The Fallen Giant: AIG Case Study

Why is AIG considered a fallen giant?

You may be surprised to find that American International Group Corporation (better known as AIG (NYSE: AIG)) is still active and is no longer considered a threat to US financial stability.

Nearly ten years after receiving government bailouts worth about US$150 billion, the US Financial Stability Supervisory Commission (FSOC) voted to remove AIG from its list of institutions with systemic risks, or, in the terminology of the title, “too big and too big. Can’t go bankrupt”. In 2013, the company repaid the last instalment of debts to taxpayers, and the U.S. government gave up its shares in AIG.

Key points

  • AIG was one of the beneficiaries of the 2008 rescue of an organization that was deemed “too big to fail”.
  • This insurance giant is one of many companies that have bet on debt-backed bonds and lost.
  • AIG survived the financial crisis and repaid huge debts to American taxpayers.

In the quarterly earnings announced in August 2019, AIG’s revenue increased by nearly 18%, and the company turned losses into profits. But it was forced to halve itself, including selling a valuable Asian unit to pay off its huge debt to American taxpayers.

See how AIG might fall

Goofy AIG

For decades, AIG has been a global giant selling insurance business. But in September 2008, the company was on the verge of bankruptcy.

The center of the crisis was in an office in London, and a division of the company called AIG Financial Products (AIGFP) almost caused the collapse of the pillar of American capitalism.

The AIGFP division sells investment loss insurance. A typical policy may ensure that investors are protected from changes in interest rates or other events that adversely affect investments.

But in the late 1990s, AIGFP discovered a new way to make money.

How the bursting of the real estate bubble broke AIG

A new financial product called a Collateralized Debt Debt (CDO) has become the darling of investment banks and other large institutions. CDO classifies various types of debt from very safe to very dangerous as a bundle and sells them to investors. Various types of debt are called grades.

Many large institutions holding mortgage-backed securities have created CDOs. Including grades full of subprime loans. In other words, they are mortgage loans issued to people who are not eligible to repay loans during the real estate bubble.

AIGFP decided to take advantage of this trend to profit. It will ensure that CDOs will not default through a financial product called a credit default swap. The chance of having to pay for this insurance seems extremely unlikely.

The CDO insurance plan has achieved great success over a period of time. In about five years, the revenue of this division increased from 737 million U.S. dollars to more than 3 billion U.S. dollars, accounting for approximately 17.5% of the company’s total revenue.

A large portion of insured CDOs appear in the form of bundled mortgage loans, of which the lowest-rated portion is subprime loans. AIG believes that defaults on these loans are trivial.

Rolling disaster

Then the foreclosure of home loans rose to a very high level. AIG must pay in accordance with its promised coverage. The AIGFP division eventually suffered a loss of approximately US$25 billion. The department’s accounting problems exacerbated the losses. This in turn lowered AIG’s credit rating, forcing the company to provide collateral for its bondholders. This makes the company’s financial situation even worse.

Obviously, AIG is in danger of bankruptcy. To prevent this from happening, the federal government stepped in. But why did the government rescue AIG while other companies affected by the credit crunch did not?

Too big to fall

In short, AIG is considered too large to fail. A large number of mutual funds, pension funds and hedge funds invest in AIG or provide insurance for it, or both.

In particular, investment banks holding CDOs with AIG insurance face the risk of losing billions of dollars. For example, media reports claim that Goldman Sachs (NYSE: GS) has $20 billion associated with various aspects of AIG’s business, although the company denies this figure.

Money market funds, which are generally regarded as safe investments by individual investors, are also at risk because many funds have invested in AIG bonds. If AIG goes bankrupt, it will set off shocks in the already shaky currency market, as millions of people suffer losses in investments that should be safe.

Who is not in danger

However, customers of AIG’s traditional business have not faced much risk. Although the company’s financial products division is close to collapse, the much smaller retail insurance division is still in business. In any case, each state has a regulatory agency to oversee the insurance business, and the state government has a guarantee clause to compensate the policyholder in the event of bankruptcy.

Although the policyholder was not harmed, others were harmed. And those investors, from individuals depositing funds in safe money market funds to large hedge funds and pension funds holding billions of dollars in risk, urgently need someone to intervene.

Government intervention

When AIG hesitated, there were negotiations between company executives and federal officials. Once it was determined that the company was vital to the global economy and that it was not allowed to fail, an agreement was reached to rescue the company.

US$22.7 billion

The amount of interest the U.S. government ultimately paid for its AIG bailout.

The Federal Reserve issued a loan to AIG in exchange for a 79.9% stake in the company. The total amount initially listed is US$85 billion, which will be repaid along with interest.

Later, the terms of the transaction were revised and the debt increased. The Federal Reserve and the Treasury Department have injected more funds into AIG, with a total estimated to be as high as 150 billion U.S. dollars.

Aftercare

AIG’s rescue plan is not without controversy.

Some people question whether it is appropriate for the government to use taxpayer money to buy a troubled insurance company. The use of public funds to pay bonuses to AIG officials has particularly aroused anger.

However, others pointed out that the rescue plan actually benefits taxpayers in the end because of the interest paid on the loan. In fact, according to reports, the government received US$22.7 billion in interest from this transaction.

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