Table of Contents Problems with AIG and Credit Default Swaps 1 Financial Crisis 1 Why study AIG case 1 Define what a CDS is and history of AIG 2 AIG background 2 What are Credit default swaps? 3 What happened at AIG? 5 Why is the AIG case so special? 7 Government Reactions 8 Expert Opinion 10 Causes, How it can be Solved, Possible Ways it Can be Prevented 11 Works Cited 14

“Financial derivative products were financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
-Warren Buffett
Problems with AIG and Credit Default Swaps
Financial Crisis:
Credit derivatives are believed to be one of the primary causes behind the financial crisis in 2008, and they continue to be an existing threat to the global economy in the future. Many economists have indicated that the breakdown in the credit derivatives market was the main reason behind the collapse of large corporations like Lehman brothers and AIG, as opposed to the subprime mortgage market.
Why study AIG case:
The failure of AIG can be primarily attributed to greed. Like many other insurance companies, AIG was too risky on credit default swaps. By the time of the crisis, the company had written more than $441 billion in swaps on bonds and securities, including mortgage-related securities. The collapse of the mortgage market unveiled the problems of credit derivative products and drew widespread attention to this huge and dangerous market. American International Group is a perfect example to explain the potential threat of credit derivatives to the global economy and the damage that they have already caused.
AIG entered the credit default swaps business in 1998, and sold billions of dollars of credit derivatives to other financial institutions as “insurance” on their investments. Most of the securities AIG covered were AAA before 2007. In late 2007, as the mortgage market began to decline, the value of these securities followed. At the same time, AIG suffered great losses from mortgage investments, which resulted in a reduction of AIG's capital reserves. Because of the decline of AIG’s financial strength and capital reserves, Standard & Poor's and Moody's downgraded AIG from AAA to A. As a result of the downgrade, AIG needed to pay back approximately $100 billion to their counterparties in accordance with the collateralization requirements under the CDS contracts. AIG then turned to the government for financial assistance. To stabilize AIG and prevent reverberations throughout the economy, the Federal Reserve Bank of New York extended to AIG a two-year emergency secured loan of up to $85 billion on September 16, 2008. In exchange, U.S. Treasury gained 80% control of the company. Since then, AIG has sold many of its businesses around the world to pay back the loan.
Define what a CDS is and history of AIG
AIG background:
American International Group, Inc (AIG) is a world leader in insurance and financial services. Prior to its collapse, AIG was the largest insurance company in the United States, and it played a leading role in global insurance industry. It is headquartered in New York City, and operates in more than 130 countries and jurisdictions. AIG’s common stock is listed on the New York Stock Exchange, as well as the stock exchanges in London, Paris, Switzerland and Tokyo. Over the years, AIG had transferred to global franchises in life and general insurance as well as wide range of financial services businesses.
The predecessor of AIG originated in 1919 in Shanghai, and was started by Cornelius Starr, an American businessman who opened up a small insurance office to sell policies to Chinese nationals. AIG then expanded from Asia to Latin America, to Europe and eventually to the United States. In 1968 Starr was succeeded by Maurice Greenberg. AIG then went public in 1969 and Greenberg built the company into a financial conglomerate and into the world’s largest insurance company. In 2006, AIG had sales of $113 billion and 116,000 employees. It was once the 18th largest public company in the world, according to the 2008 Forbes Global 2000 list. AIG was investigated multiple times by the SEC and was involved in many previous scandals. Greenberg was forced to resign as CEO in 2005 and was then replaced by Martin Sullivan. Furthermore, “AIG had to reinstate its earnings by a total of $3.5 billion dating back to 2001. AIG also had to pay $1.6 billion in fines as part of the settlement.” AIG weakened in America’s sub-prime mortgage crisis. It had traded heavily in credit default swaps and could not meet its obligations. This is why the United States government rescued AIG with an $85 billion bailout in 2008.
What are Credit default swaps?
Credit default swaps, otherwise known as CDS’s, are a form of credit insurance. Simply put, it is a when a buyer pays a premium to the seller so that in case of a negative credit event, the seller takes on the credit risk. If no credit default exists, then the seller pockets the premium and everyone is happy. The current value of this market is estimated to be $45-$60 trillion dollars. Credit default swaps were created by JP Morgan in 1995. CDS were designed as a way for banks to hedge risky loans, helping to reduce the leverage of the bank. Due to this, many people thought of credit derivatives as an, “innovative financial product that would reduce the overall risk of financial markets.” However, there are a few aspects of CDS that substantially increased the level of systemic risk in financial markets. The first major problem with CDS is that when a firm buys a credit default swap, they do not have to hold the underlying debt that the contract insures.
The second major problem with credit derivatives is how they are exchanged. Since credit default swaps are not securities, the Securities Exchange Commission does not regulate them. According to one source, “Regulation of CDS is actually prohibited under the Commodity Futures Modernization Act of 2001. Therefore, CDS are traded over the counter and not on an exchange.” Since CDS are traded over the counter, they are not registered with anyone. Therefore, “no one really knows who is on either side of a CDS contract because they can be traded many times over without having to inform the other party of the contract or anyone else.”
One of the risky investments that CDS were mainly used to hedge was mortgage-backed securities (MBS). Simply put, these are financial instruments where mortgage payments have been grouped together, securitized, and split up into tranches. MBS would then be sold to other banks so that these financial institutions can receive interest payments from the home owners. One risk associated with mortgage-backed securities is defaulting on mortgages by homeowners. They are very risky, which is why CDS were bought to insure against them defaulting.
For example, Bank of America owns $5 million in bonds issued by GM. Bank of America believes that there is a possibility that GM may default on repayments. To hedge the risk from the investment, the company will buy CDS from AIG. The CDS are worth the same as the investment and the bank needs to pay 2% interest to AIG. Usually the investment will not default; AIG receives interest from Bank of America will out any repayment. However, if GM does default, then AIG has to pay compensation to the bank $5 million, the value of the investment.
Chart 1
CDS share many characteristics with insurance, but there are some significant differences between them in various aspects. The insurance obligation is specifically listed in the documentation, while CDS only include reference name or entity. Additionally, CDS generally requires public disclosure of default in order for a claim to be filed, while insurance does not. In comparison to insurance, CDS have higher interchangeability; CDS can be assigned with consent and can be hedged.
What happened at AIG?
Most people believe that the downfall of AIG was an effect of the subprime mortgage crisis. In reality, the downfall did in fact start with the mark down of AIG’s mortgage backed securities portfolio; however, if it wasn’t for the credit default swaps exposure they would have not collapsed the way the company did. Credit-default swaps, and more specifically, poor management dealing with credit default swaps played a major role in the collapse of AIG. Once a bond defaults it may trigger the default of another bond. This process can continue because bonds have an impact on each other. Risk increases as more bonds default. Once AIG’s covered securities began to default they started losing capital from those investments and at the same time they still had collateralized debt obligations through the CDS they had sold.
In the middle of 2007, AIG officials and executives, one including Joseph Cassano, emphasized how secure these credit derivatives were and that no money would be lost from any of these transactions. Joseph Cassano is the former CFO of AIG Financial Products who played a major role in the collapse of AIG. AIG sold credit derivatives as insurance for low risk bonds to other financial institutes, such as Goldman Sachs. Goldman Sachs in August of 2007 began AIG’s collateral build up; they asked AIG to pay up collateral to cover exposure and privately AIG did post up $450 million dollars. Later on that year AIG posted up an additional $1.5 billion in collateral to Goldman Sachs.
In November of 2007, AIG reported millions of dollars in unrealized losses as a result of their credit default swap portfolio. Despite this, executives remained confident that this would not occur and continued to believe that nothing would be lost as a result of these CDS. This figure, however, was underwritten; in reality there was a vastly greater amount of unrealized losses than just $352 million. An auditor from PricewaterhouseCoopers noted this down as a “material weakness finding” and privately warned AIG about it. As a result, AIG reported an additional $1.1 billion of unrealized losses by the end of 2007. Despite this, Sullivan and other executives were still confident that the likelihood of an economic loss was slim to none. They conducted a few risk models that they remained to go by and trust upon. Once the “material weakness finding” became public AIG hiked up even further their unrealized losses totaling the amount to about $11 billion. None of this information was disclosed or open to the public until February of 2008 when AIG announced that they had posted up a total of $5.3 billion in collateral. Unrealized losses due to the CDS portfolio and the amount of posted collateral continued to rise throughout 2008. In September of 2008 the amount of posted collateral was at $16.5 billion.
Because of this, the rating agencies Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings Inc. downgraded AIG’s ratings from AAA rating to A. Because of CDS contracts this downgrade triggered even further collateralization requirements on their credit default swaps. If the value of the company a bond is being held in goes down or the value of AIG itself goes down then they must pay a collateral agreed amount to the counterparty. This downgrade caused an additional $14.5 billion in collateral bringing the total up to about $31 billion. This is when finally the company collapsed.
In total, the firm wrote up about $450 billion of credit default swaps. AIG then had costs of approximately $100 billion worth of credit default swaps towards their counterparties. AIG did not have this amount of capital to pay their obligations, which is the reason why they ended up being bailed out. The main problem was that AIG was too risky with these credit derivatives. They sold credit default swaps as insurance, but they did not have the capital to back it up in case of default or in this case collateralization.
Why is the AIG case so special?
AIG’s scale and its role in the credit default swap system distinguished it from many other collapses in the crisis, such as Lehman Brothers, Fannie Mae and Freddie Mac. First of all, the company fits the “too big to fail” rule perfectly. AIG holds more than $1 trillion in assets, and it has 116,000 employees and 74 million customers. In addition, AIG owns 71 U.S-based insurance companies and 176 other financial services companies and non-U.S. insurers. The failure of AIG will cause a domino effect to the world economy, which, although difficult to imagine, would be even worse than the current financial crisis.
Second, AIG was the linchpin of the entire credit default swap system. That means that without the government’s assistance, the failure of AIG could bring down every major bank in the world. The reason that AIG is so important to the banks is that AIG provided banks a way to get around the Basel rules with credit default swaps. The Basel II regulations are similar to the Federal Reserve requirement in U.S. Banks around the world and need to follow the rules to determine the amount of capital reserve they have to maintain in correspond with the risks of their investment. With the help of AIG, banks will be allowed to pretend they have far higher-quality loans than they actually do.
The failure of AIG would have caused an extreme impact on not only the gigantic credit derivatives market but the entire global economy as well since these CDS were sold to major financial institutions throughout the world.
Government Reactions
The federal government responded to the crisis at AIG by bailing it out. The main reason for this was because of the company’s heavy involvement with credit default swaps. An $85 billion Federal Reserve loan to AIG was announced in 2008. Since the financial crisis, many have become familiar with the term ‘too big to fail.’ Simply put, it was decided that, “AIG was deemed too huge (its assets top $1 trillion), too global and too interconnected to fail.” In other words, if it collapsed, the consequences would extend far beyond company borders, and would have a detrimental effect throughout the world.
The fact that the collapse would affect the global economy not only has to do with the size of AIG itself but the size of the credit derivatives market as well. AIG alone had sold over $500 billion worth of credit default swaps to counterparties of all different firms and clients. As shown in the chart, the credit derivatives market in 2007 was worth over $60 trillion. Not only is this far bigger than the subprime mortgage market, which was the underlying root of the economic recession, but it was also bigger than the global gross domestic product in 2007. This market is one that should be heavily managed and regulated or else it can get out of control.
It should be noted that AIG was not the only company that sold far too many credit default swaps; there were other financial institutions and banks that sold them carelessly as well. However, due to the amount that AIG sold, along with how many different firms they had as counterparties, their collapse would affect not only those counterparties but the whole global economy as well.
It is also explained in the article that, “The biggest fears had to do with the credit-default swaps, which AIG appears to have sold in large quantities to practically every financial institution of significance on the planet.” Furthermore, “RBC Capital Markets analyst Hank Calenti estimated Tuesday that AIG's failure would cost its swap counterparties $180 billion.” Therefore, although some may argue that bailout’s should be avoided because it reinforces bad behavior, the government came to this decision because AIG’s failure would have an impact on so many people.
Furthermore, "Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression," wrote money manager Michael Lewitt in the New York Times. There is also the fact that through its insurance policies AIG touches far more regular Americans (and consumers around the world) than Lehman Brothers did. Plus, AIG's insurance businesses make so much money that they could conceivably pay off the cost of the bailout within a few years. According to an article written for the New York Times in September 2008, “The AIG rescue was the most radical intervention in private business in the central bank's history. The Fed concluded that "a disorderly failure of AIG could add to already significant levels of financial market fragility."
However, the bailout was unfortunately not enough to restore confidence in the market. According to an article written for the New York Times in 2008, “Stocks dropped sharply on Wall Street Wednesday morning, as an unprecedented $85 billion government bailout of the troubled insurer American International Group failed to placate investors' fears.”
Expert Opinion:
The presiding expert opinion is that the bailout will simply reinforce bad behavior as well as place an unfair burden on the public. To use an analogy, the government bailout of AIG was like sweeping a pile of dirt under the carpet; it is a temporarily solution to the problem, but it will ultimately make the situation much, much worse. According to one expert opinion, the bailout should not have happened because it is extremely unfair for the public to have to deal with this burden, “these financial dealings are monstrously complicated, but this account focuses on something mere mortals can understand—moral confusion in high places, and the failure of governing intuitions to fulfill their obligations to the public.” Finally, “The AIG rescue demonstrated that Treasury and the Federal Reserve would commit taxpayers to pay any price and bear any burden to prevent the collapse of America’s largest financial institutions,” the COP report said. This could have been avoided, the report argues, if the Fed had listened to disinterested advisers with a less parochial understanding of the public interest.”
As time progressed, AIG was able to pay back a substantial amount of its debt. Unfortunately this particular Bailout did start up a governmental habit to interject and bailout companies that are deemed “Too Big to Fail” using taxpayer’s money. However, AIG has been doing a good job at paying back the government as well as taxpayers. This can be looked at as a good thing, but at the same time it can be considered a bad thing as well. Yes they are paying back the taxpayers and will soon be able to pay off all their debt, however this example shows that there are companies that can payback huge bailouts and it causes the government to put more confidence in these companies that are “Too Big to Fail.” The government has been getting too comfortable in bailing out companies throughout this recession and it is creating an even greater amount of moral hazard in our economy.
Companies dealing with credit default swaps or any other derivatives as risky as these need to heavily consider their actions and take more precautions on what can occur in order to prevent things to get out of control and create another situation like AIG. The government should not have to come to this point where they need to lend corporations money in order for them not to collapse, especially not using taxpayers’ money. AIG is paying back what they owe, but not everyone is capable of this.
Causes, How it can be Solved, Possible Ways it Can be Prevented According to Sewell Chan of New York Times, the ingredients leading to the financial crisis concoction included “shoddy mortgage lending, excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.” Many can agree the fault lies within credit default swaps of the financial derivatives, where AIG used them as insurance but didn’t have the necessary capital to insure all transactions sold. The Financial Crisis Inquiry Commission report adds on, “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire…the captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand and manage evolving risks within a system essential to the well-being of the American public…” The Financial Crisis Inquiry Commission believed that fault also lied in SEC, Securities and Exchange Commission, where they failed to require big banks to hold more capital to cushion potential losses and halt risky practices.
While many blame the risky financial transactions of these “too big to fail” companies, Treasury Secretary Timothy F. Geithner begs to differ; “This financial crisis was caused in large part by significant gaps in the oversight of the markets.” Sewell Chan mentions the “key turning point in the march toward financial crisis” occurred in the decision to shield financial instruments from regulation made during President Bill Clinton’s last term. Although many experts may disagree upon discussion of the financial crisis, most can agree the primary causes of this economic crisis was the lack of financial regulation. Since the financial crisis occurred in 2008, many precautions have been taken to tend the needs of the devastated economy. At the brink of the crisis, the government funded over $180 billion of tax payers money to aid AIG’s bailout. Though this is an enormous sum of aid, the company has taken appropriate action since the bailout to repay their debt. According to New York Time’s Deal Book, AIG was able to pay back $3.9 billion to the Federal Reserve 3 years early after their aircraft leasing unit, International Lease Finance Corporation, sold over $4 billion of debt to investors. While the company continues to liquidate to repay debt, the Treasury Department is now bears responsibility to sell their 92.1% stake in AIG. According to Michael J De La Merced of New York Times, the Treasury has even begun converting “its preferred shares in AIG into common stock, which it planned to sell off beginning in either March or May” to ease the liquidation process and sell shares to private investors. Though “the Obama administration is pressing aggressively for a deal to end its support of the American International Group” says Louise Story and Mary Williams Walsh of New York Times, “a rapid exit by the government could also lead to a credit downgrade, which would hurt the company’s ability to sell insurance.”
With over $680 trillion dollars in the value of derivative’s underlying assets, approximately 38$ trillion dollars are consisted of credit-default swaps. It is no surprise the failure of such a large market would lead to the financial crisis. But in an effort to prevent another financial crisis, the Obama administration is now seeking federal oversight and authority over these complex financial instruments, including credit derivatives and credit default swaps. Backed by the Treasury secretary, Mr. Geithner added that “the measure should require swaps and other types of derivatives to be traded on exchanges or clearinghouses backed by capital reserves…” According to Geithner, doing so would “probably make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets...”, but will also point the financial markets to a safer direction.

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