Chapter 22
Credit Derivatives Case Studies: AIG and Merrill Lynch
CASE STUDY ONE: AMERICAN INTERNATIONAL GROUP (AIG)1
Event Summary
The U.S. Federal Reserve, under the guidance of the Treasury Department, took control of American International Group (AIG) with an $85 billion bailout on September 16, 2008. The rescue left the U.S. government holding 80 percent of the largest insurance company in the world until the company can be recapitalized. The recapitalization was expected to occur through a sale of the insurance company's assets. A significant portion of AIG's problems were attributed to credit derivative losses suffered by its financial products division. The firm was found to have taken on too much risk, and to have not had the resources to meet calls for additional collateral, when the value of reference collateralized debt obligations (CDOs) that it had insured started plummeting. New York State Attorney General Andrew Cuomo is investigating payouts the firm made to a series of counterparties who demanded additional collateral. AIG's disclosure statements involving the collateral calls are also being investigated.
AIG's underwriting businesses were deemed essentially healthy and believed to be of interest to a variety of possible acquirers. Hank Greenberg, the founder and former chief executive of AIG, was mentioned as a possible buyer for some of the company's assets. At least one pension fund sued AIG for “gross imprudent risk taking.”
Event Details
It was unprecedented for the U.S. Federal Reserve to intervene in the rescue of an insurance company, but the decision reflects concern for how intertwined the company was with financial markets and the risk of an even larger systemic failure if the insurer was allowed to go under. Just days before the Federal Reserve stepped in to rescue AIG, it allowed Lehman Brothers to go under rather than provide financial backing. The failure to rescue Lehman Brothers was surprising, because the Federal Reserve had earlier stepped in to rescue Bear Stearns in March 2008; circumstances, however, had changed since March, and the U.S. government came under political pressure to resist appearing to be saving Wall Street while Main Street (or Middle America) suffered from the economic downturn. In the case of AIG, the Federal Reserve said that a “disorderly failure of AIG could add to already significant levels of financial market fragility.” AIG's takeover followed the September 7, 2008, government rescue of Freddie Mac and Fannie Mae.
AIG's cash shortage, which became evident by the weekend of September 6, 2008, was attributed to its financial products division, which was exposed to credit default swap (CDS) contracts, including those that insured mortgage-backed securities (MBS). Credit default swaps provide investors with a type of credit insurance in the event of a default; credit default swaps are triggered by credit events, including a bankruptcy filing. Besides AIG's importance as the largest insurer in the global markets and its book of corporate and personal insurance policies, there was worry that if the company was allowed to file for bankruptcy a new round of credit protection contracts would have been triggered, and a downward spiral would have been created, if the entities that would have to honor contracts on AIG went under and triggered a new round of payouts. The New York Times (9/18/2008) reported that while the company's core business was underwriting insurance contracts and selling annuities, it was “deeply involved in the risky, opaque market for derivatives and other complicated financial instruments that operate largely outside regulation.”
Unwinding AIG's portfolio of derivatives contracts is perhaps the largest task ahead for a senior management team that was facing many challenges. It was estimated that AIG provided $440 billion of credit insurance on debt products. Payouts on such transactions and requests for additional collateral dramatically increased since subprime mortgages, which underlie many of these complex debt securities, lost value following the market disruptions of August 2007. AIG was a counterparty to billions of dollars’ worth of other types of derivatives. There was also concern that if AIG filed for bankruptcy a series of credit default swaps tagged to its debt would have been triggered. For this reason, the government's description of the rescue used specific language that was designed to avoid triggering a credit event.
The Financial Times reported (9/18/2008) that AIG got caught in what was essentially a game of “regulatory arbitrage.” Global banks were able to use credit default swaps to offset the amount of capital they had put aside to cover certain credit risks. The banks that entered into default contracts with AIG were able to claim that they were offsetting the risk that a certain underlying credit asset would default. They were allowed to hold less cash in reserve as a result of entering these contracts. The cost of these contracts was less than the cost of holding regulatory capital. AIG advertised the credit protection that it offered as a method for providing “regulatory capital relief rather than risk mitigation.” As AIG's credit insurance business grew, it also acquired a concentration of credit risk. The Financial Times wrote that as the market for credit default swaps grew, “dangerous levels of counterparty risk would accumulate in institutions willing, as AIGFP [AIG financial products division] was, to write insurance on very attractive terms.”
When AIG first approached the Federal Reserve for assistance, it was in the belief that it would need about $20 billion in order to continue operating. New York State allowed AIG to tap into available funds from its insurance subsidiaries in order to cover the shortfall—a commingling of funds that is usually prohibited. But it became evident after J.P. Morgan Chase, Kohlberg Kravis Roberts (KKR), and J.C. Flowers pored through AIG's books that it needed not $20 billion, but $40 billion, then $65 billion, and later at least $80 billion in order to survive. AIG received a buyout offer of $10 billion from J.C. Flowers, under the condition that it would have to retain its present credit rating. KKR and Texas-Pacific Group offered $20 billion for 50 percent of the company if the credit rating was maintained, and if additional funding was provided by Wall Street and the U.S. government. A credit rating downgrade, however, was already planned for the insurance company. The major ratings firms announced on September 15, 2008, that they had downgraded the firm. A series of credit ratings downgrades meant that AIG was required by counterparties on its swaps contracts to post an additional $13.3 billion in collateral. This increased call for additional collateral is believed to have created a cash shortage at AIG and is under investigation by Attorney General Andrew Cuomo and federal regulators.
Also being investigated is the role Joseph Cassano played at the time the collateral calls were occurring. Mr. Cassano was head of AIG's ill-fated financial products division. He told AIG shareholders, “We have, from time to time, gotten collateral calls from people. Then we say to them, ‘Well, we don't agree with your numbers.’” He added that they then “go away.” He made similar statements to his firm's auditors (Cohen 2010).
Documents received by CBS News (6/23/2009) belie Mr. Cassano's comments concerning the collateral calls; an internal memo documented 84 collateral calls received by late November 2007, totaling more than $4 billion. The same set of documents indicated that 38 calls were from Goldman Sachs, 18 margin calls were from Merrill Lynch, and 25 such calls were received from Société Générale. Despite the large number of collateral calls, CBS reported that during a December 5, 2007 conference call with investors, “AIG executives were silent about the specific number of collateral calls” and appeared to “gloss over any potential problems with its CDS portfolio.” Former CEO Martin Sullivan commented on the firm's CDO portfolio during the call: “The probability that it will sustain an economic loss is close to zero.” The U.S. Justice Department is allegedly investigating this period in an effort to discern whether AIG's senior executives misled investors and auditors about the health of its CDO business.
AIG was the tenth most popular stock holding in employee 401(k) plans. It was also widely held by pension funds. The City of New Orleans Employees’ Retirement System announced on September 18, 2008, that it had filed a lawsuit against AIG Chief Executive Robert Willumstad and the board of directors of AIG, accusing them of mismanagement and “grossly imprudent risk taking.” The pension fund seeks the return of all compensation that the firm's individual defendants earned from the company, in addition to other claims for recompense. It is also probable that the firm will be the target of additional shareholder lawsuits that will contend that it failed to properly report its true financial condition and risks. The investment banks that underwrote an AIG offering in May 2008, in an effort to raise cash, are vulnerable to lawsuits alleging fiduciary breaches associated with their role as underwriters. This type of suit has already been filed against the underwriters that assisted Fannie Mae with raising funds, even though Fannie Mae was ordered to do so by its regulator.
AIG reported losses related to write-downs on credit default swaps linked partially to subprime mortgages in the fourth quarter of 2007. The firm was also the subject of continual regulatory investigations over the prior several years, which were heightened when former New York State Attorney General Eliot Spitzer was in office. Some analysts traced the firm's troubles to the Spitzer regulatory regime, which ultimately pushed out longtime CEO Maurice Greenberg.
Control Failings and Contributory Factors
Corporate/Market Conditions
AIG was heavily exposed to asset-backed securities that had subprime mortgages as their underlying instruments through the credit derivatives market. The appetite for mortgage-backed securities dissipated after the market events of August 2007, when it became evident that subprime mortgages exposed financial markets to a great deal of credit, market, and operational risk.
Strategy Flaw
AIG was unique among insurance firms, in that it took on so much capital markets–related risk and expanded aggressively into noncore businesses, such as offering a form of credit insurance through the significant role it played in credit default swap transactions. A large part of this exposure was through offering protection for bonds linked to mortgage-backed securities. Internal memos that emerged later indicated there were problems with how these contracts were structured. The documents suggested that AIG failed to include reliable thresholds before collateral calls would be triggered (thresholds determine by what percentage reference CDOs would have to decline before the seller of protection is required to post additional collateral). The memos indicate that some of AIG's CDO contracts included no threshold, and others’ thresholds were as low as 4 percent. This offered little protection against the counterparty calls for additional collateral that have been mentioned as a contributory factor to the firm's liquidity crisis in September 2008.
Failure to Disclose
Evidence presented by CBS News suggests that AIG had knowledge that its CDO portfolio might be in trouble before a meeting that it held with investors on December 5, 2007. This knowledge may have been reflected in the number of collateral calls it received on the portfolio during the period before the meeting. However, during what the news service called “a crucial meeting,” the firm's senior management commented to investors that there was no probability that the portfolio would sustain losses.
Undertook Excessive Risk
A business model that allowed one noncore division within AIG to put the rest of the firm at risk was a highly risk-taking strategy. AIG's losses, resulting from its credit derivatives exposure, reflect the high and very opaque risk inherent in credit default swap transactions. They also represent how concentrated this type of risk became within the firm; in its core insurance underwriting businesses it is unlikely that AIG would have allowed its risk exposure to become so concentrated. The risk associated with credit default swaps can rapidly expand during volatile market conditions, when default triggers exponentially kick in. As mentioned, a lawsuit filed by a New Orleans pension fund specifically targeted AIG's “grossly imprudent risk taking.”
Corrective Actions and Management Response
The terms of the rescue plan call for the issuance of a two-year bridge loan of $85 billion to AIG; in return the U.S. government takes ownership of a 79.9 percent stake in AIG. The bridge loan was granted at the high interest rate of 8.5 percentage points above the London Interbank Offered Rate (Libor) as a deterrent to any possible moral hazard. It is in AIG's interest to retire the loan as soon as possible through the sale of assets. Assuming ownership through the issuance of equity warrants was a method deployed by the government in order to prohibit shareholders from benefiting directly from the rescue of the company, which was deemed another example of potential moral hazard.
The terms of the rescue called for replacement of the firm's CEO. Edward Liddy replaced Bob Willumstad as the firm's chief executive. Mr. Liddy agreed to receive a salary of $1. In a letter to employees, Mr. Liddy, the former CEO of Allstate, indicated that he had no intention of shutting down AIG: “My intention is not to liquidate the company. Insurance operations are solid, capitalized and well funded.” He also reassured the markets when he said, “the mess we're in is solvable.” He announced on May 21, 2009, that he was resigning his position at AIG and would remain on the job only until a replacement could be found (Son 2008).
The estimate for AIG's breakup value was in the range of $150 billion. A number of names were mentioned as potential acquirers of AIG's businesses, including Prudential Financial, Prudential PLC, Aviva, Berkshire Hathaway, Munich Re, and Allianz. The senior management of AIG's profitable aircraft leasing business was attempting to put together financing for a management buyout.
AIG's board of directors issued the following statement on September 16, 2008: “The AIG Board has approved this transaction based on its determination that this is the best alternative for all of AIG's constituencies, including policyholders, customers, creditors, counterparties, employees and shareholders. AIG is a solid company with over $1 trillion in assets and substantial equity, but it has been recently experiencing serious liquidity issues. We believe the loan, which is backed by profitable, well-capitalized operating subsidiaries with substantial value, will protect all AIG policyholders, address rating agency concerns, and give AIG the time necessary to conduct asset sales on an orderly basis. We expect that the proceeds of these sales will be sufficient to repay the loan in full and enable AIG's businesses to continue as substantial participants in their respective markets. In return for providing this essential support, American taxpayers will receive a substantial majority ownership interest in AIG.”
Lessons Learned
The rescue of AIG led to the inevitable concern for associated moral hazard. The U.S. Treasury department and Federal Reserve were also under pressure to explain why they would extend emergency financing to an insurance company when just a day earlier they failed to extend a lifeline to Lehman Brothers. The issue at the crux of the decision is how intertwined the firm is in the overall economy, and how much systemic risk it poses. The decision was made that AIG was too big to fail and too intertwined in world markets. This was the result of several facts: It is one of the most widely held stocks in portfolios of many pension funds and mutual funds, and is held by a large number of retail investors; it is heavily bound into both sides of credit default transactions; and it is the largest insurer in many markets around the world. By contrast, the failure of Lehman Brothers was predicted to be more contained.
The Federal Reserve's role in stabilizing AIG represented a shift in the regulatory landscape. The Federal Reserve morphed seemingly overnight from an entity that was primarily concerned with the stability and capitalization of the monetary and banking systems, to the role of steward of the overall economy. Some overseas analysts commented that the series of rescues that have occurred during the prior few months represent a shift away from a pure free-market economy. While maintaining that they understand why the Federal Reserve stepped in to save Fannie Mae, Freddie Mac, and AIG, they also commented that hypocrisy was possible because the U.S. government and the World Bank have in the past criticized foreign governments in growth countries that attempted to stabilize ailing private entities.
CASE STUDY TWO: MERRILL LYNCH2
Event Summary
Merrill Lynch & Co., Inc. filed a lawsuit against bond insurer XL Capital Assurance Inc. on March 18, 2008. The suit alleged that a bond insurance unit of XL breached its contract when it voided default protection on $3.7 billion of collateralized debt obligations (CDOs). The default protection provided by XL was in the form of credit default swaps (CDSs). On April 1, 2008, SCA countersued, defending its termination of seven CDS written for Merrill Lynch International. On July 28, 2008, SCA agreed to pay Merrill Lynch & Co., Inc., $500 million to terminate the seven CDS contracts. At around the same time, SCA was spun off from XL Capital Ltd and renamed Syncora Holdings.
Event Details
Merrill Lynch required bond insurance to protect its holdings of senior tranches of certain mortgage-backed CDOs issued since 2005. In late 2005 the insurance firm AIG, which had previously insured some mortgage-backed securities issued by Merrill, decided it would stop selling new insurance on such securities. Merrill Lynch International then entered into seven credit default swap (CDS) contracts with XL Capital Assurance, an operating subsidiary of Security Capital Assurance Ltd. (SCA), to insure its CDOs. CDS contracts typically last for five years, although other term structures exist.
In August 2007, Merrill reportedly proposed that XL Capital Assurance insure a further $20 billion in Merrill CDOs. “Pick your deal. It's a very nice deal for XL and a big help for ML,” a Merrill salesman was alleged to have told an XL employee at the time. XL declined to take on the new business, and Merrill turned to a smaller insurer, ACA Financial Guaranty.
In February and March 2008, XL Capital attempted to void seven CDS transactions that protected the original $3.7 billion in CDOs, on the grounds that Merrill breached the terms of the contract by granting “control rights” to a third party without informing XL. The third party is reported to be bond insurer MBIA Inc. Control rights include potential actions to help senior note holders in the top tranche of a defaulting CDO obtain full payment, pitting their interests against those of lower-rated note holders. At least two of the CDOs at issue in the case received event of default (EOD) notices. In March 2008, SCA recorded a charge of $632.3 million relating to the swaps in question.
Merrill filed suit against XL in federal court in New York on March 18, 2008, claiming breach of contract, and asking the court to order that the seven CDS contracts remain in force. News of the filing triggered sales in Merrill Lynch shares, which fell 8.4 percent over the day on the New York Stock Exchange on the expectation that further CDO write-downs could follow.
Security Capital Assurance then countersued Merrill Lynch in federal court on April 1, 2008, disputing Merrill's claims and defending its terminations of the CDS contracts. SCA's suit alleged that Merrill, after forecasting a $7.9 billion write-down on subprime-related assets in the third quarter of 2007, “undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining (CDO) positions. … Determined to get these CDO risks off its books at all costs before the third quarter of 2007 closed, Merrill Lynch made the decision to blatantly ignore its prior commitments to” XL Capital. At least two of the CDS contracts signed by XL “negligently” omitted to include language specifying that XL would be granted control rights. Security Capital argued that Merrill agreed to amend the two contracts but never did so.
On April 17, 2008, Merrill Lynch announced first quarter results for 2008. The company's write-downs included “credit valuation adjustments of negative $3.0 billion related to hedges with financial guarantors, most of which related to U.S. super-senior ABS CDOs.” However, it is not known whether this refers directly to the CDS contracts that are the object of the dispute in the current case.
Control Failings and Contributory Factors
Failure to Disclose
Security Capital alleged that Merrill Lynch failed to notify XL it had granted control rights in several CDO contracts to third parties, thus breaching its contract.
Corporate/Market Conditions
Increasing rates of default on residential mortgages in the United States led to a rapid deterioration in the market for asset-backed CDOs. This in turn placed pressure on companies that wrote bond insurance on such securities.
Poor Documentation
At least two of the CDS contracts signed by XL “negligently” omitted language specifying that XL would be granted control rights. SCA argued that Merrill agreed to amend the two contracts but never did so.
Corrective Actions and Management Response
On July 28, 2008, it was announced that Merrill Lynch had agreed to allow SCA to cancel $3.7 billion in credit default swaps on mortgage-related securities, ending the litigation. In exchange for the cancellation, SCA agreed to pay Merrill $500 million. The deals were brokered by New York Insurance Commissioner Eric Dinallo. The announcement of the settlement was accompanied by news that XL Capital, the Bermuda-based re-insurer that was formerly SCA's parent, had agreed to pay SCA $1.78 billion in cash, and issued 8 million shares in SCA, which was to be renamed Syncora Holdings. In June 2008, shareholders of SCA had agreed to a renaming of the company and, at around the same time as the settlement was announced, SCA was renamed Syncora Holdings.
Lessons Learned
The fast-growing CDS market remains largely unregulated despite the large volume in contracts written. The securities have not been subjected to conditions of widespread defaults, and there has been little or no litigation testing how the contracts are written. Therefore, as a J.P. Morgan analyst commented in the Financial Times, “Dealers that retained and hedged senior AAA CDO exposures may face greater losses if monolines are successful in shifting losses due to legal issues, or [they] may face litigation from junior investors over sloppy documentation.” However, analysts also note that if a CDS dispute were to be decided in court, the standard of proof for a claim of misrepresentation would be high, given that parties on both sides qualify as sophisticated investors. However, some of these contracts are speculative investments, rather than hedges, and an unknown amount is believed to be held by highly leveraged entities with little in the way of reserves, such as hedge funds.
The well-known investor George Soros said of the instruments on April 4: “It is a totally unregulated market hanging like a Damocles’ sword over the financial system. You don't know whether your counterparty is good for its payment or not.” Many firms that bought CDS contracts to hedge their investment risk must discover who currently holds the insurance contract, as the insurer may have assigned the insurance contract to another party, who can then do the same. Thus, a company may not even know the identity of the counterparty against which it would obtain payment in an event of default.
According to an analysis by the New York Times on August 10, 2008, the agreement to settle the contracts for $500 million—about 13 percent of their face value—raised questions about the valuations of other outstanding CDS contracts. If SCA had been obliged to pay out the full value of the swaps, it is considered likely that it would have been unable to do so. Then SCA would have been placed under regulatory control and Merrill might have received little or nothing. As Commissioner Dinallo told the New York Times, “There was the looming threat of us sending the whole thing over to rehabilitation where it is still uncertain what happens.” Under a regulatory takeover, the swaps could be considered junior to other claims on SCA. “This uncertainty presented the market clearing price for the credit default swaps,” Commissioner Dinallo said, noting that at least 13 other banks had similar CDS contracts with SCA.
Mr. Dinallo pushed to have the contracts regulated as insurance products, which would require that purchasers have an “insurable interest” that the contract covers, and that sellers maintain reserves to cover the value of the contracts. Others have urged that the products (and perhaps currency and interest rate swaps, too) should be regulated as derivatives. As of November 2008, CDS contracts remain unregulated and there is no clearinghouse for the contracts.
NOTES
* This information is the sole property of Algorithmics Software LLC and may not be reprinted or replicated in any way without permission.
1. Algo First database of operational risk case studies.
2. Ibid.
REFERENCES
Cohen, William. 2010. “The Fall of AIG: The Untold Story.” Institutional Investor April 7. http://www.iimagazine.com/article.aspx?articleID=2460649.
Son, Hugh. 2008. “AIG's Liddy Plans to Keep Company in Business, Not Liquidate.” Bloomberg September 18. http://www.bloomberg.com/apps/news?sid= aqkraD7yNDEw&pid=newsarchive.
ABOUT THE AUTHOR
Algorithmics Software LLC (www.algorithmics.com) is the world leader in enterprise risk solutions, dedicated to helping financial institutions understand and manage risk. Its innovative software, content, and advisory services provide a consistent, enterprise-wide view of risk management to help firms make better business decisions and increase shareholder value.