What Happened to AIG?
Just how did the housing bubble of the early 2000s grow so big? A lot of it had to do with American International Group (AIG).
Back in 2007, AIG was the world’s largest insurance company with $850 billion in assets, offices in 130 countries, and more than 100,000 employees. It provided general insurance, life insurance, retirement insurance, and other products to more than 85% of the businesses on the Fortune 500.
As of mid-2023, it counted just half as many employees and stood at a mere fraction of its former market cap, at $43.34 billion, and the reason has everything to do with the financial crisis of 2007–2008, when it nearly collapsed. Considered “too big to fail,” its insolvency posed a systemic risk to the entire global financial system and thus needed to be rescued by the U.S. government.
Just how did this titan topple?
How Was AIG Connected to the Subprime Mortgage Crisis?
Before its spectacular crash, AIG had been known as Wall Street’s “golden goose” because of its perfect credit rating. Since the 1980s, it had boasted the highest possible rating, AAA, which was designated by Moody’s in 1986, and Standard & Poor’s even earlier, back in 1983. This allowed AIG to borrow for less, invest at higher rates of return (often in riskier securities), and profit from the spread. And because AIG was considered to be so safe, its activities received less oversight than those of many of its competitors.
“If you think about it, no one wants to buy disaster protection from someone who is not going to be around … that was our sales pitch to the Street or to banks”
—Testimony by AIG Financial Products’ managing director, Gene Park, to the Financial Crisis Inquiry Commission in 2010
In 1998, one of AIG’s subsidiaries, AIG Financial Products, which was based in Connecticut but conducted most of its operations in London, used the company’s AAA guarantee to its advantage. It became an over-the-counter dealer of what was then a little-known and exotic derivative called a credit default swap. Think of it like a form of insurance on a debt obligation, like a mortgage-backed security. The only difference was that this type of insurance received little regulation and, astoundingly, because of its sterling AAA rating, it didn’t require any collateral.
According to the Financial Crisis Inquiry Commission, which was created by Congress to understand—and ostensibly prevent—another crisis of seismic proportions, by 2003, AIG’s credit default swaps on a senior-rated category of subprime mortgage-backed securities, known as collateralized debt obligations (CDOs), were valued at $2 billion. By 2005, they had ballooned to $54 billion.
Zoom out for a second to understand the magnitude of growth in the U.S. housing market at the time because it was simply unstoppable. An era of low interest rates, easy credit, and nearly limitless demand had fueled one of the biggest asset bubbles in history. U.S. home prices doubled from 1998 to 2006, and the housing sector accounted for nearly 40% of all new jobs created. Homeownership rates soared, particularly for first-time buyers, due to a new loan category called the subprime mortgage.
These mortgages were often sold by predatory lenders targeting low-income and minority populations, often people with low credit scores who never dreamed it would be possible to own a home of their own. Americans’ mailboxes and inboxes were flooded daily with advertisements urging them to buy or refinance. Telemarketers interrupted millions of dinner times with promises of zero-money-down and no-documentation loans, which would be later dubbed “liar loans” due to misleading advertising.
Subprime mortgages had adjustable rates of interest that were pegged to prevailing interest rates, and in the event of a rate hike by the Federal Reserve, their mortgage rates would “reset,” or shoot up higher, often by several hundred dollars a month.
But as long as the housing market stayed hot, housing-related investments would, too.
Credit default swaps were supposed to protect investors against a default in mortgage-backed securities, and AIG minted profits selling billions of dollars of these toxic subprime-fueled credit default swaps to banks, both in Europe and the United States.
Banks found these deals attractive, again because of AIG’s pristine credit rating, which greatly reduced the amount of capital they needed to hold against an asset—from 8% to just 1.6%. In other words, banks believed these credit default swaps were worth the expense because they lowered their credit risk. By 2007, AIG had sold $379 billion worth of credit default swaps, only inflating the housing bubble further. AIG Financial’s operating income had grown to $4.4 billion, accounting for nearly 30% of AIG’s total business.
What Was AIG’s Accounting Scandal?
But the glint began to fade from AIG’s untarnished reputation in 2005, when auditors discovered that the company had overstated its earnings by $3.9 billion. New York Attorney General Eliot Spitzer accused the company of “improper and inappropriate” transactions and accounting irregularities, charging CEO Maurice “Hank” Greenberg for his personal involvement in overseeing the fraudulent activities. (Greenberg would later pay $9.9 million in fines.)
As a result, all three credit ratings agencies, Fitch, Moody’s, and Standard & Poor’s, downgraded AIG’s rating to AA+. This would unleash a string of dominoes that would cause the company’s eventual collapse, since losing its AAA designation meant that, in the event that the value of its CDOs fell, AIG’s trading partners could now demand that the company post collateral—hich they certainly did.
How Did AIG Fail?
One of the biggest problems with credit default swaps had to do with their lack of oversight. No one really knew what was bundled inside these packages of debt—not even the executives at AIG. For instance, one “multisector” CDO was advertised as having less than 10% subprime exposure, when in reality it was closer to 80%. When housing prices peaked in 2006, AIG started to decrease its sales of CDOs, but by then, the damage had been done. AIG had $79 billion in CDO swaps and not one dollar in collateral.
“This is horrendous business. We should get out of it.”
–AIG Financial executive Gene Parkafter learning about their CDO’s heavy exposure to subprime mortgages, included as part of the testimony to the Financial Crisis Inquiry Commission, 2010
The bottom began to fall out of the housing market in July 2007. The Federal Reserve instituted a series of interest rate hikes to quell inflation, causing millions of subprime borrowers to default on their loans. The market for mortgage-backed securities, like CDOs, simply collapsed. On July 10, the credit ratings agencies issued downgrades on 431 subprime-backed securities worth over $5.2 billion.
AIG’s counterparties had understood the implications of the company’s initial credit downgrade, and faced with the likelihood of mounting losses from their own subprime activities, Goldman Sachs, which owned $21 billion in AIG’s credit default swaps, took action. On July 11, 2007, one day after the credit downgrades, it sent a margin call to AIG on $20 billion, along with an invoice for $1.8 billion in collateral.
The game was up for AIG.
In testimony to the FCIC, AIG executives admitted surprise—even shock—over the collateral call from Goldman Sachs, in part because AIG Financial was not regulated as an insurance subsidiary, and thus they believed hedges like collateral were unnecessary.
But what might be even more astounding was the fact that AIG analysts could not effectively dispute Goldman’s collateral claims because they had no real way to value their CDOs.
AIG Financial had used an actuarial valuation model developed by a professor at the University of Pennsylvania, Gary Gorton, that did not estimate the market value of CDOs because it concluded, with 99.85% confidence, that “CDO losses were not possible.” AIG’s auditor, PricewaterhouseCoopers, backed it up, even stating, “from a risk management perspective, there are no substantive economic risks in the portfolio,” because the CDO contracts were tied to the most senior levels of mortgage-backed securities.
During AIG’s second-quarter earnings call on August 9, 2007, the company disclosed its $79 billion in credit default swaps but did not mention the collateral call from Goldman Sachs. In fact, AIG Financial’s CEO, Joseph Cassano, instead boldly attempted to reassure investors, saying “It is hard for us, without being flippant, to even see a scenario within any kind of realm or reason that would see us losing $1 in any of those [CDO] transactions.”
The next day, AIG posted a $450 million “down payment” to Goldman Sachs, but other calls would come flooding in. In September, Société Générale, the French financial services giant, demanded $40 million, then Swiss-based UBS clamored for $67 million before Goldman Sachs increased its call to $300 million.
By September, the ratings agencies had published downgrades of hundreds more CDOs. The mortgage market had entered a tailspin.
When AIG reported its third-quarter earnings on November 7, Cassano said that “AIG had more than enough resources to meet any of the collateral calls that might come in,” although, in its earnings statement, AIG had posted a $352 million charge related to its CDO portfolio as well as a $550 million valuation loss.
By November, AIG was still struggling with its valuation models. PricewaterhouseCoopers auditors met with AIG Financial executives and adopted a “negative basis adjustment” between the value of its derivatives and the value of its swap protection, changing its earnings estimates from a loss of $5.1 billion to just $1.5 billion.
However, by February 2008, the auditors had a change of heart, saying this adjustment had been “improper” and “unsupported,” and that they would need to publicly broadcast their mistake.
On February 11, 2008, just ahead of its fourth-quarter earnings announcement, AIG filed a report with the SEC about their “material weakness” between valuations—and the ratings agencies pounced. Moody’s and S&P downgraded the company again, spurring yet more collateral calls. When AIG’s fourth-quarter earnings were announced on February 11, 2008, the company posted a loss of $5.29 billion—with $2.6 billion of that stemming from its CDOs. The Office of Thrift Supervision (OTC), which regulated American insurance companies, also downgraded AIG, stating it was now a “moderate to severe supervisory concern.”
AIG was caught in a death spiral. By September 2008, AIG’s collateral calls had skyrocketed to $23.4 billion, with even more downgrades in the pipeline, which would lead to yet more collateral calls. Business at AIG had deteriorated to the point where the company was sitting on only $9 billion in cash, which would keep it afloat for little more than a week. The board of AIG held an emergency meeting with the Federal Reserve Bank of New York on Friday, September 12—in the very same building where another crisis was unfolding with Lehman Brothers.
How Did AIG Get Bailed Out?
AIG’s imminent collapse spelled catastrophe for the entire financial system. AIG was so big and had traded such a wide range of products with the biggest banks in the world, ranging from lines of credit to derivatives to securities, that in the event AIG went under, these firms would also be threatened.
Fed officials initially believed AIG would be “bailed out” by the private sector. In fact, Warren Buffett and his private equity partners had already been in talks with the company before the emergency meeting took place.
Another scenario positioned AIG’s subsidiaries as essentially loaning their parent the cash it needed to tide it over. Yet another had the German insurer Allianz taking control of AIG.
But as the weekend progressed, it became clear that these deals would not materialize. In the early hours on Monday, September 15, Lehman declared bankruptcy. This rattled the other banks to their cores; why would they assume more risk by taking on AIG’s troubles?
Initially, the Fed was reluctant to send assistance to AIG because of the “moral hazard” involved with bailing it out—in other words, it would be sending the message that poor risk management would be rewarded, which was a precedent it did not want to set.
That morning, the Fed tried to organize a consortium of banks, including JPMorgan Chase and Goldman Sachs, to loan $75 billion to AIG, but after further downgrades, AIG’s stock tanked, losing over half of its value in afternoon trading. The banks rejected the deal, choosing instead to protect their own balance sheets, many of which were also in peril.
The only solution left, it seemed, was government intervention.
“The global economy was on the brink of collapse and there were only hours in which to make critical decisions.”
–U.S. Treasury Dept spokesman, Andy Williams, in defense of AIG bailout, in testimony to the Financial Crisis Inquiry Commission, 2010
Fearing widespread financial contagion, on a late-night conference call, the Federal Reserve Board of Governors and Federal Reserve Bank of New York President Tim Geithner used section 13 (3) of the Federal Reserve Act to send AIG an initial loan of $85 billion. The federal government assumed control of AIG’s parent company as well as its primary subsidiaries.
Under the Troubled Asset Relief Program (TARP), which was passed by Congress on October 3, AIG received an additional $70 billion.
AIG remained under federal control until 2012, when the Treasury sold its final shares of AIG common stock, amounting to $22.7 billion. According to the Treasury Department website, the Treasury realized a positive return of $5 billion and the Federal Reserve gained $17.7 billion on the deal. AIG had repaid its debts, plus interest, to the United States government, which had amounted to a staggering $205 billion.
