Final Paper-Bailout of American International Group (AIG)

Syed Fakher Abbas Naqvi

Tiffin University

Investment Analysis

12/02/16

Dr. Mitchell Miller

 BAILOUT OF AIG

The 2008 financial crisis saw the US economy stumbling at its toes while also making its

mark as one of the deadliest recession since the great depression of the 1930s. The housing

market became an absolute calamity. Some skeptics blamed it to the investors, while some

blamed the government for showing the lack of competence and planning out foolish economic

and financial agendas for corporations. This contagion, which shortly and passively began in

2007 when we experienced sky-rocketing house prices plummeting downwards, spread quickly

first in US financial market leading towards its effects overseas. The recession saw the cruelest

casualties to the entire US investment banking industry, enterprises funded and chartered by the

government for mortgage lending and one of the largest commercial banks. The disaster didn't

just affect the financial sectors, but major auto companies and myriad other corporate giants

which relied on the federal bailout collapsed as a result. Amidst all these, to save the object of

our scrutiny to the last, the collapse of AIG remains one of the necessary catalysts to further

deepening the recession. Before moving forward with AIG, it was crucial to identify the

background of the crises that allows us to build a story paving up to a profound connection with

the bailout of AIG. We've already shed light on what happened during the 2008 crisis, who were

the major players and corporations that were affected. Now we must examine the insights of how

and why it all happened. A core but brief analysis of the recession will give us a clearer

understanding of AIG.

A little crash course here. The fatuity of the financiers was the precipitating factor which

saw the irresponsible flooding of mortgage lending. Loans were lavishly given out to subprime

borrowers with poor or even no credit histories who suffered a hard time, looped inside a futile

attempt to repay them. When the risky mortgages were further transferred onto the financial
engineers at the big banks, who turned them into supposedly low-risk securities by putting large

numbers of them together into specified number of groups or factions known as "Pools." The

pooling mechanism allows the risks of each loan to be unregulated and uncorrelated. The big

banks, however, were conceived by their speculation gone wrong. They argued that the property

markets in different American cities would falter and then rise again, independently of one

another. Everyone perceived it to be a self-corrected mechanism and thought it's just a

normalized fluctuation which will stabilize in time. They were wrong. Within months, the

situation became worse; the pooled mortgages were then used to back up securities not

commonly known as "Collateralized Debt Obligation." America saw a severe house price slump.

Soon, the crisis moved on from the housing market to the money market and became the greatest

macroeconomic backdrop since the great depression. Among the Corporations to be adversely

affected, AIG became a major controversy.

American International Group also known as American Insurance group (AIG) is

Americas biggest multinational Insurance Company. With over 80 million customers reaching to

over 130 countries worldwide, further employing 64000 employees in 90 countries. With

statistics like these and a corporation that big, how would you picture it demolished by the

financial crisis? The impacts would have been Glocal (Locally and globally). AIG has three

branches which form the foundational framework of its functioning. AIG Life and Retirement

Facility, AIG Property Casualty and the most crucial regarding the stimulus in the financial

crisis, United Guaranty Corporation (UGC). AIG Property Casualty works towards the insurance

products for commercial, mostly advertising but institutional and individual customers. AIG Life

and Retirement provides life insurance and retirement facilities in the United States. UGC

primarily targets mortgage guaranty insurance and mortgage insurance. AIG has its roots
involved in global capital markets operations, directly funded investment and retained interests.

With three Headquarters around the globe. The corporate headquarter in New York, Asian

Headquarters in Hong Kong and the remaining covering Europe and the Middle East

Headquarters located in London making it a globally affected player.

AIG just like other big corporations had a pivotal role in the 2008 recession. The severity

of crisis caused AIG to bear huge losses on Credit Default Swaps (CDS). Unable to pay up to

those losses would have driven it out of the global financial sector which meant huge losses not

only to the people but to the investors and a greater catastrophe for the government had it

allowed AIG to fail. The federal government had to protect the market from an even greater

collapse, so it issued a 180 billion bailout and took control of the lamentable situation. A brief

pause here. You might be wondering why its been called a bailout and not a loan. Technically,

yes it is supposed to be called a loan, but in this particular situation, since the corporation would

have gone bankrupt had the loan not been deployed, its called a bailout, because the Fed is

preventing the company to fail, it is saving it. Initially, the amount was 100 billion, but it proved

out to be increasingly insufficient which made the US Treasury on a predictable path towards

bankruptcy when another 80 billion were extracted from which the US government gained 80%

equity interest in AIG. However, this was only the beginning. Lets break it up again. The first

formal form of government assistance was carried out when the Financial Treasury provided AIG

with $40 billion from TARP (Trouble Asset Relief Program) funds. Confused? You have every

right to be, but let's break it down. TARP was an initiated by George W Bush during the 2008

financial crisis on 3rd October 2008. It was signed into law for the government to buy toxic assets

and equity reserves from different financial institutions to bolster the financial sector ultimately.

TARP was regulated under the SSFI (Systemically Significant Financial Institution Program),
and AIG was the only beneficiary of the funds under it. TARP also created a capital equity

program to allow AIG to access up to $30 billion. A story which most of us are not aware of,

which was kept in the shed that the NY Fed for further assistance to the AIG created Maiden

Lane 2 and Maiden Lane 3 Programs to use the amount of cash lent, for closing out its securities,

gain liquidity and reacquire the lent securities to strengthen the balance sheet of their insurance

subsidiaries. Maiden Lane 3 created by the NY was loaned to $30 billion to handle AIGs credit

default swaps. The US government with immediate effect formed its FCIC (Financial Crisis

Inquiry Commission) which gave its statement blaming AIG of selling massive amounts of

insurance without hedging the investment. As highlighted earlier, the carelessly gigantic sales of

Credit Default Swaps were put into market irresponsibly without putting into question the

unsurmountable future consequences that it would pose to capital reserves and hedge fund

investments. An ideal example of the lack of risk management practice and severe failures in

corporate governance.

Was the US government right to intervene and issue a massive bailout amount? From the

Fed and taxpayers point of view, Yes. In my opinion, it was an ideal attempt to at least less

worse the collateral damage, termed as controlled dismantling. Some would argue it as suicide,

but given the situation and the tools at hand, it was the right decision to make, here's why. There

has been a constant misunderstanding about AIG bailout. It's not that the government was so

generous that it didn't want AIG to fail, it was too big of a risk to take, and there were never any

other alternatives. Had it been allowed to fail and left to the market, the situation might have

ended exponentially more dreadful. The epicenter of this issue is that they were the ones who

constantly encouraged mortgage backed securities which caused the market to encircle around it.

If AIG was taken out of the picture, then there's an immediate ripple effect and everything starts
to crumble. AIG operates in over 100 countries, with thousands of people doing business with

them, had this been allowed to fail would plunge more failures. The economy was far weaker

than it ever was, it wasnt viable to leave it to the market. Policymakers argue that AIG losses

which the government took over wouldn't have disappeared even if AIG was made to fail; they

simply would have burdened to someone else in the financial system leading to more worsening.

Now theres another controversial argument here. Why did the government protect AIG and not

Lehman Brothers? Respondent of the FCIC put the question to the Fed chief Ben Bernanke?

Bernanke gives a thorough answer saying that Fed rescued AIG because many among the

government believed that the firms problems were more isolated in its financial product

businesses, which accounted for billions of dollars in bets without having the capacity to hold

enough capital to pay out once the bets were lost. The Policymakers thought AIG's insurance

business was a constant concern however this allowed them to borrow from the fed at low risk to

the taxpayers. On the Other hand, the Lehman Brothers were going through a different phase.

Their status was already fading away and their investments dropping, their prospects weren't

seeming to be bright in the future. Trading partners quitted the firm questioning the capital

position and accessibility to cash. The Fed saw a larger loss in Lehman Bros. Meanwhile they

couldn't afford to let AIG fail to call it to be "catastrophic" if they did. It would cripple all

businesses.

The question here now relates to how the bailout affected some of the major financial

institutions. Realizing the panic that had been created in the Market after the terrible loss of

Lehman Brothers, everyone saw it coming, and it was understandable. But the real beneficiaries

were not anyone among AIG'S shareholders or the insurance policy holders, all of them were

nearly wiped out due to the devastation caused. The real awardees were the counterparties and
creditors. Strong blame by the accounting irregularities, like AIG to be undervalued from an

AAA to A credit rating. This downgrade stimulated provisions in some of AIGFPs credit default

swaps which formed as a forceful requisite for AIG to provide billions of dollars in collateral to

their counterparties. Goldman Sachs was the major player that benefited from the bailout. GS

collected almost $3 billion from the AIG bailout as an indirect payout to the bets that were

placed on its parent account. Huge bulk was moving directly from the taxpayers after the Fed's

protection of AIG. It was revealed during the formation of FCIC report. With close reference to

the US- government allowing FCIC to go forward with 180 billion bailouts was crucial because

the insurer's sudden collapse posed grave possibilities of cascade losses and severe deterioration

within the entire financial system. Goldman Sachs received an enormous $12.9 billion of the

bailout money, a move which laid heavy castigations as being a heightened example of deference

and insolence. However, the FCIC further breaks down the money received showing $2.9 billion

received for "propriety trades" which are trades made on their parent account. Out of those funds,

$1.9 billion was paid after AIG had collected the taxpayer bailout. As controversial as it may

sound, it is. Many blamed it to be a perfect "backdoor bailout, and it's the truth. The Fed

suppressed the specificities of the CDS (credit default swaps) to make sure GS remained

protected. It was strategically engineered in a way as to benefit GS and its trading parties. But

Goldman Sachs wasnt the only one here, many other European financial institutions and

counterparties that benefited from the bailout with some little assistance in the form of loans

from the Federal government. Among the counterparties collecting big payments had Citadel,

Societe Generale, The Deutsche Bank, Merill Lynch and other precincts in over 15 states

including California and Virginia. Apart from Goldman Sachs, Soc Gen, a European Bank was

among the biggest receivers standing at 11.9 billion. Barclays collected $8.5 billion while the
Deutsche got $11.8 billion. Moreover, BNP Paribas got $4.9 billion, HSBC with $3.5 billion,

Bank of America with $5.2 billion, UBS received $5 billion, Ceylon with $2.4 billion.

Should financial institutions like AIG be allowed to fail? That is a question too big to

answer, a claim too big to make. Did AIG deserve the money was pretty much a side argument,

the significant thing was that if a failure to get the money comes on board, we were talking about

an entire global financial system at a risk of catastrophe? From an individualistic perspective, I'd

argue for not bailing out, let the firm be responsible for its actions and let it die. Why did the

federal government think of making this detrimental decision to pay $185 billion, that's more

than twice the net worth of Bill Gates (yes that's right) to save AIG from bankruptcy? Everyone

listening to this would have the same reaction and probably say the government has gone mad.

But think of a bigger picture, everyone wants to make money and wants to keep their jobs and

earn well. To maintain the balance, the bailout was necessary, even if you like it or not. In my

opinion, it was the right thing to do. It's imperative, that at answering this question it's wiser to

discuss the dire consequences, the bloodier picture, the aftermath had AIG not been bailed out

then to reason whether it should have been allowed to fail. So its not a question of should but

a question of an outcome of an allowance to fail. Lets discuss the consequences of a failure.

Employing over 100 million people, history is a witness that a possibility of a shutdown of a

major corporation in any way similar to the AIG from the global market can have huge,

prevailing effects lasting decades, not just on individuals and households but on businesses

which heavily depend on insurance protection.

AIG's failure directly threatened the savings of millions of Americans in ways that the

Lehman bankruptcy did not. AIG had provided financial protection to municipalities, pension

funds, and other public and private entities through guaranteed investment contracts and products
that protect participants in 401(k) retirement plans. AIGs removal would directly degrade the

influence on savings of entire American corporate population in ways many, I argue Lehman

Brothers would not. Why? Because AIG is much larger than Lehman. It had promised and

provided financial security to precincts, pension funds, and other private and public firms

through yet again promised investment agreements and products that secure participants in

retirement plans.

More conveniently, if AIG had fallen, crisis, most evidently would have diffused into the

entire insurance market. Life insurance was already in jeopardy, because they usually are,

products of people's long-term savings. In light of the collapse, policymakers would seek to

increasingly liquidate these life insurance frameworks, initially underwritten by AIG. Also

agreeing with some skeptics about the possibility of confidence that people had in AIG, once it's

been broken, since this AIG we're talking about, it would open up a deadly contagion, and no one

would invest in other life insurance companies' similar products. It was probably that this would

further worsen the already fragile condition of financial markets. Moreover, most of the AIGs

insurance companies could have been taken over by their state and foreign authorities which

would extend the uncertainty and doubts in policyholders rights and claims. Closure of its

subsidiaries would have caused a probable adjournment on claims and seizures, also impairing

them in the long term. Large cashing in on AIG's insurance policies and annual allowances

would have put limitations on the company's ability to meet their targets and responsibility to

over millions of policyholders. State and local enterprises which had lent investment funds to

AIG could have been doomed if exposed to the losses and failures in the existing plummeting

corporate budget environment. Participant's portfolios were in danger of losing out its value

which would, in turn, make AIG lose its insurance. This is because pension plans would have
been pushed to reveal their AIG affiliated assets resulting in a greater loss. The loss would spread

to money market mutual funds, which the whole American people are dependent on with their

savings. Foreign Commercial and Investment banks would have suffered from credit losses on

loans, derivative contracts and transactions threatening the opportunity for households and firms

to receive credit. Trust in insurance providers would shatter. This is why AIG shouldn't have

been allowed to fail, and it wasn't. It was the right decision to make, even though the stakes were

high, so was the cost. But only if we see the flipside of this story, wed realize the calamity it

would have brought to everyone, globally.

There are global financial institutions that have become "too big to fail." What does Too

big to fail refer to? The phrase relates to an institution that has grown so indispensably large and

with roots embedded so globally deep, that its failure would cause the economy to collapse,

directing the government to intervene and bailout these corporations. They are also termed as

SIFI's (Systemically Important Financial Institutions). Should they be broken up? Ideally yes

youd want to because theyre reaping profits unethically and immorally but the system has

developed in such a way that you cant. These SIFI have investments and influence all over the

globe and have formed a balance. Breaking them up (which I dont think seems probable in the

current status quo) would disrupt the balance of the financial system. Too big to fail also means

that theyre too big to regulate. Many of the big financial systems have doubled in size since the

2008 financial crisis, have expanded in value and reach globally. But the most of them are not

carrying out tasks and deals the legal way, and there is no one to question it because they have

become too big. In my opinion, the gravity of the situation is highly problematic, but the big

giants themselves are not causing the problems, the executives and the higher board panel

members are. They (morally corrupt) have also become too big to go to jail. Strict financial
regulatory laws should be implemented focusing on the Regulations on the executives which are

the true culprits behind this. Financial dealing should be carried out in a just and swift way.

There should be no reason to break them up, considering the fact they can't be broken up.

However, internal regulation should be carried out. It's high time to put forth regime shifting

reforms to keep the big giants on the right track otherwise another financial crisis wouldn't be far

away and this time if it happens, will be way more destructive and implosive.
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