Lehman Brothers bankruptcy on September 15, 2008 caused “The Mother of all Mondays” as called by the Wall Street Journal, the US financial earthquake triggered the world and so much so that the Moscow Stock Exchange had to shut down for four days. On September 16, AIG’s share melted from a one-year high of $80 to intra-day low of $1.25, whereas for the same period, market capitalisation of its stock dropped from $185 billion to merely $5.5 billion. Worried with insurers’ non ability to honor the financial commitments it had made through millions of contracts and its massive worldwide implications, on September 17, the Federal Reserve nationalised the largest insurer in the world by injecting $85 billion in exchange of a 79.9% stake. Thus, AIG escaped filing for bankruptcy protection, but became the biggest victim in this sub-prime mortgage triggered credit crisis, which on September 7 had forced Federal Reserve to takeover mortgage giants Fannie Mae and Freddie Mac and Merrill Lynch avoided Lehman’s fate by being bought by Bank of America.
It can be argued that the seeds for this man-made earthquake were planted when the Federal Reserve, led by Alan Greenspan, decided to lower interest rates all the way down to 1% in 2003 in an effort to counter potential deflation. The banks could not sustain this low rate and got heavily engaged in financial derivatives on the back of credit default insurance and also exporting the high yield securities in international markets. Regulators turned a blind eye as, in their view: on the one hand, this was helping the low-income people to buy houses; and, on the other, reducing the migration of investments from a weak Dollar to strong Euro and British Pound. They were not able to predict that this joy ride will be of a limited period and that the capitalism that triumphed all over the world will proceed to eat itself.
At the root cause of this crisis were the sub-prime mortgages which carried the highest default risk. Though the focus of this article is AIG, it is best to first explain the much talked about, but less understood, mortgage business. Prime mortgages are the traditional and still most prevalent type of loans. These go to borrowers with good credit who make traditional down payment and fully document their income. Sub-prime mortgages are extended to applicants deemed the least worthy because of low credit scores or uncertain income prospects, both of which reflect the highest default risk. According to Susan M. Wachter, Professor of Real Estate and Finance at the Wharton School of Management, the looser credit standards brought a mortgage boom in 2005 when sub-prime mortgages made up 22% of new loans compared to 8% in 2003. These loans had a 30-years term but with annual rate adjustments after the first two to three years and carried repayment penalties making it prohibitively expensive for borrowers to refinance when their payments got too high. Buyers got these mortgages at attractive down payments on the initial low rate, without being aware that they might not be able to shoulder the higher payments when the rate adjusted upward. The apparent blunder the lending institutions made was to offer a loss-leader price in the early years of a loan in order to get borrowers into the market, in the hope that they would make up the difference in later years. They attempted to enforce the higher price in the future through the use of prepayment penalties which did not work, said Wachter.
As to the providers of these financing, a Wharton study explains that the mortgage-backed securities are created by assembling thousands of loans into bundles and creating a series of bonds that pass borrowers’ principal and interest payments on to the bond owners. Typically, there is a series of bonds of increasing degrees of risk reflecting the borrowers’ credit worthiness. The riskier bonds pay the highest yields but are the first to lose value if borrowers fall behind in payments. Many of these lenders bought credit insurance from institutions such as AIG and besides taking a share on their own account passed the risk on to investors around the world who were eager to buy these securities since the yield offered in Treasury Bonds was producing a negative return after adding the inflation. The sub-prime market mushroomed from $240 billion in 2003 to $912 billion in 2005 and as per Panmure Gordon & Co. findings; the AIG’s US regulatory filing included a $441 billion notional exposure of its super senior credit default swap portfolio as of June 30, 2008.
Investors who bought securities backed by sub-prime loans apparently did not understand the risks either, said Wachter. “Mortgage originators had powerful incentives to originate loans, regardless of quality: every mortgage that was successfully originated and sold to an investor produced a fee for the originator.” These firms often assured investors that loans met minimum standards, and they often promised to make good in case of unexpectedly large number of defaults. But they did not have the capital to honor those promises except insurance.
To a layman, when you satisfy the greed of people to buy homes with as little as $2500 down, it should not have been a surprise that many of these borrowers walked away from their obligation when they lost jobs or ran out of business. DiMartino, an economics writer and Duca Senior Policy Advisor in the Research Department of the Federal Reserve Bank of Dallas reported that in early 2007, investors and lenders began to realise the ramifications of credit-standard easing. Delinquency rates for 6-months old sub-prime underwritten in 2006 were far higher than those of the same age originated in 2004. Lenders reacted to these signs by initially tightening credit standards more on riskier mortgages. In the October 2007 survey of the Federal Reserve, the share of banks tightening standards on prime mortgages jumped to 41%, while 56% did so for sub-prime loans. Many non-bank lenders also imposed tougher standards or simply exited the business altogether. The stricter standards meant fewer buyers could bid on homes, affecting prices for prime and sub-prime borrowers alike. Foreclosures added to downward pressures on home prices by raising the supply of houses on the market. And after peaking in September 2005, single-family home sales fell in September 2007 to their lowest level since January 1998.
On August 14, the paralysis in the capital markets led three investment funds to halt redemptions because they couldn’t reasonably calculate the prices at which their shares could be valued. This event triggered widespread concern about the pricing of many new instruments, calling into question many financial firms’ market values and disrupting the normal workings of the financial markets. Initially, it started with Citibank and later took the Wall Street and some of the European and Asian markets by surprise until the triggers of this financial earthquake were felt worldwide on September 16, 2008.
In my view there are four parties to this crisis: the borrower, the lender, the insurer and the regulator. While in the first and second there is a common element of greed which caused this crisis, the role of the third one being insurer has to by nature be prudent and finally, what was the regulator doing when all this was happening? In the following, I will deal with the role of both, but in the context of AIG.
In 1919, an American entrepreneur Cornelius Vander Starr founded American Asiatic Underwriters in Shanghai.In 1927, Starr moved his office to the building below in Shanghai where in 1931 American International Assurance (AIA) Co. Ltd. was established and in1967, American International Group, Inc. (AIG) was formed in New York
After completing my MBA in Insurance & Risk Management in 1979 from the College of Insurance (which is now part of St. Jones University), I joined AIG and was entrusted with statuary filing of returns to 50 States where six of the Group companies were registered. At that time, every line of business – personal, commercial, liability, aviation, marine and engineering etc. – was operating as independent profit centers. Before filing, the return acid tests were conducted and I had the access to Group Actuary who had the power from Group CEO Hank Greenberg to overrule the President of a subsidiary. But at the same time, Greenberg had the desire to be the market leader, and therefore, only in the early eighties, he took the industry by surprise and created new divisions to cater for Political Risk, Directors and Officers Liability, Kidnap & Ransom and Product Guarantee coverages.
Greenberg’s aim, as it could be seen from AIG’s annual reports, was to make the Group a flagship operation offering traditional and innovative covers in every part of the world. He established AIG’s offices even in small or newly born countries making it a truly international insurance conglomerate. In 2007, after four decades of its establishment with 245 companies and a trillion dollars in assets, presence in 130 countries, 116,000 employees, 700,000 agents and 74 million customers; it was by far the world’s largest insurer. Besides also underwriting traditional lines of business and selling annuities in countries such as Poland through its innovative marketing skills by appointing soap opera and ballet dancers as agents.
It was heavily engaged from aircraft leasing, mortgage financing and credit insurance as well as the vast scale asset management businesses. Sadly, in getting bigger and bigger, it deviated from the profit-centred approach on which it was founded. In the 2007 annual report, Martin Sullivan former CEO of AIG, while setting out the 2008 priorities said, “We must remain disciplined in our underwriting refusing to chase rates down in softening markets.” But the call was too late, since in case of sub-prime mortgage, in the absence of credible data, the risk was greater and required careful underwriting, yet the company accepted the business at cheap rates which is evident from its results that it could reinsure only 17% of the business producing a combined loss ratio of 190% in 2007. Thus, instead of being prudent, it ended up with an aggressive underwriting which resulted in accumulation of risks as opposed to spreading it through sound reinsurance strategy.
In response to CNBC’s Maria Bartiromo’s question on September 16, 2008, “What do you think went wrong?” Hank Greenberg said, “I think several things. Risk management controls either disappeared or were weakened. There wasn’t attention being paid to the accumulation of risk and there was a determination to grow without the right controls in the financial sector of the business. It’s a tragedy, it didn’t have to happen.” To another question: what businesses AIG should be selling that could possibly raise capital, he replied that airline leasing company and the Transatlantic Re which are no longer necessary in AIG, you could sell part of the domestic life operation and the asset management business is not necessary for AIG. He was further asked, if he took these ideas to Bob Willumstad, the current CEO of AIG? He said that he had reached out to him several times but there has been very little response.
One should not blame Willumstad, after all who wants to listen to an 80-year old man when he did not take these measures to make the Group cash rich during his own tenure. The fault also lies in the system, where for public entities; there is a need to fix the retirement age of CEO as well as Chairman of the Board. Now, finally to the role of regulators; in response to a question on BBC news on September 17 that where were the regulators when all this was happening, Sir Howard Davies, former Chairman of the Financial Services Authority of UK said that there were no regulators to monitor the Group. According to him it is a weakness in the American system that each company files its report to each of the State and unlike FSA there isn’t anybody to oversee the Group’s operation. Additionally, its annual report became so complex that to examine it, each of the 50 States needed to employ a team of experts and an actuary, which perhaps they could not afford and were satisfied to receive increasing amount of annual fee which was linked to the premiums. However, as reported in the Business Week issue of April 11, 2005, AIG faced an investigation in two reinsurance transactions which the company acknowledged as improper accounting inflating reserves up to $1.7 billion.
In the first quarter of 2005, the Group was served with subpoenas by state and federal regulators which caused decline in its stock by 22% as well as a downgrade in rating by S&P. Earlier, in the fall of 2004, the insurer paid $126 million in fines to the Securities & Exchange Commission and the Justice Department for deals it structured for outside clients that allegedly violated insurance accounting rules. AIG also came under the glare of New York Attorney General for its role in bid rigging with broker Marsh & McLennan which led to the ouster of Hank’s son Jeffrey as CEO there. The Group admitted no wrongdoing, but two of its executives plead guilty and left the company. In the back drop of all these developments, finally the AIG Board that was notoriously clubby and close to Greenberg, says Patrick McGurn of Institutional Shareholder Services, came under shareholder’s pressure and the investigators made the Directors nervous about their own ability that they even demanded Greenberg’s resignation, an unthinkable act resulting in his departure, but perhaps with his political connections, he managed a safe exit.
The matter should not have been allowed to rest on the departure of Greenberg and merely on collecting of fines, rather had the New York Governor, who on September 16 had offered $20 billion worth of State assets to bail out the insurer, intervened in March 2005 to team up with regulators to install independent directors and demanded from the Board for clearing up the mess before the close of 2005, the current crisis could have been avoided.
Many experts continue to criticise the US administrations’ decision to single out AIG and not to rescue Lehman Brothers, Goldman Sachs and General Motors. Unlike these organizations, it must be recognised that AIG was the world’s insurance power and if it was allowed to fail, its knock-on effects would have been far reaching, resulting in stoppage of insurance coverages and halt of many airlines and shipping operations where AIG was the direct insurer/reinsurer, or both. It would have been impossible for the US government to cough up trillions of dollars to pay huge losses and the crisis could have led to a worldwide economic war. Needless to say, the nationalisation of AIG has resulted in comfort to its policy holders as well as partner organisations.
