Jane Dotson
American International Group, Inc. (AIG) is an American multinational finance and insurance corporation with operations in over 80 countries. In 2007, AIG was the world's largest insurance company, with $850 billion in assets. However, the financial crisis of 2007-2008 saw AIG face significant losses, and the company was deemed too big to fail. This was largely due to its involvement in credit default swaps, which lost the company $30 billion, and securities lending, which lost the company $21 billion. AIG had sold credit default swaps to insure against default on collateralized debt obligations (CDOs), which were bundles of various types of debt, including subprime loans. When the housing bubble burst, AIG had to pay out on its insurance claims, leading to a liquidity crisis. The US government stepped in with a bailout of $180 billion, which AIG repaid in full in 2012.
| Characteristics | Values |
|---|---|
| Did AIG default on insurance payouts? | Yes, AIG defaulted on insurance payouts. |
| Reason for default | AIG insured CDOs against default through a financial product known as a credit default swap. The chances of having to pay out on this insurance seemed highly unlikely. However, in 2007, AIG had to pay out on what it had promised to cover as foreclosures on home loans rose to high levels. |
| Losses | AIGFP division incurred about $25 billion in losses. |
| Credit rating | AIG's credit rating was lowered, forcing the company to post collateral for its bondholders. |
| Bailout | The federal government stepped in and bailed out AIG. AIG received $180 billion from the U.S. government during the financial crisis of 2007–2008. |
| Controversy | The bailout was controversial as taxpayer money was used to pay out bonuses to AIG's officials. There were also death threats and security concerns for AIG employees and their families. |
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What You'll Learn
AIG's credit default swaps
Credit default swaps (CDSs) are financial instruments that act as insurance contracts on bonds. In the case of AIG, they were used to insure collateralized debt obligations (CDOs), which were bundles of various types of debt, including mortgage-backed securities.
AIG's subsidiary, AIG Financial Products, began selling credit default swaps in 1998, using the company's AAA guarantee to its advantage. These swaps were attractive to banks as they lowered their credit risk and reduced the amount of capital they needed to hold against an asset. By 2007, AIG had sold $379 billion worth of credit default swaps, with its operating income growing to $4.4 billion, accounting for nearly 30% of AIG's total business.
However, AIG's credit default swaps did not require collateral to be paid in full due to market changes, and the company started accruing unpaid debts to its swap partners. When AIG's credit rating was downgraded in 2008, the collateral provisions kicked in, and the company suddenly owed its counterparties a significant amount of money. On September 15, 2008, calls for collateral on its credit default swaps rose to $32 billion, with a shortfall of $12.4 billion.
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AIG's role in the subprime mortgage crisis
The American International Group (AIG), the world's largest insurance company, played a significant role in the subprime mortgage crisis of 2007-2010. The crisis was caused by excessive consumer housing debt, which was fuelled by the mortgage-backed security, credit default swap, and collateralized debt obligation (CDO) sub-sectors offering low-interest rates and high levels of approval for subprime mortgages.
AIG's involvement in the crisis centred on its sale of credit default swaps, a type of insurance on debt obligations, and its investment in CDOs. AIG's credit default swaps were valued at $2 billion by 2003 and $379 billion by 2007. These swaps were sold to banks, with AIG profiting from the promise to cover any losses. The company believed that defaults on the underlying loans would be insignificant.
However, when the housing bubble burst in 2007, AIG had to pay out on its promises, incurring around $25 billion in losses. This, along with accounting issues, led to a downgrade in AIG's credit rating, which meant that the company had to post collateral for its bondholders, worsening its financial situation. AIG's securities lending business also suffered losses of $21 billion, as the company had invested heavily in high-risk, long-term assets.
The company's problems were exacerbated by the fact that its credit default swaps were one-way bets, with no offsetting positions to make money if the swaps lost value. As a result, AIG faced a string of collateral calls from its trading partners, which it struggled to pay, leading to its eventual collapse.
Due to AIG's size and the number of funds invested in or insured by the company, the U.S. government stepped in to prevent its insolvency, providing a bailout of up to $180 billion.
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AIG's bailout by the US government
In 2007, AIG was the world's largest insurance company, with $850 billion in assets, offices in 130 countries, and more than 100,000 employees. It provided insurance to over 85% of the businesses on the Fortune 500 list.
However, AIG's financial situation began to deteriorate in 2005 when auditors discovered that the company had overstated its earnings by $3.9 billion. In 2007, as the housing bubble burst, AIG faced mounting losses from its subprime activities. The company had sold billions of dollars' worth of credit default swaps, which acted like insurance contracts on bonds, to banks in Europe and the United States. These swaps were tied to mortgage-backed securities (MBS), which were bundled into collateralized debt obligations (CDOs). As foreclosures on home loans rose to high levels, AIG had to pay out on these swaps, incurring about $25 billion in losses.
On September 15, 2008, AIG's credit rating was downgraded below AA-, triggering collateral calls on its credit default swaps of $32 billion and a shortfall of $12.4 billion. This led to a liquidity crisis, essentially bankrupting AIG. To prevent its collapse, the US government stepped in with a bailout package. The New York Federal Reserve Bank, led by Timothy Geithner, announced the creation of a secured credit facility of up to $85 billion, bringing AIG under government control. The total bailout package eventually grew to $142 billion, with $70 billion committed by the Treasury through TARP and $112 billion by the Federal Reserve Bank of New York.
The bailout of AIG by the US government was controversial. Some questioned the use of taxpayer money to purchase a struggling company and to pay out bonuses to AIG officials. However, the bailout ultimately benefited taxpayers, as the government made a reported $22.7 billion in interest on the deal. AIG repaid its debt to taxpayers in full by 2013 and is now considered financially stable.
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AIG's securities lending losses
AIG's securities lending business grew substantially in the years leading up to its collapse. From less than $30 billion in 2007, it reached $88.4 billion in the third quarter of 2008. The rapid growth of this business unit exposed AIG to significant risks, particularly in the form of high-yield and high-risk investments backed by subprime residential mortgage loans.
As the housing market began to decline in 2007, AIG's securities lending business faced mounting losses. The company had invested heavily in long-term, illiquid assets, making it difficult to meet the massive repayment demands when borrowers began to return their securities and request collateral.
The losses in the securities lending program were severe enough to threaten the solvency of AIG and its regulated life insurance subsidiaries. This, coupled with the losses from credit default swaps, led to AIG's eventual collapse and the need for a government bailout.
While some analysts argue that securities lending played a critical role in AIG's downfall, others disagree, asserting that the company's problems were more complex and rooted in company-wide risk management failures.
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AIG's credit rating downgrade
The problem arose when the housing bubble burst in the early 2000s, leading to a wave of foreclosures on home loans in 2007. As a result, AIG had to pay out on the credit default swaps it had sold, incurring significant losses. These losses, coupled with accounting issues and losses from securities lending, weakened AIG's financial position and led to a downgrade in its credit rating.
On September 15, 2008, all three major credit rating agencies—Fitch, Moody's, and Standard & Poor's—downgraded AIG's rating to below AA-. This downgrade triggered collateral provisions in AIG's credit default swap agreements, requiring the company to post collateral for its bondholders. The calls for collateral on its credit default swaps rose to $32 billion, with a shortfall of $12.4 billion, a significant increase from just three days earlier.
The credit rating downgrade had a domino effect on AIG's financial situation. The company's trading partners could now demand collateral, further straining AIG's liquidity. This sudden demand for collateral is likened to a "bank run," where the company's troubles lead to a rapid and significant call on its assets. The downgrade also affected the confidence of investors and counterparties, leading some to terminate their agreements and request their collateral back.
In conclusion, AIG's credit rating downgrade was a critical event that exacerbated the company's financial troubles. The downgrade triggered collateral requirements, strained liquidity, and caused a loss of confidence in the company. This series of events ultimately contributed to AIG's collapse and the need for a government bailout during the financial crisis of 2007-2008.
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Frequently asked questions
Yes, AIG did default on insurance payouts. The company sold credit protection through its London unit in the form of credit default swaps (CDSs) on collateralized debt obligations (CDOs).
AIG's credit rating was downgraded, and it was required to post additional collateral with its trading counterparties, leading to a liquidity crisis and the company's bankruptcy.
Yes, AIG received a bailout from the U.S. government during the 2007-2008 financial crisis. The Federal Reserve and the Treasury Department provided a total of up to $180 billion to prevent the company's collapse.
The bailout sparked controversy and outrage among politicians and the public. Some questioned the use of taxpayer money to rescue a private company, while others criticized the payment of bonuses to AIG's officials with government funds.
