AIG IN HINDSIGHT ... · ... (“Maiden Lane II”) and credit default swap operations (“Maiden Lane III”). In particular, ... senior credit default swap portfolio.

NBER WORKING PAPER SERIES

AIG IN HINDSIGHT

Robert L McDonaldAnna Paulson

Working Paper 21108httpwwwnberorgpapersw21108

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge MA 02138April 2015

David Autor Ben Chabot Larry Cordell Mark Finn Scott Frame Chiang-Tai Hsieh Yilin HuangArvind Krishnamurthy Anil Kashyap Andreas Lehnert Debbie Lucas David Marshall Richard MillerRichard Rosen David Scharfstein Robert Steigerwald and Tim Taylor provided helpful commentaryand feedback as did seminar participants at Case Western and the Federal Reserve Banks of NewYork and Chicago We are grateful to Kyal Berends Mike Mei and Thanases Plestis for excellentresearch assistance The views presented here are solely our own and do not reflect those of the FederalReserve Bank of Chicago the Board of Governors of the Federal Reserve System or the NationalBureau of Economic Research

At least one co-author has disclosed a financial relationship of potential relevance for this researchFurther information is available online at httpwwwnberorgpapersw21108ack

NBER working papers are circulated for discussion and comment purposes They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies officialNBER publications

copy 2015 by Robert L McDonald and Anna Paulson All rights reserved Short sections of text notto exceed two paragraphs may be quoted without explicit permission provided that full credit includingcopy notice is given to the source

AIG in HindsightRobert L McDonald and Anna PaulsonNBER Working Paper No 21108April 2015JEL No E00G01G18G2

ABSTRACT

The near-failure on September 16 2008 of American International Group (AIG) was an iconic momentin the financial crisis Two large bets on real estate made with funding that was vulnerable to bank-runlike behavior on the part of funders pushed AIG to the brink of bankruptcy AIG used securities lendingto transform insurance company assets into residential mortgage-backed securities and collateralizeddebt obligations ultimately losing at least $21 billion and threatening the solvency of the life insurancecompanies AIG also sold insurance on multi-sector collateralized debt obligations backed by realestate assets ultimately losing more than $30 billion These activities were apparently motivated bya belief that AIGrsquos real estate bets would not suffer defaults and were ldquomoney-goodrdquo We find thatthese securities have in fact suffered write-downs and that the stark ldquomoney-goodrdquo claim can be rejectedUltimately both liquidity and solvency were issues for AIG

Robert L McDonaldKellogg School of ManagementNorthwestern University2001 Sheridan RoadEvanston IL 60208and NBERr-mcdonaldnorthwesternedu

Anna PaulsonFederal Reserve Bank of Chicago230 S LaSalle StreetChicago IL 60604AnnaPaulsonchifrborg

1 Introduction

The near-failure on September 16 2008 of American International Group(AIG) was an iconic moment of the financial crisis AIG a global insuranceand financial company with $1 trillion in assets lost $993 billion during2008 (American International Group Inc 2008a p 194) and was rescuedwith the help of the Federal Reserve the Federal Reserve Bank of NewYork and the Treasury The rescue played out over many months andinvolved the extension of loans the creation of special purpose vehiclesand equity investments by the Treasury with the government assistanceavailable to AIG ultimately totaling $1823 billion The decision to rescueAIG was controversial at the time and remains so AIGrsquos fate also providedan important touchstone in discussions of financial reform AIG motivatedthe enactment of new rules governing non-bank financial institutions aswell as rules about the treatment of financial derivatives

In this paper we begin with an overview of AIGrsquos main corporate fi-nancial indicators from 2006-2009 However most of the attention paidto AIGmdashand our focusmdashconcerns the two main activities that caused theinsurance company to be driven to the edge of bankruptcy by falling realestate prices and mortgage foreclosures AIGrsquos securities lending businessand its credit default swap business Although much of the discussion con-cerning AIG has centered on its credit default swap business we will showthat losses from its securities lending business were of a similar magnitudeOn September 16 2008 the cumulative losses from these two activities wereon the order of $50 billion and both appear to have played important rolesin AIGrsquos near-failure (as also emphasized by Peirce (2014) and Taibbi (2011Chapter 3))

We then turn to a description of the government rescue of AIG includ-ing the special purpose vehicles that the New York Fed created to deal withthe assets related to AIGrsquos securities lending (ldquoMaiden Lane IIrdquo) and creditdefault swap operations (ldquoMaiden Lane IIIrdquo) In particular we examine thewrite-downs on the assets in these portfolios from each assetrsquos inceptionto October 2014 AIGrsquos real estate positions were apparently motivatedby the belief that these investments would not default The analysis shedslight on a claim often made by AIG executives that their mortgage-relatedinvestments might have suffered a decline in their market value in the short-term but that they would pay off over time This claim implicitly attributesany price decline in such securities to short-term illiquidity The head ofAIGFP Joseph Cassano often referred to the mortgage-related securitiesthat AIG insured through credit default swaps as ldquomoney goodrdquo (for ex-

2

ample see American International Group Inc (2007c)) Mark Hutchingswho ran AIGrsquos securities lending business made similar statements aboutthe real-estate related investments financed by securities lending (Hutch-ings 2010) However this stark claim that assets were ldquomoney goodrdquo isnot borne out a number of AIGrsquos mortgage-related investments sufferedprincipal write-downs

In our concluding section we discuss the question of how to think aboutAIG as a financial firm

It is important to be clear about what we do not do in this paper Wedo not analyze AIGrsquos regulatory oversight prior to the crisis We discusswhat happened in the AIG rescue but we do not analyze alternative poli-cies or capital structures for a rescue We discuss the specific parties whobenefited most from the rescue but we do not address the broad questionof what might have happened to the financial system had AIG failed Therewas certainly reason for concern In testimony about the AIG rescue Fed-eral Reserve Chairman Ben Bernanke (Bernanke 2009) noted that AIG had$20 billion of commercial paper outstanding and $50 billion of exposureto other banks via loans lines of credit and derivatives Lehman Broth-ers had around $57 billion in commercial paper and its failure wreakedhavoc on money market mutual funds (Federal Deposit Insurance Corpo-ration 2011) Policymakers and academics have written extensively aboutpotential systemic consequences from the failure of a large interconnectedfinancial firm like AIG for example V V Acharya Gale and Yorulmazer(2011) Brunnermeier and Pedersen (2009) Kacperczyk and Schnabl (2010)Duarte and Eisenbach (2014) and Ellul et al (2014) among many others

2 AIG Financials 2006-2009

AIG was an international insurance conglomerate with four main linesof business 1) General Insurance including propertycasualty and com-mercialindustrial insurance 2) Life Insurance and Retirement includingindividual and group life insurance and annuities 3) Asset Managementincluding private banking brokerage and investment advisory servicesand 4) Financial Services including a capital markets division consumerfinance and aircraft leasing Looking at that list of lines of business it isnot at all obvious why AIG had significant exposure to risks from fallingreal estate prices and default rates on subprime mortgages

Each year public firms must file with a 10K report with the Securitiesand Exchange Commission with an in-depth presentation of its financial

3

position In its 2007 10K report AIG listed $106 trillion in assets Amer-ican International Group Inc (2007d p 130) Table 1 presents financialindicators for 2006ndash09 which help to put AIGrsquos 2008 performance intoperspective The firm was showing some reasons for concern in 2007 in-cluding losses in the Financial Services division and unrealized losses inits credit default swap business But in 2008 AIG lost money in all of itsmain lines of business with the largest losses in the Life Insurance andFinancial Services divisions In both cases the losses stemmed from heavybets on real-estate-related financial products The Life Insurance divisionlost money primarily because of securities lending ($21 billion in losses)where life insurance company assets were loaned in exchange for cash thatwas used to invest in mortgage-related securities In the case of financialservices AIG had written credit default swaps on mortgage-related bondslosing $286 billion in 2008 American International Group Inc (2008a p265) The securities lending business will be discussed in the next sectionthe credit default swap business will be discussed in the section after thatAIGrsquos reported 2008 revenue of $111 billion incorporates the losses fromsecurities lending credit default swaps and other sources

3 AIGrsquos Securities Lending Business

During 2008 AIGrsquos life insurance subsidiaries lost approximately $21 billionfrom securities lending in which the life insurance subsidiaries loaned outassets and invested the proceeds in risky assets including assets backed bysubprime residential mortgage loans In this section we discuss AIGrsquos se-curities lending activity which created unique problems because of its linksto AIGrsquos state-regulated life insurance subsidiaries Recently Peirce (2014)has examined the securities lending business in detail We argue that it isimpossible to evaluate the potential consequences of an AIG failure withoutunderstanding AIGrsquos life insurance and securities lending activities

31 What Is Securities Lending

In a securities lending transaction one party borrows a security from an-other and deposits collateral typically cash with the securities lender Theborrower may use the security as part of a short-selling strategy or to de-liver a particular security to a customer The securities lender invests thecash collateral and earns a yield from these investments less a rebate paidto the securities borrower Absent default the lender remains the eco-

4

Table 1 AIG financial indicators by operating segment 2006-2009 $ Billions

Item 2006 2007 2008 2009

Revenues 11339 11006 1110 9600Earnings 1405 620 -9929 -1231

Realized capital gains 011 -359 -5548 -686Unrealized CDS losses (AIGFP) 0 -1147 -2860 142

Operating IncomeGeneral Insurance 1041 1053 -575 017

Life Insurance amp Retirement Services 1012 819 -3745 204Financial Services 038 -952 -4082 052

Asset Management 154 116 -919 NAAssets

General Insurance 16700 18171 16595 15473Life Insurance amp Retirement Services 55096 61316 48965 55349

Financial Services 20249 19398 16706 13282Asset Management 7828 7727 4685 NA

Source American International Group Inc (2008a p 71 194 and 225) andAmerican International Group Inc (2009 p72 195 and 230)Notes In 2009 results from asset management activities were included inthe Life Insurance amp Retirement Services category Revenue is composed ofpremiums and other income net investment income realized capital gains(or losses) and unrealized CDS losses Earnings are equal to net income (orlosses) as reported on AIGrsquos consolidated statement of income Realizedcapital gains are primarily comprised of sales of securities and other in-vestments foreign exchange transactions changes in the fair value of nonAIGFP derivative instruments that do not qualify for hedge accountingtreatment and other-than-temporary impairments on securities Unreal-ized CDS losses are the unrealized market valuation loss on AIGFPrsquos supersenior credit default swap portfolio Operating income is equal to pre-taxincome (or loss) for each business segment Assets are equal to year-endidentifiable assets for each business segment

5

nomic owner of the security that is on loan earning its return includingany dividend or coupon payments The cost to the security borrower is thedifference between the return the borrower could have earned investing thecash collateral and the rebate fee which is a market price determined bythe scarcity of the security on loan The term of a securities lending trans-action may extend for various periods up to several months but in manycases either party can terminate the transaction early The borrower canend the transaction by returning the security to the lender at which timethe lender must also return the cash deposit to the borrower A problemcan arise if many borrowers simultaneously decide to end transactions andthe securities lender does not have or cannot raise sufficient cash to meetthese demands in a timely fashion1

32 Characteristics of AIGrsquos Securities Lending

AIGrsquos securities lending activities were conducted ldquoprimarily for the benefitof certain AIG insurance companiesrdquo (AIG 2007b p 108) These activi-ties were centralized in a non-insurance subsidiary AIG Global SecuritiesLending (GSL) which served as an agent for AIGrsquos subsidiary life insur-ance companies The life insurance companies provided securities primar-ily corporate bonds to GSL These securities were loaned to banks andbroker-dealers in return for cash collateral that was invested by GSL Theinvestment proceeds were used to fund the rebate to the security borrowerand the remainder was split 50-50 between GSL and the insurance compa-nies Nearly all of AIGrsquos security loans had a one month term (Hutchings2010)2

AIG expanded its securities lending rapidly in the run-up to 2008 Atthe end of 2003 the firm had less than $30 billion in securities lendingoutstanding At the peak in 2007Q3 AIG had securities lending outstandingof $884 billion (American International Group Inc 2007e p 2) AIG hadsecurities lending of $70 billion the second quarter of 2008 which then fellalmost to zero by the fourth quarter of 2008

AIG consistently lent more than 15 percent of its domestic life insuranceassets in 2007 for example the figure was 19 percent By comparison

1Securities lending transactions are very similar to repurchase agreements as discussedin Adrian et al (2013) For additional background on securities lending see Aggarwal Saffiand Sturgess (2012) and Bank of England (2010)

2Term arrangements can be fixed or indicative If they are indicative they can beterminated early without penalty (Bank of England 2010) We do not have informationabout whether AIGrsquos arrangements were fixed or indicative

6

Metlife another active insurance securities lender never had more than 10percent of its domestic life insurance assets on loan

Typically securities lending collateral is invested in short-term highlyliquid securities A firm cannot easily lend its securities for cash collateral ifpossible borrowers of those securities fear that their cash collateral may notbe secure However AIG invested a substantial portion of the cash collateralit received from securities borrowers in longer term illiquid instrumentsincluding securities dependent on the performance of subprime residen-tial mortgages At the end of 2007 65 percent of AIGrsquos securities lendingcollateral was invested in securities that were sensitive either directly orindirectly to home prices and mortgage defaults These securities includedsecurities backed by residential and commercial mortgages as well as secu-rities backed by credit card auto and home equity loans It also includedcollateralized debt obligations which are structured financial instrumentsthat are backed by a pool of financial assets often the riskier tranches ofmortgage-backed securities Cash flows to collateralized debt obligationsare divided into tranches ranked from junior to senior Any losses arefirst allocated to the more junior tranches until their value is exhausted astructure which offers protection to senior tranches

Of the remainder of AIGrsquos securities lending collateral 19 percent wasinvested in corporate bonds and 16 percent was in cash or other short-term investments American International Group Inc (2007d p 108) Forcomparison a Risk Management Association Survey (Risk ManagementAssociation 2007) of securities lenders shows that on average 33 percent oflending proceeds was invested in mortgage-backed securities asset-backedsecurities (a broad category of securities backed by securities like credit cardreceivables and auto loans) and collateralized debt obligations 42 percentin corporate bonds and 25 percent in cash and short-term investments

AIGrsquos use of securities lending collateral to purchase residentialmortgage-backed securities and collateralized debt obligations is similarto the broader phenomenon described in Krishnamurthy Nagel andOrlov (2014) of financial firms using short-term funding like repurchaseagreements and securities lending to fund assets that had previously beenfunded through insured bank deposits AIGrsquos investments of securitieslending collateral in real-estate-related instruments accelerated after2005 On the other hand AIGFP decided to stop increasing its exposureto real-estate-related risk near the end of 2005 It took some time toimplement this decision however and deals that were in the pipeline werecompleted and as a result AIGFPrsquos real estate exposure continued to growIn addition some of the collateralized debt obligations that AIGFP insured

7

were ldquoactively managedrdquo which meant that the manager of the securitycould replace maturing refinanced and defaulting mortgages with newones including the particularly default-prone mortgages that were madein 2006 and 2007

The AIG securities lending business was characterized by a large liq-uidity and maturity mismatch Securities borrowers can demand the returnof their cash collateral on short notice However AIG was investing thiscash in long-term assets whose market values and liquidity could vary sub-stantially in the short run As long as AIG could make new security loanswhen existing ones came due it could maintain its investments in long-run illiquid assets But an arrangement based on a liquidity and maturitymismatch like this one is clearly vulnerable to bank-run dynamics Thesecurity borrowers have incentives that are similar to bank depositors wholack deposit insurance Depositors will rush to withdraw cash when theyare concerned about their bankrsquos solvency They want to make sure thatthey get their funds before the bank runs out of money Similarly secu-rity borrowers who are worried about the AIGrsquos ability to return their cashon demand are likely to ask for it to be returned And efforts to satisfythese demands will further erode AIGrsquos liquidity and generate losses thatwill prompt other securities borrowers to demand the return of their cashcollateral

Indeed before AIG was rescued on September 16 2008 securities lend-ing counterparties began to terminate these lending agreements Standardand Poorrsquos Moodyrsquos and Fitch all lowered AIGrsquos credit rating in May orJune 2008 AIG announced large second-quarter losses on August 6 2008The possibility of further losses and still-lower credit ratings appears tohave accelerated the counterpartiesrsquo efforts to reduce their securities lend-ing exposure to AIG Because the combination of falling real estate pricesand higher mortgage foreclosures had reduced the market price of securi-ties tied to these underlying assets and because it did not have access toother sources of liquidity AIG was unable to generate sufficient funds tomeet redemption requests and to return the cash collateral Moreover itslosses on securities lending threatened the regulatory capital positions ofAIGrsquos life insurance subsidiaries a point we discuss later and one that isalso emphasized by Peirce (2014)

Like many episodes during the crisis AIGrsquos securities lending problemscan be viewed through the lenses of both liquidity and solvency AIGsummed up its dilemma with respect to securities lending with considerableunderstatement in its 2008 10K report (American International Group Inc2008a) ldquoDuring September 2008 borrowers began in increasing numbers

8

to request a return of their cash collateral Because of the illiquidity in themarket for RMBS [residential mortgage-backed securities] AIG was unableto sell RMBS at acceptable prices and was forced to find alternative sourcesof cash to meet these requestsrdquo On Monday September 15 2008 aloneAIG experienced returns under its securities lending programs that led tocash payments of $52 billion (American International Group Inc 2008ap 4)

On September 16 2008 AIG received ldquoalternative sources of cashrdquo fromthe Federal Reserve Bank of New York The cash was initially in the formof loans However the New York Fed soon set up several limited liabilitycompanies as financial vehicles to handle its rescue of AIG In December2008 Maiden Lane II purchased AIGrsquos remaining portfolio of residentialmortgage back securities in which it had invested securities lending col-lateral for $205 billion a 48 discount relative to their par value of $393billion According to the Congressional Oversight Panel (2010 p 45) AIGrsquossecurities lending counterparties demanded the return of $24 billion in cashcollateral between September 12 and September 30 2008 Ultimately AIGreported losses from securities lending in excess of $20 billion in 2008

33 Securities Lending and Bankruptcy

What would have happened to AIGrsquos insurance companies and securitieslending counterparties in the event of an AIG bankruptcy Generallyif a securities lender seeks bankruptcy protection the borrower simplytakes ownership of the security that it borrowed any additional claimsassociated with the transaction would be resolved in bankruptcy Thevalue of the security on loan is marked to market daily and the collateralis adjusted accordingly so any additional claims if a security lender goesbankrupt would typically be small Because securities lending transactionsare exempt from the ldquoautomatic stayrdquo provisions of the bankruptcy codemdashthat is the rule that once bankruptcy has been declared creditors cannotmove to collect what they are owedmdashresolving these securities lendingtransactions should be fast and straightforward

However AIGrsquos securities lending was conducted largely on behalf of itslife insurance companies which were regulated at the state level If AIG haddeclared bankruptcy the resolution of claims related to securities lendingwould likely have depended on the actions of state insurance regulatorsWhen a life insurance company cannot meet its financial obligations astate insurance commissioner will take control of the companyrsquos operations

9

and place it in receivership3 Federal bankruptcy law does not apply toinsurance companies although the actions taken under state receivershipstatutes are generally patterned after federal bankruptcy However certainimportant exceptions to this practice may have been material for AIG in2008

If AIG had sought bankruptcy protection state insurance commission-ers would probably have seized AIGrsquos insurance subsidiaries Dinallo (2010)In these circumstances the status of securities lending transactions mighthave varied depending on where a particular AIG insurance subsidiary waslocated As of 2008 of the ten states where AIGrsquos life insurance subsidiarieswere located only Texas had passed a version of the Insurer Receiver-ship Model Act (IRMA) written by the National Association of InsuranceCommissioners (NAIC) which allows securities lending and other quali-fied financial contracts to receive the same exemption from the automaticstay provisions in an insurance resolution that would apply in bankruptcy4

Texas-domiciled companies supplied the securities for 58 percent of AIGrsquossecurities lending However the legal treatment of counterparties to theremaining 42 percent of the securities supplied by life insurers located inother states would have been uncertain in an insurance insolvency AIGrsquos2007 10K points out that ldquothe securities on loan as well as all of the assetsof the participating companies are generally available to satisfy the liabilityfor collateral receivedrdquo (American International Group Inc 2007d p 108)

An additional protection for some securities borrowers would havearisen from a unique aspect of AIGrsquos lending program Rather than thetypical practice of requiring collateral of 102 percent of the value of thesecurity being lent AIG began lending securities with less than 100 percentcollateral with the AIG parent company making up the difference to theinsurance subsidiary (American International Group Inc 2008a p 3) AIGseems to have accelerated this practice as its liquidity issues grew moreacute For example in an August 14 2008 email a Federal Reserve Bank ofNew York employee noted that ldquoCSG (Credit Suisse Group) does not needthe securities it borrows but instead AIG is using the deals to raise cashAs such CSG is looking to take a haircut on AIGrsquos securities as opposed toposting cash to AIG in excess of the securities value which is the market

3The state receivership process has three stages 1) conservation 2) rehabilitation and 3)liquidation The receivership process can involve transfers of blocks of assets and liabilitiesto other companies If the company cannot be rehabilitated or sold it is declared insolventand the commissioner liquidates the company and distributes assets or the proceeds fromasset sales to approved claimants in the manner prescribed by the statersquos receivership laws

4See Fitch Ratings (2006) and Law360 (2012)

10

standardrdquo (Federal Reserve Bank of New York 2008) By 2008 AIG hadalso boosted rebate fees paid to securities borrowers and was making losseson securities lending arrangements but felt this was warranted in order toavoid a ldquorun on the bankrdquo scenario Hutchings (2010)

When the borrowing firm does not post enough cash to fund ldquosubstan-tially all of the cost of purchasing replacement assetsrdquo then from an ac-counting perspective the transaction will be treated as a sale rather than asa securities lending transaction American International Group Inc (2008ap 166) reported losses of $24 billion on securities lending transactions thathad to be reclassified as ldquosalesrdquo in 2008

Overall this analysis suggests that losses for AIGrsquos securities lendingcounterparties would have been small had AIG sought bankruptcy protec-tion and if the counterparties were able to take possession of the securitiesthat they had borrowed Securities borrowers who held securities worthmore than the cash they were due from AIG would not have suffered lossesin an AIG bankruptcy barring uncertainties associated with state insur-ance law Note that this conclusion only takes into account the potentialfor direct losses Counterparties needing to unwind or liquidate positionsquickly might have suffered indirect losses as well

34 Impact of Securities Lending on AIGrsquos Domestic Life Insur-ance Subsidiaries

The losses for life insurance companies engaged in securities lending canbe attributed to two factors losses on sales of assets incurred when thosesecurities were sold for cash when borrowed securities were being returnedand unrealized mark-to-market losses on similar assets that had not yet beensold Together these losses put AIGrsquos domestic life insurance companiesunder considerable regulatory pressure Life insurance regulators establishminimum levels of capitals that take into account each companyrsquos assetrisk insurance risk market risk interest rate risk and business risk (alongwith an adjustment to account for the fact that these risks are not perfectlycorrelated) When capital falls below a certain threshold state insuranceregulators are required to intervene to protect policyholders

Looking at their official end-of-the-year balance sheets AIGrsquos life insur-ance subsidiaries appear to have made it through 2008 with a comfortablecushion of capital relative to regulatory minimums However these figuresinclude over $19 billion in capital infusions in the third and fourth quartersof 2008 that were only possible because of the rescue of AIG Table 2 showsthe capital positions of the eleven AIG life insurance subsidiaries that had

11

more than $5 billion in assets at the end of 2007 For each company the tableshows 2007 assets and the share of those assets that were on loan throughAIGrsquos securities lending business securities lending losses in 2008 and thecompanyrsquos regulatory capital as of the end of 2008 both with and withoutthe capital infusions made possible by the rescue Eight of these elevencompanies would have had negative capital without the capital infusionsThe rescue funds recapitalized the life insurance companies and kept themsolvent despite their securities lending losses This ultimately benefitedAIGrsquos life insurance policy holders

The urgency of the problems in AIGrsquos life insurance subsidiaries is re-flected in the rapidity with which they were recapitalized By September30 2008 just 14 days after the initial loan to AIG $133 billion of the loanproceeds from the Federal Reserve Bank of New York had already gone to-ward recapitalizing the life insurance subsidiaries (Congressional OversightPanel 2010 p 84) Ultimately at least $58 billion of the total governmentassistance to AIG went to addressing problems related to securities lending$19 billion in capital infusions to the life insurance subsidiaries to addresssecurities lending losses $367 billion to repay collateral to securities lend-ing counterparties ($195 billion from Maiden Lane II plus $172 billion fromthe revolving credit facility that the New York Fed established in the initialstages of the rescue) as well as an additional $31 billion from the revolv-ing credit facility to repay securities obligations (Congressional OversightPanel 2010 p 237)

4 AIGrsquos Credit Default Swap Portfolio

We now turn to a discuss AIGrsquos credit default swap business with the goalof understanding the position in which AIG and its counterparties foundthemselves on September 16 2008

41 Credit Default Swaps

A credit default swap is a derivative financial instrument that behaves likean insurance contract on a bond or a similar financial security The writer ofthe credit default swap who is the insurance seller promises to pay to thebuyer of a credit default swap the difference between the market value andthe par value of the insured bond if a ldquocredit eventrdquo occurs (For presentpurposes setting aside the sometimes arcane details of these contracts itis sufficient to think of a credit event as the failure of the bond to make a

12

Table 2 The role of the rescue in recapitalizing AIGrsquos Life Insurance Subsidiaries $ Million

2007 2008Company State Assets ($) Assets Realized Sec Post-rescue Regulatory Regulatory

Loaned in Lending Capital Capital CapitalSec Lending Losses Infusions $ with rescue without rescue

ALICO DE 101632 45 470 967 4332 3365VALIC TX 63999 151 3563 3621 2940 -681AIG Annuity TX 50553 397 7109 6048 3242 -2806Am General Life TX 33682 313 3790 3084 2844 -240SunAmerica Life AZ 39455 271 2281 1366 4805 3439AIG SunAmericaLife

AZ 35072 61 425 281 1317 1036

AIG Life DE 10790 236 870 679 465 -214Am Gen Life ampAccident

TN 9134 339 977 786 594 -192

First SunAmerica NY 6479 303 654 947 550 -397Am International NY 7093 351 771 801 458 -343United States Life NY 5315 251 395 456 305 -151Total AIG Life 364770 190 21305 19036 22393 3357

Source Authorsrsquo calculations from insurance regulatory filings accessed through SNL Financial and March 5 2009Hearing before the Senate Committee on Banking Housing and Urban Affairs httpwwwgpogovfdsyspkgCHRG-111shrg51303pdfCHRG-111shrg51303pdf (page 43) Table includes details for active securities lendingparticipants with assets of at least $5 billion The ldquoTotal AIG Liferdquo row includes all AIG life insurance subsidiariesCapital is regulatory capital

13

promised payment as in a default) There are two ways that the writerof a credit default swap like AIG can suffer a loss Obviously a loss canoccur if a credit event means that the bond or security no longer makes itspromised payments But in addition a loss can occur when the probabilityof a future credit event rises and so the price of buying a new credit defaultswap for protection against that loss also rises In this case the firm thatoriginally sold the credit default swap at a lower price has suffered a losson a mark-to-market basis and that loss is incorporated in its accountingstatements The use of mark-to-market accounting was controversial duringthe financial crisis (Heaton Lucas and McDonald 2010) but it is standardpractice for most derivatives Mark-to-market losses on AIGrsquos credit defaultswap contracts were $286 billion in 2008 (American International GroupInc 2008a p 265)

42 AIGrsquos Credit Default Swaps

As of December 31 2007 AIG had written credit default swaps with a no-tional value of $527 billion These swaps were written on corporate loans($230 billion) prime residential mortgages ($149 billion) corporate debt-collateralized loan obligations ($70 billion) and multi-sector collateralizeddebt obligations ($78 billion) (American International Group Inc 2007dp 122) (AIG also had an additional $15 trillion of other derivative expo-sures including over $1 trillion in interest rate swaps) The credit defaultswaps written on multi-sector collateralized debt obligations proved themost troublesome Again a collateralized debt obligation is a financialsecurity backed by an underlying stream of debt payments which can befrom mortgages home equity loans credit card loans auto loans and othersources The payments on this security are then divided into tranches sothat junior tranches will bear losses before senior tranches domdashallowing thesenior tranches to receive a higher credit rating It is even possible to create acollateralized debt obligation by combining tranches of other collateralizeddebt obligations a so-called CDO-squared AIG insured collateralized debtobligations backed by a variety of assets but including a substantial sharebacked by mortgages including both residential and commercial as wellas prime subprime and Alt-A (which fall between prime and subprime onthe risk spectrum) (American International Group Inc 2008a p 139)5 Itis important to realize that AIGrsquos credit default swap exposure resulted in

5Details of one of AIGrsquos multi-sector credit collateralized debt obligation are summarizedin Appendix A Source documents for many CDOs are available online at httpfciclawstanfordeduresourcestaff-data-projectscdo-Library

14

a ldquoone-wayrdquo bet on real estate that is a decline in real estate prices anda rise in foreclosures would impose costs on AIG but a rise in real estateprices or a fall in foreclosures would not benefit AIG In contrast market-making financial firms (like a stockbroker-dealer) typically seek to hedgeany significant directional exposure so that they make profits regardless ofwhether the price of the underlying asset (say the price of a stock) rises orfalls

American International Group Inc (2007d p 122) characterized $379billion of its credit default swaps (out of $527 billion) those on corporateloans and prime residential mortgages as used for ldquoregulatory capital reliefrather than risk mitigationrdquo primarily by European banks These do notappear to have been especially risky in its 2008 10-K (American Interna-tional Group Inc 2008a p 118) AIG reported a mark-to-market loss of$379 million on this portfolio 01 percent of the notional value MoreoverAIG expected that the swaps would be terminated by the counterpartiesonce they were operating under the Basel II capital rules (American Inter-national Group Inc 2007d p 122) This suggests that the counterpartybanks considered themselves compliant with Basel II although they werenot yet regulated under those rules

AIG began originating multi-sector credit default swaps in 2003 at atime when the firm was rated AAA Over half of AIGrsquos cumulative issuancesof credit default swaps however occurred after the firmrsquos credit rating wasdowngraded twice in 2005 AIGFP reportedly decided to stop originatingcredit default swaps in December 2005 at which point they still had $80billion of commitments (Polakoff 2009 p 5)6

43 Collateral and Variation Margin

AIGrsquos credit default swap contracts were traded over-the-countermdashthat isdirectly with counterpartiesmdashas opposed to being traded on an exchangeand cleared through a clearinghouse The standard master agreement forover-the-counter derivatives is provided by the International Swaps andDerivatives Association and includes a credit support annex which speci-fies how counterparty credit risk will be addressed Both the master agree-ment and annex can be customized when negotiating a deal

By construction many derivatives contracts have zero market value atinception this is generally true for futures swaps and credit default swaps

6The AIG portfolio of credit default swaps does not directly show up on its balance sheetdue to accounting conventions

15

When a position has zero market value the two parties to a contract can bymutual consent exit the contract without any obligation for either to makeany further payment to the other Note that one or both parties may beusing the contract to hedge a position in which case exiting would leave atleast one party with unhedged risk to consider

As time passes and prices move a contract initiated with zero marketvalue will generally not remain at zero market value Fair value will bepositive for one counterparty and negative by an exactly offsetting amountfor the other In such cases it is common for the negative value party tomake a compensating payment to the positive value counterparty Sucha payment is referred to as margin or collateral the two terms mean thesame thing7 Collateral can flow back and forth as market values changeIt is important to note that this transfer of funds based on a market valuechange is classified as a change in collateral and not as a payment Thereason is that the contract is still active so collateral is held by one partyagainst the prospect of a loss at the future date when the contract maturesor makes payment on a loss If the contract ultimately does not generatethe loss implied by the market value change the collateral is returnedThe accounting treatment of collateral recognizes this description and thereporting of collateral on the balance sheet depends upon the existenceof a master netting agreement When full variation margin is regularlyexchanged the value of the contract is in effect regularly reset to zeromeaning that the counterparties can agree to exit the contract without anyfurther payments

44 AIGrsquos Collateral Practices

The post-crisis investigation shed light on AIGrsquos collateral arrangementswith various counterparties Most of the credit default swap contractswritten by AIG did not call for full exchange of variation margin Ratherthey carried a wide range of collateral provisions (details are summarizedin American International Group Inc (2007a) and American InternationalGroup Inc (2007b) and standard collateral practices are discussed in ISDA(2010)) Some contracts made no provision for any exchange of collateralMost often AIG would make collateral payments only if the decline in valueof the insured assets exceeded some predefined threshold These thresholds

7Technically payments due to market value changes are variation margin Another use ofcollateral is to protect against possible future market value changes This kind of collateralcalled ldquoinitial marginrdquo or the ldquoindependent amountrdquo was typically not used in OTC marketsin dealer-to-dealer transactions prior to the crisis and is not relevant for discussing AIG

16

often depended on AIGrsquos credit rating which meant that a corporate ratingsdowngrade could lead to a large required collateral payment

Selected examples from December 2007 (American International GroupInc 2007b) illustrate agreements ranging from full mark-to-market to an 8percent threshold with various credit rating triggers for AIG and in somecases for the underlying collateral Here are three examples GoldmanSachs had 44 transactions with AIG with a total notional value of $1709billion The threshold (level of market value change required to trigger acollateral payment) was ldquo4 as long as AIGFP is rated in the AAAa cate-goryrdquo (American International Group Inc 2007b p 4) Societe Generalehad 38 transactions with AIG with a total notional value of $1864 billionThe threshold was ldquo8 as long as AIGFP is rated AAAa2 and ReferenceObligation is rated at least in the AAAa category the Threshold is reducedbased on a matrix that takes into account lower ratings of AIGFP andorthe Reference Obligationrdquo (American International Group Inc 2007b p6) Finally RBS had four transactions with AIG with a total notional valueof $135 billion AIG had to make variation payments for any market valuechange the threshold for these was zero (American International GroupInc 2007b p 6)

The assets underlying the multi-sector collateralized debt obligationswere not easily traded As a consequence there were running disagree-ments between AIG and its counterparties later documented by the FederalCrisis Inquiry Commission about their mark-to-market value at any giventime and hence the amount of collateral that AIG owed counterparties

Because many of the AIG credit default swap agreements did not in-clude full payment of mark-to-market variation margin AIG could and didaccumulate unpaid losses An unpaid variation amount is economicallyequivalent to a loan from the counterparty to AIG If AIG has $1 billion inunpaid variation margin it is as if AIG borrowed $1 billion from the coun-terparty In addition a party accumulating unpaid losses may be unwillingto exit a derivatives contract because doing so would force it to make fullcollateral payments Presumably this is why the credit support annex ofswap agreements will often contain provisions that allow the purchaser ofa credit default swap to terminate the agreement if the issuer of the swapexperiences a credit downgrade

AIG had first reported a loss on its written credit default swaps in2007 losing $115 billion on all such swaps for the yearmdash$111 billion inthe fourth quarter alonemdashwith 98 percent of the total coming from creditdefault swaps on multi-sector collateralized debt obligations (American

17

Table 3 Evolution of collateral calls and collateral posted for AIGrsquos CDS onMulti-Sector CDOs $ Millions

Goldman Sachs Societe Generale All Counterparties Total

Date Call Posted Call Posted Call Posted Shortfall6302008 7493 5913 1937 1937 15780 13241 25399122008 8979 7596 4280 4008 23441 18922 4519

9152008 10072 7596 9833 4320 32013 19573 124409162008 10065 7596 9818 5582 33879 22445 11434

Source AIGGoldman Sachs Collateral Call Timeline FCIC httpfciclawstanfordedudocumentsview2172AIG was downgraded on September 15 2008 as a result of which manymulti-sector CDS counterparties were contractually entitled to additionalcollateral

International Group Inc 2007d p 83)8 Losses continued in 2008 Table 3depicts the evolution of collateral calls between June and September 2008for Goldman Sachs and Societe Generale (AIGrsquos two largest credit defaultswap counterparties) as well as for all counterparties combined As ofJune 30 2008 counterparties had called $1578 billion and AIG had posted$1324 billion The totals climbed gradually until on September 12 totalcalls amounted to $2344 billion with AIG having posted $1892 billionThus prior to the rescue AIG had already provided almost $20 billion tocounterparties

The effect of ratings triggers is evident in a comparison of collateral callsfor September 12 2008 and those for September 15 2008 the day on whichall three ratings agencies downgraded AIG below AA- Total collateral callsincreased by $86 billion to $32 billion AIGrsquos collateral shortfall rose from$45 billion to $124 billion Societe Generalersquos call on that day rose by 55

8AIGrsquos credit default swap business was barely disclosed prior to 2007 The phraseldquosuper seniorrdquo referring to tranches of collateralized debt obligations appears four times inthe 2006 annual report and 114 times in 2007 ldquomulti-sectorrdquo does not appear in 2006 butappears 23 times in 2007 ldquoCDOrdquo (for collateralized debt obligation) appears twice in 2006and 93 times in 2007 AIGrsquos 2006 annual report discloses that it had written $4836 billionin credit default swaps but provides no details whereas the 2007 report reports notionalvalues of credit default swap by category AIGrsquos first public disclosure of credit defaultswaps written on the multi-sector collateralized debt obligations came on August 9 2007during a second-quarter earnings call (Financial Crisis Inquiry Commission 2011 p 268)The lack of disclosure is surprising given that the credit default transactions increased thesize of AIGrsquos balance sheet by 50 percent in economic terms

18

billion

45 What Would Have Happened to Credit Default Swap Coun-terparties if AIG Had Declared Bankruptcy

If AIG had declared bankruptcy on September 16 2008 what would havebeen the direct effect on credit default swap counterparties It is of courseimpossible to answer this question definitively but some straightforwardobservations are possible

AIG had 21 counterparties for its multi-sector credit default swaps Ofthose nine had collateral calls exceeding $500 million and six of thosemdashGoldman Sachs Societe Generale Merrill UBS DZ Bank and Rabobankmdashhad a difference greater than $500 million between the collateral they hadrequested and the amount AIG had posted Table 4 shows these collateralshortfalls for the six largest counterparties to AIGrsquos multi-sector credit de-fault swaps as of September 16 2008 and also shows the shortfall relativeto shareholder equity for each counterparty Of the $114 billion that AIGowed to counterparties on its credit default swaps on September 16 2008these six banks accounted for $10 billion

If AIG had defaulted the counterparty banks to the credit default swapson the multi-sector collateralized debt obligation would have likely facedthree direct consequences First the banks would have kept the collateralalready posted by AIG This is a result of the rule mentioned earlier thatderivatives are exempted from the automatic stay in bankruptcy (for discus-sion see Edwards and Morrison (2005) and Bolton and Oehmke (forthcom-ing)) Second the banks would have been treated as general creditors forany collateral that had been requested but AIG had not yet posted Thirdthe banks would have retained the asset or position that had been hedgedby the defaulted credit default swap

Assuming that assets were valued correctly and that the September 152008 downgrade of AIG to an A rating eliminated remaining any remainingthresholds that might have further increased collateral calls the economiccost of an AIG default for its counterparties would be equal to the collateralshortfall that is the difference between called and posted collateral Howsignificant would this shortfall have been for the counterparty banks Ascan be seen in Table 4 even for the six banks that were individually owedmore than $500 million in no case did the shortfall exceed 10 percent oftheir equity capital

However comparing the actual loss with counterparty equity may betoo sanguine because it assumes that counterparties would simply absorb

19

Table 4 AIGrsquos counterparties for CDS on multi sector CDOs CollateralShortfall relative to equity and Asset Sales necessary to maintain pre-shortfall equity to asset ratio $B

Total Shareholder Collateral Shortfall ImpliedAssets Equity Shortfall Equity Asset Sales

9162008 ([3][2]) ([4]times[1])[1] [2] [3] [4] [5]

Goldman Sachs 10818 456 25 541 585Societe Generale 16944 560 42 756 1281Merrill Lynch 8758 384 10 270 236UBS 17845 415 10 241 430DZ Bank 6770 106 07 700 474Rabobank 8940 450 06 131 117

Total asset sales to return to pre AIG shortfall equity to assets 3124

Source Financial Crisis Inquiry Commission (2010) and author calculationsusing 2008 Q2 and Q3 financials Goldman Sachs Merrill Lynch and UBSassets shareholders equity and tier 1 capital come from 2008-Q3 financialstatements Societe Generale DZ Bank and Rabobank values come from2008-Q2 financial statements Column [5] is equal to column [4] multipliedby column [1] and represents the assets sales that would be necessary ifthe AIG collateral shortfall from column [3] was realized and the firm inquestion chose to preserve its original equity to asset ratio

20

the loss This assumption faces at least three potential problems FirstBrunnermeier and Pedersen (2009) and Duarte and Eisenbach (2014) amongothers emphasize the possibility of fire-sale spillovers Institutions mightrespond to the loss in capital by selling assets in order to return to theirpre-loss leverage ratios This could lower asset prices and lead to mark-to-market losses at other firms who might in turn sell assets to get backto target leverage ratios Our back of the envelope calculations presentedin Table 4 suggest that if these six banks had chosen to respond by sellingassets to get back to their pre-AIG default debt to equity ratios they wouldhave needed to sell $312 billion in assets Second the cancellation of thecredit default swaps would leave many of the counterparties with unhedgedexposure to real estate risk Retaining this risk could reduce the capacityfor risk-taking Third even if one concludes that counterparties could haveabsorbed losses due to an AIG failure other market participants would nothave known at the time who was exposed and in what amount For thisreason the failure of any large financial firm can be stressful for the financialsystemmdasha conclusion that is not particular to credit default swaps or AIG

Another consequence of AIGrsquos failure would have been cancellation ofthe $387 billion of other credit default swaps mainly held by Europeanbanks Collateral calls related to these positions totaled just $500 millionon September 16 2008 (Congressional Oversight Panel 2010 p 42) andas noted above the institutions were apparently anticipating the swaps toexpire when they adopted Basel II capital rules The cancellation of theseswaps would have created a capital deficiency but it is not clear that thiswould have been economically important In any event European financialregulators would have had the option to forebear for a time with enforcingthe capital rules thus allowing a period for adjustment

Overall how much did the rescue of AIG benefit its multi-sector creditdefault counterparties Some media reports suggest that $62 billion intaxpayer funds were paid to AIGrsquos multi-sector credit default swap coun-terparties (for example Orol (2010)) In fact the direct counterparty benefitfrom the rescue is smaller We can divide the payments to AIGrsquos creditdefault swap counterparties into three categories

First there are collateral payments AIG made prior to the rescue Thesepayments would have been retained by counterparties in a bankruptcyand therefore cannot be attributed to the rescue These payments totaled$224 billion with $185 billion associated with multi-sector collateralizeddebt obligations that became part of the Maiden Lane III Fed-created spe-cial purpose vehicle (see also Congressional Oversight Panel (2010 p 93))Second there are collateral payments made by AIG after the rescue These

21

payments could only be made because of the rescue and clearly offset lossesthat counterparties would have sustained in the absence of a rescue Thisamount provides a lower bound on the assistance received by counterpar-ties to the credit default swaps due to the rescue AIGrsquos 2008 10-K reportstotal collateral payments for credit default swaps of $401 billion for 2007and 2008 suggesting that $177 billion was paid after the rescue (As con-firmation of this amount the Congressional Oversight Panel (2010 p 93)found that collateral payments of $165 billion were made after the rescuefor the assets that became part of Maiden Lane III) Finally Maiden LaneIII made cash payments of $268 billion in exchange for the assets that AIGhad insured These payments were equal to the estimated fair market valueof the assets at the time (SIGTARP 2009) While there may not have beenmany buyers for these assets even at 47 of face value in the fall of 2008 itis inappropriate to consider the entire amount of the price that Maiden LaneIII paid for the credit default swap as a direct benefit to the counterpartiesIndeed as we discuss in the next section this portfolio of assets appreciatedand was later sold for a modest gain

5 Performance of Maiden Lane Assets

The Federal Reserve Bank of New York created several special purposevehicles as part of the rescue of AIG Among them Maiden Lane II pur-chased the remaining securities lending invested collateral from AIG andMaiden Lane III acquired from AIGFPrsquos counterparties the collateralizeddebt obligations that AIG had insured This acquisition terminated theassociated credit default swaps Maiden Lane II was funded by a $195billion loan from the New York Fed and $1 billion from AIG that wouldabsorb the first $1 billion in losses Maiden Lane III was funded by aloan from the New York Fed of $243 billion and $5 billion in equityfrom AIG (Congressional Oversight Panel 2010 p 87 91) The NewYork Fed has thoroughly documented the resulting cash flows at httpwwwnewyorkfedorgmarketsmaidenlanehtml These data in combi-nation with information from various other sources allow us to examinehow the value of these securities evolved both while they were held in theMaiden Lane vehicles and afterward

22