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«Robert McDonald and Anna Paulson October 2014 WP 2014-07 AIG in Hindsight1 October 22, 2014 Robert McDonald Kellogg School of Management, ...»

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AIG in Hindsight

Federal Reserve Bank of Chicago

Robert McDonald and Anna Paulson

October 2014

WP 2014-07

AIG in Hindsight1

October 22, 2014

Robert McDonald

Kellogg School of Management, Northwestern University and NBER

Anna Paulson

Federal Reserve Bank of Chicago

The near-failure on September 16, 2008, of American International Group (AIG) was an


iconic moment in the financial crisis. The decision to rescue AIG was controversial at the

time and remains so. Large bets on real estate pushed AIG to the brink of bankruptcy. In one case, AIG used securities lending to transform insurance company assets into residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs), ultimately losing at least $21 billion and threatening the solvency of the life insurance companies. AIG also sold insurance on multi-sector CDOs, backed by real estate assets, ultimately losing more than $30 billion. These activities were apparently motivated by a belief that AIG’s real estate bets would not suffer defaults and were “money-good.” We find that these securities have in fact suffered write-downs and that the stark “money-good” claim can be rejected.

1Ben Chabot, Mark Finn, Arvind Krishnamurthy, Anil Kashyap, Andreas Lehnert, Debbie Lucas, David Marshall, Richard Miller, Richard Rosen, David Scharfstein, and Robert Steigerwald provided helpful commentary and feedback, as did seminar participants at Case Western and the Federal Reserve Banks of New York and Chicago. We are grateful to Kyal Berends, Mike Mei, and Thanases Plestis for excellent research assistance. The views presented here are solely our own and do not reflect those of the Federal Reserve Bank of Chicago or the Board of Governors of the Federal Reserve System. All errors are those of the authors.

1 The near-failure on September 16, 2008 of American International Group (AIG) was an iconic moment of the financial crisis. AIG, a global insurance and financial company with $1 trillion in assets, lost $99.3 billion during 2008 (AIG 2008b, p. 194) and was rescued with the help of the Federal Reserve Bank of New York, the Federal Reserve, and the Treasury. The rescue played out over seven months and involved the extension of loans, the creation of special purpose vehicles (SPVs), and equity investments by the Treasury.

AIG’s fate also provided an important touchstone in discussions of financial reform. AIG motivated the enactment of new rules for derivatives, the creation of an orderly liquidation authority, as well as rules governing non-bank institutions, allowing them to be designated as “systemically important,” and subject to Federal Reserve oversight.

The decision to rescue AIG was controversial at the time and remains so. Most of the attention paid to AIG—and our focus—concerns two activities. First, AIG Financial Products (AIGFP) wrote credit default swaps (CDS) on over $500 billion of assets, including $78 billion on multi-sector collateralized debt obligations (CDOs) (AIG 2007b, p. 122).

These swaps were held by other financial institutions. Second, AIG used loans of insurance subsidiary assets to finance the outright purchase of RMBS and real-estate-related CDOs.

On September 16, 2008, the cumulative losses from these two activities were on the order of $50 billion, and both appear to have played important roles in AIG’s near-failure.

A central purpose of this paper is to examine in detail AIG’s CDS and securities lending activities. These are the primary means by which AIG took on real estate exposure, and details of this risk-taking are available because of the rescue. We use available data,

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performance of the assets underlying AIG’s bets.

An issue central to any discussion of AIG is the question of whether the firm’s difficulties stemmed from illiquidity or insolvency. The term “illiquidity” is imprecise, but at a minimum means that assets cannot be quickly sold at fair value and is often meant to refer to a price decline that is temporary. “Insolvency” usually means that the fair value of a firm’s assets is less than the par value of liabilities. Illiquidity and insolvency are linked: A firm that can sell assets only at a steep discount to fair value may be insolvent as a consequence. We make no attempt to assess AIG’s overall solvency, but we do consider whether AIG’s real estate positions incurred permanent losses.

The insolvency vs. illiquidity debate is prominent with AIG, because AIG’s real estate positions were apparently motivated by the belief that these investments would not default. The head of AIGFP, Joseph Cassano, often referred to the CDOs insured by AIGFP as “money good.” 2 This implicitly attributes any price decline to illiquidity. Mark Hutchings, who ran AIG’s securities lending business, made similar statements about the RMBS and CDO investments financed by securities lending. 3 To the extent that these assets subsequently suffered write-downs resulting in real losses (insolvency) rather than temporary price declines (illiquidity), the money-good claim proved to be false.

2For example, Cassano made these remarks in a December 5, 2007 investor presentation:

http://www.fcic.gov/documents/view/1139. AIG structured the insurance it provided on CDOs such that “the risk of loss is considered to be insignificant”. The insurance was structured so that AIG would face no modeled losses with 99.85% confidence under a scenario whose mean was set at the worst post World War II recession (Price Waterhouse Coopers, 2007).

3Hutchings makes these remarks in an interview with the Financial Crisis Inquiry Commission

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2008. We compare AIG’s real estate holdings to the holdings of other financial firms and find that AIG’s positions are roughly comparable to those of Citigroup and Bank of America, two other firms that received extensive support during the crisis.

In Section 2, we examine AIG’s securities lending operations. By the end of 2007, AIG had loaned $75 billion in securities, with 65% of lending proceeds invested in mortgagebacked securities. The securities lending business was characterized by a large liquidity and maturity mismatch, making it vulnerable to borrowers redeeming en masse.

Ultimately, the company’s total losses from securities lending amounted to at least $21 billion; and we show that, without rescue funds, these losses threatened the solvency of some of AIG’s life insurance subsidiaries. With standard bankruptcy resolution, securities lending counterparties are protected by collateral in the form of the borrowed securities, and the RMBS losses would have been borne by the insurance subsidiaries. Because of cross-state variation in laws governing the resolution of life insurance companies, the effects of an AIG bankruptcy that led to insurance insolvencies could have been uncertain for securities lending counterparties.

In Section 3, we examine AIG’s credit default swap operations. By September 16, 2008 AIG’s multi-sector CDS portfolio had lost more than $33.9 billion. However, AIGFP had posted $22.4 billion in collateral, leaving counterparties with exposure to AIG of $11.5 billion. The maximum exposure of the largest individual AIGFP counterparties (accounting for 90% of the exposure) was less than 10% of their equity capital as of June 30, 2008. 4 We 4We obtained similar results using financial information from September 30, 2008.

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positions do not appear to have played a significant role in its near-failure.

In Section 4, we describe the special purpose vehicles that the New York Fed created to deal with the assets related to AIG’s securities lending and CDS operations. In order to assess the money-good claim, we examine write-downs on the assets in these portfolios from inception to September 2014. The money-good claim is equivalent to asserting that price declines during the crisis were temporary and due to illiquidity, but many of the securities we examine have suffered real losses. In interpreting this finding, it is important to keep in mind that prices reflect expectations over all possible future outcomes, and history reveals only one outcome. Policy interventions are part of that history, and price changes can be due to changes in liquidity or in real outcomes, or both. Even with hindsight, it is generally impossible to attribute price changes to one effect or the other.

Although we cannot explain prices or price changes, we can assess the claim that assets were money good. We show that they were not: Both the insured CDOs and the RMBS investments financed by securities lending suffered principal write-downs. To date, the assets in aggregate have experienced principal write-downs of almost 4%, with most of the write-downs occurring after assets were sold by the Federal Reserve Bank of New York. As we discuss, this is almost certainly an underestimate of the ultimate write-downs.

In Section 5, we present our conclusions.

It is important to be clear about what we do not do in this paper: We do not address the broad question of what might have happened to the financial system had AIG failed, nor do we analyze the form of the rescue and whether it was profitable or justified. Similarly,

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academics have written extensively about potential systemic consequences from the failure of a large, interconnected financial firm like AIG. 5 See, for example, Acharya, Gale, and Yorulmazer (2011), Brunnermeier and Pedersen (2009), Kacperczyk and Schnabl (2010), Duarte and Eisenbach (2013), and Ellul, Jotikasthira, Lundblad and Wang (2014), among many others. We discuss the issues raised in these papers and others to the extent that they are important for understanding the implications of AIG’s securities lending and CDS for multi-sector CDOs.

Our reexamination of AIG is with the benefit of hindsight. Multiple parties have studied the crisis in general and AIG in particular (for example, the Congressional Oversight Panel, the Financial Crisis Inquiry Commission (FCIC), and the Government Accountability Office). In addition, the Federal Reserve Bank of New York has made public data on the assets in the SPVs that it managed.

1. AIG before September 16, 2008

AIG was an international insurance conglomerate with four main lines of business:

• General Insurance: property/casualty and commercial/industrial insurance;

• Life Insurance and Retirement: individual and group life insurance and annuities;

• Asset Management: private banking, brokerage, and investment advisory services;

5In testimony about the rescue, Federal Reserve Chairman Ben Bernanke noted that AIG had $20 billion of commercial paper outstanding and $50 billion of exposure to other banks via loans, lines of credit and derivatives.

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aircraft leasing.

As with other large financial firms, AIG’s fate during the financial crisis was determined largely by the extent of its exposure to real estate, including subprime mortgages. We construct an “adjusted balance sheet” in order to compare AIG’s real estate exposure with that of other firms.

Real Estate Exposure We make two adjustments before we compare AIG's real estate exposure with that of other financial firms. First, AIG had a large written CDS portfolio which, although disclosed in footnotes, does not directly show up on the balance sheet. Second, a number of large banks had off-balance-sheet exposure to real estate through asset-backed commercial paper conduits (ABCP), which also do not show up on the balance sheet (Acharya, Schnabl, and Suarez, 2013). Both CDS and ABCP are equivalent to levered asset purchases, so it is possible to correct for both items by constructing adjusted balance sheets using this equivalence.

In its 2007 10K report, AIG listed $1.06 trillion in assets (AIG, 2007b, p. 130). We incorporate CDS by recognizing that at issuance, a credit default swap is economically equivalent to a purchase of an insured asset financed by issuing floating rate debt (Duffie, 1999). If a firm with $100 in assets and $90 of debt writes a CDS on $50 of CDOs, the economic result is as if the firm had $150 in assets, $50 of which are CDOs, financed with $140 in debt. Note that the issuance of CDS implicitly changes assets and debt but not equity. Scaled appropriately, this is approximately AIG’s situation: Accounting for written CDS in this fashion increases its balance sheet by 50%.

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financed with $100 of commercial paper, this is economically equivalent to the bank having an additional $100 of both assets and debt. These adjustments are crude along at least two dimensions: They do not account for asset quality and they implicitly assume that the firms, except AIG, have net CDS positions of zero. Detailed data on CDS writing activities for the other firms are not available.

Table 1 compares AIG's adjusted real estate exposure with that of another large insurance company, Metlife, and with Citigroup, Bank of America, and JPMorgan Chase.

Accounting for CDS as part of the adjusted balance sheet increases AIG’s assets by 50% and similarly raises its leverage ratio from 11 to 17. Among these firms, AIG appears comparable to Bank of America and Citigroup, with high leverage and a high ratio of real estate exposure to assets and real estate to equity. AIG’s effective real estate holdings were almost four times its book equity.

Consequences of Real Estate Exposure Unsurprisingly, AIG’s large real estate exposure led to large losses during the financial crisis. Table 2 presents financial indicators for 2006–09, which help to put AIG's 2008 performance into perspective. AIG collapsed in 2008, losing money in all of its main lines of business, with the largest losses in the Life Insurance and Financial Services divisions. In both cases, the losses stemmed from heavy bets on real-estate-related financial products. In the case of financial services, AIGFP had written CDS on mortgagerelated bonds, losing $28.6 billion in 2008 (AIG, 2008b, p. 265). The life insurance division lost money primarily because of securities lending ($21 billion in losses), where life

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