Describe AIG’s activities before the financial crisis. Describe AIG FP’s activit

Question

Describe AIG’s activities before the financial crisis.

Describe AIG FP’s activities before the financial crisis.

What is a CDS and how does it work? What is the risk to AIG from selling CDSs?

What is counterparty risk and why was AIG an attractive trading partner (prior to 2005)?

Why did AIG believe that its investment in CDS with subprime collateral was relatively safe?

What happened to AIG in 2005?

What happened to AIG in 2008?

Why did the Federal Reserve bail out AIG in 2008?

What do you see as the major causes of the problems at AIG?

Do you think the bailout was a good idea?  

Explanation / Answer

American International Group, Inc., also known as AIG, is an American multinational finance and insurance corporation with operations in more than 80 countries and jurisdictions. As of December 31, 2017, AIG companies employed 49,800 people. The company operates through three core businesses: General Insurance, Life & Retirement, and a standalone technology-enabled subsidiary. General Insurance includes Commercial, Personal Insurance, U.S. and International field operations. Life & Retirement includes Group Retirement, Individual Retirement, Life, and Institutional Markets.

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. A credit default swap is, in effect, insurance against non-payment. Through a CDS, the buyer can mitigate the risk of their investment by shifting all or a portion of that risk onto an insurance company or other CDS seller in exchange for a periodic fee. In this way, the buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the debt security. For example, the buyer of a credit default swap will be entitled to the par value of the contract by the seller of the swap, should the issuer default on payments.

While the general view of the AIG collapse is that it was a function of collapse of the mortgage-backed securities market, in truth it was a direct consequence of AIG’s CDS exposure. Four weeks ago, AIG was a triple-A rated insurance company. Today, it is being dismantled. If AIG had large investment losses in mortgage-backed securities, but no CDS exposure, AIG would still be in business today.

Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk is a risk to both parties and should be considered when evaluating a contract. In most financial contracts, counterparty risk is also known as default risk.

Counterparty risk gained visibility in the wake of the global financial crisis. AIG famously leveraged its AAA credit rating to sell (write) credit default swaps (CDS) to counterparties who wanted default protection (in many cases, on CDO tranches). When AIG could not post additional collateral and was required to provide funds to counterparties in the face of deteriorating reference obligations, the U.S. government bailed them out.

In 2005, AIG became embroiled in a series of fraud investigations conducted by the Securities and Exchange Commission, U.S. Justice Department, and New York State Attorney General's Office. Greenberg was ousted amid an accounting scandal in February 2005. The New York Attorney General's investigation led to a $1.6 billion fine for AIG and criminal charges for some of its executives. Martin J. Sullivan became CEO of the company in 2005.

The collapse and near-failure of insurance giant American International Group (AIG) was a major moment in the recent financial crisis. AIG, a global company with about $1 trillion in assets prior to the crisis, lost $99.2 billion in 2008. On September 16 of that year, the Federal Reserve Bank of New York stepped in with an $85 billion loan to keep the failing company from going under.

Because AIG’s near-failure was a prominent and iconic event in the financial crisis, it provided a touchstone for subsequent financial reform discussions, and a great deal of information about AIG and the rescue is in the public domain. Both the Congressional Oversight Panel and the Financial Crisis Inquiry Commission produced detailed reports that included accounts of AIG, and the Federal Reserve Bank of New York made public a detailed account of its involvement.

The company’s credit default swaps are generally cited as playing a major role in the collapse, losing AIG $30 billion. But they were not the only culprit. Securities lending, a less-discussed facet of the business, lost AIG $21 billion and bears a large part of the blame. On September 15, 2008, the day all three major agencies downgraded AIG to a credit rating below AA-, calls for collateral on its credit default swaps rose to $32 billion and its shortfall hit $12.4 billion—a huge change from $8.6 billion in collateral calls and $4.5 billion in shortfall just three days earlier. While this debt kicked in automatically because of the provisions in AIG’s agreements, rather than the willful terminations of its securities lending agreements.

AIG had written credit default swaps on over $500 billion in assets. But it was the $78 billion in credit default swaps on multi-sector collateralized debt obligations—a security backed by debt payments from residential and commercial mortgages, home equity loans, and more—that proved most troublesome.

AIG was a central player in the financial crisis of 2008. It was bailed out by the federal government for $180 billion, and the government took control. The Financial Crisis Inquiry Commission (FCIC) of the US government concluded AIG failed primarily because it sold massive amounts of insurance without hedging its investment. Its enormous sales of credit default swaps were "made without putting up initial collateral, setting aside capital reserves, or hedging its exposure — a profound failure in corporate governance, particularly its risk-management practices." The US government sold off its shares after the crisis and completed the process in 2012.

Major cause of AIG crisis

In simple terms, AIG’s collapse came as a result of the following sequence of events:

1. In the wake of the decline in real estate prices, the market value of mortgage-backed securities declined.

2. Under accounting rules that were established after the downfall of Enron — implemented to require rapid disclosure of investment losses — AIG marked down the value of its mortgage-backed securities portfolio.

3. These investment losses resulted in a reduction of AIG’s capital reserves — the core measure of its financial strength.

4. As a result of the decline in AIG’s capital reserves, Standard & Poor’s and Moody’s Investors Service downgraded AIG from triple-A to the single-A level.

5. These rating downgrades to the single-A level triggered collateralization requirements under AIG’s CDS contracts.

6. The amount of the collateral that AIG had to produce under its estimated $450 billion of CDS contracts approximated $100 billion.

Credit default swaps written by AIG cover more than $440 billion in bonds 2. We learned this week that AIG has nowhere near enough money to cover all of those. Their customers-those banks and hedge funds buying CDSs-started getting nervous. So did government regulators. They started to wonder if AIG has enough money to pay out all the CDS claims it will likely owe.

In late 2008, the federal government bailed out AIG for $180 billion, and technically assumed control, because its failure would endanger the financial integrity of other major firms that were its trading partners--Goldman Sachs, Morgan Stanley, Bank of America and Merrill Lynch. It saw the government grab almost 80 percent of its common stock amid the bailout (a proportion that eventually rose to 92 percent), and is asking for a cool $40 billion to make it whole. Government has no obligation to live up to some abstract notion of fairness when it seizes assets to prevent a global crisis. Morally, the claim is even weaker. A.I.G.’s stock would have been worthless absent a bailout; it is now worth about $80 billion. Or, as the government’s lawyers have put it, the shareholders’ stake after Washington took most of the company was “worth more than their 100 percent equity stake before the rescue.

Overall I can say that Bailout was not a good idea in case of AIG in 2008.

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