Insurance giant AIG was the biggest casualty of the credit crisis. It was put on state benefits to help it survive. Cris Sholto Heaton reports from the deathbed.
Why does AIG matter?
2008 was the year of the bail-out. Banks across the world have survived only with the aid of taxpayers and central banks. But while the likes of RBS and Lehman have drawn the most headlines, the largest bail-out – and the one that could cost us the most – wasn’t a bank. AIG – best known in Britain for sponsoring Manchester United – is one of the world’s largest insurers. It’s also at the heart of the credit crisis, soaking up over $170bn of US government aid so far, as it struggles to survive huge potential claims against it.
What exactly did AIG do?
AIG was a huge writer of credit default swaps (CDS). These are essentially unregulated insurance policies against a borrower defaulting on its debt. At the end of September 2008, AIG had net notional CDS exposure of $372.3bn. Notional exposure is the total amount of CDS sold – AIG would only have to pay that much if every insured loan defaulted and no money was recovered. That’s unlikely, just as it’s unlikely that AIG would have to pay out on more than a fraction of its regular insurance policies. But there’s a key difference: unlike regular insurance, CDS sellers have to post collateral to prove they can make the payments if the loans default. They also have to increase the amount they post if the cost of CDS in the market rises. However, the amount depends on the seller’s credit rating; until September, AIG had the fourth-highest rating (AA-), so it had to post relatively little.
So how did AIG get in this mess?
The London-based AIG Financial Products unit sold CDS on a huge number of assets, including a net $71.6bn (at end September) in collateralised debt obligations (CDOs). CDOs are pools of loans, in this case mostly consisting of US mortgage debt, including subprime mortgages. As it became clear how bad US mortgage defaults would be, AIG had to book huge potential losses on these CDS. It also owned large amounts of residential mortgage-backed securities (RMBS), and so had to mark down its assets at the same time as it was marking up its liabilities. In September, as AIG’s position worsened, the rating agencies cut its credit rating. So AIG’s counterparties demanded more collateral, even as the group was struggling to raise cash for day-to-day operations in the frozen credit markets.
How did the state get involved?
AIG was on the verge of collapse and the Federal Reserve and Treasury blanched at the idea of the panic that would ensue if it failed after Lehman Brothers. European banks may have been a specific risk: while CDO exposure was the centre of AIG’s problem, it sold even more ($250bn net notional) in regulatory capital CDS to these banks. These are insurance policies on a bank’s loan portfolio, which in turn allow it to consider the loans as less risky. That reduces the amount of capital it must hold against its assets. So an AIG failure could have left many European banks severely undercapitalised.
What did the Fed do?
It began by granting AIG an $85bn bridge loan in exchange for a 79.9% stake in the company, then later opened another $37.8bn lending facility. That obviously wasn’t enough. Since then, the Treasury has injected $40bn in capital into the firm in exchange for a 2% equity stake. Some of AIG’s RMBS portfolio has been sold to a special purpose fund backed by up to $22.5bn from the Fed, while another fund is buying up the CDOs that AIG insured so the CDS contracts can be annulled; the Fed is provided up to $30bn in funding for that. The bridge loan has been reduced to $60bn and the other loan facility closed, but AIG can also borrow up to $20.9bn from the Fed’s commercial paper lending facility. So, netting things out, America is currently committing up to $173.4bn – but it’s clearly on the hook for as much as this black hole needs. How much of this largesse is ever repaid is anyone’s guess. AIG’s eventual losses are unclear, even for CDOs, where defaults are underway. Losses in the European bank protection portfolio and another $50.7bn in corporate debt CDS have probably barely begun. What does this say about the dangers of CDS?One thing should be clear: any claim that the risk of an unregulated CDS market was exaggerated are wrong. Risk was not dispersed as supporters claimed. The net notional amount of CDS outstanding is probably between $3.5trn and $6trn and taken with AIG’s net notional of $370bn, that suggests that between 5% and 10% of exposure ultimately lay with a single company. An AIG collapse would have caused blind panic; much of the financial system is probably still alive only because America has AIG on a $170bn life support.
Is AIG still paying bonuses?
Not according to the company. In November, AIG announced that senior executives would get no bonuses for this year, in addition to other restrictions on pay. But in a quiet SEC filing the day before Thanksgiving it disclosed that it will instead make ‘retention payments’ of up to $4m to 168 executives. Unfortunately for AIG, the press caught them out and questions are being asked in Congress. AIG claims that these payments are necessary to hang on to key managers, although it seems questionable that there are so many jobs in financial services just now that the staff will bolt if not bribed. Regardless, making misleading statements like this seems a bad idea for a firm that’s being kept alive solely by taxpayer money.