AIG Fallout

8/8/2019 AIG Fallout

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` It was the week that shook the financial world to the core.

` On Friday, Sept. 12, traders left the New York Stock Exchange for the

weekend.

`

But key banking officials, began a series of weekend meetings in aneffort to prevent a possible collapse of the global financial system.

` Over the next seven days financial leaders, captained by Treasury

Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke,

produced a rapid succession of moves that reversed a decades-longtrend toward financial deregulation and fundamentally changed the

face of the American financial system.


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` The trading week ends with the fate of 158-year-old Lehman

Brothers in grave doubt.

` Its stock had fallen sharply due to fears over its financial condition.

` Paulson, Bernanke, and New York Fed President Tim Geithner begina series of meetings with top bankers in an effort to engineer a

bailout of Lehman, which had bet heavily in the subprime mortgage

market.

` Two possible buyers emerge: Britain's Barclays and Bank ofAmerica.


4/21

` Talks on a possible Lehman buyout continue.

` The would-be rescuers look to the government to take on some of

the risk, as it did in the shotgun sale of Bear Stearns to JPMorgan

Chase in March and the effective nationalization on Sept. 8 ofmortgage giants Fannie Mae and Freddie Mac.

` Government officials hold fast that there will be no federal bailout.

` Talks are inconclusive.


5/21

` The negotiators continue meeting, facing a deadline to act before

Asian markets open for Monday morning trading.

` But government officials insist there will be no federal backing of aLehman rescue.

` With no help from Washington forthcoming, Barclaysthe onlypossibility left after Bank of America leaves the table.

` Meanwhile, Merrill Lynch CEO John Thain, seeing the writing onthe wall, arranges the sale of his company to Bank of America for

about $50 billion.

` In one day, the fates of two storied companies are sealed.


6/21

` Lehman Brothers Holdings, the bank's holding company, files for

Chapter 11 bankruptcy protection and says it will try to sell key

business units.

` Investor concern now turns to the fate of AIG, fearing a liquidity

crisis.` Rating agencies cut AIG's credit rating.

` The stock market plummets. The Dow Jones industrial average

drops more than 504 points, or 4.4%

` The failure also roils overseas stocks, sending them plunging.

` Concerns about a slowing economy take oil below the psychological

benchmark of $100 a barrel


7/21

` The Federal Reserve meets and keeps the federal funds rate

unchanged at 2%.

` Asian markets, some of which had been closed for a holiday on

Monday, plummet

` The Russian stock market goes into a tailspin, with the largest

exchange down more than 17% before the Russian governmenthalts trading

` Managers of the Primary Fund, a supposedly supersafe money

market fund, say that shares have fallen below the sacrosanct $1

valuation.

` Meanwhile, Goldman Sachs and Morgan Stanley, report strongerthan expected results.


8/21

` Amid all the turbulence, U.S. officials decide that AIG is indeed "too

big to fail.

` In a move that would have been unthinkable before the credit crisis

began, the Fed arranges to lend $85 billion

` Exchange of 79.9% equity stake.

` The deal is announced Tuesday evening.

` Even before the deal is finalized, the Dow reverses an earlier loss

and gains 141 points.


9/21

` The government bailout of AIG fails to stem investor fears as theyflee to safety.

` Credit markets tighten.

` The New York Times reports that Washington Mutual , the nation's

largest thrift, has put itself up for sale

` The Dow plunges 449 points.


10/21

` The New York Times reports that Morgan Stanley has "stepped up"

merger talks with Wachovia

` The Fed moves to pump money into the financial system through

lending programs operated by several overseas central banks and

the Fed's own moves.

` At the same time, the government begins action on the hugest

bailout of all, committing hundreds of billions of taxpayer dollars to

buy troubled mortgage assets from beleaguered financial

institutions.

` Stocks rally. The Dow closes up 410 points.


11/21

` The buyout plan with few firm details is announced and stocks soarworldwide.

` SEC places a temporary ban on the short-selling of nearly 799

financial stocks.

` The Dow closes up 368.75 points, 45 points below where it was a

week earlier but still 911 points over its bottom on Thursday

morning.

` It will be hard to match events that have reshaped the U.S. financial

landscape for years, if not decades to come.


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` AIG has grown to become the world's biggest insurer. Withoperations in over 130 countries and a customer base of 74 million

worldwide, the company has a balance sheet size in excess of $1

trillion.

` AIG is mainly in the business of life, commercial and property

insurance besides retirement products.` There is no sudden increase in claims in any of these businesses,

anywhere in the world.

` In fact, these business lines of AIG remain very healthy, are market

leaders in many countries and hold much value.

` All those subsidiaries, like the joint ventures with Tata group in

India, are well capitalised and can service all potential claims.


13/21

` However, unlike most other insurers, AIG also had a business of

insuring investors in bonds and credit derivatives against defaults.

` This business was under a separate division called AIG Financial

Products or AFP and mostly issued derivative instruments called

Credit default swaps or CDS.

` Investors seeking risk protection bought CDS from issuers like AFP,

which stood guarantee against any default by the issuer in case of a

bond or retail borrower in case of a credit derivative like mortgage-

backed securities.


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` A CDS contract involves the transfer of the credit risk of municipal

bonds, emerging market bonds, mortgage-backed securities,or corporate debt between two parties.

` It is similar to insurance because it provides the buyer of the

contract, who often owns the underlying credit, with protection

against default, a credit rating downgrade, or another negative

"credit event.

` Seller- receives a periodic protection fee and is obligated to pay

only if a negative credit event occurs.

` It is important to note that the CDS contract is not actually tied to a

bond, but instead references it.

` For this reason, the bond involved in the transaction is called the

"reference entity."


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` An investor with a positive view on the credit quality of a company

can sell protection and collect the payments that go along with itrather than spend a lot of money to load up on the company's

bonds.

` An investor with a negative view of the company's credit can buy

protection for a relatively small periodic fee and receive a big payoff

if the company defaults on its bonds or has some other creditevent.

` CDS contracts are regularly traded.

` Value fluctuates- based on probability.

` Increased probability- worth more for buyer and vice versa.

` Trader speculates that credit quality of reference entity will

deteriorate in the future, he will buy protection for the short term

in the hope of making profit.

` CDS are traded OTC and intricate knowledge of the market.


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` CDS issuers like AIG enjoyed AAA credit ratings and hence the

default risk on the insured securities was considered almosteliminated.

` When defaults are low, CDS is a good business for issuers with

healthy cash flows.

` AIG expanded this business furiously and easily became the market

leader.` At the peak, AFP had underwritten bonds and credit derivatives

worth nearly $500 billion.

` Sub Prime crisis hit and defaults started rising.

` AIG started shelling out huge sums to settle the claims and made

increasingly higher provisions, quarter after quarter.

` To make it worse, the company also had other businesses directly

related to US mortgages and suffered huge losses there as well.


17/21

` This steady erosion forced AIG to raise more than $20 billion in

additional capital earlier this year

` At the beginning of the April-June quarter, the company had more

than $15 billion in additional capital.

` By the first week of September, that excess capital was wiped out

and the company was desperately seeking nearly $25 billion in

additional funds to protect itself from further credit rating

downgrades.

` $25 billion doesn't appear like a big deal for the AIG group which

has investments of over $750 billion.

` But, all that money is insurance premium received from its main

businesses and set aside to cover future liabilities.` AIG, the parent company, has no access to even a small part of it.


18/21

` Desperate attempts to find private investors failed and finally

pushed AIG into the hands of the Fed.` The Fed's takeover of AIG is not an open ended, sweetheart deal.

Existing shareholders will see their holdings cut to a fifth of whatthey were and the Fed will get an 80-per cent stake without payinga dollar.

` The $80 billion in credit support comes at a very heavy cost, LIBORplus 850 basis points.

` Quite profitable for the Fed if AIG repays the loan without defaults.

` The Fed statement makes it clear that the loan is secured by all theassets of AIG and has to be "repaid from the proceeds of the sale of

the firm's assets` So, the very high interest rate is to force AIG to liquidate its assets

within the loan period of two years.


19/21

` If the Fed wants AIG to be liquidated anyway, why not just allow the

company to collapse right now?

` The Fed is not worried about a failure per se, but a "disorderly"

failure will be of serious concern.

` If left alone, AIG will be forced to liquidate its valuable business

assets at very low valuations to meet its liabilities.

` It is quite possible that it will not be able to raise sufficient cash tomeet its CDS obligations.

` That would be disastrous for CDS holders, many of them struggling

global banks.

` This will erode market confidence even further and unleash

another wave of write-downs.


20/21

` On the other hand, the Fed's credit facility will enable AIG to meet

its immediate cash requirements.

` The company gains time, up to two years, to liquidate its assets.

` It is possible that markets would have stabilised when AIG starts

looking for potential buyers and hence can avoid a fire sale.

` This is a far less risky and infinitely more preferable option than

letting AIG go bankrupt.

` In other words, the Fed preferred the slow death of AIG to a quick

kill.


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a) Capital Punishment

b) Follow Legal Process

c) Invest their money with Lehmann Brothers.

- Cyrus BroachaThe Week that Wasnt

Xxxxxxxxxxxxxxxxxxx

-Arun

AIG Fallout

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