Oh, how the mighty have fallen

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First published in ITIJ 99, April 2009

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The bailout bonanza - David Craik recaps on the turbulent past few months for America International Group

It’s been a spectacular fall from grace for AIG. Twelve months ago it was a well respected insurance giant with operations in 130 countries and was the world’s 18th-largest public company according to the Forbes Global 2000 list. But a year on, the company has had to accept a multi-billion dollar Government bailout to prevent its collapse, posted the largest quarter corporate loss in US history and a US Senator has felt so sure of the public’s contempt of the organisation that he could publicly call for its executives to take the ‘Japanese’ approach to responsibility and kill themselves.

So what’s gone wrong at AIG and is it too late for anything to go right?

Its troubles first became apparent in early September 2008, when the US financial system was rocked by the effects of the sub-prime mortgage collapse and the global credit crunch. The US Government took over mortgage-lending giants Fannie Mae and Freddie Mac, which were on the brink of failure, but did not do the same for investment bank Lehman Brothers. It filed for bankruptcy court protection and the US Government was left to watch share prices plummet at home and abroad in its wake.

It then emerged that AIG’s London-based Financial Products division had incurred severe losses on underwriting credit default swaps, which insure against default on assets tied to corporate debt and mortgage securities including sub-prime. Despite stating that its basic insurance businesses were ‘fully capable of meeting their obligations to policyholders’ the company faced collapse. Fearing another Lehman’s effect, the Government decided to act, believing it would be ‘catastrophic’ to allow the insurer to fail. Banks and mutual funds would be severely affected if the insurer were to default. So the Government bailed out AIG with an initial $85-billion loan in return for an 80 per cent stake. “The loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy,” it said.

Troubles deepen

Fast forward to early March and the bailout had swelled to $150 billion without any subsidiaries being sold. It would turn out to be a month of deepening woe for AIG.

It started with the reporting of a fourth quarter loss for 2008 of $61.7 billion, compared with a loss of $5.3 billion in the same period in 2007. It was the largest quarterly loss ever recorded by a US public company. AIG reported that it had written down $25 billion in assets, with repayments to the Government costing $7 billion.

"AIG must 'adhere to the mos stringent limitations on executive compensation'"

The company said its results had been ‘negatively affected’ by the continued severe credit market deterioration, particularly in commercial mortgage backed securities but that insurance premiums had declined only ‘modestly’ by 1.9 per cent. The firm added that pressure to sell off its business units to repay the Government had worsened its position. It had been trying to sell two subsidiaries, American Life Insurance Company and American International Assurance Company, but had been thwarted by the global economic downturn. Chief executive Edward Liddy described the market as a ‘pretty crummy place right now’.

But a solution was at hand.

AIG said it would repay as much as $26 billion in existing loans from the Government with preferred stakes in the two subsidiaries. The intention being that the Government would sell the stakes and pocket the money when the markets recover. AIG then also announced its intention to form a General Insurance holding company, including its Foreign General Insurance unit, its Commercial Insurance Group and other property and casualty operations, to be called AIU Holdings. It said the formation would ‘help protect and enhance the value of these key businesses. It will help position them for the future as more independently run, transparent companies’. The Government responded to the results and the announcements by declaring that it would give AIG another bailout of $30 billion on more lenient loan terms than the bailout it had given last year. It said, though, that AIG must ‘adhere to the most stringent limitations on executive compensation’ and enforce restrictions on ‘corporate expenses’.

Then the bonuses row appeared.

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AIG, it emerged, had awarded executives from its Financial Products Division $165 million in bonuses – despite its giant Government bailout and its own role in its near collapse. This prompted Republican Senator Charles Grassley to recommend ‘resignation or suicide’ for AIG executives. The depth of feeling caused by AIG’s actions was stark amongst the US public and Government alike. US Treasury Secretary Timothy Geithner attempted to block the payments and President Obama demanded immediate restructuring of AIG’s bonus payments system. He described the bonuses as an ‘outrage’.

Liddy responded that executive bonuses would be sharply cut this year, but he added that the 2008 bonuses would go ahead as planned as they were legally binding. He also refused to give New York’s Attorney General, Andrew Cuomo, the identities of those workers who had received the bonuses. Cuomo threatened to subpoena AIG to force it to give up the names and threatened to investigate whether the bonuses breached state law. On Wednesday 18 March, Liddy went before a congressional hearing and declared that ‘mistakes were made at AIG on a scale that few could have imagined possible’. He even described the bonuses as ‘distasteful’ and urged recipients to return half of the money back. In surreal scenes small crowds of protestors in US cities took to the streets the next day to complain about AIG’s use of taxpayers’ money and the part played by financial companies in the economic downturn. One New York protestor said: “I am outraged at the continued misbehaviour of our financial companies that are trying to destroy the country.”

On the same day as the protests, the US House of Representatives voted to impose a 90-per-cent tax on bonuses for executives whose salaries exceed $250,000 and whose companies receive at least $5 billion in Government bailout money. AIG then decided to give Cuomo the bonus details that he had previously asked for. But it was not over for AIG quite yet, as 19 US states demanded to know the same details so they could initiate steps to recover the bonuses.

Silver lining

Despite the gloom, there are areas of positivity for AIG, one of which is its travel insurance arm. Jeff Rutledge, president of AIG Travel, told ITIJ in a statement that his division had seen little adverse affect from the year of misery: “The worldwide travel market is being challenged. The global economic situation is affecting our industry. There are, however, silver linings in this cloud. In times of uncertainty, people have an increased awareness of risk. What we’re seeing is a general downturn, but sales are resilient.” He continued to reassure the industry: “Clients choose to work with AIG Travel because we are a market leader with an unmatched, global franchise. AIG Travel is continuing to establish new relationships, including multiple deployments of airline partnerships. In total, we have a worldwide distribution network of more than 30,000 partners. We are encouraged by the demand for travel insurance, which has been holding up very well despite the general economic conditions. And as we look to the future, we are optimistic. Our business continues to be strong while we maintain a protected, well capitalised surplus. As always AIG Travel is meeting our policyholder obligations and is focused on customer service.”

The biggest consequence of AIG’s troubled year is that as part of its latest restructuring, AIG Travel has now become a member company of AIU Holdings. AIG describes these member companies as ‘well capitalised and financially strong’. Nicolas Walsh, vice chairman of AIU Holdings, adds that the travel portfolios remain core businesses within AIU.   

piggybankSo we have AIG in a mess, caused primarily by its move into credit default swaps, but its core insurance businesses in apparently healthy form. What then are we likely to see happen next? The answer is a murky one. After its horrific results announcement, the US Government reaffirmed its commitment to AIG and said that the $30-billion bailout may not be the last. A Government statement read: “Given the systemic risk AIG continues to pose and the fragility of markets today, the potential cost to the economy and the taxpayer of government inaction would be extremely high.” It added that ‘possible further government support’ would be necessary if ‘markets do not stabilise and improve’. But since these statements were released, we have had the bonus row and the furious public reaction. Can this support still be guaranteed?

"If AIG goes under, then the fallout will be felt hugely by banks around the world"

Robert Haynes, senior insurance analyst at CreditSights, says the Government does not have the option of letting AIG ‘blow up’. The theory is that if AIG goes under, then the fallout will be felt hugely by banks around the world. They would have to absorb gigantic losses, putting their finances under even greater strain than they are now. In an economic and political climate where Governments throughout the world are devising and engineering solutions to restore capital and confidence to the banking sector this, some analysts say, would be disastrous. But Christopher Whalen, co-founder of Institutional Risk Analytics, which provides analysis and ratings for banks, believes the opposite. He describes the Government bailouts as ‘band-aids’, which increase the risks to taxpayers. He is supportive of forcing AIG into liquidation and selling off its healthy insurance businesses. “The future can be summed up by bankruptcy and liquidation,” Whalen told ITIJ.  “The Government cannot fund AIG’s losses, the numbers are too big. The Government makes the problem worse. We could be muddling through this crisis for a decade.” What is clear is that AIG need to start selling some of its assets to repay the increasingly bitter taxpayer. But given the continued economic downturn, this will be no easier in the second half of the year than it has been in the first.

What will AIG try to sell?

An AIG source said it had ‘comprehensive agreements’ with the Government and the company remained committed to an ‘orderly restructuring’, which repaid US taxpayers and preserved the ‘vitality’ of AIG’s insurance business. Regarding AIU Holdings the source said: “The establishment of AIU Holdings will assist AIG in preparing for the potential sale of a minority stake in the business, which ultimately may include a public offering of shares depending on market conditions.”

Liddy has said the fixing of AIG could take ‘several years’ but it is clear the company believes it has time to turn its operations around. However, the bonus row may have taken that time away. It seems that public opinion and the Government’s reaction to that in the next few days and weeks will determine whether AIG will be changed in an ‘orderly’ fashion or whether it will be left to go to the wall.