Why did AIG Collapse?

Originally posted by Metal Brain
Hold on. Why are you blaming Reagan? I thought I established what bills caused the deregulation. Reagan had nothing to do with those. Bill Clinton was president.

Originally posted by Scriabin
sorry to upset your equanimity, but I've told you repeatedly that I do not accept what you say as the truth merely because you've said it. In fact, I don't really attribute a high level of confidence in anything you may say as you tend to be a rather unreliable source.

I was referring to the deregulatory philosophy of Reagonomics, not to Ronald Reagan.
...[text shortened]... a lot of other people's time that way. I won't take time to explain this again about you.

Originally posted by Scriabin
Ok, genuises. Let's hear you tell us all why the conglomerate insurance and financial giant AIG, which operated in 130 countries with net assets of over $1 trillion collapsed.

What happened, why did it happen, what effect did it have on the world's economy, and whose fault is it?

Originally posted by Scriabin
thank you. my question answered sir.

this is an exemplary way to respond to a question about reality -- with facts, with insight and with citation to the source for the facts.

I likes it.

Now, tell me what the US regulator could or should have done to head this off?

How could they, assuming they didn't know what they didn't know due to the compa ...[text shortened]... to disclose?

How are CDS and CDOs regulated and by whom?

In short, how do we fix this?

Originally posted by Merk
It wasn't, at root, a CDS or CDO problem. It was a capital excess problem.

Originally posted by Scriabin
a capital excess problem? explain your terms pls.

It was fundamentally a liquidity problem caused by the way the CDS and CDO instruments were crafted. At least, that is what the OTS examiners found and that's what the Agency will tell Congress.

Originally posted by Scriabin
a capital excess problem? explain your terms pls.

It was fundamentally a liquidity problem caused by the way the CDS and CDO instruments were crafted. At least, that is what the OTS examiners found and that's what the Agency will tell Congress.

Originally posted by Scriabin

Now, tell me what the US regulator could or should have done to head this off?

How could they, assuming they didn't know what they didn't know due to the company's cover up and misrepresentation or failure to disclose?

How are CDS and CDOs regulated and by whom?

In short, how do we fix this?

Originally posted by Merk
It wasn't, at root, a CDS or CDO problem. It was a capital excess problem.

CDS are financial products that are not regulated by any authority and impose serious challenges on the ability to supervise this risk in unregulated business segments. Adding to these constraints is the absence of any prudential derivatives regulator or standard market regulation.

The complexity of CDS contracts masked risks and weaknesses in the program that led to one type of CDS to perform extremely poorly and another type to perform nearly as expected. Losses from AIG’s domestic multi-sector CDS portfolio were 150 times greater than the European Regulatory Capital CDS book, which was four times larger than the domestic CDS portfolio.

The most significant difference between the two CDS portfolios lies in the numerous, varying contractual triggers, settlement alternatives, and valuation mechanisms.

The large majority of the CDS written on domestic multi-sector CDOs required physical settlement in which AIG was required to pay the total unpaid principal and accrued interest upon the occurrence of a credit event, such as underlying securities downgrades and over-collateralization provisions.

Valuations were based on the declining market value of the protected securities, which in turn were impacted by market illiquidity.

This required AIGFP to post nearly $31 billion in collateral with its CDS counterparties in mid 2008.

In contrast, the large majority of the European Regulatory Capital CDS contracts provide for cash settlement when credit losses are realized.

The valuation of these CDS was not impacted by market illiquidity. The estimated market losses for the comparable period were $200 million.

Additionally, the current regulatory means of measuring off-balance sheet risks do not fully capture the inherent risks of CDS.

In the case of AIG, there was heavy reliance on rating agencies and in-house models to assess the risks associated with these extremely complicated and unregulated products.

Models tend to be static and do not always accurately capture the dynamics of the real world.

In retrospect, failure to consider valuation and liquidity exposure was a major shortcoming of the modeling process causing a shortfall in the capital allocation and adequacy analysis.

Finally, the New York Times reports tonight:

The federal government agreed Sunday night to provide an additional $30 billion in taxpayer money to the American International Group and loosen the terms of its huge loan to the insurer, which is preparing to report a $62 billion loss on Monday, the biggest quarterly loss in history, people involved in the discussions said.

The intervention would be the fourth time that the United States has had to step in to help A.I.G., the giant insurer, avert bankruptcy. The government already owns nearly 80 percent of the insurer’s holding company as a result of the earlier interventions, which included a $60 billion loan, a $40 billion purchase of preferred shares and $50 billion to soak up the company’s toxic assets.

Federal officials, who worked feverishly over the weekend to complete the restructuring, said they thought they had no choice but to prop up A.I.G., because its business and trading activities are so intricately woven through the world’s banking system.

But the deal also presents more financial risks to taxpayers at a time when the public and Congress have been sharply questioning the wisdom of risking federal money to bail out private enterprises.

The government’s commitment to A.I.G. far eclipses its rescue of other financial companies, including Citigroup, which has received $50 billion in rescue financing, and Bank of America, with $45 billion.

Credit rating agencies like Moody’s, Fitch Ratings and Standard & Poor’s had been preparing to sharply downgrade A.I.G.’s credit ratings on Monday because of the record quarterly loss. That would have forced A.I.G. to default on its debt, threatening to set off shock waves throughout the financial system as banks holding A.I.G. derivatives contracts would probably demand cash collateral and other payments from A.I.G. during a time when it has little to spare.

The major credit-rating agencies were briefed on the pending deal between A.I.G. and the government, the people involved in the talks said, and they have committed not to downgrade the company’s debt as a result.

Under the deal, the government will commit $30 billion in cash to A.I.G. from the Troubled Asset Relief Program, should the company need it, according to the people involved in the talks. A.I.G. is not expected to draw down the money immediately, but the government’s commitment was enough to satisfy the rating agencies.

Another part of the deal would allow A.I.G. to exchange some of its preferred nonvoting shares, which paid a 10 percent dividend, for new preferred shares that do not require a dividend. That would save A.I.G. $4 billion annually.

To further ease A.I.G.’s debt burden, some of its other debt to the government would be converted into equity in two of the insurer’s subsidiaries in Asia — American International Assurance and the American Life Insurance Company.

Both units are performing well. This would give the government direct ownership in those subsidiaries and provide saleable assets to American taxpayers even if the A.I.G. holding company were to default on its loans.

The government stake in American International Assurance is likely to be controversial. The unit had been put up for sale recently, without success. That suggests that the government is giving A.I.G. better terms than private investors were willing to give, exposing the government to further accusations that it is providing a handout to A.I.G.

Also as part of the deal, the government would agree to lower the interest rate on all remaining A.I.G. debt to match the London Interbank Offered Rate, or Libor. That would replace the previous rate, which was three percentage points higher than Libor. That move would save A.I.G. $1 billion in interest payments.

The loss that A.I.G. is preparing to report on Monday would be the largest ever by any company in a single quarter. Still, of the $62 billion loss being reported, only about $2 billion is a cash loss. The rest is the result of noncash items like write-downs on the value of the company’s assets.

The new cash commitment reached on Sunday represented the fourth time since September that the federal government has taken steps to keep A.I.G. from collapsing. The previous rescues were intended to stabilize A.I.G. and buy it time to restructure. But the rescues were insufficient, in part because A.I.G. has either invested in or insured so many assets that keep losing value as the economy sours.

In September, the Federal Reserve lent A.I.G. $85 billion when the company suddenly found itself unable to meet a round of cash calls. To secure the emergency loan, A.I.G. issued the Fed warrants for slightly less than 80 percent of the company’s shares.

Officials said at the time that they thought the loan would provide A.I.G. all the cash it could possibly need. The government brought in a seasoned insurance executive, Edward M. Liddy, to sell off some of A.I.G.’s operating units to raise money, since the rescue loan had to be paid back within two years. Mr. Liddy drew up a plan, saying he expected a smaller, well-capitalized version of A.I.G. to remain after the restructuring.

But in just weeks it became clear that A.I.G.’s problems were so grave the $85 billion would not be enough. It was using up that money alarmingly fast, thus burdening itself with higher than expected debt-servicing costs, because it had to pay the Fed a higher rate of interest on the part of the loan that it drew down.

In October, the government cut A.I.G. some slack by creating a new $38 billion facility to shore up its securities lending business, and gave the company access to a new commercial paper program, which had a much lower interest rate than the rescue loan.

But that was not enough either. In mid-November, the government restructured its loans to A.I.G., raising its total commitment to $150 billion. The new arrangement reduced the rescue loan to $60 billion and stretched out its term to five years instead of two.

At the same time, it injected $40 billion into A.I.G. in exchange for preferred shares. And it created two special-purpose entities to take the most toxic assets then plaguing A.I.G. out of play.

Those arrangements kept the government’s stake in A.I.G. at just below 80 percent. The government has not wanted to go above 80 percent, because it would then have to consolidate all of A.I.G.’s assets and liabilities into its own finances, putting taxpayers on the hook for the claims of roughly 76 million insurance policyholders around the world.

While November’s restructuring did buy A.I.G. more time, it was not able to sell the operating units that Mr. Liddy put up for sale — or, when assets were sold, the prices were shockingly low.

The very simple way I see it is that corporate risk management went out of the window as a bunch of banks and other investors bought, sold and bundled bad books to sell on. No one took a proper look at the quality of the book (the "assets" ) they were selling and buying, while regulators turned a blind eye to capital adequacy ratios. It was greed and complacency combined with a lot of ignorance.

Originally posted by buffalobill
The very simple way I see it is that corporate risk management went out of the window as a bunch of banks and other investors bought, sold and bundled bad books to sell on. No one took a proper look at the quality of the book (the "assets" ) they were selling and buying, while regulators turned a blind eye to capital adequacy ratios. It was greed and complacency combined with a lot of ignorance.

Originally posted by Scriabin
I think you've got something there.

Let's both stand outside while they clean it up, shall we?

Is it worth mentioning that those who bundled and sold knew very well they were going against the professional risk managers' warnings -- at least this is true at Fannie Mae.

There will be a Senate committee hearing before Sen. Dodd on March 5 on AIG.

Might want to tune in.