Daniels Fund Ethics Initiative University of New Mexico http://danielsethics.mgt.unm.edu

Coping with Financial and Ethical Risks at American International Group (AIG)
INTRODUCTION When American International Group (AIG) collapsed in September 2008 and was subsequently saved by a government bailout, it became one of the most controversial players in the 2008–2009 financial crisis. The corporate culture at AIG had been involved in a high-stakes risk-taking scheme supported by managers and employees that appeared entirely focused on short-term financial gain. Out of a firm of 116,000 employees, one unit with around 500 employees, AIG Financial Products, was chiefly to blame for bringing down the company, and former CEO Ed Liddy, who was summoned by former Treasury Secretary Hank Paulson, estimates that of that number only twenty to thirty people were directly involved. The AIG Financial Products unit specialized in derivatives and other complex financial contracts that were tied to subprime mortgages or commodities. While its dealings were risky, the unit generated billions of dollars in profits for AIG. Even so, during his long tenure as CEO of AIG, Maurice “Hank” Greenberg had been open about his suspicions of the AIG Financial Products unit. After Greenberg resigned as chief executive of AIG in 2005, the Financial Products unit became even more speculative in its activities. Immediately before its collapse, AIG had exposure to $64 billion in potential subprime mortgage losses. The perfect storm formed with the subprime mortgage crisis and a sudden sharp downturn in the value of residential real estate in 2008. Since much of the speculation in the Financial Products unit was tied to derivatives, even small movements in the value of financial measurements could result in catastrophic losses. In this case, we trace the history of AIG as it evolved into one of the largest and most respected insurance companies in the world, and explore the more recent events that led to its demise. AIG had a market value of close to $200 billion in 2007, but by 2009 this amount had fallen to a mere $3.5 billion. Only a government rescue of what has amounted to $180 billion in loans, investments, guarantees, and financial injections prevented AIG from facing total bankruptcy in late 2008. The government rescued the company not to keep it from bankruptcy, however, but to prevent the bankruptcies of many other global financial institutions that depended on AIG as counterparty on collateralized debt obligations. If AIG had been allowed to fail, it is possible that the financial meltdown that occurred in 2008–2009 would have been worse. This case first examines the events leading up to the 2008 meltdown, including the philosophy of top management and the corporate culture that set the stage for AIG’s downfall. Next, we review the
This case was developed by O.C. Ferrell, John Fraedrich, and Jennifer Sawayda. It is provided for the Daniels Fund Ethics Initiative at the University of New Mexico and is intended for classroom discussion rather than to illustrate effective or ineffective handling of administrative, ethical, or legal decisions by management. Users of this material are prohibited from claiming this material as their own, emailing it to others, or placing it on the Internet. Please call O.C. Ferrell at 505-277-3468 for more information. (2013)

events that occurred in 2008, including ethical issues related to transparency and failed internal controls. Finally, we look at the role of the government and its decision to bail out AIG. AIG’S HISTORY The saga of American International Group (AIG) began in 1919 with the American businessman Cornelius Vander Starr, who founded a company in Shanghai representing American insurance companies selling fire and marine coverage in Asia. Starr’s success in Shanghai quickly led to expansion across Asia; Starr opened a branch of the company in the United States in 1926. While AIG began as a representative of American insurance companies abroad, in the United States it provided insurance risk coverage to insurance companies as a way to disperse liabilities. Reinsurers such as AIG were created to remove some of the risk associated with large disasters. Because of AIG and others, insurance companies could grow faster than ever before. Insurance companies are educated risk takers. When insurance companies feel they have too much risk, they go to their reinsurance companies, such as AIG, to take out insurance so that if something catastrophic happens, they can still pay their clients. AIG utilizes models to determine how much insurance it can sell to insurers and still pay out. To put it simply, AIG charges insurance companies a premium in order to allow them to spread their risk so that they can sell insurance policies and grow more rapidly. In 1968 Maurice “Hank” Greenberg, a native New Yorker and experienced insurance executive who had been with AIG for many years, took over as CEO. AIG grew exponentially during his tenure. By the end of the 1980s the company had become the largest underwriter of commercial and industrial coverage in the United States and the leading international insurance organization. AIG continued to expand throughout the 1990s, led by its return to China as the first foreign insurance organization granted a license by the Chinese authorities to operate a wholly owned insurance business in Shanghai. (While many foreign organizations are required to have Chinese investors, wholly owned foreign businesses do not have this requirement.) AIG later expanded to Guangzhou, Shenzhen, and Beijing, as well as Vietnam. In 2001 AIG established two joint ventures in general insurance and life insurance in India with the Tata Group, the leading Indian industrial conglomerate. New AIG subsidiary companies followed the fall of the Soviet Union into Eastern Europe, with general and life insurance companies forming in Russia, Poland, Hungary, and the Czech Republic, among other emerging markets. In 2001 AIG purchased American General Corporation, a top U.S. life insurer. This acquisition made AIG a leader in the U.S. life insurance industry and consumer lending. For the individual consumer, business, financial professional, or insurance professional, AIG provides accident and health insurance, auto insurance, life insurance, banking and loans, retirement services, travel insurance, additional services, and annuities. Immediately before its 2008 collapse, AIG had revenues exceeding $110 billion, total assets of over $1 trillion, and 116,000 employees around the world.

AIG’S CULTURE Maurice “Hank” Greenberg was the CEO of AIG for 38 years, and was therefore a key player in shaping the modern face and corporate culture of the company. Many considered Greenberg a genius in the insurance business, and arguably he was one of the most successful and influential executives in the industry. But critics called him autocratic in his drive to expand the company into an international powerhouse. During his career, Greenberg championed innovative products that insure almost any type of risk, including Internet identity theft and hijacking. At least four U.S. presidents sought his advice on international affairs and financial markets. Greenberg was always known for utilizing his contacts and influence to help advance the company. Over the years, Greenberg aggressively lobbied for laws and rulings favorable to AIG. He was very involved with international politics and helped the U.S. government to secure information and develop back-door channels for classified dealings. In return, AIG was given the benefit of the doubt when regulatory agencies came questioning the company’s doings. When billions or trillions of dollars are involved, global corporations have powers equal to or greater than those of governments and regulatory agencies. In spite of Greenberg’s active networking, the early 2000s found AIG under investigation by the Securities and Exchange Commission for its “finite insurance” deals—contracts that covered specific amounts of losses rather than unexpected losses of indeterminate size—and what appeared to be loans (since premiums were structured to match policy payouts and eliminate risk) rather than genuine risk allocation vehicles. A federal inquiry later found information that Greenberg might have been personally involved in creating a bogus reinsurance transaction with the General Re Corporation to fraudulently boost AIG’s reserves. New York Attorney General Eliot Spitzer subpoenaed Greenberg, who treated the summons far more lightly than he should have. As rumors swirled, AIG’s stock began to plummet, and the AIG board started to become concerned. In 2005 Greenberg was forced out as CEO. Next Martin Sullivan held the CEO position for three years, followed by Robert Willumstad for three months. Willumstad was forced to step down in 2008 in the wake of the corporation’s meltdown. He was replaced by Edward Liddy, former CEO of The Allstate Corporation. The SEC leveled charges of fraud against Greenberg resulting from the circumstances surrounding his departure. In order to settle the charges that AIG manipulated financial statements in 2005, the company paid the SEC $1.6 billion in 2006, and Greenberg agreed to pay an additional $15 million in 2009. WHAT HAPPENED AT AIG TO CAUSE ITS DEMISE? The heart of AIG’s troubles leading up to the 2008 bailout was a kind of derivative called credit default swaps (CDSs). Credit default swaps are financial products that transfer the credit exposure (risk) of fixed-income products (bonds) between parties. The buyer of a credit swap receives credit protection, as the seller of the swap guarantees the creditworthiness of the product. The risk of de-

fault is thereby transferred from the holder of the fixed-income security to the seller of the swap. One single credit default swap can be valued at hundreds of millions of dollars. As a reinsurer, AIG used CDSs as a kind of insurance policy on complex collateralized debt obligations (CDOs). The company issued the swaps and promised to pay these institutions, AIG’s counterparties, if the debt securities defaulted. However, AIG did not have a large enough safety net to weather the subprime mortgage collapse. These insurance contracts became essentially worthless because many people could not pay back their subprime mortgages and AIG did not have the creditworthiness for the big collateral call. The government took the drastic step of bailing out the company, providing the funds to purchase the CDOs that were being held by banks, hedge funds, and other financial institutions, and in the process ended up with 79.9 percent ownership of AIG. The U.S. government is now the senior partner in a special-purpose entity that will receive interest and share liability in the ownership of these tainted investment instruments. The government had feared that if AIG were allowed to go bankrupt, many banks throughout the world would have gone bankrupt as well. As we have noted, one unit of the company, AIG Financial Products, was the source of many of the company’s woes. Founded in 1987 by Howard Sosin to trade over-the-counter derivatives, its creation was timed perfectly to ride the derivatives market boom. By and large, Financial Products was run like a hedge fund out of Wilton, Connecticut, and London. Hedge funds are a special type of fund available to a select range of investors. They seek to utilize a wide variety of investment tools to mitigate, or hedge, risk. Often the term refers to funds that use short selling as a means of increasing investment returns. Short selling is betting that the stock price of a company will change during a specified period of time. When the stocks move the expected direction, the investor makes money. AIG Financial Products specialized in derivatives that generated billions of dollars in profits over the years. Derivatives are financial contracts or instruments whose value is derived from something else such as commodities (corn, wheat, soybeans, etc.), stocks, bonds, and even home mortgages. Gains or losses from derivatives come from betting on the movement of these values. The unit also dealt in mortgage securities, a sector that turned rancid with the collapse of the housing bubble. Former New York Attorney General Eliot Spitzer, a champion of financial sector reform, claimed that AIG Financial Products was “the black hole of AIG.” When Howard Sosin joined AIG he was given an unusual deal—a 20 percent stake in the unit and 20 percent of its profits. While AIG can be described as a conservative global conglomerate selling insurance policies to businesses and individuals, the Financial Products unit was staffed by quantitative specialists with doctorates in finance and math. Employees of the unit conducted themselves like investment bankers. In the late 1990s, under the leadership of Joseph Cassano, AIG Financial Products ramped up its business of selling credit default swaps, which were at the heart of the 2008–2009 financial meltdown. AIG Financial Products expanded into writing swaps to cover debt that was backed by mort-

gages. The unit sold swaps to large institutional investors. These collateralized debt obligations were backed by mortgages, and the swaps issued by AIG backed some $440 billion worth of obligations. To put this in perspective, the entire market worth of AIG was around $200 billion at the time. AIG made millions selling collateralized debt obligations (CDOs) and was able to post modest margin requirements, which is the amount the company keeps as a deposit to protect against the risk of loan defaults or nonpayments. For example, to buy stock on margin, you must have at least 50 percent of the purchase price in your account. AIG was able to make these CDO deals with a very small fraction of actual money on hand. Unfortunately, some of these CDOs were attached to home mortgages. In spite of the risk, the company involved itself in bad mortgage lending by financial institutions that did not have sufficient capital to cover the loans, which in turn had bought this type of insurance from AIG that created an unstable financial environment. The loans and the CDOs were often sold to people who could not repay their debt. CEO Greenberg became concerned about this unit’s derivative dealings and asked a group to shadow its trades. Greenberg was uncomfortable with the results and thought the unit was taking too many risks. However, Greenberg left the company in 2005 because of regulators investigating AIG over its accounting practices. AIG sold credit protection on CDOs by simply writing pieces of paper that stated that AIG would cover the losses in case these obligations went bad. AIG agreed to either take over the obligations or cover the losses on CDOs. While AIG made billions of dollars in profits and managers received millions of dollars in compensation for selling these so-called insurance policies, it turned out to be a high-risk house of cards. The tools, CDOs, and CDSs were used recklessly and failed to assess systemic risk of counterparties not measuring their own exposures and not paying their obligations. The Financial Products unit was under investigation around the world, including by the United Kingdom’s Serious Fraud Office. However, its probe against AIG’s Financial Products unit was eventually dropped. Although they have since gained notoriety, before 2008, derivatives were not widely understood by the public, mass media, regulators, and even many of the executives who were overseeing their use. AIG could have taken another approach, buying mortgages or CDOs and then having some other party package them into a credit default swap as insurance, but since AIG was an insurer it simply wrote policies on CDOs, increasing revenues with the hope that only a few would default. AIG LACKED TRANSPARENCY There were suggestions that AIG knew of potential problems in valuing derivative contracts before the financial meltdown occurred. Outside auditors raised concerns about being excluded from conversations that concerned the evaluation of derivatives. As AIG’s auditor, PricewaterhouseCoopers (PwC) had a right to know about the models and about market indicators that indicated that the value of AIG swaps should be lowered. During this period, however, AIG executives Cassano and Sullivan continued to reassure investors and auditors that AIG had accurately identified all areas of exposure to the U.S. residential housing market and stated their confidence in their evaluation

methods. The Justice Department launched a probe of AIG executives, including Joseph Cassano, to investigate whether they had misled investors, but eventually decided not to bring criminal charges against them. The market indicators in question came in the form of demands for collateral by AIG trading partners. At a congressional hearing, Sullivan stated that he believed the evaluations to be accurate based on the information he possessed at the time. This situation is similar to executives at Enron claiming they did not know that Enron had utilized the derivatives and off-the-book balance sheet partnerships that caused its demise. Many Enron executives ended up being found guilty of crimes. AIG PROVIDED INCENTIVES TO TAKE RISKS What were the factors within the corporate culture of AIG that promoted speculative risk-taking? Part of the problem may have been AIG’s incentives. The AIG culture was focused on a reward system that placed little responsibility on executives who made very poor decisions. Although they produced nearly $40 billion in losses in 2008, a number of managers were selected to receive large bonuses. AIG offered cash awards and other perks to 38 executives and a retention program with payments from $92,500 to $4 million for employees earning salaries between $160,000 and $1 million. After receiving more than $152 billion in federal rescue funds, AIG publicly claimed that it would eliminate some of these bonuses for senior executives while all the time planning to hand out cash awards that doubled or tripled the salaries of some. AIG asserted that these types of payments were necessary to keep top employees at AIG, even as control of the company was being handed over to the government. The fact of rewards doled out in the face of excessive risk-taking and possible misconduct has met with outrage among most stakeholders. The main reason that AIG was bailed out at all was that the government was seeking to prevent the failure of some of the world’s largest banks, thereby potentially causing a global financial catastrophe. AIG’s actions reflected an ethical culture that neglected its most important stakeholders. The demise of AIG’s Financial Products unit resulted in part from excessive risk-taking by economists and other financial experts using computer models that failed to take into account real-world market risks. For example, AIG paid Gary Gorton, a finance professor at the Yale School of Management whose work had been cited in speeches by Federal Reserve Chairman Ben Bernanke, large consulting fees for developing computer models to gauge risk for more than $400 billion in complicated credit default swaps. Remember that a single swap can be valued at hundreds of millions of dollars. AIG relied on Gorton’s models to determine which swap deals were low risk. Unfortunately, these models did not anticipate how market forces and contract terms could turn swaps into huge financial liabilities. AIG did not assign Gorton to assess those threats, and therefore his models did not consider them. Like other major firms, AIG entered a very lucrative but perilous new market without truly understanding the sheer complexity of the financial products it was selling. What the company learned

too late was that computers and academic experts cannot determine all of the variables, forces, and weights that cause a high- or low-risk investment to go bad. The blame lies with business placing too much trust in models that turn out to contain faulty assumptions. Models cannot predict with absolute certainty what humans will do because humans are not always rational. Warren Buffett, chief executive of Berkshire Hathaway and a billionaire many times over, has said, “. . . beware of geeks . . . bearing formulas.” AIG’S CRISIS AND BAILOUT AIG’s problems came to a boil in September 2008. Due to the many issues outlined earlier, AIG’s stock was downgraded by the rating companies, which caused the stock to drop, causing a run on the reinsurer’s liquid assets (cash on hand) that revealed its lack of liquidity. Simply put, AIG did not have the capital to repay investors asking for their money back. AIG ultimately owed Wall Street’s biggest firms about $100 billion for speculative trades turned bad; $64 billion of that was tied to losses on subprime mortgages. The company allegedly placed billions of dollars at risk through speculation on the movements of various mortgage pools, and there were no actual securities backing these speculative positions on which AIG was losing money. The losses stemmed from market wagers that were essentially bets on the performance of bundles of derivatives linked to subprime residential mortgages. The government rescue of AIG protected many of its policyholders and counterparties from immediate losses on traditional insurance contracts, but these speculative trades were not a part of the government risk rescue. Over the course of a month, the government doled out over $152 billion in taxpayer money, creating a line of credit for the company and buying up AIG stock. This was a highly controversial move, particularly since the government had not done the same thing for the other struggling financial giant, Lehman Brothers. In March 2009, the government made the controversial decision to dole out another $30 billion in capital to AIG. The decision was made even more contentious when it was revealed that $165 million of the bailout money had gone to bonuses of employees of the failed Financial Products unit. The company stated that the bonuses were part of the employees’ contracts and could not be revoked. Both consumers and government officials were outraged. Pressure on AIG became so great that CEO Edward Liddy asked executives who were making over $100,000 a year to return the bonuses. The House of Representatives voted to implement a 90 percent tax on bonuses at companies that received over $5 billion in bonus funds. However, due to the high level of pressure against the company, most of the executives in question returned the money. In 2010 AIG announced that it was revamping its bonus system. While previous bonuses were largely based on length of time employed with the company, AIG vowed to better align future bonuses with performance. To prevent such an occurrence from happening in the future, the government also resolved to increase its oversight of new bailout funds.

When questioned about the decision to repeatedly bail out AIG, Federal Reserve Chair Ben Bernanke told U.S. lawmakers, “AIG exploited a huge gap in the regulatory system. There was no oversight of the financial products division. This was a hedge fund, basically, that was attached to a large and stable insurance company.” He stated that AIG was the single case out of the entire 2008–2009 financial crisis that made him the angriest. However, Bernanke went on to say, “We had no choice but to try to stabilize the system because of the implications that the failure would have had for the broad economic system.” Although the bailouts were massive, they did not cover all that AIG owed, and the company has had to sell off numerous assets. Two-thirds of the company needed to be sold in a tough market for sellers, resulting in auctions of dozens of the company’s units around the world. Many of these sales resulted in disappointing prices for AIG. For example, Munich Re, the world’s biggest reinsurer, agreed to buy AIG’s Hartford unit for $742 million, about a third less than AIG had paid for it eight years before. The company also gave more than 2,000 employees cash incentives to stop them from quitting, saying that the payments were necessary. “Anybody who wants to start an insurance company or beef up their position, they will come to our organization and pick people off,” said thenCEO Edward Liddy in an interview. “If that happens, we can’t maintain the businesses we want to keep and we won’t be able to sell them for the kinds of values that we need.” Former CEO Greenberg insists that the company’s upper management was the root cause of the collapse after he left. “AIG had a unique culture when I was its CEO, particularly in comparison with the way many large public companies operate today,” he said. “Neither I nor other members of my senior management team had employment contracts. I received no severance package in connection with my retirement, and I never sold a single share of AIG stock during the more than 35 years that I served as CEO.” In a 2008 interview, Greenberg explained what he sees as the real cause of the financial collapse. He blames low interest rates and excessively easy credit for the reckless risktaking and poor decisions made within the financial industry. He also cites excessive leveraging and mark-to-market accounting practices as contributing to the meltdown. “Mark-to-market” means assigning a value to a position held in a financial instrument based on the current market price for the instrument. For example, the final value of a financial contract (say, grain futures) that expires in nine months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would have at the end of each day. Greenberg believes that all these factors grew out of control to the point where the entire system had nowhere to go but toward failure. The controversies regarding AIG have not ended with government ownership. In fact, the problems that critics had identified regarding the company’s culture and reckless spending were on full display a mere two months after it had received its bailout money. Top AIG executives were spotted holding a lavish conference at a posh Point Hilton Squaw Peak Resort in Phoenix for 150 financial planners and top AIG executives. The three-day event reportedly cost over $343,000. Representatives of the corporation defended the conference, stating that most of the costs were underwritten by sponsors; however, such an episode mere weeks after receiving a government bailout funded by taxpayers did not sit well with stakeholders. Many believe it demonstrated how little remorse AIG

has for the decisions leading up to the failure, and how little has changed since the company received government money. CHANGES AT AIG AIG has a tough road ahead of it, not only in repaying taxpayers but also in restoring its damaged reputation. The best way for AIG to restore its credibility will be by increasing its transparency and accountability. This requires a more realistic assessment of its risks and liabilities. In 2011 AIG decided to increase its claims estimates for insurance policies that it had sold in the past, particularly those associated with its property and casualty insurance business Chartis. AIG increased loss reserves for these insurance policies by $4.1 billion, a move that eliminated much of its operating profit for 2010 but served to clean up its balance sheet. AIG began selling off some of its businesses in September 2008 to generate the proceeds needed to repay taxpayers. The company sold its American Life Insurance Division to MetLife for $16.2 billion, offered its Asia-based life insurer AIA Group as an initial public offering raising $20 billion, and sold its ownership of Nan Shan Life, the third largest insurance company in Taiwan, for $2.2 billion. The sale of assets continued for four years, ending in September of 2012. Additionally, AIG reached an agreement with the U.S. government, intending to end its involvement with AIG by the end of 2012. In early 2011 the government began selling off its 92.1 percent stake in AIG through stock offerings. Together the AIG and the Treasury released $8.89 billion in stock. In all, the U.S. government invested $182 billion in AIG. By the end of 2012, AIG had repaid the full amount back to the American people plus an additional $22 billion in interest payments. They are beginning to pay down their debts, make new investments, and will soon re-commence dividend payments. However, the success of AIG’s stock will largely be based upon how well investors believe AIG will perform in the future. AIG will need to learn from its prior mistakes and continue to reestablish investor trust if it hopes to return to its once famed profitability. CONCLUSION The question remains: Was a bailout really necessary? Some, such as Greenberg himself, say yes. “You have to have a bailout,” Greenberg argued. “But I would call it something else rather than a bailout. That implies the wrong thing. It is really also helping Main Street, not just Wall Street, because if the economy doesn’t grow, jobs are going to be lost and we’re going to go into a depression rather than a recession. The taxpayer is not going to take a hit long-term because the money involved will be repaid over a period of time.” Others are not so certain. Critics of the AIG and auto industry bailouts, for example, cite a lack of accountability in how the funds are to be used. Many also oppose this level of government intervention in corporations because it seems to be rewarding companies that have blatantly ignored the needs and desires of their stakeholders in favor of enriching themselves in the short term. Even months after the bailout, AIG continued to lose massive amounts of money. Although the company

is beginning to show signs of recovery, the damage to its reputation over this matter has been massive, and some critics wonder if it will ever recover. The company has also had a difficult time selling off its assets in order to repay its debts, as many of its potential buyers also have been working to recover from the 2008–2009 recession. Without a doubt, the failure of AIG was massive and, bailout or not, its effects have rippled across the globe. QUESTIONS 1. Discuss the role that AIG’s corporate culture played in its downfall. 2. Discuss the ethical conduct of AIG executives and how a stronger ethics program might help the company to strengthen the ethics of its corporate culture. 3. What could AIG have done differently to prevent its failure and subsequent bailout?
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