What Went Wrong at AIG?
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Finance & Accounting Aug 3, 2015

What Went Wrong at AIG?

Unpack­ing the insur­ance giant’s collapse.

What went wrong during the AIG financial crisis?

Yevgenia Nayberg

Based on the research of

Robert McDonald

Anna Paulson

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.

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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.

Nev­er­the­less, many of us — econ­o­mists includ­ed — remain fuzzy about what hap­pened. How, exact­ly, did AIG get to the point of fail­ure? In a recent paper, Robert McDon­ald, a pro­fes­sor of finance at the Kel­logg School of Man­age­ment, and Anna Paul­son of the Fed­er­al Reserve Bank of Chica­go, pull togeth­er dis­parate data and infor­ma­tion to cre­ate an eco­nom­ic nar­ra­tive of what went wrong.

AIG is a mys­tery to a lot of peo­ple and it’s very com­pli­cat­ed,” McDon­ald says. There were mul­ti­ple mov­ing parts.”

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, the authors concluded.

What’s more, McDon­ald and Paul­son exam­ined the asser­tion that the mort­gage-backed secu­ri­ties under­ly­ing AIG’s trans­ac­tions would not default. After the cri­sis, there was a claim that these assets had been mon­ey-good,” mean­ing they were sound invest­ments that may have suf­fered a decline in the short term but were safe over­all, McDon­ald says. I was deeply inter­est­ed in learn­ing whether that was true.”

There was this idea that real estate invest­ments were safe because the secu­ri­ties had a AAA cred­it rat­ing.” —Robert McDonald

Their analy­sis showed, in fact, that these assets end­ed up los­ing mon­ey in the long term — mean­ing AIG exec­u­tives’ asser­tions about the safe­ty of these invest­ments were incorrect.

Risky Cred­it Default Swaps

Most of the post-mortems of AIG focus on its sell­ing of cred­it default swaps, which are finan­cial instru­ments that act like insur­ance con­tracts on bonds. In these trans­ac­tions, the insur­ance sell­er (in this case, AIG) in some ways becomes the bond owner.

Think about home insur­ance,” McDon­ald says. If you’ve sold insur­ance on a house, and the house burns to the ground, you have to pay. The insur­ance sell­er has the same risk as an unin­sured home­own­er.” Like­wise, if the bonds AIG insured did not pay out, the com­pa­ny was on the hook for those losses.

Over the course of these agree­ments, the val­ue of the under­ly­ing asset will change, and one par­ty will pay the oth­er mon­ey, called col­lat­er­al, based on that change; that col­lat­er­al can flow back and forth between the two par­ties as the mar­ket moves. AIG’s cred­it default swaps did not call for col­lat­er­al to be paid in full due to mar­ket changes. In most cas­es, the agree­ment said that the col­lat­er­al was owed only if mar­ket changes exceed­ed a cer­tain val­ue or if AIG’s cred­it rat­ing fell below a cer­tain lev­el,” McDon­ald says.

AIG was accru­ing unpaid debts — col­lat­er­al it owed its cred­it default swap part­ners, but did not have to hand over due to the agree­ments’ col­lat­er­al pro­vi­sions. But when AIG’s cred­it rat­ing was low­ered, those col­lat­er­al pro­vi­sions kicked in — and AIG sud­den­ly owed its coun­ter­par­ties a great deal of money.

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, it’s still a lit­tle like a bank run, in the sense that all of a sud­den you’re in trou­ble, and the fact that you’re in trou­ble means you get a big call on your assets,” McDon­ald says.

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’s prob­lems were exac­er­bat­ed by the fact that these were one-way bets. AIG didn’t have any off­set­ting posi­tions that would make mon­ey if its swaps in this sec­tor lost money.

Secu­ri­ties Lend­ing Rounds Out the Story

McDon­ald and Paulson’s analy­sis showed that there was more to the prob­lem than just the cred­it default swaps. Secu­ri­ties lend­ing lost the com­pa­ny a mas­sive amount of mon­ey as well.

Secu­ri­ties lend­ing is a com­mon finan­cial trans­ac­tion where one insti­tu­tion bor­rows a secu­ri­ty from anoth­er and gives a deposit of col­lat­er­al, usu­al­ly cash, to the lender.

Say, for instance, that you run a fund with a large invest­ment in IBM. There will often be rea­sons peo­ple want to bor­row your IBM shares, and this is a stan­dard way to make a lit­tle extra mon­ey on the stock you have,” McDon­ald says. AIG was pri­mar­i­ly lend­ing out secu­ri­ties held by its sub­sidiary life insur­ance com­pa­nies, cen­tral­ized through a non­in­sur­ance, secu­ri­ties lend­ing – focused subsidiary.

Com­pa­nies that lend secu­ri­ties usu­al­ly take that cash col­lat­er­al and invest it in some­thing short term and rel­a­tive­ly safe. But AIG invest­ed heav­i­ly in high-yield — and high-risk — assets. This includ­ed assets backed by sub­prime res­i­den­tial mort­gage loans.

They had this propen­si­ty to invest in real estate,” McDon­ald says. There was this idea that real estate invest­ments were safe because the secu­ri­ties had a AAA cred­it rat­ing.” In the run-up to Sep­tem­ber 2008, AIG secu­ri­ties lend­ing busi­ness grew sub­stan­tial­ly, going from less than $30 bil­lion in 2007 to $88.4 bil­lion in the third quar­ter of 2008.

The bor­row­ers of a secu­ri­ty can typ­i­cal­ly ter­mi­nate the trans­ac­tion at any time by return­ing the secu­ri­ty to the lender and get­ting their col­lat­er­al back. But since AIG had invest­ed pri­mar­i­ly in longer-term assets with liq­uid­i­ty that could vary sub­stan­tial­ly in the short term, return­ing cash col­lat­er­al on short notice was not so easy.

Peo­ple were wor­ried about AIG in the sum­mer of 2008,” when an ana­lyst report sug­gest­ed the com­pa­ny was in for trou­ble, McDon­ald said. AIG’s cred­it rat­ing had been down­grad­ed by all three major agen­cies in May and June of 2008, and in August and Sep­tem­ber, peo­ple start­ed to ter­mi­nate their agree­ments,” ask­ing for their col­lat­er­al back.

The val­ues of the secu­ri­ties under­ly­ing these trans­ac­tions were falling, due to falling real estate prices and high­er fore­clo­sures, and AIG did not have enough oth­er liq­uid assets to meet all the redemp­tion requests. And just as a pos­si­bly crum­bling bank can lead depos­i­tors to with­draw their cash in a hur­ry, AIG’s weak­ened stance led even more secu­ri­ties lend­ing coun­ter­par­ties to return their secu­ri­ties and ask for their cash — which left AIG worse off still.

Not Mon­ey-good”

Prob­lems in both its secu­ri­ties lend­ing busi­ness and its cred­it default busi­ness made AIG dou­bly vul­ner­a­ble — and meant it had a great deal of out­stand­ing debts. Wher­ev­er coun­ter­par­ties could extract them­selves from exist­ing busi­ness, or not roll over exist­ing agree­ments, they did: Every­one want­ed to unwind their posi­tion with [AIG],” McDon­ald says. And because of that, the firm sim­ply had to sup­ply bil­lions of dol­lars they couldn’t eas­i­ly come up with.”

But lack of liq­uid assets, McDon­ald found, was not the only problem.

McDon­ald and Paul­son elicit­ed help from col­leagues in the Fed­er­al Reserve sys­tem to tap a data­base that has infor­ma­tion about every under­ly­ing com­po­nent in a pack­aged secu­ri­ty — mean­ing each indi­vid­ual mort­gage in a mort­gage-backed secu­ri­ty — to deter­mine how sound AIG’s secu­ri­ties were. They con­clud­ed that the secu­ri­ties were not in fact as sound as AIG’s exec­u­tives had purported.

The pure liq­uid­i­ty sto­ry says that if we’d sim­ply loaned AIG the mon­ey and walked away, every­thing would ulti­mate­ly have been fine,” McDon­ald says. The fact that these under­ly­ing assets did end up suf­fer­ing sub­stan­tial loss­es, even though the [gov­ern­ment res­cue] did save the day, sug­gests that this wasn’t just about liq­uid­i­ty.” The exec­u­tives’ claim that the assets were mon­ey-good,” he says, can be sound­ly rejected.

About the Writer

Valerie Ross is a science and technology writer based in New York, New York.

About the Research

McDonald, Robert L., and Anna Paulson. 2014. “AIG in Hindsight”. Journal of Economic Perspectives. 29(2): 81–106.

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