The Fall of AIG

When economic historians pick through the rubble of the Panic of 2008, there will be lots of difficult questions to answers. The one I will never understand is how AIG (AIG) collapsed.
Sheesh…how frickin stupid do you have to be to ruin AIG?
Lehman and Bear I get, but let’s face it, insurance isn’t that difficult to make money in. Some companies make a lot more than others, but making a profit is a pretty easy concept in insurance. Manage your risk and charge more than you pay. Repeat.
Sure, a disaster can hurt or ruin your business, but you have to be an idiot to ruin it from the inside. Sure enough, that’s what AIG did. Actually, their insurance business was doing well. It was their idiotic forays in the CDS market that sank the company.
The Wall Street Journal looks at AIG’s collapse and Gary Gorton, the finance professor at the center of it all:

AIG’s credit-default-swaps operation was run out of its AIG Financial Products Corp. unit, which had offices in London and Wilton, Conn. In essence, AIG sold insurance on billions of dollars of debt securities backed by everything from corporate loans to subprime mortgages to auto loans to credit-card receivables. It promised buyers of the swaps that if the debt securities defaulted, AIG would make good on them. AIG executives, not Mr. Gorton, decided which swaps to sell and how to price them.
The swaps expose AIG to three types of financial pain. If the debt securities default, AIG has to pay up. But there are two other financial risks as well. The buyers of the swaps — AIG’s “counterparties” or trading partners on the deals — typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG’s own corporate-debt rating is cut. In addition, AIG is obliged to account for the contracts on its own books based on their market values. If those values fall, AIG has to take write-downs.
Mr. Gorton’s models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn’t attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG’s finances.
The problem for AIG is that it didn’t apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate. The firm left itself exposed to potentially large collateral calls because it had agreed to insure so much debt without protecting itself adequately through hedging.
The credit crisis hammered the markets for debt securities, sparking tough negotiations between AIG and its trading partners over how much more collateral AIG should have to post. Goldman Sachs Group Inc., for instance, has pried from AIG $8 billion to $9 billion, covering virtually all its exposure to AIG — most of it before the U.S. stepped in.
Such payments continued after the government bailout. AIG already has borrowed $83.5 billion from the Federal Reserve, a little more than two-thirds of the $123 billion in taxpayer loans made available to AIG so far. In addition, AIG affiliates recently obtained from the government as much as $21 billion in short-term loans called commercial paper. Much of the $83.5 billion has been used to meet the financial obligations of the financial-products unit. If turmoil in the markets causes prices of many assets to fall further, the government might have to cough up more money to help keep AIG afloat. Cutting it off would risk renewing the market upheaval the policy makers have struggled to tame.

Posted by on November 3rd, 2008 at 12:44 pm


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