Ronald Gift Mullins reviews what went wrong at the insurance giant.

A century ago, minus a decade, American International Group began as a one-man shop in Shanghai, China, then with steely determination, laser focus and awesome perspicuity multiplied mightily to become the colossus that girdled the globe.

With more than 250 insurance companies/subsidiaries and assets close to a trillion dollars, revenue of a hundred billion-plus and profits in the tens of billions, AIG’s continued triumphs far into the future could not be assailed. Yet, in less than a year, it has stumbled and fallen to its knees, begging cup in hand. What on earth happened?

In AIG’s depressing chronicle, it was maybe the lack of internal oversight (probably not pursued too strenuously) of AIG Financial Products Corp (AIGFP), because this operation produced sizeable income for the parent company.

Based in London, AIGFP and its subsidiaries, according to several AIG annual reports, “enter into a broad range of financial derivatives transactions and invest in a wide range of debt and equity securities. AIGFP offers its institutional and high-net-worth clients standard and customised financial solutions for their corporate finance, financial risk management and investment needs.”

In AIG’s annual reports, the results of AIGFP are included with other units within AIG Financial Services. Thus determining what the returns were year by year for AIGFP is nearly impossible. Further obfuscating the transparency, AIGFP is tossed into Capital Markets with other AIG units that sell similar products. In the AIG 2005 annual report came this optimistic, self-congratulatory note: “Capital Markets is well regarded in the industry for its intellectual capital and its proven track record.

It consistently combines high counterparty credit quality with market risk lower than its capital market peers. In 2005, Capital Markets’ results were affected favourably by growth in their credit derivatives, commodity index and currency-linked products.”

Exclaim for joy

And why not exclaim for joy over the “favourable growth” of specific financial products! Almost unbelievably the operating income of the Financial Services group skyrocketed to $4.28bn in 2005 from $2.18bn in 2004.

While it is uncertain that this extraordinary leap of operating income was attributable to actions of AIGFP, it was during this period that the granting of mortgage housing loans was greatly engorged. Every American, it seemed, wanted to “make a house a home”, and many with more desire than lucre set off to obtain a loan. Unable to qualify for a prime loan, they were happily signed up by most any institution that had some ready cash for a subprime loan. These high-risk loans usually cost more in upfront costs and had higher interest rates than prime loans.

These financial institutions now had billions of dollars tied up in mortgage loans (many awarded to people showing little evidence of financial wherewithal) and what better way to capitalise on their value than slice and dice them into bonds offering buyers an assortment akin to the fat menu of a flashy diner. AIGFP, leaping at a prime opportunity to make a killing on these mortgage bonds, began arranging for credit default swap (CDS) contracts.

On the hook

The seller of CDS contracts promises to indemnify a buyer if the issuer of a bond or other obligation cannot pay principal and interest. The seller of the CDS receives regular payments until the contract is paid off or for a set period of time. These contracts were traded willy nilly and no state or federal authority at that time regulated them. With the housing market going through the roof, the CDS market exploded to more than $45tr in mid-2007, according to the International Swaps and Derivatives Association. CDSs were to provide peace of mind for the buyer and seller as there was little chance a bond would actually go into default. If one did, God forbid!, the seller of the CDS would have to pay the buyer of the mortgage-backed security the principal.

“The operating income of the Financial Services group skyrocketed, but the entire capital of the parent AIG was on the hook.

During the years following 2005, as adjustable interest rates began rising, millions of new mortgage holders found they had to make higher monthly payments. Many homeowners, especially those who had only qualified for subprime loans at steep interest rates, faced foreclosure and/or bankruptcy. AIGFP had sold a tremendous volume of CDSs over the years and millions had flowed into the coffers of AIG. As of 31 December, 2007, according to the AIG annual report, AIGFP had $527bn in notional exposure from its super senior credit default swap portfolio. The entire capital of the parent AIG was on the hook to pay for defaults of the loans underlying the CDSs. Then, defaults of these loans began to rise, setting off claims against the CDSs.

At first, AIG executive management pooh-poohed any suggestions that these credit default swaps were materially, negatively affecting the earnings of AIG.

As the months ran out in 2008, however, the company slowly and reluctantly admitted that it had some grave losses from its credit default swaps in the billions and billions—bankruptcy loomed; it was in real trouble.

Cup in hand

Frantic, AIG sought giant-sized loans from the private financial sector, but found the once “come in, come eight in” doors closed: “Sorry.” New York State did grant the company the right to transfer $20bn from other companies it owned, but this was too little. Finally, on 16 September, AIG accepted the terms dictated by the Federal Reserve Bank of New

York for providing a two-year, $85bn secured revolving credit facility to AIG “that will ensure the company can meet its liquidity needs”, a company news release said: “Policyholders of AIG companies around the world can rest assured that AIG’s commitments will continue to be honoured.”

The terms for the loan include granting the US government warrants for 79.9% of AIG stock; paying 8.50 percentage points over three-month LIBOR; putting the current rate at well over 11%.

It will also pay commitment fees of 2% initially of the total loan facility, and subsequently a fee on undrawn amounts of 8.5% a year. The agreement also required that a new CEO be installed (Edward Liddy). To pay back the loan, AIG has to sell assets: which ones, are to be announced soon.

When the For Sale list does come out, watch out!

The demand for them could create a tumultuous bidding war. The loan may be paid off in record time.

Ronald Gift Mullins is an insurance journalist based in New York City.

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