well developed; no one at AIG understood the company better than Greenberg, and AIG was relatively rudderless after he left.

Two units within AIG were the dominating causes of its losses in 2008. The first was AIG Investments (AIG-INV), which was responsible for the company’s global securities lending. The second was AIG Financial Products (AIGFP),352 which was responsible for selling CDS to customers. Together, they were a destructive duo.

AIG-INV

AIG Investments (AIG-INV) was an internal arm of AIG’s Asset Management business segment. It consolidated firm-wide securities lending activities and managed them professionally. Most of the securities lent by AIG-INV were owned by AIG’s insurance subsidiaries, which were heavily regulated. The lent portions of these insurance subsidiaries’ investment portfolios varied considerably, and at the end of August 2008, AIG-INV had ramped up its program to $69 billion in borrowings outstanding.353

AIGFP

AIGFP was an arm of AIG’s Financial Services business. It started in January 1987, when Hank Greenberg and three former Drexel Burnham Lambert (DBL) traders (Howard Sosin, Randy Rackson, and Barry Goldman) founded Financial Products, with Sosin serving as the company’s president and chief operating officer (COO). Financial Products used complex derivatives to profit from gaps in financial market prices and regulations. It engaged in many diverse activities, such as commodities, credit, currencies, energy, equities, and interest rate trades, as well as developing a diversified securities portfolio, financed by issuing notes and bonds. For Greenberg, the creation of Financial Products was an opportunity to diversify AIG’s revenue base with innovative financial products and to broaden its global reach. Three factors were responsible for its initial success. AIG contributed two of them, with its deep financial pockets and triple-A credit rating, and the DBL group brought the third, with its sophisticated understanding of risk modeling. These activities were supposed to be hedged, but that changed.

In 1992, the business relationship between Greenberg and Sosin soured, leading to Sosin’s resignation in 1993. Greenberg formally brought Financial Products under the AIG umbrella, as AIG Financial Products (AIGFP), and housed it in the Capital Markets division of the company’s Financial Services business segment.354 After Sosin left, Thomas R. Savage became AIGFP’s CEO in 1994 and remained in this position until 2001. Afterwards, Joseph J. Cassano assumed these responsibilities until 2008. Savage was at the helm in 1998, when AIGFP offered its first CDS (to JPMorgan Chase), and Cassano led the unit from 2007 to 2008, when AIGFP suffered its colossal losses. Cassano resigned from his job at AIGFP in February 2008 (effective March 31) but continued to consult for the subsidiary until October, earning $1 million per month.355

Securitization: MBS, ABS, CDOs, and MBOs

A CDS relies on securitization, the process of creating and selling newly created securities backed by cash flows of underlying, interest-earning assets, such as residential and commercial real estate mortgages, credit card receivables, home-equity loans, automobile loans, student loans, boat loans, equipment leases, recreational vehicle loans, and senior bank loans. Figure 10.1 shows the securitization process.

It starts with individuals or businesses borrowing from financial intermediaries, also called “originators,” who then choose whether they wish to hold onto these loans or sell them. If they hold these assets, securitization does not occur. By contrast, selling them jump-starts the securitization process and serves two useful purposes. First, it replenishes the originators’ financial resources and enables them to lend again. Second, sales transfer the risks associated with the underlying loans from originators to others—and beyond.

The next step in the securitization process is to establish a special purpose vehicle (SPV) responsible for buying loans from originators. The SPV finances these purchases by bundling the underlying loans, creating securities backed by their cash flows, and selling the securities to investors. If the newly created securities have the same risks and cash flows as the underlying securities, they are often called “pass-through securities.” Mortgage-backed securities (MBS) are backed by the cash flows and risks of underlying mortgage loans, and asset-backed securities (ABS) are backed by the cash flows and risks of other (non-mortgage) assets. These securities often combine safe and risky underlying assets in order to diversify and average the risks faced by investors.

Securities with risks, returns, maturities, and payments different from the underlying assets are called collateralized mortgage obligations (CMO) or collateralized debt obligations (CDOs). Securitizers transform the cash flows and risks of underlying securities by “tranching,” which means slicing, dicing, reconstructing, and prioritizing the underlying cash flows so newly issued securities appeal to a wider range of investors. Instead of investors earning the average yield on a pool of underlying debt instruments, tranching separates them so that investors can choose from a menu of risks.

Figure 10.1 shows images of plateaued waterfalls to represent the various levels of riskiness for these tranched securities. The least risky are “super-senior” and “senior” securities because they are first to receive returns and principal repayments. The riskiest securities (e.g., equity) receive returns and principal repayments after the less-risky layers have been paid. Only after a portfolio’s credit losses exceeded certain attachment points (i.e., threshold levels) would the mezzanine, senior, or super senior layers experience losses. By tranching the cash flows of underlying securities, SPVs can create triple-A-rated securities out of underlying assets composed entirely of distressed loans, such as subprime mortgages.

Credit rating agencies evaluate the riskiness of securities issued by SPVs.356 Investors who purchase SPV-issued securities are the ultimate bearers of the risks. Investors who want formal protection against default can purchase CDS from companies such as AIG. For this protection, investors make periodic payments (called credit spreads) and, in return, are compensated if a “credit event,” such as default or failure to pay, occurs.

AIGFP benefitted from the boom in U.S. housing prices and securitization mania during the early to mid-2000s. The rising demand by private securitizers for credit protection increased AIGFP’s CDS sales, refocusing AIGFP’s attention from protecting CDOs (mainly corporate debt) to MBS and CMOs. Starting in 2006, the contents of AIGFP’s pools of protected securities began to erode, as they became populated with increasingly weaker loans. When the U.S. housing market buckled in 2007, AIGFP found itself protecting a pile of toxic mortgage waste.

Table 10.1 shows the notional values of AIG’s company-wide derivatives exposures at the end of 2007, with credit default swaps accounting for only 26 percent of the total. Of AIG’s worldwide credit derivative exposures (i.e., $562 billion), AIGFP accounted for almost 95 percent (i.e., $533 billion).357

Table 10.1: Notional Value of AIG’s Derivative Positions: December 31, 2007

	Millions	Percent of Total
Interest Rate Swaps	$1,167	55%
Credit Default Swaps	$561.8	26%
Currency Swaps	$224.3	11%
Swaptions, Equity & Commodity Swaps	$178.9	8%
Total	$2,132	100%

Source: AIG, 2007 Annual Report, Page 163

AIG’s Chief Regulators

Where were U.S. and global financial regulators during AIG’s meltdown? The answer is they were there but, unfortunately, virtually powerless to act. Legally, CDS are financial protection contracts and not insurance. Insurance requires buyers to have “insurable interests,” which means buyers must own or have a financial interest in the assets (e.g., homes) they are protecting. Consider the implications (and incentives) if anyone could buy fire insurance on your house. CDS contracts do not have this restriction. Buyers can purchase protection on any securities, including those they do not own. If CDS were insurance contracts, the insurance commissions and departments of the all the locations in which it operated would have regulated AIG. Similarly, if CDS were considered gambling bets, regulators would have had jurisdiction. CDS evaded regulation by the SEC and Commodity Futures Trading Commission (CFTC) because they were traded over the counter and not on exchanges.

Any remaining doubts in the United States about whether the SEC, CFTC, or state insurance authorities should regulate credit derivative products were laid to rest in 2000, when the U.S. Congress passed the Commodity Futures Modernization Act (CFMA), which explicitly stated that if over-the-counter contracts were made between sophisticated parties, they were not securities, futures contracts, or gambling bets. As a result, neither the CFTC under the Commodity Exchange Act (1936), the SEC under U.S. federal securities laws, nor U.S. states under their insurance or gaming rules had regulatory jurisdiction over them.

The only U.S. regulator with plausible authority over AIG was the OTS. This power was gained in 2000, when AIG filed for and was granted a federal charter for AIG Federal Savings Bank (AIGFSB). Because AIG’s diverse global activities could potentially threaten AIGFSB’s solvency and liquidity, the OTS had permission to look into any AIG-related nook and cranny it desired, but AIGFP was London-based and its credit protection activities were considered non-threatening. Therefore, the OTS focused its attention elsewhere.

Foreign regulators also had authority over AIG and could have intervened, but they abdicated most of their responsibilities. European Union (EU) authorities might have been especially effective, but they relinquished most of their powers to the United States by deeming it an “equivalent regulator.” As a result, EU watchdogs intervened only when AIG’s activities affected European banks via Banque AIG. Because AIGFP’s Regulatory Capital Portfolio was not the source of its financial problems EU authorities had no strong motivation to get involved.

Two points are significant concerning AIG’s credit protection operations. First, the company’s Financial Services business activity rather than its Life Insurance and Retirement Services segment conducted them. One reason for this separation might have been that the risks associated with corporate defaults, which are protected by credit protection contracts, are different from mortality risks, which are protected by life insurance contracts. For one, defaults are closely correlated with cyclical movements in macroeconomic conditions. If one company fails, others are likely to do the same. Because these risks are correlated, they are not easy to diversify or estimate. By contrast, the death of one policyholder is not closely correlated to the deaths of other policyholders. Therefore, these risks are more independent and easier to diversify and predict. Had credit derivatives been managed like insurance products rather than financial products, they might have been put into the hands of more seasoned veterans, who could have developed better risk valuation models and allocated reserves to back the company’s contingent CDS liabilities. Aside from collateral deposits, which were marked to market, AIGFP made no provisions for its CDS exposures.

The second significant point about AIGFP was its autonomy. In fact, it is nebulous whether this strategic activity was ever vetted and approved by AIG’s board of directors. The subsidiary’s insulation was so great that neither AIG’s Derivatives Review Committee, specifically created to oversee firm-wide derivatives risks, nor the company’s Credit Risk Committee supervised AIGFP or evaluated its risks.364

What Went Wrong?

AIG’s financial condition turned sour in 2007 and became life-threatening in 2008. Table 10.2 shows why. In 2007, AIG’s Financial Services business segment suffered a $9.5 billion loss. Fortunately, other business segments were more than able to offset it. As a result, the company’s operating income for 2007 was nearly $9.0 billion. During the first nine months of 2008, all of AIG’s major business lines reported operating losses—especially Financial Services (−$22.9 billion) and Life Insurance and Retirement Services (−$19.6 billion). By year’s end, these losses worsened, with the same two segments losing $40.8 billion and $37.4 billion,365 respectively. The cause of these losses was the crumbling U.S. real estate market. During 2007 and 2008, AIGFP sold massive amounts of credit protection contracts (i.e., CDS), with exposures to subprime U.S. real estate mortgages (i.e., MBS and CMOs). At the same time, AIG’s Life Insurance and Retirement Services business was a counterparty to imprudent and speculative securities lending operations involving excessive investments in residential mortgage-backed securities (RMBS) and CMOs.366

Table 10.2: AIG’s Operating Income: Year-End 2007, September 30, 2008, and Year-End 2008 (Figures in Millions of Dollars)

Source: AIG, 2008 Form 10-K, p. 225, AIG Financial Supplement: Third Quarter 2008, p. 2, and 2007 Form 10-K, p. 149.

AIG made two strategic mistakes during the 2007–2008 period. The first involved CDS sales through AIGFP’s four portfolios—two Arbitrage and two Regulatory Capital. The second mistake entangled AIG’s securities lending operations, which AIG-INV managed.

AIG’s Credit Protection Exposures

Table 10.3 shows the net notional sizes of AIGFP’s Arbitrage and Regulatory Capital Portfolios at year’s end 2007 and 2008, as well as September 30, 2008—just two weeks after AIG’s bailout. The two Regulatory Capital portfolios (i.e., Corporate Loans and Prime Residential Mortgages) comprised between 66 and 78 percent of AIGFP’s total CDS exposures, which meant the Arbitrage Portfolios were a clear minority, accounting for only 22 to 34 percent of the total.

Table 10.3: AIGFP’s Credit Derivative Portfolios: Net Notional Amounts (Figures in Billions of Dollars)

Source: AIG, 2008 Annual Report, Page 130 and 131 and AIG, 2008 Form 10-Q, p. 114.

Table 10.4 shows the unrealized market valuation losses for AIGFP’s Arbitrage and Regulatory Capital Portfolios. The Regulatory Capital Portfolio was relatively healthy, reporting virtually no losses because its protection contracts were written mainly on underlying bank assets with very high credit quality (e.g., super senior debts). By contrast, the Arbitrage Portfolio was responsible for 98 to 100 percent of AIGFP’s reported losses even though its positions were a minority of the subsidiary’s total CDS exposures. Of the two arbitrage portfolios, the Multi-sector CDO portfolio was responsible for 92% to 98% AIGP’s total CDS losses.

The problem with the Multisector CDO portfolio was its vulnerability to the U.S. housing market. At the end of 2007, $61.4 billion (79%) of this portfolio had some exposure to U.S. subprime mortgages.367 When the subprime crisis struck in 2007, the portfolio’s market value crashed, causing credit-rating downgrades of the underlying securities, igniting massive increases in unrealized (i.e., valuation) losses, and triggering a surge in collateral calls. During the first nine months of 2008, AIGFP’s $72 billion Multisector CDO portfolio lost $19.9 billion (see Table 10.4). By year’s end, accumulated losses equaled $25.7 billion. The weight of these losses was heavy, but the collateral calls they triggered were the basis for AIG’s $182.5 billion bailout.

Table 10.4: Unrealized Market Valuation Losses: Year-End 2007, Third Quarter-End 2008, and Year-End 2008 (Figures in Millions of Dollars)

* AIGFP believed that counterparties to these transactions were no longer obtaining regulatory capital relief.

Source: AIG, 2008 Annual Report, p. 265, and AIG, U.S. SEC, 2008 Form 10. p. 114.

The overwhelming majority of AIGFP’s losses were from its Multi-sector CDO portfolio, but there is a story behind the story that makes these losses even more interesting. In 2005 (three years before the bailout), AIGFP realized that its multi-sector positions had become toxic and stopped writing new real-estate-related multi-sector contracts. Had the subsidiary kept only its legacy positions, losses in 2007 and 2008 would have been substantially reduced, but it did not. Between 2005 and 2008, AIGFP’s traders managed its multi-sector security pools by inserting subprime and Alt-A contracts for those that left the pools. As the percent of these harmful contracts rose, AIGFP’s exposure to the U.S. housing market increased and eventually caused significant losses.

Securities Lending at AIG

AIG-INV managed AIG’s worldwide securities lending activities. For the most part, the financial assets it lent were fixed-income securities owed by AIG’s insurance subsidiaries. The high degree of insurance regulation guaranteed that these financial assets were relatively safe. Some of AIG’s insurance subsidiaries lent more than others, with portfolio portions ranging from about 4.5 to 40 percent.376 At the end of August 2008, AIG-INV had increased its securities lending program to $69 billion.377

Figure 10.2 shows each step of AIG’s securities lending process. Suppose American General Life (AGL), an AIG insurance subsidiary, used $100 million of insurance premiums to purchase ten-year, 5 percent GE bonds. It deposited the securities with AIG-INV and AIG-INV lent them to Bridgewater Associates (BA), a Connecticut-based hedge fund. Suppose further that BA had a 102 percent cash collateral requirement.378

AIG’s Bailout

AIG realized that it had serious, life-threatening liquidity problems that were quickly becoming insolvency problems as well. Massive amounts of collateral had been sold at a loss to fund margin calls. Last-minute discussions to find a private financial solution failed. In these turbulent financial times, the risks were just too high. The lethal blow came on September 15, 2008, when the three major credit rating agencies downgraded AIG.

One reason a private solution could not be found was the difficulty estimating AIG’s precise liquidity needs. Another was the overall economic and financial environment. Large financial companies needed to worry about their own survival before they could consider rescuing others. In March 2008, Carlyle Capital Corporation defaulted and JPM purchased Bear Stearns. In June, Bank of America acquired failing Countrywide Financial Corp and the OTS closed the doors of IndyMac. In September, the same month AIG was bailed out, Fannie Mae and Freddie Mac were forced into conservatorship by the U.S. government (September 7), Lehman Brothers filed for bankruptcy and was sold to Barclays (September 15), and the net asset value of Reserve Primary, a U.S. mutual fund, fell below $1 (September 16). In the midst of this turbulence, the three major credit rating agencies downgraded AIG (September 16), causing more than $20 billion in collateral calls and transaction termination payments.390

Over the course of the next three months and into 2009, the drumroll of financial distress continued. The SEC temporarily banned short sales of U.S. financial companies (September 17); Morgan Stanley and Goldman Sachs became commercial banks (September 21); Washington Mutual Bank was closed by the OTS and subsequently acquired by JPM (September 25); Wells Fargo acquired Wachovia Corporation (October 12); PNC Financial Services Group, Inc. purchased National City Corp. (October 24); American Express and American Express Travel Related Services became bank holding companies (November 10); Lincoln National, Hartford Financial Services Group, and Genworth Financial became savings & loan associations (November 17); Bank of America acquired Merrill Lynch (November 26); CIT Group Inc. became a bank holding company (December 22); GMAC LLC and IB Finance became bank holding companies (December 24); and General Motors and CIT Group filed for bankruptcy (June 1, 2009 and November 1, 2009, respectively). Interbank lending dried up, causing the cost of short-term funds to rise precipitously. AIG stood in the midst of this financial turmoil without its stellar credit rating and without access to sufficient short-term or long-term funding sources.

By mid-September 2008, AIG was on the brink of bankruptcy. Its stock had fallen by 80 percent since the beginning of the month and it was threatened with being delisted from the New York Stock Exchange. Ben Bernanke, chairman of the Federal Reserve, Henry Paulson, U.S. Secretary of Treasury, and Timothy Geithner, president of the Federal Reserve Bank of New York (FRBNY), worked together to find a private solution. When none could be found, they concluded their choice was binary: either bail out AIG fully or let it declare bankruptcy. They chose the bailout alternative, but there was a problem. Who had the funds and authority to do so?

Until passage of the Emergency Economic Stabilization Act (EESA), on October 3, 2008, the U.S. government lacked authority help AIG. Similarly, the OTS and state insurance regulators lacked authority and access to sufficient funds. The only U.S. regulator with sufficient funds and authority was the Fed, but public statements of Ben Bernanke and Timothy Geithner minimized the chances of that happening. They were concerned about moral hazard and the message a Fed bailout might send to the rest of the financial industry and had strong preferences for a private rescue package, such as one that saved Long-Term Capital Management in 1998 or, more recently, Bear Stearns in March 2008.

The Fed was empowered to help AIG by the emergency assistance section (i.e., Section 13(3)) of the Federal Reserve Act, passed in 1913 and significantly liberalized in 1991. It gave the Fed lender-of-last-resort powers in cases of extreme financial emergency. Three conditions had to be met for the Fed’s help to be given to a non-bank: (1) at least five of the Fed’s seven-member Board of Governors needed to determine that “unusual and exigent” circumstances existed; (2) the financial assistance had to be “indorsed or otherwise secured”391 (i.e., collateralized) to the satisfaction of the Federal Reserve; and (3) the Federal Reserve needed to determine that adequate funding from private sources was not available.

There were clear but relatively weak precedents for Fed loans to AIG. During the Great Depression in the 1930s, Section 13(3) was used 123 times to extend about $1.5 million in support to private domestic businesses. It was not used again until 2008, when the Fed made the first of three loan commitments to AIG.

On September 16, 2008, the Fed extended to AIG a two-year, $85 billion, taxpayer-backed loan organized through a financing vehicle called the Revolving Credit Facility (RCF). The loan’s terms were virtually identical to a private-sector deal for $75 billion organized the previous day but which never materialized. RCF called for: (1) interest payments equal to LIBOR + 8.5 percent (2) a 2 percent commitment fee on the loan principal, (3) 8.5 percent charge on any undrawn portion of the facility, and (4) U.S. government ownership of 79.9 percent of AIG’s shares.392

In June 2008, Martin J. Sullivan stepped down as AIG’s President and CEO. He was replaced by Robert B. Willumstad, who took over the roles of Chairman and CEO until September 2008, when Edward M. Liddy assumed these responsibilities. Liddy agreed to serve until the end of 2009 at a salary of $1 per year, with no bonus, severance, or equity compensation.393

On October 3, 2008, the EESA was signed into law, creating the Troubled Asset Relief Program (TARP). Under it, the U.S. Treasury was authorized to purchase and guarantee up to $700 billion of distressed U.S. assets, in general, and mortgage-backed securities, in particular, as well as directly infuse banks with cash via preferred stock acquisitions. Its terms were more lenient than those demanded by the Fed. Therefore, AIG used the EESA funds to restructure its interest, maturity, and collateral terms with the Fed. For example, on November 10, the U.S. Treasury announced its intention to use $40 billion of TARP funds to purchase perpetual serial preferred AIG shares. AIG was the only beneficiary of this initiative, which was called the Systemically Significant Failing Institutions program (SSFI).394 Simultaneously, the FRBNY: (1) reduced, by $60 billion, the credit line AIG had under RCF; (2) extended the maturity of its loan to AIG from two to five years; (3) lowered the interest rate, and (4) reduced its fees.

On October 6, 2008, the Federal Reserve Board approved additional support for AIG via a special borrowing facility (SBF), which allowed the FRBNY to provide AIG with overnight lending up to $37.8 billion. Under this agreement, the FRBNY would borrow investment-grade, fixed-income securities from AIG’s life insurance subsidiaries and pay cash collateral.

With credit agencies viewing AIG’s survival as unlikely, the company was in need of a more durable solution. Consequently, on November 10, 2008, the FRBNY and U.S. Treasury announced a wide-ranging, multifaceted plan to address AIG’s liquidity and capital difficulties. Two special purpose, limited liability companies were created—the first called Maiden Lane II and the other Maiden Lane III (ML-II & ML-III, respectively).395

ML-II was created to purchase heavily discounted securities directly from AIG’s insurance subsidiaries. With these funds, AIG repaid its outstanding debts under the SBF and terminated securities lending positions for which AIG-INV invested collateral in RMBS. The Fed authorized the FRBNY to lend AIG up to $22.5 billion. The first distribution from the fund occurred on December 12, 2008.

Under ML-III, the FRBNY was authorized to lend up to $30 billion for the purchase of underlying securities in AIGFP’s Multisector CDO Portfolio. AIG also made a $5 billion equity contribution, and as a result, AIG-INV’s counterparties received full notional values for their CDOs, even though the market values were about half that amount. With the collateral AIG had already deposited, these new funds allowed AIG to terminate its toxic CDS contracts ($62.1 billion worth)396 and eliminate the threat they posed to additional collateral funding. The first distribution from this fund occurred on November 25, 2008.

For the rest of 2008, changes in AIG’s bailout package focused mainly on debt restructuring and interest reductions. For example, on December 1, 2009, AIG created SPVs for two of its foreign insurance subsidiaries, American International Assurance Company, Limited (AIA) and American Life Insurance Company (ALICO). Under these deals, the FRBNY purchased sufficient preferred shares in the two SPVs (i.e., AIA Aurora LLC and ALICO SPV) to reduce AIG’s outstanding RCF debt by $25 billion. AIG used the funds to improve the balance sheets of AIA and ALICO. On January 16, 2009, the FRBNY created the AIG Credit Facility Trust (AIG Trust), to manage and eventually dispose of the U.S. governments’ equity stake in AIG.

Asset prices continued to decline throughout 2008 and into 2009. AIG reported year-end losses for 2008 of $99.3 billion and fourth quarter losses of $61.7 billion, compared to losses of $5.3 billion during the fourth quarter of 2007.397 Faced with the prospect of even lower credit ratings, on March 2, 2009, the Fed and U.S. Treasury announced plans to restructure AIG’s existing aid and provide a TARP-related, five-year standby facility, exchanging $29.8 billion for preferred stock. Other modifications were also negotiated in March to make AIG’s balance sheet look healthier to credit rating companies.

Table 10.5 shows the final amounts authorized and borrowed/used under the multiple bailout packages offered to AIG.

Table 10.5: Bailout Funds Authorized and Used by AIG (Billions of Dollars)

‘* Funds from the TARP and Commercial Paper Funding Facility were used to pay down the RCF. Because the funds were repaid, these figures do not include $37.8 billion in loans to AIG insurance subsidiaries under the securities lending program. Because it was a source of liquidity for many firms and not just AIG, the figures also exclude $15.2 billion in funding that AIG received under the Fed’s Commercial Paper Funding Facility.

Source: William K. Sjostrom, Jr., “The AIG Bailout,” Washington and Lee Review, 66(3) (2009): 943, 975. With its initial funding from the FRBNY in place, AIG worked on plans to sell many of its global businesses and pay back its Fed and government loans.

What If AIG Was Allowed to Fail?

Since its rescue, many have wondered about the possible consequences if AIG had declared bankruptcy. The conclusions are hard to draw because there were just too many unknowns, such as cross-border implications, possible conflicts of interest, effects on banks’ regulatory capital, counterparty impacts, and external contagion.

Criticisms of the AIG Bailout

Ben Bernanke and Timothy Geithner claimed that their decision was binary: completely bail out AIG or let the company default. But it is not clear that these were the only alternatives. For instance, short-term loans or bridge loans could have been extended, giving private parties more time to find a solution. Government guarantees could have made the acquisition of AIG more appealing to private parties. Troubling to many was the list of possible suitors, which was almost identical to the list of financial institutions that had the most to gain from a Fed or government bailout of AIG (see Table 10.6). Critics rightly asked if Wall Street was bailing out Wall Street with taxpayer funds. The bailout’s timing and terms have also been questioned. Why did regulatory authorities wait so long to act? Was AIG really too big to fail? Was there really a need to fully compensate all counterparties—even those making speculative bets?

Table 10.6: Top Ten Beneficiaries from AIG’s Bailout (Figures in Billions of Dollars)

Source: United States Government, Congressional Oversight Panel, June Oversight Report: The AIG Rescue, Its Impact on Markets, and the Government Exit Strategy, June 10, 2010, 88 and 93.

Postscript

To repay its debts to the Fed, AIG aggressively divested many subsidiaries, repurchased stock, made structural operational changes, and decreased AIGFP’s exposures. Its most noteworthy divestitures (complete and partial) included Unibanco AIG Seguros (2008), HSB Inspection and Insurance (2008), AIG Private Bank (2008), Deutsche Versicherungs- und Rückversicherungs AG (2008), 21st Century Insurance (2009), Transatlantic Re (2009), parts of its Asset Management operations (2009), American Life Insurance Co (ALICO in 2010), PineBridge Investments (2010), American General Finance (2010), AIG Starr (2010), AIG Edison (2010), Nan Shan Life (2011), AIA (2012), and United Guaranty (2016).

During 2012, the U.S. Treasury gradually sold all its equity interest in AIG, and in 2017 the U.S. Financial Stability Oversight Council removed the company from its list of financial institutions deemed “too-big-to-fail.” As Table 10.7 shows, AIG repaid a total of $205 billion, fully covering the U.S. Treasury’s and Fed’s bailout funds ($182.5 billion) and left the U.S. government with a return of $22.7 billion, a yearly return of about 1.3 percent over the nine-year period.

Table 10.7: AIG’s Bailout and Repayment (Figures in Billions of Dollars)

* Notice that most accounts cite the bailout equaling $182.5 billion.

Source: U.S. Department of the Treasury, Investment in AIG: Program Status. Available at https://www.treasury.gov/initiatives/financial-stability/TARP-Programs/aig/Pages/status.aspx, Accessed on December 8, 2017.

In 2010, the Wall Street Reform and Financial Protection Act (the Dodd-Frank Act) was passed by the U.S. Congress and signed into law by President Barack Obama. It tried to remedy many of the financial problems perceived to have caused the sub-prime crisis and subsequent Great Recession, such as: (1) addressing systemic threats to the U.S. financial system by breaking up companies that are too big to fail or by taking over gigantic financial institutions that are failing; (2) protecting investors, furthering capital formation, and promoting efficient markets by monitoring and examining U.S. credit-rating agencies; (3) preventing financial contagion by restricting bank holding company investments; and (4) reducing moral hazard by requiring securitizers to hold a portion of their issues (i.e., to have “skin in the game”).400

Conclusion

During a conference call with investors in August 2007, AIGFP’s CEO, Joseph J. Cassano, said: “It is hard for us, without being flippant, to even see a scenario within any kind of realm or reason that would see us losing $1 in any of those transactions.”401 He was not alone. In December 2007, AIG’s new CEO, Martin Sullivan, reinforced Cassano’s sentiments, saying because AIG’s CDS business is “carefully underwritten and structured with very high attachment points to the multiples of expected losses, we believe the probability that it will sustain an economic loss is close to zero.”402 According to AIG’s top officials, the company’s chance of never paying a cent in claims was 99.85 percent.403

Time and circumstances proved them wrong. AIG followed two roads to ruin, as it strayed outside its core competences. The first road involved imprudent, one-sided, and massive sales of CDS contracts, taking the company to the door of bankruptcy. The second involved speculative uses of securities lending operations, which converted safe, premium-financed, liquid assets of AIG’s insurance affiliates into speculative, illiquid investments financed with funds that could vanish virtually overnight.

AIG illustrates how a highly respected and financially successful company can quickly find itself in the throes of a financial death spiral. By mispricing liquidity risk, it was forced to make billions of dollars in collateral payments, which eventually exceeded the company’s funding abilities. As U.S. housing markets collapsed, AIG’s collateral payments increased precipitously, causing its initial liquidity problem to soon become solvency problems as well. A series of credit rating downgrades and unrealized losses on both its CDS positions and invested collateral on securities lending deals caused AIG’s counterparties to flee, asking, before they left, for their collateral back.

In the end, AIG was saved by a series of Federal Reserve and U.S. government bailout packages totaling $182.5 billion. How the bailout was managed, the lack of sufficient regulatory safeguards, possible costs to U.S. taxpayers, as well as the stakeholders punished and those who were not remain hot points of conversation which will last for years.

Looking back on this financial disaster, from almost any perspective, the same question arises. Why would AIG, a traditionally conservative company with a core competency in measuring and pricing insurance risks, jeopardize everything to sell financial protection and speculate with collateral from securities lending operations, two areas in which it had no comparative advantage? For an extremely small financial reward, the liquidity and counterparty risks seem too large for this to have been a well-considered business decision. AIGFP’s Capital Markets unit was a diminutive part of AIG parent’s total revenues, never reaching above 3 percent, but its contribution to AIG’s net income ranged between − 6.2 percent and +25.4 percent. In 2007, AIG’s Capital Markets unit lost $10.6 billion,404 with AIGFP losing $11.5 billion on its super senior CDS portfolios. These losses surpassed what AIGFP earned from 1994 to 2006. In 2008, AIGFP’s losses on its super senior CDS portfolios spiraled to $28.6 billion.405

After the bailout, AIG announced its intention to focus on U.S. property and casualty insurance, foreign general insurance, and certain foreign life insurance businesses.406 It wound down AIGFP, transacting new business only to hedge or otherwise mitigate risks. To survive, AIG would need to fix the goodwill and trust lost through this ordeal. The company also needed access to stock markets but realized that new issues at decent prices would not be made soon. Counterparties needed assurances that AIG would be a going concern. Without them, they would have little incentive to expand their credit and business limits, allowing AIG to hedge, finance working capital needs, and increase its purchases and sales of securities, commodities, and other assets. The company also needed to restore its credit rating to a respectable level so that it could borrow at competitive rates. Finally, AIG needed to convince insurance regulators to reduce their restrictions on subsidiary dividend flows and other distributions to AIG parent. Without these funds, AIG had little chance of building enough financial assets to eventually assist subsidiaries that needed support (e.g., capital and liquidity).

Review Questions

Bibliography

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CDS’s are traded over the counter (i.e., not on exchanges). Protection buyers and sellers are primarily banks and institutional investors, such as hedge funds, insurance companies, and other financial intermediaries. Typically, credit protection contracts are standardized “Master Agreements,” which use documentation from the International Swaps and Derivatives Association (ISDA). These agreements set out payment terms, credit events, and other details defining the relationship between counterparties. Documentation also includes a “credit support annex” (CSA), detailing the agreement’s collateral requirements, including trigger points at which additional collateral is needed (e.g., due to a change in credit rating by the CDS seller or guarantor).

Credit derivatives are often called “synthetic” because their values are tied to changes in default and nonpayment risks, rather than the prices of debt instruments, such as bonds or loans. The term “credit derivative” is generic and includes credit default swaps, contracts on credit indices, and contracts on credit tranches. Credit default swaps protect their owners from the negative financial consequences of bankruptcy and credit quality deterioration for either one borrower or a pool of them. If the contract protects just one borrower, it is called a single name credit derivative. If the contract offers protection based on the credit quality of a standardized borrower pool, it is called a credit derivative index contract. Finally, if the credit derivative is based on exposures to parts of a credit index’s loss distribution, the contract is called a credit derivative tranche. The four most common types of credit derivative tranches, from the lowest to highest risk, are: (1) super senior, (2) senior, (3) mezzanine, and (4) equity (often called the “first loss”).

Credit derivatives have seven major components:

Credit derivatives are similar but not identical to insurance contracts. One difference is insurance buyers are required to have “material interest,” a formal way of saying that they must own or have a financial position in the homes, cars, or boats they insure. Insurance buyers are not allowed to purchase policies on someone else’s property. Credit derivatives buyers are not required to have material interests.

There are important differences between insurance products and financial products, such as credit derivatives, in terms of regulation. In the United States, the states have regulatory authority over insurance products, meaning there are fifty different sets of rules and regulations. As for financial products, U.S. exchange-traded instruments are regulated by the SEC and CFTC. Credit derivatives escape most state regulations because they are not considered insurance contracts, and they escape most federal regulations because they are traded over the counter (i.e., not on exchanges).

Once issued, credit derivatives can be bought and sold in secondary markets. Their spreads vary directly with changes in market perceptions about the borrower’s credit risk. Those who believe a company’s credit spread will widen try to buy credit derivatives at low values and sell them later, after their spreads have widened. Those who believe a company’s credit spread will narrow sell credit derivatives at high prices in the hope they can buy to close later (i.e., hedge) when these spreads have fallen.407

Credit Derivatives Hedging, Trading, and Speculation

Suppose it is March, and JPMorgan Chase (JPM) buys credit protection worth $1 billion ($1,000 million) in notional value from AIG. The reference obligation is a five-year American Airlines (AA) note, with a credit spread of 400 basis points (i.e., 4 percent) per annum, paid quarterly. To reduce counterparty risk, JPM requires AIG to post initial collateral, which rises and falls as the contract matures and is marked to market. Consider the consequences if JPM is hedging versus speculating.

Hedging

Suppose JPM owns the AA securities and is protecting itself from a possible credit event. JPM’s first credit spread payment of $10 million is made on March 20 and covers the March–June period. If AA experiences no credit event during this period, AIG keeps the full credit spread. Similarly, in June, JPM pays an additional $10 million for June–September protection. Again, if no credit event occurs, AIG keeps the spread payment. Up until this point, AIG has collected $20 million in credit spreads and made no claim payments.

Suppose things change during the final quarter of the year (i.e., September-to-December). AA declares bankruptcy in November, causing the value of its five-year notes to fall by 40 percent.408 If the agreement calls for cash settlement, AIG pays JPM $400 million, which is the difference between notional value ($1,000 million) and market value ($600 million) of AA’s five-year notes (see Figure A 10.1.1). If the agreement calls for delivery of the AA notes, then JPM delivers them and receives $1,000 million from AIG. In either case, the result it the same: JPM is fully indemnified.

Speculating

Companies speculate by buying credit protection when spreads are narrow (i.e., when the perceived probability of default is low) and selling it later when spreads widen. Alternatively, speculators sell credit derivatives when credit spreads are wide and then cover these exposures by buying them later at narrower spreads. Figure A 10.1.2 provides an example of how JPM might speculate to earn profits from changes in AA’s credit spread. Suppose the initial spread is 400 basis points per year (i.e., 4% per year). If AA’s credit risk rises and new contracts have spreads equal to 480 basis points, then protection for new contracts costs $48 million per year. JPM can lock in profits by selling credit protection on AA notes to a new counterparty, like Credit Suisse (CS). As a result:

–JPM buys credit protection from AIG for $40 million per year, and simultaneously sells credit protection to CS for $48 million per year, netting $8 million per year. As a result, having bought and sold credit derivative contracts on the same reference entity, for the same notional amount, and same maturity, JPM no longer has a net credit risk exposure on the AA notes.

–CS buys credit protection from JPM for $48 million per year. Therefore, it has a long credit protection position.

–AIG sells credit protection to JPM for $40 million per year. Therefore, it has a short credit protection position.

What would happen if AA declared bankruptcy and the value of AA’s five-year notes fell by 40 percent? If the credit derivative contracts called for cash settlement, AIG’s payment of $400 million would go to CS via JPM. Alternatively, if delivery of AA’s five-year notes was contractually required, CS would: (1) purchase the AA notes in the open market for $600 million, (2) deliver them AIG via JPM, and (3) receive payment of $1,000 million in claims from AIG via JPM.