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CREDIT CRISIS: THE STORY OF AMERICAN INTERNATIONAL GROUP’S (A.I.G)

FINANCIAL MISMANAGEMENT AND BAILOUT

by Rovarovaivalu Vesikula

Financial Systems – ECON 220

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Abstract

Credit default swaps (CDSs) are contracts between buyers and sellers of protection against default. They

are a form of debt insurance, or more precisely derivatives contracts that investors buy to either insure

against or profit from a default. CDS contracts act as a form of debt insurance in that they provide a

means of protection against credit risk. In the aftermath of the global financial crisis, the CDS earned the

threatening reputation of being the ‘financial weapon of mass destruction’. This was particularly evident

in A.I.G’s near demise as about $21 billion was recorded in unrealized mark to market losses due to its

AIGFP subsidiary’s CDS business going under. Despite this alarming figure, many experts and

academics alike overlook the other source of AIG’s big losses – its Securities lending business which

recorded a total loss of about $20 billion. .This paper hence examines A.I.G’s CDS and Securities lending

business and discusses the role AIG’s financial mismanagement had in amplifying the 2008 financial

crisis.

INTRODUCTION

In his 2008 annual report to AIG shareholders, former Chairman and Chief Executive

Officer Edward Liddy offered some words of consolation to those that suffered severe financial

losses during the 2008 financial crisis. The consolation was warranted, as the economic

meltdown experienced in that year was unprecedented. American International Group, otherwise

known as A.I.G, has been identified as playing a central role in the 2008 financial crisis. The

insurance conglomerate had about $1 trillion in assets prior to the crisis but lost a total of $99.3

billion in the aftermath. AIG was deeply interconnected in not only the US economy but also

dealt in the finances of other countries as well. It serviced over 88 million customers in 130

countries and employed more than 64,000 people in 90 countries (McDonald and Paulson, What

Went Wrong at AIG? 2015). The United States Federal Reserve, Federal Reserve of New York

and the United States Treasury all understood the importance of keeping the giant afloat and so

stepped in with an initial 2 year emergency bailout of $85 billion. AIG was providing over $400

billion worth of credit protection to banks and other clients around the world through its credit

default swap business. In addition, AIG was also a major participant in foreign exchange and

interest rate markets (American International Group Inc., and Subsidiaries 2009). The bailout

was crucial in keeping the ―too big to fail‖ corporation from going under and causing

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reverberations throughout the economy. The bailout did not stop at $85 billion. It actually grew

to an eventual amount of $182 billion in response to the rising credit needs of AIG. The one

caveat of this assistance was that A.I.G had to hand over 80 percent of its equity to the US

government through its perpetual preferred shares. In 2012, AIG was able to repay back the

entire loan albeit some compromises and cancellations, and transition back from being majority

owned by the US government to being privately owned. The US government also gained in

terms of interest payments accrued on the loan totaling $197 billion which was a gain of $15

billion.

A.I.G’s major involvement in the financial crisis became apparent when it was no longer

able to honor the CDSs (Credit Default Swaps) it had sold to banks. Shalendra Sharma (2013)

argues that A.I.G’s downfall was a result of its substantial one sided exposure to default risk

through the 100 percent selling of CDSs but zero purchasing of CDSs to hedge against any future

default risks it might incur. In other words, A.I.G was undercapitalized because it was overly--

optimistic that the underlying assets, particularly the mortgage backed securities (MBSs) it was

issuing CDSs for, would not default in the long-term. It therefore did not protect itself from that

potential risk. When the housing bubble burst, what followed almost immediately was the rapid

increase in defaults on MBSs across the board. Such a dramatic and sudden outcome resulted in

A.I.G having to make huge pay outs to honor the CDSs it sold to banks. This pushed the

insurance giant to near bankruptcy, and if it were not for the swift response of the US

government in the form of the $85 billion bailout, A.I.G would have surely collapsed. The focus

of this paper is to highlight AIG’s mismanagement of its finances through its CDS and securities

lending business. This paper is divided into Section 1: Background of A.I.G’s CDS and

Securities lending business, Section 2: When and How both these lines of business began failing.

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Section 3:the types of government bailout and how it improved AIG’s finances. And finally the

conclusion in which will be discussed a few important insights that AIG’s poor finances brought

to the forefront.

1. BACKGROUND

AIG operates through four main lines of business: General Insurance, Life Insurance and

Retirement, Asset Management and Financial Services. During the 2008 financial crisis, all four

lines of business incurred significant losses; however the majority of those losses stemmed from

AIG’s Life Insurance and Financial Services business lines which dealt specifically in securities

lending and credit protection issuance through CDS’s. Two specific subsidiaries were

responsible for the failed investments: (i) AIG GSL (Global Securities Lending) which was a

noninsurance subsidiary that sold AIG insurance companies’ corporate bonds to banks,

brokerage firms and others in exchange for cash collateral and (ii) AIGFP (Financial Products),

the London based and Joseph Cassano-led subsidiary that was responsible for the issuing of

CDS’s on multi-sector CDO’s (Collateralized Debt Obligations) backed by subprime mortgage

loans that defaulted leading up to the crisis.

Table 1, AIG Financial Indicators - Source: (McDonald and Paulson, AIG in Hindsight 2015)

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Table 1 shows that AIG was recording significant revenues in all its four businesses in

the years leading up to 2007. However, by the fourth quarter of 2007, there was some cause for

concern as AIG’s first substantial losses were being realized in its CDS and Financial Services

line of business. By 2008, all four lines of businesses were recording losses numbering in the

billions with Life Insurance and Financial Services recording an average of $40 billion each in

losses.

1.1 SECURITIES LENDING MISMANAGEMENT

During the 2008 crisis, AIG lost $21 billion from its Securities lending business. To

provide some context, a Securities lending transaction is one where the issuing party exchanges

assets in the form of securities such as corporate bonds for cash collateral. The security issuer

invests the cash collateral and earns returns, less rebates paid to its securities borrowers in the

form of interest or coupon payments. Problems may arise when many securities holders

simultaneously end their transactions quickly and demand back their cash collateral, which the

securities issuer may not have at that point in time.

AIG GSL lent securities out on behalf of AIG’s insurance companies. These life

insurance subsidiaries include ALICO, VALIC, AIG Annuity, American General Life and

SunAmerica Life. All the aforementioned subsidiaries received the largest capital infusions,

totaling in the billions, from the bailout with the exception of ALICO which received $470

million. ALICO however was sold to MetLife in 2010 for $15.5 billion in cash and MetLife

stock and the proceeds went directly to pay off the Federal Reserve of New York loan.

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AIG GSL’s main function was to invest the cash collateral into other securities that

could earn high yields, usually long-term securities, and use the proceeds to pay off any

outstanding rebates to honor its securities debt obligation. Any remaining portions were then

split equally between AIG GSL and the insurance companies. The magnitude and rapidity at

which AIG’s securities lending business grew can be seen in the amount of securities lending

outstanding it had in Q3 of 2003 which was $30 billion, to how much it was in Q3 of 2007,

which was $88.4 billion, almost a 200 percent increase. Furthermore, AIG insurance companies

lent out more than 15 percent of its domestic life insurance assets, compared to MetLife, the

company that acquired AIG’s ALICO subsidiary, which never lent out more than 10 percent.

And finally, AIG GSL’s cash collateral investment strategy went against what was considered by

Risk Management Association (2007) as securities lenders average investment ratio, which was

on average, 33 percent of cash collateral were invested into mortgage-backed securities, asset

backed securities and collateralized debt obligations, while the remainder of 42 percent was

invested in corporate bonds and 25 percent in cash and short-term investments. AIG GSL’s

investment ratio was 65 percent for MBS, ABS and CDO’s, 19 percent for corporate bonds ansd

16 percent for cash short-term investments. The rapidity which AIG’ s securities lending

business grew and its heavy betting on mortgage related financial products set the tone for its

financial collapse which will be discussed in Section 2.

1.2 CREDIT DEFAULT SWAP PORTFOLIO

AIG’s London based financial services subsidiary AIGFP receives no mercy in being

criticized by former AIG Chairman and CEO Edward Liddy as being the main reason that AIG

recorded substantial unrealized market valuations on their CDS portfolio. AIGFP was created in

1987 but only began selling CDS’s in 1998 to other financial institutions to protect against the

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default of certain securities. By the end of December, 2007, AIG had written CDS’s with a total

notional value of $527 billion. Of this amount, $441 billion were written by AIGFP. The CDS’s

were separated as such: Corporate Loans ($230 billion), Prime residential mortgages ($149

billion), Corporate debt/Collateralized loan obligations ($70 billion), and multi-sector CDO’s

($78 billion). Collateralized debt obligations are financial securities backed by an underlying

stream of debt payments, which can be from mortgages, home equity loans, credit card loans,

auto loans, and other sources. The payments on this security are then divided into tranches, so

that junior tranches will bear losses before senior tranches do—allowing the senior tranches to

receive a higher credit rating (McDonald and Paulson, AIG in Hindsight 2015). The multi-sector

CDO’s on AIGFP’s CDS portfolio proved to be the most troublesome because of its deep ties to

the residential, commercial as well as prime and subprime housing market. The multi-sector

CDO’s that AIG had written CDS’s for were backed by a substantial share of mortgage backed

securities. Importantly, AIG had not offsetting position to hedge against the occurrence of credit

events which would obligate it to pay the insurance as promised by its CDS’s. In other words,

AIG had a one-way bet on real estate. In contrast market-making financial firms usually seek to

hedge any directional exposure so that they make profits regardless of whether the real value of

the underlying asset they have invested in rises or falls. As AIG’s securities lending business was

setting itself up for failure by betting too heavily in the housing market, so was AIGFP’s CDS

trading strategy.

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2. THE CRASH AND THE ENSUING FAILURE

2.1 SECURITIES LENDING GOES DOWNHIL

As stated in Section 1.2, AIG GSL had placed heavy bets in the Housing market by

investing 65 percent of its cash collateral into mortgage backed securities; asset backed securities

and collateralized debt obligations. Two important things worsened AIG GSL’s lending

situation: firstly, it was issuing short term life insurance securities that had maturities of one

month but was investing the cash collateral into long term and highly illiquid assets. And

secondly, before AIG was rescued on September, 2008, major credit rating agencies such as

Standard & Poor’s, Moody’s, and Fitch all lowered its credit rating which caused a ―bank run‖

scenario in which security borrowers/holders started demanding their cash collateral back

(McDonald and Paulson, AIG in Hindsight 2015).

One implication of the two above situations is that AIG was already in a fragile position

to pay back its short-term securities borrowers the cash collateral owed to them because of the

fact that it was investing in long term illiquid assets. To offset this fragility and risk, AIG GSL

would just issue more securities and use the proceeds/cash collateral to pay back any cash

collateral and coupon payments owing. The other implication is that when the housing market

crashed, all the returns expected from the mortgage backed securities and CDO’s stopped, which

meant that AIG GSL had to halt any debt servicing to its securities holders as well as proceeds

payments to the insurance companies it was working for. AIG’s securities lending counterparties

demanded the return of $24 billion in cash collateral between September 12 and September 30,

2008. Ultimately, AIG reported losses from securities lending in excess of $20 billion in 2008.

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2.2 CREDIT DEFAULT SWAP TRAP

AIGFP began issuing multi-sector CDS’s in 2003 back when the subsidiary was AAA

rated. By December 2005, it had halted its CDS exposure but by that time it had already about

$80 billion of commitments (Naifer 2014).

Table 2, AIG CDS Counterparties, Source: (McDonald and Paulson, AIG in Hindsight 2015)

For its multisector CDS’s, AIG had 21 counterparties. About 9 of the 21 had collateral calls in

excess of $500 million, and 6 of those 9, namely Goldman Sachs, Societe Generale, Merrill,

UBS, DZ Bank and Rabo Bank, had a difference greater than $500 million between the collateral

they were requesting and the amount AIG had posted. In Table 2 these collateral shortfalls for

the six largest counterparties to AIG’s multisector credit default swaps are shown as of

September 16, 2008, furthermore, it also shows the shortfall relative to shareholder equity for

each counterparty. Of the $11.4 billion that AIG owed to counterparties on its credit default

swaps on September 16, 2008, these six banks accounted for $10 billion.

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3. GOVERNMENT BAILOUT

AIG’s rescue appeared on September, 2008 in the form of a $85 billion two-year

emergency loan. Almost immediately AIG injected the much needed capital infusions into both

its CDS line of business and securities lending. In Table 3 below, 11 of AIG’s life insurance

companies received capital infusions which allowed it to pay back the cash collateral owing to

its securities borrowers. VALIC, AIG Annuity, American General Life and SunAmerica Life all

received capital infusions over $1 billion with the highest being $6 billion. These were the

companies that sold the most securities and whose securities credit ratings were downgraded the

most (Gethard 2008).

Table 3, AIG Life Insurance Subsidiaries, Source: (McDonald and Paulson, AIG in Hindsight 2015)

The remainder of the bailout was used to provide additional collateral to AIG’s CDS

trading partners. Now faced with the problem of repaying the loan, AIG put together its best and

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brightest for the sole purpose of divestiture and restructuring (Peirce 2014). Despite the $85

billion relief, AIG was still struggling to address its two liquidity issues: the multi-sector CDO’s

and securities lending (McDonald and Paulson, What Went Wrong at AIG? 2015). These issues

combined with the state of the economy plus the distrust of banks and investors in AIG, meant

that it was going to be difficult for the insurance giant to come up with the loan repayment in the

specified time period. Thus on November 10th

, 2008, The New York Federal Reserve introduced

a comprehensive plan that would allow more flexibility and time to AIG to repay its loan as well

as receive more credit to bring it back to its feet. Two important provisions of the plan came in

the form of Special Purpose Vehicles called Maiden Lane II and Maiden Lane III. In addition,

the US Treasury also gave assistance in the form of the Temporary Assistance Relief Program

(TARP).

MAIDEN LANE II & MAIDEN LANE III

Both ML II and ML III were funded primarily through the government with a very small

contribution from AIG. ML II would acquire all of AIG’s securities lending assets so that AIG

GSL would be able to repay all the cash collateral back to its counterparties. ML III was tasked

with acquiring the multi-sector CDO’s guaranteed by AIGFP’s CDS’s. The main feature of these

provisions was that any market value appreciations in the securities would go to the US

government with only a small portion being held by AIG (American International Group Inc.,

and Subsidiaries 2009).

TARP

The purpose of the program was to purchase 80 percent of AIG’s equity by purchasing

$40 billion worth of perpetual preferred shares that paid a 10 percent coupon rate including

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dividends. The proceeds of the shares sale went to paying down the US Government’s loan

(Davidson 2008).

CONCLUSION

The near demise of AIG brings to the forefront the discussion of just how much

regulation financial institutions, which are considered ―too big to fail‖, should be subject to. The

US Government bailout to AIG is considered the largest ever in US history. The Dodd-Frank

Wall Street and Consumer Protection Act signed into federal law in 2010 by President Obama

bring forth greater regulation of credit rating agencies, improvements to the asset-backed

securitization process as well as greater transparency and accountability from Wall Street.

AIG’s speculative and one-sided finance strategy was reckless and irresponsible. As this

paper has demonstrated, the primary reason for AIG’s near demise is not attributed to the

securities lending and credit default swap process, although it does require improvements, but

more rather it is attributed to AIG’s over-optimism and reckless risk taking without hedging

those risks.

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