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The Causes And Effects Of Aigs Collapse Finance Essay

The Vanguard Group, among many other mutual fund companies, has been wary of investing in controversial organizations. In recent years, there have been many companies that have come under fire from public and governmental authorities for poor or fraudulent business practices; as a result of the companies’ mismanagement, the investors have lost the assets they’ve placed within those companies. We were posed the question “How can Vanguard detect and avoid investing in these contentious organizations?” In order to find the answer, we were asked to select and analyze a company that has gained notoriety for its excessive losses; our choice was the American International Group (AIG). This purpose of this report is to outline AIG’s situation and synthesize the relevant information to support the Vanguard Group’s future investment decisions. The report details the events and decisions leading up to the collapse, the effects of the collapse and the subsequent bailout, and the consequences that follow AIG into the present day; we utilized within perspectives of workers within AIG and outside analysts as our sources. While this case analysis contains valid information from scholarly and professional sources, it is not heavy in the area of statistical data; we feel an excessive amount of statistics and numerical figures takes focus away from the study of the substantial management and regulatory decisions involved in the matter.

By all accounts, the major downfall of AIG was due to its use of credit default swaps (CDS). Credit default swaps are a type of financial instrument that derive value from the risk of a bond, loan, or other financial asset; since a ruling by Congress in 2000, these derivatives have been largely unregulated. In his research, Harrington (2009) stated that AIG Financial Products was one of the many investment firms and banks involved with CDS that quickly grew into a troublesome venture. According to Sjostrom (2009), AIG’s portfolio consisted of $526 billion in credit default swaps by the end of the 2007. In the scholarly journal, Sjostrom described AIG’s involvement with a combination of collateralized debt obligations (CDOs), which primary assets ranged from asset and mortgage backed securities to corporate loans and bonds. These CDOs had an assortment of credit ratings that were valued from AAA to BB. AIG held $61.4 billion on CDOs on mortgage backed securities alone; this included higher risk or subprime loans. In its 2007 annual report, AIG began to acknowledge the credit quality decline to its high risk borrowers. As the borrowers began to default on these loans, in due course, led to reductions in value of AIG Financial Products’ CDS portfolio totaling $31.1 billion in 2007 and until September 2008.

In late 2007, it was becoming clear to investors and federal agencies that AIG had sold insurance on financial assets without setting aside reserves to pay out claims. AIG’s auditors, PricewaterhouseCoopers, informed AIG that there was uncertainty in the value of the CDS presented a significant weak point in the AIG’s controls. In an interview with Loomis (2010), former AIG chief lawyer Anastasia Kelly claimed that the company attempted to find reference prices for the CDOs to determine the value of the CDS and remedy the weaknesses; she claimed this was a significant challenge because were no markets to examine for reference. AIG’s securities lending program was becoming a major problem for the company. AIG Investments, who maintained the lending program, loaned securities to various financial institutions in exchange for cash placed by the borrower. AIG Investments in turn, invested the monetary deposit in securities in hopes to earn a return for reward for lending securities. News spread about AIG’s reductions, so borrowers became concerned about money they had with AIG Investment. As a result, lent securities were returned and asked for their collateral back. For many, it was unfortunate that there was a massive amount of cash invested by AIG Investment in mortgage-backed securities that had dived in value and its ease of resale. Because of the de-valuation, the program lacked enough funds to suit obligations. Amidst all of this, AIG transferred billions of dollars in cash and paid it out to the borrowers in short notice.

The situation continued into 2008, while the economy spiraled into recession; the CDS were becoming more volatile and there was no solution in sight, beyond bankruptcy. AIG’s CEO at the time, Bob Willumstad, contacted Timothy Geithner of the New York Federal Reserve and discussed possible government intervention and assistance for AIG. According to Pleven (2009), a declaration of bankruptcy by AIG would have meant losing 74 million policy holders, which would have forced the company to replace insurance contracts during a time of recession. According to Dinallo (2010), the Federal Reserve had $76 billion at risk with AIG; Timothy Geithner claimed America’s financial system risked complete collapse if AIG were to fail. In September 2008, AIG’s credit was downgraded and AIG had become unstable; in order to save the company and the assets of the United States, the Federal Reserve extended an $85 billion credit line to AIG.

AIG had been granted a bailout by the United States government. A bailout is a federal act of giving capital to a company to prevent its financial collapse; it is not a mercy granted lightly, but one given to companies that are thoroughly entwined with the financial structure of the entire country. According to Gross (2010), a combination of federal agencies provided $182 billion to aid in AIG’s recovery; $40 billion consisted of tax payer funds funneled from the Treasury Department. The Federal Reserve then created two investment vehicles to remove volatile and insolvent assets from AIG’s balance sheets; the first investment bought $20.8 billion of mortgage-backed securities at half the price, while the second investment bought a portfolio of collateralized debt obligations from former AIG customers. AIG had to sell two of its two insurance units to the Federal Reserve in order to generate $52 billion to pay its creditors. Damage was not localized to its finances alone; AIG suffered heavy blow to its credibility, reflected in a 97% drop in its stock prices in 2008 and the public outrage to its management of bailout funds, which included the controversial payment of executive bonuses. According to Son (2010), AIG continues to report losses to the present day. While that would appear discouraging, AIG losses are a result of a stern commitment to paying off its creditors; examination of the company on a quarter by quarter basis in 2009 even reveals a rise in insurance sales for three consecutive quarters. The market slowly moves towards recovery and AIG carries on, surviving and attempting to recover in financial matters and in face.

TABLE 1. Breakdown of American International Group's Bailout as of November 16, 2009

Program

Committed

Billions of US Dollars

Invested

Billions of US Dollars

Description

Asset purchases

a)Credit debt obligation

b) Mortgage-backed securities purchases

52.5

Composed of

30

+

22.5

38.6

Composed of

22.9

+

15.7

$30 billion from New York Fed for purchasing clients’ collateralized debt obligations and $22.5 billion for purchasing clients’ mortgage-backed securities.

Bridge loan

25

44

Loan to be reduced from $60 billion to $25 billion as government takes shares in AIG subsidiaries and receives cash flows from life insurance policies. AIG must pay 3% plus 3-month Libor rate to government in interest on the 5-year loan.

Government stakes in subsidiaries

26

0

Government to hold preferred interest in entities holding all the common stock of American Life Insurance Company and American International Assurance Company, two life insurance holding company subsidiaries of AIG.

TARP investment

70

44.8

$40 billion in preferred shares were converted to so-called non-cumulative shares that more closely resemble common stock. Treasury later offered another $30 billion in preferred shares for up to 5 years, in return for a 10% dividend.

Other

8.5

0

Government giving AIG $8.5 billion and, in exchange, is receiving cash streams from the premiums of blocks of life insurance policies.

AIG total

182

127.4

Source: From “CNNMoney.com's bailout tracker,” November 16, 2009, cnn.com. Retrieved April 24, 2010.

Considerations for Investment

(Major Revision incoming)

When examining a company for investment, investors must consider the level of regulation a company is under. The main consideration that was overlooked by investors in the AIG case was the under-regulation of its division. Dinallo (2010) explained that under federal law, AIG was given the right to select its own regulator for its parent company and its noninsurance products. If we can be sure that the regulator is trustworthy and efficient, we can spend less time researching company beyond the returns it can bring. We can also evaluate many companies at once using the quality of the regulator as a starting point. However, relying solely on the regulator is the equivalent of putting all our eggs in one basket. Since we will not conduct an intensive research regiment, we will not know much about the company itself.

Investors should also examine the company’s financing practices. For AIG, they were financed by the use of CDS as collateral, high risk financial instruments that were not only difficult to value, but also backed by highly insufficient reserves. (Advantage) Simple financial rules are in effect for this examination; the more debt you use to finance your company, the more return there is for the investors. There is a peak to this rule and we can determine that with more research. Financing practices also reveal much about the company’s philosophy; conservative versus expansive, high risk high yield, low risk low yield. (Disadvantage) Preoccupation with financial practices could jade our decisions. If we are too concerned with the use of debt, we could lose out on potentially high returns. (More to be added)

Rather than examining specific areas for red flags, investors could also conduct a complete investigation on a company to determine investment eligibility. Complete examination of company history, corporate structure, practices, and federal and public relations would be useful for any investor concerned with a company’s reputation and risk for controversy. (Advantage) We’ll know the company in and out. Vanguard can be confident in its decisions and predict the actions of the company it invests in. (Disadvantage) The time spent researching the company could be a major time waste, potential investment may decrease in value. While we could focus on multiple companies, the in-depth research required reduces the amount of companies we examine at any one time.

Conclusion

The crisis at AIG has many lessons to teach investors. AIG used high risk items as collateral when they couldn’t back up the value with reserves. When creditors came for their money, they couldn’t afford to pay. As a consequence, AIG had to be bailed out. They suffered major financial losses that continue to this day, along with a stained reputation that taint future dealings; despite this, they continue to persevere. Investors must learn to research the companies they intend to invest in. We recommend that Vanguard take extra precaution and assign teams to research companies in an in-depth and comprehensive manner. (Benefit)If Vanguard takes this recommendation seriously, it will avoid potentially controversial companies and protect its investments.

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