Liquidity Risk Management Case Study: American International Group (AIG)
AIG Financial Productions Corporation (AIG FP) a subsidiary of AIG issued and traded credit default swaps. These non-traditional insurance instruments insured the counterparty in the event of default on collateralized debt obligation payments. The company believed that the risk was very small because they primarily insured AAA- rate tranches which they presumed would be close to risk-free. However what they failed to factor was the significant risk factor that as per contractual agreement they were required to post collateral with the counterparties in the event that values on the underlying CDOs declined; also that in the eventuality of a down-grade in their credit ratings they would be required to post additional collateral with their counterparties. During the years prior to the financial crisis and even during the crisis AIG was confident that the risks that they were exposed to, in terms of declining values of CDOs and down-grades, were negligible because they believed that the market would eventually recover and that they were too big an entity to fail.
In August 2007, subsequent to growing delinquencies in the subprime market and falling values of mortgage-backed instruments, Goldman Sachs demanded that AIG post collateral to cover its exposure to the fall in market value of its CDO portfolio. In October 2007 Goldman again insisted on yet more collateral from AIG. In total AIG ended up posting around $2 billion in collateral with them upto end-October 2007.
In November 2007, AIG reported $352 million in unrealized losses on its CDS portfolio. However AIG also reported that they would most likely not realize these losses as they believed that the market would recover. What they also reported was that there were disagreements between counterparties and AIG regarding the amount needed as collateral. This suggested that there were differences in the valuations given to the underlying CDO portfolio by the insurance company and their counterparties. Further, AIG’s external auditor PricewaterhouseCoopers privately warned the CEO that there were material weaknesses in the way AIG’s managed the risk of its CDS portfolio in particular with the risk models that they used to value the portfolio and assess its risk.
In December 2007 AIG reported a further $1.15 billion in unrealized losses on its CDS portfolio. Despite this substantial increase in losses AIG continued to tell investors that based on their risk models they believed that there was a very negligible possibility that any of these losses would actually be realized.
On 11th February 2008 the company disclosed the concerns of their auditor regarding the material weakness of their valuation and risk models used for the CDS portfolio. In light of these concerns the company revised unrealized losses November-estimates upwards to $5.96 billion and on 28th February 2008, they disclosed revised year-end unrealized losses of $11.5 billion. They also reported that they had been required to post a total of $5.3 billion as collateral to date. AIG again tried to assuage investors’ fears by emphasizing that these losses were not expected to be realized as the unrealized value would be reduced as the market recovered. They also informed that that the chief of AIGFP, Joe Cassano, the unit responsible for this swap portfolio had resigned.
On 8th March 2008, AIG reported additional unrealized losses for the first quarter on $9.1 billion also revealing that the total collateral that it had been required to post had risen to $9.7 billion.
On 20th March 2009 in order to strengthen its capital position it was able to raise $20 billion in private capital.
In June- August 2008 it reported $5.6 billion unrealized losses for the second quarter of 2008 and that total collateral posted now stood at $16.5 billion. The CEO of AIG, Martin Sullivan resigned and was replaced by Robert Willumstad.
On 9th September 2008 AIG’s share price fell sharply by 19%, the biggest drop since it became a public company in 1969, in response to investors’ fears regarding the potential collapse of Lehman Brother’s and its systemic impact on AIG’s ability to meet its own commitments as well as the fact that AIG was finding it difficult to raise capital.
Following the bankruptcy filing of Lehman Brothers after the government’s refusal to provide it with a bailout and the unexpected systemic impacts that the announcement had had on the financial markets, the Federal Reserve began to have concerns regarding the potential collapse of AIG if it was allowed to fail. In view of this on 14th September 2008, Federal Reserve asked private entities to provide AIG with short term bridge loans to help AIG meet its liquidity demands. In addition the FDIC relaxed rules to allow AIG to around $20 billion from its subsidiaries.
Despite these efforts from the regulators, on 15th September 2008 credit rating companies downgraded AIG’s credit rating below AA-levels because of its increasing inability to meet collateral demands as well as because of its growing residential mortgage-backed losses. Following the down grading counterparties demanded $14.5 billion to be posted as additional collateral. In addition to this investors discovered that AIG’s subprime and Alt-A mortgages were valued significantly higher as compared to similar assets on Lehman’s balance sheet. In light of these developments AIG’s share price declined sharply by 61%.
On 16th September 2008, with AIG’s share price still headed downwards, the Federal Reserve bank announced a bailout package for the insurer. It provided an $85 billion credit-liquidity facility, backed by collateral consisting of assets of AIG and its subsidiaries, payable at an interest rate 8.5% over the 3-month LIBOR, in exchange for warrants for a 79.9% equity share in the company. These terms were accepted by AIG’s board. This turned out to be the first of a number of bailouts provided by the government to AIG to keep it from failing.
On 17th September 2008, the CEO, Willumstad was forced to resign and was replaced by Edward Liddy.
In early October 2008, the Fed provided an additional $37.8 billion to AIG, the second bailout, as it struggled to meet demands of cash from its clients withdrawing from its securities lending program. In the case of the latter, AIG had lent clients securities in return for cash which it had in turn invested in other securities. Due to the loss in value of these other securities AIG could not honor the demands of its clients. With the new bailout facility the Fed agreed to borrow these other securities in return for cash so that AIG could in turn close the outstanding deals with its clients.
The government also imposed bonus and pay restrictions for its employees and executives on AIG.
AIG continued to use the loan to pay off its obligations on credit default swaps purchased to hedge against defaults of Lehman and other bankrupted entities. It also announced plans to sell of its life insurance operations in various countries. However, AIG’s credit default spreads continued to widen during this period, an indicator that the company was headed for default. In light of this the government announced a third bailout on 10th November 2008. As part of this bailout, the terms and conditions of AIG’s original bailout loan were modified including lowering the interest rate and extending the term of the loan. In addition the government agreed to purchase $40 billion of senior preferred stock as well as it created two entities that would purchase over $50 billion worth of residential mortgage-backed securities, that were either owned by AIG and CDOs owned by counterparties and guaranteed by AIG’s CDS.
By February 2009, AIG had raised only $2.4 billion in divestures and asset sales. However news reported indicated that CEO was not going ahead with plans to fund bailout loan repayments through the sales of AIG assets because of the difficulty in finding strong potential buyers and because of the declining valuation of its insurance assets. Following reported losses of $61.7 billion, the government enhanced the rescue package to AIG on 2nd March 2009 by providing more favorable terms such as lower, non-cumulative, dividend payments on the preferred stock already purchased by the government, purchasing an additional $30 million worth of preferred stock and restructuring of the company including putting two life insurance subsidiaries into separate trusts of which the Federal Reserve would purchase up to $26 billion in preferred stock.
In early August 2009, CEO Liddy was replaced by former MetLife CEO Robert Benmosche as president and CEO of AIG.
Since receiving its first bailout AIG has continued to sell its assets, including its asset management businesses and major insurance subsidiaries, using the proceeds to pay-off its loan to the government. In September 2010 it announced a plan to repay the government loan off early by allowing the US Treasury to swap the preferred stock that it holds for common stock, a 92% stake in AIG, which could then be sold in the market. In addition it would pay off the Federal Reserve loan through earnings and asset sales. AIG is expected to sell $10-$30 million shares to the public in a re-IPO of the company, with the US Treasury being the primary seller to the deal, in April- May 2011.