00:56 27/11/2023 What Went Wrong at AIG?

Yevgenia Nayberg

FINANCE & ACCOUNTING AU G 3 , 2 0 1 5

What Went Wrong at AIG?

Unpacking the insurance giant’s collapse during the 2008 financial crisis.
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.
Because AIG’s near-failure was a prominent
and iconic event in the financial crisis, it
https://insight.kellogg.northwestern.edu/article/what-went-wrong-at-aig
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
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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.”
Why Did AIG Really
Fail?
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
https://insight.kellogg.northwestern.edu/article/what-went-wrong-at-aig
What Went Wrong at AIG?
overall, McDonald says. “I was deeply
interested in learning whether that was
true.”
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
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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.
way bets. AIG didn’t have any offsetting
positions that would make money if its
swaps in this sector lost money.

AIG was accruing unpaid debts—collateral

it owed its credit default swap partners, but Securities Lending
did not have to hand over due to the
agreements’ collateral provisions. But when Rounds Out the Story
AIG’s credit rating was lowered, those
collateral provisions kicked in—and AIG McDonald and Paulson’s analysis showed
suddenly owed its counterparties a great that there was more to the problem than
deal of money. just the credit default swaps. Securities
lending lost the company a massive amount
On September 15, 2008, the day all three of money as well.
major agencies downgraded AIG to a credit
rating below AA-, calls for collateral on its Securities lending is a common financial
credit default swaps rose to $32 billion and transaction where one institution borrows a
its shortfall hit $12.4 billion—a huge change security from another and gives a deposit of
from $8.6 billion in collateral calls and $4.5 collateral, usually cash, to the lender.
billion in shortfall just three days earlier.
Say, for instance, that you run a fund with a
While this debt kicked in automatically
large investment in IBM. “There will often
because of the provisions in AIG’s
be reasons people want to borrow your IBM
agreements, rather than the willful
shares, and this is a standard way to make a
terminations of its securities lending
little extra money on the stock you have,”
agreements, “it’s still a little like a bank run,
McDonald says. AIG was primarily lending
in the sense that all of a sudden you’re in
out securities held by its subsidiary life
trouble, and the fact that you’re in trouble
insurance companies, centralized through a
means you get a big call on your assets,”
noninsurance, securities lending–focused
McDonald says.
subsidiary.
AIG had written credit default swaps on
Companies that lend securities usually take
over $500 billion in assets. But it was the
that cash collateral and invest it in
$78 billion in credit default swaps on multi-
something short term and relatively safe.
sector collateralized debt obligations—a
But AIG invested heavily in high-yield—and
security backed by debt payments from
high-risk—assets. This included assets
residential and commercial mortgages,
backed by subprime residential mortgage
home equity loans, and more—that proved
loans.
most troublesome. AIG’s problems were
exacerbated by the fact that these were one-

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00:56 27/11/2023
“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
https://insight.kellogg.northwestern.edu/article/what-went-wrong-at-aig
What Went Wrong at AIG?
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,
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suggests that this wasn’t just about

liquidity.” The executives’ claim that the
assets were “money-good,” he says, can be
soundly rejected.

FEATURED FACULTY

Robert
McDonald
Gaylord Freeman
Distinguished Chair in
Banking; Professor of
Finance

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.
Read the original

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