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Role of AIG in Sub-Prime Crisis

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Prateek Batra

on 12 February 2013

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Transcript of Role of AIG in Sub-Prime Crisis

American International Group, Inc. Role of in Sub-prime Crisis The 1. Historically, bond issuers almost never go bankrupt.
2. Attractive opportunity for banks and hedge funds
3. Late '90s, CDSs became a great way to make a lot more money compared to traditional investment methods.
4. Over the past few years, CDSs helped transform bond trading into a highly leveraged, high-velocity business.
5. Many CDSs were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis
6. MBS and CDO became nearly worthless, Credit Default Swap Origination of the modern CDS Collapse of AIG and Aftermath ^ As 2007 progressed, so did the losses on AIG's books and CDS
^ AIG tried to manage the problem through accounting maneuvers by undergoing sham transactions to affect the balance sheet
^ In Feb 2008, AIG posted $5.3 bn in collateral against CDS contracts it had written
^ By Apr 2008, AIG posted an additional $4.4 bn in collateral. However, the company did not have cash
^ Lead to lowering of credit ratings by major rating agencies.
^ Dire need for cash due mounting losses on warehoused CDO "assets" on the company's BS necessitated a massive infusion of capital AIG before the Sub-Prime Crisis - Founded in 1919 as American Asiatic Underwriters
- Business in 130 countries, with 116,000 employees servicing 74 million customers
- Diverse businesses as aircraft leasing & life insurance, along with its principal business of mortgage insurance
-Since 1987, AIG, through its AIG Financial Products division, had been involved in credit default swaps
-In early 2007, AIG reported assets of $1 trillion, with $110 billion in income
-By 2008 its CDS portfolio had reached an estimated total of $450 billion The Bail-out... 1. Under the terms for Bailout, In Sep 2008, Fed lent upto $85bn to AIG, and the US Govt will effectively get 79.9% equity stake in the insurer in the form of equity participation notes
2. The 2 year loan carried an interest rate of LIBOR + 8.5 percentage points
3. Loan was secured by AIG's assets, including its profitable insurance businesses giving Fed some protection Regulatory Changes The Sub-Prime Crisis ^ U.S. housing bubble peaked in 2005–2006
^ % of new lower-quality subprime mortgages rose from 8% or approximately 20% from 2004 to 2006
^ Over 90% of these subprime mortgages in 2006 were adjustable-rate mortgages
^ Ratio of debt to disposable personal income rose from 77% in 1990 to 127% at the end of 2007, much of this increase was mortgage-related
^ Mortgage-backed securities (MBS) - derives its value from mortgage payments and housing prices
^ House prices peaked in mid-2006. As ARMs began to rise mortgage delinquencies (defaults and foreclosure) soared
^ March 2007 - value of American subprime mortgages was estimated at $1.3 trillion
^ Securitization - sell the mortgages and distribute credit risk to investors through MBS and CDO Difference between CDS & an Insurance Contract o An insurance contract provides an indemnity against the losses actually suffered by the policy holder on an asset in which it holds an insurable interest. CDS provides an equal payout to all holders, calculated using an agreed, market-wide method. The holder does not need to own the underlying security and does not even have to suffer a loss from the default event
o The seller might in principle not be a regulated entity (though in practice most are banks)
o The seller is not required to maintain reserves to cover the protection sold
o Insurance requires the buyer to disclosure all known risks, CDS do not
o Insurers manage risk primarily by setting loss reserves based on the Law of large numbers and actuarial analysis.Dealers in CDS manage risk primarily by means of hedging with other CDS deals and in the underlying bond market
o CDS contracts are generally subject to mark-to-market accounting, introducing income statement and balance sheet volatility while insurance contracts are not A CDS is .... - J.P. Morgan had extended a $4.8 billion credit line to Exxon
- Exxon faced the threat of $5 billion in punitive damages for Exxon Valdez oil spill
- A team of J.P. Morgan bankers led by Blythe Masters then sold the credit risk from the credit line to the EBRD in order to cut the reserves that J.P. Morgan was required to hold against Exxon's default a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event

- The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.
- In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan The The 7. Seemingly low-risk event-an actual bond default-was happening daily
8. The banks and hedge funds selling CDSs were no longer taking in free cash; they were having to pay out money
9. Most banks, though, were not all that bad off, because they were simultaneously on both sides of the CDS trade.
10. AIG was on one side of these trades only
11. AIG seems to have thought CDS were just an extension of the insurance business. But they're not – Assumed low correlation between insurance triggering events 12. Credit default swaps written by AIG cover more than $440 billion in bonds
13. AIG has nowhere near enough money to cover all of those
14. Customers became nervous
15. Moody downgraded rating – Need for more collateral/liquidity – Started selling assets
16. Stock price plummeted – Making it harder to raise capital
17. Overnight, the banks have to buy replacement coverage at much higher rates
18. Banks all over the world are instantly worth less money Comments 1. Providing bailout to AIG, marked a dramatic turnabout for the Federal Government.
2. A week before the bailout Govt, pulled the plug on Lehman Brothers allowing the big I-Bank to fail, stating all those responsible for the crisis should suffer.
3. Treasury Secretary, Henry Paulson and Federal Reserve Chairman, Ben Bernanke stated,"They were motivated by the worries that Wall Street's financial crisis could begin to spill over into seemingly safe investments held by small investors, such as money-market funds that invest in AIG debt. After the global subprime crisis, swaps are cleared through exchanges or clearinghouses —

..... but they are still exempt
from all insurance regulatory oversight "Quote - UnQuote" "I think if there's a single episode in this entire 18 months that has made me more angry, I can't think of one, than AIG"
-- Fed Chairman Ben Bernanke (during the Senate hearing on the federal budget, March 2009) Thank You !! Risks in financial systems - Credit risk : The risk that the borrower will fail to make payments and/or that the collateral behind the loan will lose value
- Asset price risk : The risk that asset itself will depreciate in value, resulting in financial losses, markdowns and possibly margin calls
- Counter party risk : The risk that a party to an MBS or derivative contract other than the borrower will be unable or unwilling to uphold their obligations
- Liquidity risk : The risk that money in the system will dry up quickly and a business entity will be unable to obtain cash to fund its operations soon enough to prevent an unusual loss
- Systemic risk : The aggregate effect of these and other risks is called systemic risk, which refers to sudden perceptual, or material changes across the entire financial system, causing highly "correlated" behavior and possible damage to that system The Sub-Prime Crisis ^ American homeowners, consumers, and corporations owed roughly $25 trillion during 2008
> American banks retained about $8 tn of that total directly as traditional mortgage loans
> Bondholders & other traditional lenders provided another $7 tn
> The remaining $10 tn came from the securitization markets
^ Fannie Mae and Freddie Mac (GSE) - purchases mortgages, buy and sell mortgage-backed securities (MBS), and guarantee nearly half of the mortgages in the U.S.
^ CDS were lightly regulated, largely because of the Commodity Futures Modernization Act of 2000
^ Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG) bet they would not.
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