Falling Giant: A Case Study of AIG

Why Could AIG Have Been Considered a Falling Giant?

You may be surprised to learn that the American International Group Inc., better known as AIG (NYSE: AIG), is still alive and kicking, and is no longer considered a threat to the financial stability of the United States.

Almost a decade after it was handed a government bailout worth about $150 billion, the U.S. Financial Stability Oversight Council (FSOC) voted to remove AIG from its list of institutions that are systemic risks, or in headline terms, "too big to fail." In 2013, the company repaid the last installment on its debt to taxpayers, and the U.S. government relinquished its stake in AIG.

Understanding How AIG May Have Fallen

High-Flying AIG

For decades, AIG was a global powerhouse in the business of selling insurance. But in September 2008, the company was on the brink of collapse.

The epicenter of the crisis was at an office in London, where a division of the company called AIG Financial Products (AIGFP) nearly caused the downfall of a pillar of American capitalism.

The AIGFP division sold insurance against investment losses. A typical policy might insure an investor against interest rate changes or some other event that would have an adverse impact on the investment.

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

How the Housing Bubble's Burst Broke AIG

A new financial product known as a collateralized debt obligation (CDO) became the darling of investment banks and other large institutions. CDOs lump various types of debt from the very safe to the very risky into one bundle for sale to investors. The various types of debt are known as tranches.

Many large institutions holding mortgage-backed securities created CDOs. These included tranches filled with subprime loans. That is, they were mortgages issued during the housing bubble to people who were ill-qualified to repay them. 

The AIGFP decided to cash in on the trend. It would insure 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.

A big chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that defaults on these loans would be insignificant.

A Rolling Disaster

And then foreclosures on home loans rose to high levels. AIG had to pay out on what it had promised to cover. The AIGFP division ended up incurring about $25 billion in losses. Accounting issues within the division worsened the losses. This, in turn, lowered AIG's credit rating, forcing the firm to post collateral for its bondholders. That made the company's financial situation even worse.

It was clear that AIG was in danger of insolvency. To prevent that, the federal government stepped in. But why was AIG saved by the government while other companies affected by the credit crunch weren't?

Too Big To Fail

Simply put, AIG was considered too big to fail. A huge number of mutual funds, pension funds, and hedge funds invested in AIG or were insured by it, or both.

In particular, investment banks that held CDOs insured by AIG were at risk of losing billions. For example, media reports indicated that Goldman Sachs Group, Inc. (NYSE: GS) had $20 billion tied into various aspects of AIG's business, although the firm denied that figure.

Money market funds, generally seen as safe investments for the individual investor, were also at risk since many had invested in AIG bonds. If AIG went down, it would send shockwaves through the already shaky money markets as millions lost money in investments that were supposed to be safe.

Who Wasn't At Risk

However, customers of AIG's traditional business weren't at much risk. While the financial products section of the company was close to collapse, the much smaller retail insurance arm was still very much in business. In any case, each state has a regulatory agency that oversees insurance operations, and state governments have a guarantee clause that reimburses policyholders in cases of insolvency.

While policyholders were not in harm's way, others were. And those investors, who ranged from individuals who had tucked their money away in a safe money market fund to giant hedge funds and pension funds with billions at stake, desperately needed someone to intervene.

The Government Steps In

While AIG hung on by a thread, negotiations took place among company executives and federal officials. Once it was determined that the company was too vital to the global economy to be allowed to collapse, a deal was struck to save the company.

The Federal Reserve issued the initial loan to AIG in exchange for 79.9% company's equity. The original amount was listed at $85 billion and was to be repaid with interest.

Later, the terms of the deal were reworked and the debt grew. The Federal Reserve and the Treasury Department poured even more money into AIG, bringing the total up to $142 billion.

The Aftermath

AIG's bailout did not come without controversy.

Some questioned whether it was appropriate for the government to use taxpayer money to purchase a struggling insurance company. The use of public funds to pay out bonuses to AIG's officials in particular caused outrage.

However, others noted that the bailout actually benefited taxpayers in the end due to the interest paid on the loans. In fact, the government made a reported $22.7 billion in interest on the deal.