By August 2008, the American International Group was, as far as the general public knew, a titan of the financial services industry — the world's largest insurer and an icon of corporate strength. The truth, however, was far different, and barely a month later, the company's financial liabilities had been revealed, its credit rating downgraded, and suddenly pressed to deliver cash liabilities it simply did not have. Overnight, AIG went from cock of the walk to the verge of bankruptcy in one of the most spectacular meltdowns in modern corporate history. It was an event that for many, has become the signal moment of the global financial crisis that began in 2008 and has not yet fully ended.
AIG, of course, was essentially bought out by the federal government in a last-ditch effort to save the company, and in so doing, to prevent potentially catastrophic collateral damage to the rest of the world economy, had the giant company truly failed. AIG's defenders have long asserted that the company's troubles were not insurance-based; they were the work of what amounted to a rogue financial products office in London that vastly overextended its reach on trafficking toxic debt. The fundamentals of the company, or so the conventional wisdom goes, were solid, especially on its insurance operations.
Indeed, the wide-ranging federal regulation of the financial services industry that followed (namely, the Dodd-Frank Wall Street Reform and Consumer Protection Act) was meant to prevent another AIG situation from ever taking place. But these efforts have been met with much opposition from the insurance industry itself, especially any regulatory efforts that seek to oversee how insurers invest their money, and the degree to which their products and services access the volatile equity markets of the world.
The opposition makes sense. After all, if AIG was not an insurance failure, then why are insurers being subject to greater scrutiny, and to rules that constrain their ability to make the best use of financial marketplace opportunities? The reason is because the conventional wisdom on AIG is wrong. The level and extent of AIG's financial instability, government documents now show, had compromised the stability not just of itself, but of large swathes of the larger insurance industry, including life insurers — which have traditionally considered themselves apart from the entire AIG fiasco and doubly undeserving of additional regulatory oversight.
The truth is that, as evinced by public documents released over the last 18 months, AIG's meltdown nearly look many other companies with it, and only the timely intervention of the federal government — wielding huge amounts of taxpayer cash and guarantees — saved it. Had AIG been allowed to go insolvent or bankrupt, so too could have numerous other companies, including life insurers, and perhaps a substantial chunk of the world economy. What we know as the Great Recession could have been something much, much worse, and it all comes back to how AIG's problems spread across a vast web that ultimately drew in many companies that, whether they realized it or not, had also become part of the problem. AIG had become like a nuclear reactor about to blow, and the companies most at risk were like liquefied natural gas plants in the same town, maybe having nothing directly to do with the cooling towers, but directly in harm's way nonetheless, and in a capacity to compound the initial damage once the core melted down.
ANATOMY OF A MELTDOWN
In 2009, William K. Sjostrom, Jr. — now a Professor of Law at the James E. Rogers College of Law at the University of Arizona — published in the Washington & Lee Law Review what would become a definitive account of exactly how and why AIG came so close to failure.
In Sjostrom's article, "The AIG Bailout," he noted that by the time federal regulators had stepped in to save AIG in September 2008, the company was drowning in a toxic mix of credit default swaps, asset-backed securities, securitization, tranching, and collateralized debt obligations conducted within an Byzantine corporate structure that contained insurance companies, financial companies, banking companies, leasing companies and other assets that spanned the globe.
AIG received aid from the Federal Reserve Board through five lending facilities starting on Sept. 16, 2008, but only because of the Reserve Board's authority to lend to nondepository institutions in "unusual and exigent circumstances." According to Sjostrom, this was the first such lending since the 1930s.
Once AIG had to be rescued by the federal government, the company's fall was swift. On February, 2008, AIG had $1 trillion in assets and had announced earnings of $6.2 billion ($2.39 per share); but just a few months later it had fallen into the unhappy arms of the Federal Reserve Bank of New York.
By Sjostrom's calculations, AIG's fall stemmed a staggering $32.4 billion in losses racked up by AIG Financial Products unit — a small outfit in AIG's London office that is largely held responsible for AIG's troubles — from January 2007 through September 2008. These losses were almost entirely from AIGFP's credit default swap activities.
At the same time, the Fed was barred by law from regulating insurance holding companies, as demanded by both the industry and by Congress through legislation passed in 1999.
According to Sjostrom, this mix of conditions allowed for AIG to leverage its then-AAA credit rating and trillion-dollar balance sheet through its CDS business.
"Counterparties were presumably willing to pay AIGFP a higher premium for protection because of AIG's guarantee," Sjostrom said, "than they would pay for the same protection from a seller with a lower credit rating, lesser balance sheet, or less-favorable guarantee."
AIG had noted in a May 2008 conference call presentation that its CDS business was very similar to its profitable excess casualty insurance business. Sjorstrom quoted a former AIGFP senior executive who characterized writing CDSs as "free money" because AIGFP's risk models indicated that the underlying securities would never go into default.
"The CDSs would expire untriggered, and AIGFP would pocket the premiums," Sjorstrom said in his paper. "Basically, AIGFP speculated against a drop in credit quality with respect to innumerable asset-backed securities."
But Federal Reserve Board chairman Ben Bernanke, who was among a number of Fed and Treasury to come under intense fire for the decision to bail out AIG — even now he is still taking heat for it in the ongoing Republican primary debates — had another view.
In March 2009 testimony before the Senate Banking Committee, he said that nothing made him more angry than AIG's ability "to exploit a huge gap in the regulatory system." In so doing, AIG's CDS business included contracts that required payments to life and P&C insurance policyholders worldwide. This not only made it especially difficult for the Fed to keep AIG going, but it also refutes repeated claims by members of Congress, officials of the National Association of Insurance Commissioners and industry officials that AIG's insurance subsidiaries (including their life subsidiaries) were solvent and capable of paying claims absent of federal intervention.
Case in point: A June 2010 report from the Congressional Oversight Panel—the group created by Congress to monitor federal expenditure of funds under the Troubled Asset Relief Program — names names on who benefited from the federal government buying controlling interest in AIG.
Foremost among them are AIG's insurance subsidiaries, which received nearly $21 billion in capital contributions in 2008. This included $4.4 billion to non-U.S. life insurance companies, with $1.8 billion to Nan Shan in Taiwan and the remaining amount flowing to insurance companies in Hong Kong and Japan. $16.5 billion went to U.S. life insurance companies. By receiving capital contributions from the government, the COP says, these foreign and domestic life insurance subsidiaries were able to meet their obligations under the securities lending program and avoid liquidity or solvency concerns and potential ratings downgrades.
Moreover, in 2009, AIG's life insurance subsidiaries received $1.14 billion in capital contributions from AIG. These contributions were made to strengthen the subsidiaries' capital position and risk-based capital ratios.
In a 2009 paper by David Wood of the Ventura, California-based law firm Anderson Kill Wood & Bender, the massive bailout of AIG was the government's only tenable option.
"The sheer magnitude and complexity of such a bankruptcy would risk a less probable but far more troubling result," Wood wrote. "If recent events in the financial world teach us anything, it should be to pay attention to the remote risks, the so-called Black Swan events. A.I.G. is so big and multiheaded that a well-funded, creative and aggressive trustee or creditors' committee is almost guaranteed. If ever there were an incentive to challenge the conventional wisdom concerning accessing insurance company subsidiaries, it would be here and now."
Wood's writing proved accurate, especially where AIG's life operations were involved. In an October 2011 study by the Government Accountability Office, the Board of Governors of the Federal Reserve System were shown a slide in October 2008 indicating that one of the options for protecting AIG life insurance policyholders was to have the Fed purchase AIG's life insurance subsidiaries and remove them from the AIG estate altogether. (This was subsequently confirmed by a three-page report on AIG's website indicating the divestitures the company has undertaken over the last three years as it slims down.)
According to the report, AIG had insurance, financial, non-financial, and banking operations all over the world, in such diverse countries as Poland, Argentina, South America, Taiwan, China, Japan, Canada, etc., before the Fed and Treasury stepped in.
Moreover, the GAO study said that between September 16, 2008 and January 2009, insurance companies other than AIG lost approximately $1 trillion in market value, and many of them were on the verge of bankruptcy. But by the end of 2009, the company's situation had improved to a point that bankruptcy ceased to be a focus in consideration of options. This, the GAO noted, was a direct result of federal intervention.
RUNNING FOR COVER
While it is clear that a lot of AIG's problems grew out of the operations of Financial Products group — which when federal regulators examined its books was found to have insured $2.77 trillion notional amount of mortgage backed securities — dealing with it was beyond the means of state regulators. And the job of federal officials tasked with dealing with AIG's problems was made more difficult by prickly attitudes from members of Congress seeking political cover from the AIG debacle. This, according to reports reviewed by National Underwriter — which include the GAO study, the June 2010 Congressional Oversight Panel report, and an October 2012 report by the Pennsylvania Insurance Department.
For example, after testimony before a January 2010 hearing on AIG by the House Oversight and Investigations by Timothy Geithner, Rep. Darrell Issa (R-Calif.), the committee's ranking Republican member, said he "no confidence" in Geithner and called for his resignation, accusing Geithner of being either incompetent or of trying "to cover up the details of what was going on through payoffs of the CDS."
The next witness was Henry Paulson, Treasury secretary during the latter days of the Bush administration, when AIG's board placed its fate in the hands of federal regulators. Rep. Cliff Stearns (F-Fla.) wasted no time grilling him by way of cross-referencing on things Geithner said earlier.
Stearns said that Geithner's testimony suggested a frightening prospect of revolution in the streets if AIG had not been bailed out. "He intimated our Constitution would not have been able to be enforced. There would be a revolution in this country," Stearns said. "Do you think it is at that extreme if we let AIG go bankrupt, we would have had that kind of collapse and revolutionary spirit in this country? Is that what your position is today?"
While Paulson tried to distance himself from Stearn's interpretation of Geithner's comments, the point had been made: there were those in Congress unhappy that the Fed had used such special capabilities to rescue AIG, a power it had not wielded since the Great Depression and one that the American public largely did not realize existed.
The Fed used extraordinary powers, since removed, through its Section 13 (3) to intervene with AIG and provide it with funds and oversight…despite the fact that it was barred by law from regulating AIG. A provision of the Gramm-Leach-Bliley Act of 1999 that specifically barred the Fed from regulating insurance companies. That provision was eliminated through the Dodd-Frank Act in 2010.
The provision was drafted by Jeb Hensarling, then an aide to Sen. Philip Gramm, R-Texas, as part of the GLB. Hensarling is now a Texas congressman, a member of the leadership of the House Financial Services Committee and last fall served as co-chairman of the "super committee" that failed to craft a deficit reduction package. He is also the favored candidate to replace Spencer Bachus (R-Ala.) as the chairman of the Committee on Financial Services when Bachus hits his term limit in 2013 and steps down.
As for the GAO report, it is based on interviews GAO officials had with various state and federal officials, plus access to documents used by the Fed and Treasury to outline their options.
