What happened to AIG and why did it fail?

AIG and its subsequent failure are one of, if not the most well-known company failures in financial history. Of the more recent bankruptcies filed for companies like Enron and Worldcom, the effects and unforeseeable consequences of the failure of a company like AIG would be much more widespread and felt by many more Americans at the lay person level. AIG is primarily an insurance company that sells Property casualty, life, and travel insurance to customers the world over. However, there was another arm to the company known as AIG FP or American International Group Financial Products division. This division dealt in the financial markets as more than an intermediary, but actually as a trader.

The most publicized and understood version of what happened at AIG is that the federal government bailed them out. The term bailout has come to be understood as a final resort transaction with no official means of repayment or penalty. However, this simply is not what happened. The truth of the matter is that AIG deviated from its core business of insurance and the profit margins that come with the premium to risk spread. A great majority of the equity that had existed in AIG came from the sale of credit default swap contracts through the financial products division. These contracts had implicit assumptions of quality and of financial stability. These stipulations in the contracts warranted that if the credit rating of AIG fell, the risk of the counterparties went up significantly and that there must be compensation for this. The basic product underlying all of these contracts was the ever popularized Asset Backed Security, or, to be more specific, the ABS CDO or collateralized debt obligation. As almost any American would be able to tell you, at this time in 2008, these asset backed securities were based on defaulting mortgages. Credit default swaps can be lucrative when defaults are low, however, the agreements can quickly cost a company billions if defaults increase sharply.

Some of the most interesting information of the entire financial crisis comes from AIG and more specifically from the Financial Products Division. This division was an almost infinitesimal piece of AIG in terms of real estate occupied and employees present. However, it was out of this small setting that Joseph Cassano and his employees issued credit default swaps on over $441 billion in securities that were originally rated AAA. This refers to the tranches that were created for the asset backed securities and more specifically the senior tranche, or least risky. The problem here is that when the company reorganized its tranches to be able to sell more of the repackaged security, they simply upgraded the Mezzanine tranche to Senior, so as to increase the credit worthiness of the security that they were selling. Of the $441 billion of securities traded by the financial products division, over $57.8 billion were based in subprime loans (Pittman).

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In 2008, this is exactly what happened to AIG and their Financial Products division. In 2007, AIG FP lost more than $10 billion and by the end of the second quarter of 2008 they had lost an even more impressive $17 billion in that division alone. This investment portfolio was significantly more risk seeking than any of the other investment portfolios of AIG, however, these were the most toxic at the time. Due to the overwhelming losses to AIG’s capital reserves, they began to be the subjects of increased scrutiny by the SEC as well as credit rating agencies such as Moody’s and Standard & Poors. The rating agencies quickly downgraded the company and its Credit Rating (S&P), causing AIG to have to fulfill the requirements of their Credit Default Swap contracts and costing the company over $13 billion dollars of its capital reserves.

After the requirement to pay, the company was seen as almost being insolvent. The limits of their liquidity crisis were fast approaching bankruptcy. This is where the story begins for most people, and where the term Government Bailout comes into play. After the downgrading of their credit and the falling of AIG stock price from a 12 month average of approximately $70/share to $1.25 on September 14, 2008, the federal government attempted to get a private loan for AIG to stay liquid and above water during the financial crisis at one of its worst moments. JP Morgan Chase and Goldman Sachs were called upon to try to finance the deal. This was unsuccessful, but the government wanted to find out if there would be widespread effects to the failure of a corporate giant such as AIG. Morgan Stanley was hired to assess the systematic risks associated with failure of such a large company. Not only did AIG effect the lives of more common Americans than companies such as Goldman Sachs, but the counterparties involved in their Credit Default Swap contracts stood to lose upwards of $180 billion dollars if the company was to go under. Below is the highly sought after schedule A, or list of derivative contracts.

Schedule A (Derivative and off balance sheet instruments)

After all was said and done, the company entered into a 24 month secured credit facility that AIG could access up to $85 billion from. The loan was secured by AIG’s assets including the non-regulated Financial Products division. It came at a cost of LIBOR +8.5% to AIG (Gretchen Morgensen). The federal government received stock warrants for 79.9% of the company as a result of this deal and later increased its ownership stake to approximately 91.2% after purchasing a second round of $40 billion with the Troubled Asset Relief Program. This is seen as the government bailout.

In the most simplistic sense, the government took action that it had to to keep the financial system from suffering massive losses to AIG and its counterparties in their Credit Default Swaps as well as the millions of other Americans that are affected by AIG and its subsidiaries on a daily basis. This is why AIG was given the attention and capital that it so desperately required and companies such as Goldman Sachs were allowed to fail.

Was it Preventable and How?

The AIG liquidity crisis and the numerous U.S. market failures can be attributed to the lack of affective government Regulation. Over the past few years regulation of Financial Institutions has been highlighted by the media and congressional action. This highly debated issue has been a major concern for decades as the financial industry continues to change and new financial products become created. The most recent market failure is mostly due to the expanding derivatives market and its role in the failure of numerous financial institutions including AIG. Past regulation legislation has clearly failed in properly regulating the new derivatives market and preventing firms from harming the overall U.S. market. New regulation is now in the process of being created to update the current Regulatory institutions so that they are able to accommodate the new financial products and protect the U.S. market / economy.

The financial industry has drastically changed over the past few decades. With the creation of computer trading, complex models and derivatives the job of regulating financial institutions has become far more complex. One of the first government actions to control these institutions from potentially harming the overall economy was the creation of the Glass-Steagall Act of 1932. This legislation was aimed at protecting depositor’s money and limiting the ways in which banks could invest their deposits. By eliminating full service – Universal banking the government believed that it could prevent another financial catastrophe after the great depression. Glass-Steagall however was repealed in 1999 and was followed by many de-regulatory actions. This era of de-regulation is what many think allowed the growth of reckless trading and speculative betting since government agencies were powerless to stop such actions.

The failure of AIG is what really brought light towards the problems of government regulatory agencies. After the bailout people began to search for who was to blame for the companies collapse and the adverse affects it had on the economy. Since AIG is such a large corporation it was not clear initially who or what department was responsible for the extreme losses. The sub division called AIG Financial Products was found to be the main culprit for the collapse. This department was engaging in credit default swaps and risky derivatives trading. Since the company operated similar to a thrift the “Federal Office of Thrift Supervision” was viewed as the primary regulating agency. This agency was also responsible for regulating other failures such as Indymac and Washington Mutual. Once AIG began to fail extreme amount of pressure were put towards reforming the regulation system, Ben Bernake said, “AIG exploited a huge gap in the regulatory system”.

Since the bailout the President and Congress have passed some legislation in hopes of preventing similar failures in the future. The Dodd-Frank act of 2010 is the main piece of regulatory legistation reform that has been passed since the financial collapse. In this act past laws including ones from the Glass-Steagall act are reinstated and combined with new reform in order to better regulate modern day financial companies. Included in Dodd-Frank is a section eliminating the Federal Office of Thrift Supervision, which was powerless to control and monitor large corporations like AIG. Many people compare AIG to their regulators as ” A super heavyweight boxer against a 13 year old boy”. In order to give regulators more power the Dodd-Frank act created two more agencies, The Financial Stability Oversight Council and the Office of Financial Research. These 2 agencies were given the responsibilities from the previous office of thrift supervision along with other failed regulatory offices. The main change in regulation power came from the new ability for the regulators to monitor ANY risks to the U.S. financial system and the power to consult State regulatory offices overseeing insurance companies. Many other proposed laws have been discussed to further the financial security of the U.S. economy. One such rule is called the “Volcker Rule” which proposes that depository institutions should be prohibited from proprietary trading, much like in Glass-Steagall. As the economy continues to stabilize and grow regulatory legislation such as the Dodd-Frank act will become extremely important in order to prevent another great failure like AIG. The struggle between the free market economy and government regulation will continue to be a major source of debate for many years to come.

Risk Management Errors

We don’t live in a world where conventional risk management textbooks prepare us. Not one firm forecast the true impact of the economic crisis and its consequences. These consequences continue to take business academics and tenured economist by surprise. The banks have multiplied the crisis because of the so-called risk management models, which increased their exposure to risk instead of limiting it and rendered the global economic system more unstable than ever. In the late 2000’s many firms learned that instead of trying to anticipate low-probability, high-impact events, they should reduce their vulnerability to them.

In August 2007 during a conference call with investors, many high-ranking AIG officials stressed the near zero risk probability of credit-default swaps. This was the first in many risk management errors. AIG’s chief risk officer was quoted as saying “the risk actually taken is very modest and remote.” A credit default swap is a bilateral contract between the buyer and seller of protection. The CDS refers to a “reference entity” or “reference obligor”, usually a corporation or government. The reference entity is not a party to the contract. The protection buyer makes quarterly premium payments, the “spread”, to the protection seller. AIG did not understand the risk involved in these credit default swaps and that misunderstanding was largely in part to CEO Martin Sullivan. He was quoted as saying “”It is hard for us with, and without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions…. We see no issues at all emerging. We see no dollar of loss associated with any of that business.” The lack of knowledge and the massive amount of confidence lead AIG down the path to destruction.

In November of 2007, AIG reported a $352 million unrealized loss from its credit-default swap portfolio, but to keep investors happy AIG was quoted as saying it’s “highly unlikely” that they would lose any money one the deals. Moving on to December AIG disclosed 1.10 billion in further unrealized losses to its swap portfolio, bring the grad total to 1.5 billion in loses. Throughout a conference call with investors, CEO Martin Sullivan explains that the probability that AIG’s credit-default swap portfolio will sustain an economic loss is close to zero. AIG’s thought its risk-modeling system had proven “very reliable,” Sullivan said, and since the transactions were so “conservatively structured,” AIG had “a very high level of comfort” with its risk models. Moving on to February, AIG set its 2007 total realized loses to 11.5 billion. AIG also disclosed that I had posed 5.3 billion in collateral as well. This was the first time the company had disclosed the amount of money in collateral.

In the late months of 2008, the government pledged 115 billion to AIG in bailout funds to try to hedge the crisis. The US board of Governors and Treasury announced the restructuring of the government’s financial support to AIG. This restructuring included a treasury purchase of AIG preferred shares through the TARP program. This program reduced the 85 billion dollars in AIG revolving credit to 60 billion and created two limited liability companies. In the late months of 2008 to 2010 the powerhouse fell apart.

Who was responsible?

American International Group’s monumental collapse like any other disaster derived at first from ambition. Then, in turn, this same ambition begot greed. In retrospect, looking back on the AIG’s collapse, we can say there were many individuals that were responsible for the devastating disaster in the wake of the economic crisis of 2008. First, we must start from the top of the organization and work our way through the corporate hierarchy to lay out the appropriate blame to the responsible parties.

Starting in 1987, when the Financial Products division within AIG was created by a joint venture between Howard Sosin and the AIG CEO, Hank Greenberg. The tumultuous relationship built on greed was doomed from the beginning as the ambitious Sosin only needed Greenberg’s financial and brand backing whereas Greenberg’s leadership style was with an iron fist. Lacking the trust in Sosin, Greenberg eventually did enough micro-managing to get Sosin to leave the company on bad terms and eventually replaced him with one of his protégés, Joseph Cassano. Under Sosin, Financial Products was a large profit, no material loss division within AIG that generated millions in profits during his tenure. In contrast, Cassano’s tenure was an aggressive and risky operation that he deemed a ” no lose situation” when in fact it eventually led to AIG’s collapse and a subsequent bailout by the federal government. Under his control, the Financial Products division indulged in extensive selling of credit default swaps on mortagages which at its height AIG had guaranteed some $440 billion in obligations. In all, Joseph Cassano and the lack of corporate governance within AIG allowed him to single handedly bring a company that was once looked at as one of the safest and secure institutions to place your money in as one the biggest failures in the modern day economy.

Ripple effect on the market/economy?

In the wake of the financial crisis in 2008, the collapse of such a company with the size and stature of AIG would have been catastrophic to the entire financial world as we know it. Most systematically its downfall would have led to the eventual collapse of other banks with it because subprime issues in the underlying credit default swaps AIG was selling. In theory, every bank would have been able to look at their balance sheets and note that they were suffering from the same type of subprime issues that would have destroyed AIG had there not been a bailout by the federal government. Ultimately, the risky debt obligations that the credit default swaps were based on were being defaulted at a high rate and there was no way possible for AIG at the end of the day to honor all of its obligations to speculators and banks alike who purchased these financial instruments as forms of insurance against default.

On another note, another economic industry that suffered was the travel industry. In the wake of the government bailout of AIG, executives were spotted relaxing in a luxurious resort in California. Because of this, AIG received bad press from the media and taxpayers, alike. Other companies took note of this bad press and immediately cancelled any type of conferences in exotic and expensive locations in order to avoid that same bad press.

Sources

Mark Pittman (2008-09-29). “HYPERLINK “http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTzTYtlNHSG8″Goldman, Merrill Collect Billions After FedHYPERLINK “http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTzTYtlNHSG8″‘HYPERLINK “http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTzTYtlNHSG8″s AIG Bailout LoansHYPERLINK “http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTzTYtlNHSG8″”. Bloomberg News. http://www.bloomberg.com/apps/news?pid=newsarchiveHYPERLINK “http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTzTYtlNHSG8″&HYPERLINK “http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTzTYtlNHSG8″sid=aTzTYtlNHSG8. Retrieved 2011-04-08.

“HYPERLINK “http://marketplace.news.yahoo.net/pressrelease.aspx?id=96684″SHYPERLINK “http://marketplace.news.yahoo.net/pressrelease.aspx?id=96684″&HYPERLINK “http://marketplace.news.yahoo.net/pressrelease.aspx?id=96684″P: Ratings on American International Group Lowered and Kept on CreditWatch NegativeHYPERLINK “http://marketplace.news.yahoo.net/pressrelease.aspx?id=96684″”. Yahoo News. 2008-09-16. http://marketplace.news.yahoo.net/pressrelease.aspx?id=96684. Retrieved 2011-04-08

Gretchen Morgensen; Mary Williams Walsh (2008-09-14). “HYPERLINK “http://www.nytimes.com/2008/09/15/business/15aig.html?hp”Rush Is On to Prevent AIG From FailingHYPERLINK “http://www.nytimes.com/2008/09/15/business/15aig.html?hp””. The New York Times. http://www.nytimes.com/2008/09/15/business/15aig.html?hp. Retrieved 2011-04-08