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AIG has been among the leading companies in the insurance industry ranked 14th in the Fortune 500 companies, operating over a decade globally offering various insurance options for companies and individuals including 98% of the Fortune 500 companies, 96% of Fortune 1000, and 90% of Fortune Global 500, and insures 40% of Forbes 400 Richest Americans. With a strong history and reputation in the industry and persistent operations around the world, AIG was believed to be resistant to any crash or collapse. Huge amount of funds in terms of institutional investors, mutual funds, pension funds and hedge funds were insured by AIG. Investment banks had billions of dollars insured by AIG and trusted the company for protecting them against any breakdown. Leading companies such as Goldman Sachs (NYSE:GS) had $20 billion worth entities insured by AIG.
The majority of financial industry faced blows of financial crisis in one or other ways. The company announced an earnings of $6.20 billion or $2.39 per share, within six months the company was on the verge of bankruptcy. In 2008, AIG failed badly in maintaining its AAA reputation and was nationalized against a bailout of about $80 billion on the suggestion of then National Treasury secretary Hank Paulson to assist the company in meeting its financial obligations.
Before these extreme measures were taken, there were several factors that led the company into the collapse. The epicenter of the issue is considered to be rooted from the AIGFP (AIG Financial Products) division in London which offered insurance against critical investments with high risks. AIGFP also introduced a financial tool called Collateralized Debt Obligation (COD) that supported and bundled various types of debts. With its flexible nature it became widespread investment banks and financial institutions.
Another important factor for the financial breakdown of AIG was its $526 billion worth of portfolio of credit default (CDS) swaps a credit derivative popular among financial institutions. CDs gained a lot of attention as the perfect way to get more profit as compared to traditional investment methods. At one point, CDs transformed bond trading into a more leveraged business options as it was easier to trade CD contracts as compared to buy or sell bonds. The popularity of CDs can be proven by the fact that by the end 2007 the CDs market was about $60 trillion globally. As the financial crisis started showing its effects the CODs and mortgage backed securities started becoming worthless, suddenly the CDs trading was not only about profits but big payouts also started pouring in. Most of the financial institutions and investment banks were trading the CDs both ways thus though they had to pay some but also got some money in too. AIG on the other hand had no way to recover from the CD payouts as it only sold CDs thus once the bonds became defaulting they had to make the payouts to fulfill their obligations. AIG had always been reputable in the insurance industry and it processed CDs like insurance plans, when that was not the case and the company learned it the hard way. AIG had written more than $440 billion CD swaps for bonds, the crash of bond market was like a chain reaction and it caused a stir of nervousness among the investment banks, AIG customers as well as among the related government departments as AIG could not afford to payout that amount of money in return of defaulting bonds.
AIGFP division of AIG sold insurance for risky tranches in form of CDs for various loans and debt securities as according to the management of that division, CDs were comparable to gold as it would never default thus AIGFP will earn premiums without paying out anything. The scenario proved to be not researched or thought-out and the result was a huge sum of payouts that the company was obliged to pay. AIG was on verge of bankruptcy and serious threat of lowering credit rating by the credit rating agency as none had the trust that AIG could manage that amount of payouts.
One of the most important steps that AIG missed during the peak of CDs was to be more vigilant of the risky investments especially in the real estate market. The company had a proven record in the insurance industry and it misunderstood the way bond and investment funds could go wrong. Even though AIG tried to raise money by selling once of its division but the stock prices kept declining thus the company could not attract private investors to pitch in money, the only choice was government funding. At this point, Federal reserves issued a loan of about $80 billion at 8.5% for a two year repay term against 80% of the company’s equity. According to news reports the amount was increased later and is now about $150 billion. Experts believe that the bailout for AIG was to save its huge customers such as Goldman Sachs, Morgan Stanley, Bank of America and Merrill Lynch (as well as a dozens of European banks) as the bankruptcy of AIG could cost more than $180 billion for the customers and the result could be larger than any other financial crisis faced by global economy.
Conclusion:
AIG was once thought of as too big to collapse as it enjoyed AAA credit rating and a reputable position with huge corporations, investment banks and several individuals including the America’s richest as its customers. AIG faced a sudden collapse due to its lack of judgment in writing CDs with collateral obligations which started defaulting at a exponential rate and the company was unable to guarantee the payouts. AIG was unable to raise enough funds for the payouts even after selling off its trillion dollar assets, the only survival strategy was to accept a loan by federal reserves on the cost of selling its 80% of equity to government.
AIG made a bad choice of business by writing CDs on risky CODs with subprime mortgage loan as it was a relatively a new concept and enough research was not put in before operating on CDs and CODs. The management of AIGFP at that time believed that CDs were a virtual equivalent of gold but it turned out wrong. The timing for AIG possible crash was bad as the financial market already faced aftershocks of collapse of Bear Stearns, Freddie Mac, and Fannie Mae and Lehman Brothers and the government understood that the collapse of AIG could result in a bigger global crisis. The bailout faced a lot of criticism as billions of taxpayer’s dollars were used as the bailout amount that kept increasing to sustain the company. The financial market regulators need to understand the ways CDs could be traded with more security and need to define clear regulations concerning these CDs that could be adaptable to the ever evolving financial market. The lack of regulations for risky investments, CODs and subprime mortgage loans and a lack of judgment by the falling giants like AIG added up to create the financial breakdown and affected the shareholders and the industry.
Bibliography
DAVIDSON, ADAM. "How AIG fell apart." Reuters (Sep 2008). web.
Gethard, Gregory. "Falling Giant: A Case Study Of AIG." Investopedia (n.d.). web.
William K. Sjostrom, Jr.∗. "The AIG Bailout." 2009.
