The cause of the AIGs collapse Essay

Introduction

American International Group, Inc. (AIG), world leaders in insurance and financial services, is the leading international insurance organization with operations in more than 130 countries and jurisdictions. AIG companies serve commercial, institutional, and individual customers through the most extensive worldwide property-casualty and life insurance networks of any insurer. In addition, AIG companies are leading providers of retirement services, financial services, and asset management around the world.

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However, AIG suffered a liquidity crisis following the subprime mortgage loan crisis and its credit downgrading, including $9.11 billion of net unrealized market valuation losses on Capital Markets’ super senior credit default swap portfolio in the first quarter of 2008. On September 16, 2008, AIG collapsed and became a state-owned corporation when the United States Federal Reserve Bank rescued it by offering a loan to AIG as much as $182.5 billion, in exchange for 79.9% of the equity of AIG.

Analysis

The collapse of AIG can be explained by the following internal and external factors.

Internal Factors

(i) Inadequate internal controls

AIG Financial Products Corp. (AIG-FP) is a wholly owned subsidiary of American International Group, Inc. and founded in January 1, 1987. It was set up to branch out from AIG’s core insurance business by creating a division focused on complex derivatives trades that took advantage of AIG’s AAA credit rating. In 1999, JP Morgan, an investment bank, asked for insurance on its complex corporate debts and other mortgage-related bonds in case of default. As the company models showed that there was a 99.85% chance for AIG-FP would never have to pay on those kinds on insured contracts and the other side parties would have difficulty in demanding payment anyway, AIG-FP started to provide more and more insurances against defaults on corporate debts and other mortgage-related bonds in case of default and which were called credit default swaps. This kind of activity brought more than $5 billion in profits between 1987 and 2005.

At the end on 2005, Eugene Park, one AIG-FP executive, found that many collateralized debt obligations which being insured contained too large proportion of sub-prime mortgages. They would increase the default risk if the housing market collapsed or come up with more collateral when the credit ranking downgraded. Park expressed his concerns to Cassano, a former AIG-FP CEO, and Cassano decided to stop making any credit default swaps but he could not clear the collateralized debt obligations which were worth $80 billion that was already swapped and recorded in AIG-FP’s books.

Cassano hided the truth and told investors that “It is hard for us, 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.” However, the fact could not be covered for long. The stock price of AIG fell 25% and the loss on the credit default swaps was $352 million in October and November 2007.

Furthermore, Pricewaterhouse Coopers, AIG’s auditing firm, found that the valuation for the AIG-FP’s derivatives portfolio was unrealistic because it had assumed that the insurance would be valued more highly than the CDOs under the increasing CDO prices. The change of valuation basis would increase the losses on the credit default swap portfolio from $1billion to almost $5billion for that period. In order to deliver a good message to investors, Cassano and Sullivan, a former AIG CEO, had shut out the firm’s internal accountant and was not willing to allow the transactions of AIG-FP to be properly audited.

It can be seen that some AIG CEOs practiced the high-handed behaviour in the company and hided those unfavourable messages and truth on losses on credit default swaps and even delivered the fraudulent presentation to investors.

(ii) Poor risk management

AIG used to provide insurance and financial services, but its involvement in risk management as well as hedging and investment products makes it operated as an investment banks which expose to much higher risk like default risk.

AIG was one of the first firms to make credit default swaps which were still the newest products for creating and trading derivatives from AIG-FP. Greenberg, a former AIG’s CEO, had generated more than $5 billion in profits for AIG before he left the firm in March 2005. However, Martin Sullivan, the successor of Greenberg, made many damage to the company and hence the AIG’s profits were down-turning year by year. He was criticized to provide incapable of managing the risk taken on by Greenberg and deteriorated it by allowing new derivative bets on collateralized debt obligations and he did not understand the meaning of risk management.

When the securities tied to subprime mortgages began to collapse and a growing crisis of confidence spread throughout the nation’s financial system, the instruments rapidly lost their value. The credit default swaps which were the AIG traded sophisticated instruments wiped out the company’s bottom line and made a lost $9.11 billion in assets coupled with a $6.82 billion loss on investments. At that moment, Sullivan blamed that the losses were caused by “extremely adverse external conditions” in housing and credit markets and not related to the core AIG’s insurance business and “do not reflect the underlying strengths and potential of AIG”.

Sullivan also showed his poor stewardship by writing the statement “the severity of the unrealized valuation losses and decline in value of our investments were underestimated the extent of the problems in the credit market” and expressed that A.I.G. had badly underestimated the extent of the problems in the credit market.

During the hard time, AIG’s management was still confident to express that the company have significant excess capital positions did not foresee the type of losses they were on the verge of getting. In fact, its assets lost $9.11 billion in value in the first quarter alone and coupled with a $6.82 billion loss on investments, decimated the company’s bottom line. It ca be seen that the poor risk management in AIG’s management and their inability to predict the extent of the losses raised questions about its leadership going forward.

External Factors

(i) The effect of subprime mortgage loan crisis

The Federal Reserve cut the interest rates sharply to stimulate the American economy after stock markets plunging and the nation in stock after the attack on the World Trade Centre. The increasing demands for housing bit up the house prices dramatically and attracted many home buyers who were affordable to buy houses or not to make quick profits on homes by taking on big mortgage. Banks and other mortgage companies started to grant a subprime mortgage to clients with poor credit history in order to make more loans to resell. Traditionally, banks will charge higher interest rates for clients with poor credit because of their higher default risks. However, some new mortgage likes interest-only adjustable-rate mortgages (ARMs) and option ARMs were introduced to arrange low initial monthly payments for home buyers to borrow more loans. As the higher risks attached with the combination of subprime borrowers and their unmanageable ARMs with little down payment, unverified and hence unreliable incomes, borrowers were more likely to default. Therefore, banks try to shift those default risks to others by selling those mortgage loans to other investors.

The mortgage lenders bundled all individual mortgages or other loans and sold them as tradable securities like collateralized debts obligations (CDOs) and others mortgage-backed securities (MBSc) to other investor like investment bankers. Then the lenders did not own the loans anymore and transfer the attached default risks to investment bankers. With securitization, the mortgage lenders were encouraged to originate loans and resell them to investment bankers like Leman Brothers and Morgan Stanley, and use the proceeds to make more loans. That was why the mortgage lenders were keen on offering subprime mortgages without requiring borrowers to evident they had sufficient incomes or savings o meet the initial and monthly payments.

With the climbing property values, investment bankers invented increasingly complex and sophisticated securities backed by mortgage loans and trade them as with other bonds and stocks in the market. However, trading securities incurs risks. They are often highly leveraged, borrowing to make big bets on securities ranging from U.S Treasury bonds to risky securities backed by mortgages. Therefore, investment bankers could make credit default swap (CDS) contract with the financial guarantors like AIG to spread over the default risks on the securities. Credit default is a swap contract in which the buyer of the CDS makes a series of payments to the seller and receives a payoff if a credit instrument goes into default. It provides a default protection on assets tied to cooperate debts and mortgage-backed securities. These financial institutions sell insurances on bonds and guarantee to pay back investors fully if the bonds default. In order to make huge profits, they sold hundreds of billions of dollars in insurance contracts in the credit default swap market in which investors buy and sell insurance on a wide array of bonds and CDOs.

Investors kept the money flowing into ever hotter and faster growing housing markets caused a housing bubble eventually. The housing price was diminishing and the property lost much values. A bubble develops when an asset’s price becomes disconnected from its fundamental value. Mortgage lenders ran out of tricks for keeping monthly payment down. As credit condition weakened, mortgage lenders and investors grew less willing to take on the risk and subprime borrowers began defaulting en masses. From summer 2007 to spring 2008, first mortgage loan defaults soared from more than 1.5 million to 2.2 million.

There is closed relationship between the homebuyers, the mortgage lenders, the investment bankers and the financial guarantors. They rely on each others. The mortgage lenders transfer the default risk by selling those bundled individual mortgages or other loans as tradable securities like CDOs and others MBSc to other investor like investment bankers. Then, the investment bankers shifted the default risk by making insurances from financial guarantors. As the calamity in the housing and mortgage markets unfolded, the insurers’ capital base was cut sharply. Finally, financial guarantors who held and insured too many defaulted CDOs and MBSc and cannot compensate those insurance buyers and were forced to collapse. Obviously, AIG is one of the suffered financial guarantors and became to a state-owned enterprise finally.

(ii) Credit Downgrading

Venture with higher credit rating is labelled as a financially strong company in the market. A credit rating of AAA gives many advantages to company like a bigger competitive advantage in the markets and lower financing costs. Besides, more deposits and investments can be made because the lenders and investors have confidence in the company with a higher credit rating and hence they are not afraid to any money unpaid. Thus, they would like to get as high credit rating as possible.

AIG was once an AAA-rated company but it was downgraded in 2005 and several times in 2008. With the backing of a credit rating of AAA, AIG sold a lot of credit default swaps contracts and many collateralized obligation debts included buddle mortgage-backed securities. Under the swap’s term, AIG is required to post billions of dollars of collateral if its credit rating was cut. It is also demanded to post collateral if the market value of the credit default obligations it insured fell, even if there were no credit downgrades or default on the credit default obligations.

In September 2009, AIG was downgraded again to AA credit rating by the rating agencies. The downgrade triggered many collateral calls and forced AIG to hand over billions of dollars in collateral to its trading partners but it did not have the money to cover. As the level of exposure to AIG’s credit default swaps losses was higher than everyone expected, it was still hard to keep AIG afloat with a possible $75 billion bridge loan was obtained from Goldman and JP Morgan. Finally, AIG had no solution but sold its 79.9% of stock in exchange for $85 billion credit line from the Federal Reserve to the U.S. government and AIG became a state-owned company.

(iii) Lack of regulatory supervision

Policymakers and regulators had an unappreciated sense of the flaws in the financial system, and those few who felt something was amiss lacked the authority to do anything about it. A deregulatory zeal had overtaken the federal government, including the Federal Reserve, the nation’s key regulator. The legal and regulatory fetters that had been placed on financial institutions since the Great Depression had been broken. There was a new faith that market forces would impose discipline, lenders did not need regulators telling them what loans to make or not make. Newly designed global capital standards and the credit rating agencies would substitute for the discipline of the regulators. Even after mortgage loans started going bad an masse, the confusing mix of federal and state agencies that made up the nation’s regulatory structure had difficulty responding, after regulators finally began to speak up about subprime and the other types of mortgage loans that had spun out of control, such lending was already on its way to extinction. What regulators had to say was all but irrelevant.

Therefore, AIG was over-leveraged because regulators were not monitoring the contracts and could only guess at the size of the general derivatives market.

Solutions

It is important that we focus before long on how to avoid the next crisis.

(i) Establish clear mortgage lending rules

A number of steps have been proposed that could prevent a repeat of the housing meltdown once the current crisis is past. Most notable would be the Federal Reserve’s adoption of clear guidelines for appropriate mortgage lending: under the Fed’s proposed rules, lenders must consider the borrower’s ability to repay and also verify the borrower’s income and assets. Prepayment penalties are barred if a homeowner refinances within 60 days after an adjustable loan reset, and borrowers must establish escrow accounts for taxes and insurance. These commonsense lending rules would apply to all mortgage lenders given the Fed’s broad authority.

(ii) Modify mark-to-market accounting

In the midst of the subprime shock, trading in the mortgage securities market literally froze. With no buyers, even Aaa rated prices for these securities went into free fall. To keep this from happening in the future, mark-to-market accounting rules could be tweaked so that changing asset prices are phased in over time, say over one year. Instead of marking an asset to the price that prevailed last quarter, institutions could use the average market price of the asset over the past four quarters. Banks would still have to lower the value of their holdings as prices fell but note as rapidly. This would also limit accounting gains if prices were to shoot up quickly for whatever reason, helping restrain institutions from overextending credit when markets are hot.

(iii) Raise financial transparency and accountability

Both transparency and accountability are vital to a well-functioning financial system. Ensuring them requires confident regulatory oversight, which, in turn, must be empowered by Congress and the executive branch. Now that the Federal Reserve has explicitly backstopped the broker-dealer industry via its new credit facilities and its resolution of the AIG collapse, the quid pro quo should be a more watchful and questioning eye on that industry’s capital and activities. This will also provide a better window into the hedge fund industry. The SEC must also become more aggressive about policing financial statements, audit opinions, credit ratings, and analyst reports.

There is a balance to be struck between the benefits of transparency and accountability and the costs of greater disclosure by financial players. The subprime shock showed how unbalanced things had become. It is up to regulators to set it right.

(iv) Overhaul financial regulation

The regulatory framework overseeing the nation’s financial system needs a good overhaul. The current regulatory structure allowed the most aggressive lenders to avoid regulatory scrutiny. Regulators were also hamstrung in efforts to impose greater discipline on the industry given the difficulties coordinating among themselves.

In the long term, the Treasury’s plan proposes consolidation of the current regulatory structure into three principal agencies. The basic concept of regulation would shift; instead of agencies monitoring specific types of financial institutions, regulators would specialize in various types of risks and activities. The Federal Reserve would look out for the stability of the entire financial system; its mandate would include any risk that threatened the system, whether it involved banks or hedge funds. The Fed is uniquely suited for this task given its central position in the global financial system, its significant financial and intellectual resources, and its history of political independence.

A second regulatory agency would oversee any financial institution receiving an explicit government guarantee. Lenders couldn’t choose their regulator as they do now and would have consistent standards to work with. The third regulatory agency would aim to protect consumers by monitoring how all financial institutions market their products. Financial institutions and their products no longer fit in narrowly defined boxes. The risks they take cut across markets and extend around the globe.

Conclusion

If AIG disappeared, it could wipe out uncountable workers’ nest eggs and create harmful ripple effects worldwide. Although the next financial crisis is not in sight, there is no question that another one will arrive eventually. Therefore, understanding the roots of the AIG shock is necessary to avoid or better prepare for the next financial crisis.

References

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2. Unwinding at AIG Prompts Pasciucco to Ponder Systemic Failure, July 1, 2009.http://www.bloomberg.com/apps/news?pid=20601109&sid=afD X3.N1Kdgw

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