AIG traces its roots back 90 years when an American entrepreneur named C.V. Starr founded AIG’s earliest predecessor company in Shanghai. What began as a small insurance business grew to become one of the world’s largest companies. By early 2007 AIG had assets of $1 trillion, $110 billion in revenues, 74 million customers and 116,000 employees in 130 countries and jurisdictions. Yet just 18 months later, AIG found itself on the brink of failure and in need of emergency government assistance.
What Happened?
Building upon its premier global life franchise and general insurance, AIG expanded into a range of financial services businesses. One of these, created in 1987, was AIG Financial Products (AIGFP), a company that provides clients with risk management solutions. Among other activities, AIGFP sold credit default swaps to other financial institutions to protect against the default of certain securities. Many of these securities at the time were given a bond rating of AAA and higher. However, in late 2007, as the U.S. residential mortgage market began to deteriorate, these securities were severely impacted. As a result, AIG recorded severe unrealized valuation losses on AIGFP’s credit default swap portfolio.
At the same time, AIG incurred heavy losses in the value of its securities lending operation, which invested in high-grade residential mortgage-backed securities. Through this program, AIG made short-term loans of certain securities it owned to generate revenues. At the same time, other AIG real estate-related investments also suffered sharp value losses.
Throughout the crisis, AIG’s insurance businesses were adequately capitalized. The losses that occurred as a result of AIGFP’s action had no impact on AIG policyholders. AIG’s insurance companies are closely regulated by New York and other states and regions worldwide. Their reserves are protected through regulations that prevent the removal of capital so that each AIG member insurance company has adequate assets to back each policy and meet all policyholder obligations.
Even though AIG had incurred virtually no actual credit losses, the severe write-downs led to downgrades in its credit ratings. In addition, AIG was forced to post billions of dollars in collateral to cover potential losses to holders of AIG credit default swaps. Meanwhile, the world capital and credit markets deteriorated rapidly, making it virtually impossible to access other sources of capital to fund these collateral requirements or meet other cash needs.
Deteriorating conditions in global financial markets only made matters worse for AIG. The collapse of respected financial institutions such as Bear Stearns and Lehman Brothers sent shockwaves through the world economy. The failure of the U.S.-sponsored mortgage companies Fannie Mae and Freddie Mac added to the financial disruption. During this time, AIG was seeking private capital solutions to its liquidity problem, exploring possible solutions with state insurance regulators in New York and Pennsylvania. However, as the market deteriorated further, AIG’s share price dropped. In mid-September 2008, AIG’s credit ratings were downgraded once again, triggering additional collateral calls and cash-flow issues in excess of $20 billion. Suddenly, AIG, although solvent, faced an acute liquidity crisis.
Because of its size and substantial interconnection with financial markets and institutions around the world, the federal government and financial industry immediately recognized that an uncontrolled failure of AIG would have had severe ramifications. In addition to being the world’s largest insurer, AIG was providing more than $400 billion of credit protection to banks and other clients around the world through its credit default swap business. AIG also provides credit support to municipal transit systems and is a major participant in foreign exchange and interest rate markets.
Initial Investment From the U.S. Government
To stabilize AIG and prevent the potential ripple effects should it fail, the United States government extended a two-year emergency loan of $85 billion on September 16, 2008. The facility carried a rate of LIBOR (the London Interbank Offered Rate – a widely used benchmark used to set short-term interest rates) plus 8.5%, a commitment fee of 2% on the loan principal and a fee on the undrawn portion of 8.5%. Additionally, the government would be entitled to 79.9% ownership of the company and also, at the government’s request, AIG agreed to elect a new Chairman and Chief Executive Officer. After consultation with the U.S. Treasury and Federal Reserve Bank of New York, AIG’s Board of Directors elected Edward M. Liddy Chairman and Chief Executive Officer.
With the loan in place, Mr. Liddy devised a restructuring plan to enable AIG to sell many of its leading businesses around the world and pay back the government loan with interest. However, AIG still had to address the two principal sources of its liquidity losses: the multi-sector credit default swap portfolio and the securities lending operation.
As the financial industry continued to falter in October and November, it became apparent that the terms of AIG’s original government loan would not provide the flexibility necessary for AIG to resolve its financial challenges. A revised plan was needed to better address the company’s liquidity losses and give the company more time and greater flexibility to sell assets and repay the government. On November 10, 2008, the original government loan was restructured to include a $40 billion investment by the U.S. Treasury through the Troubled Asset Relief Program (TARP) and a five-year Federal Reserve Bank of New York credit facility with a borrowing limit of up to $60 billion. In addition, two financing entities, Maiden Lane II and Maiden Lane III, were created to acquire AIG’s multi-sector credit default swap assets and AIG’s securities lending assets respectively. The entities were funded primarily by the Federal Reserve Bank of New York with a smaller capital contribution by AIG. Under the terms of the agreement, the majority of any appreciation in the securities held by the entities would go to the government.
Economic and Market Conditions Worsen
The assistance provided by the U.S. government in November succeeded in addressing AIG’s liquidity issues. However, economic and capital market conditions continued to deteriorate, which created significant mark to market losses for AIG in the fourth quarter of 2008. At the same time, potential buyers of AIG’s businesses were facing significant financial challenges of their own, which diminished their ability to raise capital to purchase AIG assets.
As economic and capital market conditions worsened, AIG worked with the U.S. government on developing a new set of tools to help AIG achieve a comprehensive restructuring over the next several years. On March 2, 2009, AIG announced these new tools, which include exchanging the U.S. Treasury’s cumulative preferred shares in AIG for preferred shares that more closely resemble common equity; a new five-year standby equity capital facility, which will allow AIG to raise up to $30 billion of capital by issuing non-cumulative preferred stock to the U.S. Treasury from time to time as needed; debt-for-equity swaps that allow AIG to tap the value of its insurance companies to repay a portion of the government credit facility; elimination of the LIBOR floor on the credit facility, which will lower AIG’s interest cost; and continued access to the credit facility, although with reduced borrowing capacity.
AIG’s Plans Going Forward
A comprehensive and orderly restructuring of AIG is essential to repay the support is has received from the U.S. government. The company’s overall structure is too complex, too unwieldy and too opaque for its component businesses to be well managed as one entity. So AIG is now executing a strategy, in close cooperation with the Federal Reserve and U.S. Treasury, to protect the value of its component businesses, capture that value to pay back monies owed to the government, and position its businesses for the future as more independently run, transparent companies.
The corporate leadership team now in place has made progress executing its restructuring plan by: reducing the excessive risk from exposure to certain financial products, derivatives trading activities, and securities lending; rationalizing AIG’s cost structure; selling easily separable assets; and stabilizing the company’s liquidity.
The new set of tools announced on March 2, 2009 will allow AIG to redirect is restructuring plan away from relying solely on immediate sales for cash to a process that allows AIG to maximize the value of its individual business for the benefit of all stakeholders, including U.S. taxpayers. AIG expects to achieve a complete and orderly restructuring over the next several years through a process that protects policyholders, continues to reduce risk, and produces strong, focused franchises that can operate as independent entities. In the meantime, the leaders of AIG’s insurance companies remain focused on running well-capitalized and competitive enterprises.
AIG is dedicated to maintaining its well-known underwriting discipline and providing value to policyholders, agents and the other business partners who are central to its success. AIG’s employees, the vast majority of whom have had nothing to do with the problems that have devastated AIG and wiped out some or all of their life savings, are at the heart of this effort. They have reduced costs and sharpened their focus on AIG’s customers despite very difficult conditions.
AIG also recognizes the importance of its relationship with the U.S. government. AIG has taken several steps in this regard, including restrictions on executive compensation, suspension of federal lobbying and cessation of corporate political contributions. In addition, AIG is engaged in improving transparency by working with regulators on capital adequacy, appropriate accounting treatment during times of market disruption, and risk management metrics.
Resolving the economic problems facing the U.S. and world markets will require a cooperative effort by the public and private sectors. AIG is committed to playing a constructive role in this process to ensure that it can serve shareholders and pay back taxpayers as it contributes to the U.S. and world economies.