Introduction
When the financial world started experiencing the credit crunch, AIG ranked among the biggest insurance corporations employing more than 100,000 people across the world.
The bulk of their business was in conventional insurance. However, over time, they had also moved beyond their traditional insurance business and AIG to become a major seller of credit default swaps.
AIG’s financial instruments
Credit default swaps are basically financial instruments for swapping the risk of debt default. Essentially they work as an insurance policy but since they are not regulated and therefore do not qualify to be termed as insurance policy. In essence, the assets that had been secured by mortgages and corporate debts were insured by the swaps. In the event which AIG went bankrupt, other financial institutions would have followed suit.
This is majorly the reason that led to the near demise of AIG, which had in excess of $ 10 billion CDS write-down. Most banks had bought CDS protection from AIG which meant that If AIG was unable to honor their contractual obligation, as and when they fell due, then every one of those banks has lost that protection. Once mortgage backed bonds started defaulting, they had to fork out lots of money to pay them out. AIG had more than enough assets to cover the swaps, but could not sell the assets and pay for the swaps as when they fell due. This resulted in the ripple effect. When collapse was imminent, the government had to inject eighty five billion dollars to keep the company on its feet.
Variables that may have caused AIG to need a bail out.
Ferrell, O. et al (2009) cites the lack of accountability in how funds are utilized as a cause of AIG’s near bankruptcy. AIG is accused of lax oversight and reckless investments which caused massive disruption throughout the economy. A.I.G.’s crisis was fuelled primarily out of its products, which were complex debt securities and credit default swaps.
As mentioned earlier, swaps are financial instruments that are not regulated by the US Securities & Exchange Commission in as much as these instruments perform the same conventional function as an insurance policy they are not insurance and are therefore not monitored. Factors within the corporate culture of AIG may have promoted speculative risk taking. Part of the problem may have been AIG’s incentives. The AIG culture was focused on a reward system that placed little responsibilities on executives who made very poor decisions. In 2008 AIG made $40 billion in losses and at the same time a number of managers were selected to receive large bonuses. Even after receiving the federal rescue funds, they planned to hand out cash awards that doubled salaries of some employees asserting that these types of payments were necessary to keep top employees at AIG.
Another factor that contributed to the near bankruptcy was engaging in financial products which resulted from excessive risk taking and using computer models that failed to take into account real world market risks. Therefore the failure to assess the risk of credit default swaps correctly caused the demise of AIG and pushed the federal government to rescue it and the U.S banking system
Finally, AIG entered a very lucrative but perilous new market without understanding the sheer complexity of the financial products that it was selling. AIG placed too much trust in models with faulty assumptions that could not determine all the variables, forces and weights that cause a high-or-low risk investment to go bad.
Was the bailout really necessary?
A lot of financial critics oppose this level of government intervention in corporations because it seems to be rewarding companies that blatantly ignored the needs and desires of their stakeholders in favor of enriching themselves in the short term. In as much as AIG bankruptcy would have adversely affected the U.S economy and launched shock waves across other nations’ economies. Critics insist that the idea is not simply bail out AIG but also to determine what went wrong and institute measures that would prevent such events from happening in future.
Bridge loan versus bailout
A bridge loan is financing that is offered at very low interest rates and would therefore be a subsidy. This is different from a bailout which is largely seen as the outright grant of cash. The US Federal reserve infusion was largely seen as a bailout, whether a bailout or bridge financing, the intervention was necessary to avert a disastrous financial crisis.
References
Ferrell, O. et al (2009). Business ethics, ethical decision making & cases, (7thEdition). Boston, MA: Prentice Hall