By August 2008, the American International Group was, as far as the general public knew, a titan of the financial services industry — the world’s largest insurer and an icon of corporate strength. The truth, however, was far different, and barely a month later, the company’s financial liabilities had been revealed, its credit rating downgraded, and suddenly pressed to deliver cash liabilities it simply did not have. Overnight, AIG went from cock of the walk to the verge of bankruptcy in one of the most spectacular meltdowns in modern corporate history. It was an event that for many, has become the signal moment of the global financial crisis that began in 2008 and has not yet fully ended.
AIG, of course, was essentially bought out by the federal government in a last-ditch effort to save the company, and in so doing, to prevent potentially catastrophic collateral damage to the rest of the world economy, had the giant company truly failed. AIG’s defenders have long asserted that the company’s troubles were not insurance-based; they were the work of what amounted to a rogue financial products office in London that vastly overextended its reach on trafficking toxic debt. The fundamentals of the company, or so the conventional wisdom goes, were solid, especially on its insurance operations.
Indeed, the wide-ranging federal regulation of the financial services industry that followed (namely, the Dodd-Frank Wall Street Reform and Consumer Protection Act) was meant to prevent another AIG situation from ever taking place. But these efforts have been met with much opposition from the insurance industry itself, especially any regulatory efforts that seek to oversee how insurers invest their money, and the degree to which their products and services access the volatile equity markets of the world.
The opposition makes sense. After all, if AIG was not an insurance failure, then why are insurers being subject to greater scrutiny, and to rules that constrain their ability to make the best use of financial marketplace opportunities? The reason is because the conventional wisdom on AIG is wrong. The level and extent of AIG’s financial instability, government documents now show, had compromised the stability not just of itself, but of large swathes of the larger insurance industry, including life insurers — which have traditionally considered themselves apart from the entire AIG fiasco and doubly undeserving of additional regulatory oversight.
The truth is that, as evinced by public documents released over the last 18 months, AIG’s meltdown nearly look many other companies with it, and only the timely intervention of the federal government — wielding huge amounts of taxpayer cash and guarantees — saved it. Had AIG been allowed to go insolvent or bankrupt, so too could have numerous other companies, including life insurers, and perhaps a substantial chunk of the world economy. What we know as the Great Recession could have been something much, much worse, and it all comes back to how AIG’s problems spread across a vast web that ultimately drew in many companies that, whether they realized it or not, had also become part of the problem. AIG had become like a nuclear reactor about to blow, and the companies most at risk were like liquefied natural gas plants in the same town, maybe having nothing directly to do with the cooling towers, but directly in harm’s way nonetheless, and in a capacity to compound the initial damage once the core melted down.
ANATOMY OF A MELTDOWN
In 2009, William K. Sjostrom, Jr. — now a Professor of Law at the James E. Rogers College of Law at the University of Arizona — published in the Washington & Lee Law Review what would become a definitive account of exactly how and why AIG came so close to failure.
In Sjostrom’s article, “The AIG Bailout,” he noted that by the time federal regulators had stepped in to save AIG in September 2008, the company was drowning in a toxic mix of credit default swaps, asset-backed securities, securitization, tranching, and collateralized debt obligations conducted within an Byzantine corporate structure that contained insurance companies, financial companies, banking companies, leasing companies and other assets that spanned the globe.
AIG received aid from the Federal Reserve Board through five lending facilities starting on Sept. 16, 2008, but only because of the Reserve Board’s authority to lend to nondepository institutions in “unusual and exigent circumstances.” According to Sjostrom, this was the first such lending since the 1930s.
Once AIG had to be rescued by the federal government, the company’s fall was swift. On February, 2008, AIG had $1 trillion in assets and had announced earnings of $6.2 billion ($2.39 per share); but just a few months later it had fallen into the unhappy arms of the Federal Reserve Bank of New York.
By Sjostrom’s calculations, AIG’s fall stemmed a staggering $32.4 billion in losses racked up by AIG Financial Products unit — a small outfit in AIG’s London office that is largely held responsible for AIG’s troubles — from January 2007 through September 2008. These losses were almost entirely from AIGFP’s credit default swap activities.
At the same time, the Fed was barred by law from regulating insurance holding companies, as demanded by both the industry and by Congress through legislation passed in 1999.
According to Sjostrom, this mix of conditions allowed for AIG to leverage its then-AAA credit rating and trillion-dollar balance sheet through its CDS business.
“Counterparties were presumably willing to pay AIGFP a higher premium for protection because of AIG’s guarantee,” Sjostrom said, “than they would pay for the same protection from a seller with a lower credit rating, lesser balance sheet, or less-favorable guarantee.”
AIG had noted in a May 2008 conference call presentation that its CDS business was very similar to its profitable excess casualty insurance business. Sjorstrom quoted a former AIGFP senior executive who characterized writing CDSs as “free money” because AIGFP’s risk models indicated that the underlying securities would never go into default.
“The CDSs would expire untriggered, and AIGFP would pocket the premiums,” Sjorstrom said in his paper. “Basically, AIGFP speculated against a drop in credit quality with respect to innumerable asset-backed securities.”
But Federal Reserve Board chairman Ben Bernanke, who was among a number of Fed and Treasury to come under intense fire for the decision to bail out AIG — even now he is still taking heat for it in the ongoing Republican primary debates — had another view.
In March 2009 testimony before the Senate Banking Committee, he said that nothing made him more angry than AIG’s ability “to exploit a huge gap in the regulatory system.” In so doing, AIG’s CDS business included contracts that required payments to life and P&C insurance policyholders worldwide. This not only made it especially difficult for the Fed to keep AIG going, but it also refutes repeated claims by members of Congress, officials of the National Association of Insurance Commissioners and industry officials that AIG’s insurance subsidiaries (including their life subsidiaries) were solvent and capable of paying claims absent of federal intervention.
Case in point: A June 2010 report from the Congressional Oversight Panel—the group created by Congress to monitor federal expenditure of funds under the Troubled Asset Relief Program — names names on who benefited from the federal government buying controlling interest in AIG.
Foremost among them are AIG’s insurance subsidiaries, which received nearly $21 billion in capital contributions in 2008. This included $4.4 billion to non-U.S. life insurance companies, with $1.8 billion to Nan Shan in Taiwan and the remaining amount flowing to insurance companies in Hong Kong and Japan. $16.5 billion went to U.S. life insurance companies. By receiving capital contributions from the government, the COP says, these foreign and domestic life insurance subsidiaries were able to meet their obligations under the securities lending program and avoid liquidity or solvency concerns and potential ratings downgrades.
Moreover, in 2009, AIG’s life insurance subsidiaries received $1.14 billion in capital contributions from AIG. These contributions were made to strengthen the subsidiaries’ capital position and risk-based capital ratios.
In a 2009 paper by David Wood of the Ventura, California-based law firm Anderson Kill Wood & Bender, the massive bailout of AIG was the government’s only tenable option.
“The sheer magnitude and complexity of such a bankruptcy would risk a less probable but far more troubling result,” Wood wrote. “If recent events in the financial world teach us anything, it should be to pay attention to the remote risks, the so-called Black Swan events. A.I.G. is so big and multiheaded that a well-funded, creative and aggressive trustee or creditors’ committee is almost guaranteed. If ever there were an incentive to challenge the conventional wisdom concerning accessing insurance company subsidiaries, it would be here and now.”
Wood’s writing proved accurate, especially where AIG’s life operations were involved. In an October 2011 study by the Government Accountability Office, the Board of Governors of the Federal Reserve System were shown a slide in October 2008 indicating that one of the options for protecting AIG life insurance policyholders was to have the Fed purchase AIG’s life insurance subsidiaries and remove them from the AIG estate altogether. (This was subsequently confirmed by a three-page report on AIG’s website indicating the divestitures the company has undertaken over the last three years as it slims down.)
According to the report, AIG had insurance, financial, non-financial, and banking operations all over the world, in such diverse countries as Poland, Argentina, South America, Taiwan, China, Japan, Canada, etc., before the Fed and Treasury stepped in.
Moreover, the GAO study said that between September 16, 2008 and January 2009, insurance companies other than AIG lost approximately $1 trillion in market value, and many of them were on the verge of bankruptcy. But by the end of 2009, the company’s situation had improved to a point that bankruptcy ceased to be a focus in consideration of options. This, the GAO noted, was a direct result of federal intervention.
RUNNING FOR COVER
While it is clear that a lot of AIG’s problems grew out of the operations of Financial Products group — which when federal regulators examined its books was found to have insured $2.77 trillion notional amount of mortgage backed securities — dealing with it was beyond the means of state regulators. And the job of federal officials tasked with dealing with AIG’s problems was made more difficult by prickly attitudes from members of Congress seeking political cover from the AIG debacle. This, according to reports reviewed by National Underwriter — which include the GAO study, the June 2010 Congressional Oversight Panel report, and an October 2012 report by the Pennsylvania Insurance Department.
For example, after testimony before a January 2010 hearing on AIG by the House Oversight and Investigations by Timothy Geithner, Rep. Darrell Issa (R-Calif.), the committee’s ranking Republican member, said he “no confidence” in Geithner and called for his resignation, accusing Geithner of being either incompetent or of trying “to cover up the details of what was going on through payoffs of the CDS.”
The next witness was Henry Paulson, Treasury secretary during the latter days of the Bush administration, when AIG’s board placed its fate in the hands of federal regulators. Rep. Cliff Stearns (F-Fla.) wasted no time grilling him by way of cross-referencing on things Geithner said earlier.
Stearns said that Geithner’s testimony suggested a frightening prospect of revolution in the streets if AIG had not been bailed out. “He intimated our Constitution would not have been able to be enforced. There would be a revolution in this country,” Stearns said. “Do you think it is at that extreme if we let AIG go bankrupt, we would have had that kind of collapse and revolutionary spirit in this country? Is that what your position is today?”
While Paulson tried to distance himself from Stearn’s interpretation of Geithner’s comments, the point had been made: there were those in Congress unhappy that the Fed had used such special capabilities to rescue AIG, a power it had not wielded since the Great Depression and one that the American public largely did not realize existed.
The Fed used extraordinary powers, since removed, through its Section 13 (3) to intervene with AIG and provide it with funds and oversight…despite the fact that it was barred by law from regulating AIG. A provision of the Gramm-Leach-Bliley Act of 1999 that specifically barred the Fed from regulating insurance companies. That provision was eliminated through the Dodd-Frank Act in 2010.
The provision was drafted by Jeb Hensarling, then an aide to Sen. Philip Gramm, R-Texas, as part of the GLB. Hensarling is now a Texas congressman, a member of the leadership of the House Financial Services Committee and last fall served as co-chairman of the “super committee” that failed to craft a deficit reduction package. He is also the favored candidate to replace Spencer Bachus (R-Ala.) as the chairman of the Committee on Financial Services when Bachus hits his term limit in 2013 and steps down.
As for the GAO report, it is based on interviews GAO officials had with various state and federal officials, plus access to documents used by the Fed and Treasury to outline their options.
It represents for the first time the government view of what led to the decision of the federal government to rescue AIG and the details of how these officials restored stability and solvency to the huge company.
Confirmation of Paulson’s comments that AIG was in deep trouble came through comments in the GAO study by Eric Dinallo, then New York Insurance Superintendent, cited in the report as the “lead life insurance regulator.” Dinallo is now a partner at Debevoise & Plimpton in New York.
“The lead life insurance regulator told us it did not understand the extent of potential risks AIGFP posed to the AIG parent company that in turn could have created risks for the regulated insurance subsidiaries,” the GAO report said.
That confirmed Paulson’s comments at the January 2010 hearing in response to Stearn’s questioning. “There was no single regulator that had a line of sight on the total company,” Paulson had said. “So there were regulators that looked at different pieces of it, and if the company had gone down, it would have been a huge mess.”
Likewise, the GAO account also backs up Geithner’s answers under hostile questioning, in which he makes the case that the people who were responsible for overseeing the insurance companies in question simply did not understand the scope of the risk they were overseeing. They could not, in Geithner’s words, know the extent to which the finances of the insurance companies were so deeply connected to their holding company, and to the financial products division that was taking on such incredible amounts of risk. AIG’s corporate structure was simply too tangled to cleanly separate those elements from each other.
“Why would we have not, if it had been possible to separate the place that was taking the firm down, to separate that cleanly? We would have done that in a second,” Geithner said. “In fact, much of what the management of the firm is trying to do today, still, 15 months [after the government takeover], is designed to achieve that objective,” Geithner said.
The lead life insurance regulator also told the GAO that AIG was disclosing relatively little information in its regulatory filings about the program and its losses, which were off-balance sheet transactions, the report said.
“Another state insurance regulator told us that as part of its review, it noted that AIG life insurance companies engaging in securities lending were not correctly providing information in annual statements or taking an appropriate charge against capital for the securities lending activities,” the GAO report said.
The GAO said that this regulator said it began discussions with the company about securities lending in 2006. AIG told the GAO that it was unaware of the regulator’s concerns.
The lead life insurance regulator met with AIG management in October and November 2007 and presented the securities lending issues it had noted at a “supervisory college” meeting held by AIG’s then-consolidated regulator, the Office of Thrift Supervision.
“The lead life insurance regulator told us it did not share with all participants that it had identified off-balance-sheet losses but that it privately advised OTS that it saw unrealized losses building in AIG’s securities lending portfolio, with the total reaching an estimated $1 billion by November 2007,” the GAO said.
GAO said the New York insurance regulator “also told us this was the first time OTS learned about issues in the company’s securities lending program.”
That the operating insurance subsidiaries were involved in AIG’s problems was confirmed by a further report, issued by the Pennsylvania Insurance Department in Oct. 2010.
It said three of AIG’s property and casualty insurance subsidiaries regulated by Pennsylvania had issued cross-guarantees of insurance policies issued by other AIG insurance subsidiaries in order to secure a higher financial rating of the policy for the other insurance companies. “The purpose of such policyholder guarantees was to secure the affiliates’ financial strength ratings,” the report said.
These commitments were to life as well as P&C subsidiaries of AIG, the PID report said. According to the COP report, this would have included $38 billion in so-called “stable wrap contracts,” or guaranteed investment contracts, held in defined benefit contribution plans in some of the nation’s largest public companies. Geithner, Bernanke and Paulson were among government officials who cited this as one of the reasons they intervened in AIG.
These were cross-guaranteed by the AIG parent company, according to the report. In other words, if there were problems with other companies, the AIG parent company would have stood behind the subsidiary’s commitment.
The companies issuing the guarantees were National Union, New Hampshire and American Home, the report said.
Specifically, according to the PID report, “Under the terms of the policyholder guarantees, the guarantors would be obligated to pay amounts due to insureds and claimants under policies, annuities, guaranteed investment contracts and funding agreements and return premiums (collectively the policyholder obligations). Payment by a guarantor under the policyholder guarantees is not contingent upon the insolvency or other financial distress of the guaranteed affiliate.”
In other words, even though the three firms regulated by Pennsylvania were property and casualty subsidiaries of AIG, some of the guarantees were for products sold by life subsidiaries of AIG.
Further confirmation that AIG was an unregulated cauldron in danger of spinning out of control by Sept. 2008: Federal officials “concluded that a collapse of AIG would have been much more severe than that of Lehman because of AIG’s global operations, large and varied retail and institutional customer base, and different types of financial service offerings.”
Specifically, the Federal Reserve and Treasury said that a default by AIG would have placed considerable pressure on numerous counterparties and triggered serious disruptions in the commercial paper market. Moreover, AIGFP counterparties would no longer have had protection against losses if AIG Financial Products, defaulted on its obligations and collateralized debt obligation values continued to decline.
Federal Reserve Bank of New York (FRBNY) officials reported that AIG had fragmented and decentralized liquidity management in early 2008—before the government intervention—and that AIG understood corporate-level liquidity needs but not the needs of subsidiaries, including AIGFP.
One of the options considered after the initial outlay, made in return for 79.9% of AIG stock, was government purchase of AIG life insurance subsidiaries, the GAO report said.
As such, FRBNY officials considered a proposal to directly support AIG’s insurance subsidiaries in order to preserve their value, according to an Oct. 2 presentation by FRBNY officials to the FRBNY and the Fed board itself.
“The presentation notes that these potential support actions would include “keepwell” agreements and excess-of-loss reinsurance agreements, which would ultimately terminate upon sale of the subsidiary,” the GAO report said. “A slide presentation further noted that this approach would have allowed officials to address credit rating concerns by severing the link between the ratings of AIG’s parent and its subsidiaries.”
The final nail in the coffin confirming that taming AIG was far beyond the control of state regulators, was a comment from the GAO report that between September 16, 2008, and January 2009, insurance companies other than AIG lost approximately $1 trillion in market value, and many of them were on the verge of bankruptcy.
“By the end of 2009,” the report said, “the company’s situation had improved to a point that bankruptcy ceased to be a focus in consideration of options, according to the officials.”
Clearly, a major part of this stability stemmed from the fact that by the end of 2009 the federal government had provided AIG with the ability to borrow up to $182 billion in cash, that it was guaranteeing its commercial paper operations, and had provided cash to AIG by creating two facilities, Maiden Lane II, and Maiden Lane III.
The latter moves stabilized the life subsidiaries by ending the use of high-quality bonds held by AIG’s life subsidiaries as part of their reserves to collateralize purchase of MBS of various grades, including some of the sub-prime variety.
By this time, the Fed had largely replaced AIG’s management and imposed discipline on the company’s money management operations. It had also created enough confidence with creditors at this time through the implicit taxpayer guarantee of AIG’s operations, to allow for a disciplined wind-down of AIG’s $2.77 trillion credit default swap operation.
LEST WE FORGET
The AIG of yesterday is not the AIG of today, nor is the financial services industry what it once was. The spectacular collapse of AIG, and the degree to which it had commingled its own risk with the risk of other entities provided for precisely the kind of situation that able oversight is supposed to prevent. Obviously it did not, and that failure is easily distributed among AIG’s own actions, its regulators, legislators who pushed for weakened oversight, and virtually anyone who took part in a business model of repackaged debt that ultimately got everybody drinking from the same poisoned well. In the end, who is to blame for AIG? Pretty much everyone.
But that is not the important lesson here. The important lesson is that the life insurance sector indeed had much to lose had AIG collapsed, and life insurers themselves were far more intimately connected with AIG’s inordinate risk profile than the industry cares to admit. Thankfully, it did not end in widespread disaster, but it would appear that the only reason why it did not was because of timely, massive and effectively unprecedented federal regulation. Nobody wants a repeat of the AIG scenario, just as nobody wants the federal government to get involved in business any more than it has to be. But in an age of Dodd-Frank regulation, and as the insurance and banking sectors begin to look at new ways of innovating new ways to work the financial markets, the lessons of AIG and of the enormous fallout it could have had on the life insurance world should not be forgotten. Not by legislators, not by regulators, and most of all, not by the insurers themselves.