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How CLO, CDO, and Credit Default Swaps Brought AIG to its End! Essay

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Updated: Apr 25th, 2019

A good understanding of what CDS is and the impact it has in the financial market is important. Securities is the term used to refer to combined financial instruments such as shares, bonds and treasury bills (Warren 293). A CDS is like an insurance policy. As an unoriginal financial instrument (derivative), it serves to protect against the failure to pay by a corporation or a person who is in debt.

Just as securities are tentative in the financial market, so is CDS. Everything was right for AIG until the point when the level of CDS became uncontrollable. An unchecked accumulation of CDS was the beginning of the end for the once World’s greatest insurer.

In many business entities holding companies may have subsidiary (subordinate) or even associate (connected) companies. For AIG, owning several subsidiaries can be regarded as an obvious phenomenon by virtue of its expansive business empire (Skeel & Cohan 28). A subsidiary of AIG was responsible for the onset of the collapse.

The subsidiary offered protection to buyers against losses that accrued from debts and loans. CDOs and mortgages (loans acquired to purchase houses) were also sold making the subsidiary collect a lot of premium in the process (Adam 43). The earnings were very high and this encouraged the business on these unoriginal financial securities.

A collapse of the housing market was the commencement of increasing rates of foreclosures. The mortgage pools which AIG had insured were devalued implying a low face value (Lewitt 2008). The credit crisis was on the rise as the credit rating of the company recorded remarkable drops in 2007.

It was funny to reflect on the historical growth of the company that had began in 1919 in China. A 40-year tenure for the then CEO Maurice Greenberg ended in 2006. The period was characterized by a positive business growth that made AIG enjoy a trillion-dollar balance sheet (Warren 141). The realization that all was not well was not directly addressed by the management. The use of some accounting exercises was adopted in order to otherwise convince the public that all was working.

It is after a thorough inspection of the books of accounts that it was realized that indeed AIG had for a long time been overvaluing its CDO liabilities and swap related write downs. In fact the investigation brought to light the fact that the losses were in excess of $20 billion in the first quarter of 2008.Losses were the order of the day for AIG as it succumbed to effects of CDS decline.

Cumulative losses summed to $ 18 billion for the three quarters that proceeded the year 2008 (Adam 44). $ 5.3 billion was posted as security against CDS contracts that AIG had written. The lowering of the firm’s credit rating triggered the rise of security margin by a further $ 14 billion. A massive injection of capital to offset these losses was necessary.

The greatest problem, however, lies with the valuation of CDOs (Warren 287). Unlike shares which are valued on existing market conditions, CDOs are complex in nature and the valuation of the different types of CDOs varies. Indexing is the only available mode of valuation that is available.

This involves referencing the different debts and loans entities. The dependence on the index for a value is so biased and may end up being misleading in the real financial world. Mortgage-duration analysis may not be of use in the determination of value but may negatively affect the index. The fact that CDOs can be used to speculate the nature of the index in future may negatively affect the value of CDOs (Warren 293).

The presence of pessimistic speculators in the market may indeed negatively affect the index thereby reducing the sales of such CDS. The CDS market may and had a negative impact on AIG. For instance one may be running a profitable company that is let down by the thought that it may be unable to fund the loan. The CDS bet therefore played a crucial role in ensuring that AIG did not receive additional funding at a time when things were really not in order.

The CDS business has grown over the years since the late 1990s as one of the best ways of raising money as opposed to common financial tools. The fact that it is insurance on bonds make it rather complicated. A company may issue bonds that will be bought by a bank. The bank is entitled to receive some payments from the issuing company. The bank receives no payment once the issuer of the bond becomes bankrupt.

The person who sold the CDS then is tasked with the paying of the bank. It is rather unfortunate that any available means available are used to settle these debts. For example AIG had to let out and sell some of its assets in order to pay some of its creditors (Faber 21). It had to pay all the financial institutions that had a stake in the CDS business. A 5-year old prediction made by a billionaire Warren Buffet was not taken seriously by the financial investors.

In fact he issued a lengthy presentation on the worrying trends of CDS business. He had witnessed the rising trends that had seen so many banks engage in this type of business. AIG too had followed suit and things never seemed as good as they appeared (Warren 147). He was critical of the various financial derivatives and regarded them as future financial weapons. His sentiments were echoed with the realization that AIG was financially trailing.

CDS contribute a meager 10% of the derivatives while interest rate swaps contribute 75% of the global $530 trillion derivative market. The CDS are financial tools that enable the transfer of nonpayment risk of owning a corporate bond to another party.

For Instance Company X, a pension company may be known to own $200 million of Y bonds but is for the idea of insuring against bond default. This can be done by negotiating a $200 million, five-year CDS with AIG (Gilbert 162). The terms under the swap will see company X make an annual swap payment of say 1% of the $200 million. AIG would be faced with the contractual obligation of paying X for any losses in the event that Y defaulted.

CDS direct exposure can be regarded as the genesis of all the problems that befell AIG leading to its failure. The share price at AIG recorded a drastic drop from $ 76 to $ 2 within a year (Amerman 51). This only made matters worse since most people were unwilling to invest in such a deteriorating firm. It is argued that even though AIG had immense losses on mortgage securities but maintained a low level of exposure on CDS, things would not be as bad as they were.

The major events that led to the fall of AIG are of importance to the business world. Mortgages are valued depending on the prices of real estates. A high price in real estates translates into a high market value of mortgage-backed securities. A drop in real estate prices leads to a corresponding drop in the market value of mortgages.

Lack of strict following of the accounting rules saw the company mark down the market value of its mortgages (Warren 148). The losses suffered were so immense and eventually led to the reduction of the company’s capital reserve. Usually, a capital reserve serves to protect a firm from unexpected risks that come in future. The financial strength of an organization is determined by the level of the capital reserve maintained.

Unlike provisions that serve to protect against known risks such as bad debt, the capital reserve of AIG had to be reduced in order to pay off the creditors. The reduction in capital reserve was followed by the down grading of the company from a triple-A to a single-A level (Saporito, 2009). This realization only made investors and other stakeholders to reduce their interactions with the company for fear of further collapse.

The downgrading of the firm necessitated an increase in the security (or collateral) factors as a result of excessive CDOs and AIG had to produce a total of $ 100 billion as collateral for its $ 450 billion worth of CDS contracts (Gilbert 165).

This amount was not readily available and the company was tending towards becoming bankrupt. The realization that the company was on its knees attracted several public uproar of whether the federal government could assist in financing the insurer. However, the then US Democratic presidential candidate said that the government had little to do with the collapse.

The Federal government otherwise injected $ 85 billion emergency loan in order to save the fallen organization. The loan was to accrue an interest of 11.5%. The federal government was in return to enjoy a 79.9 % stake in the company. The management of the company was also to change as agreed by the company owners and the government. Those at the controls of the company during its collapse were to pave way for others who would in effect take the company to higher heights.

The AIG story serves as a lesson to the many financial, health and banking institutions that operate on short term goals that are aimed at maximizing profit and reducing the operating costs. The most important aspect in any business management approach adopted is the consideration that risks exist. The real cause of AIG’s collapse is the fact that the senior management was not considerate of both systematic and business risks that would befall the insurance company.

Business risks are those associated with price and cost of production. Systematic risks are those that affect particular types of industries. For example the banking industry may be affected by cases of money laundering. Systematic risks such as recession and inflation may thus negatively affect the normal operations of an organization. It is therefore important to ensure that long-term goals are given priority over short term goals.

AIG would not have collapsed if emphasis was placed on implementation of long term goals that aimed at increasing the firm’s capital reserve and not necessarily the profit. It should also be noted that tangible assets play a crucial role in preventing situations of bankruptcy and collapse. As most investors check on the viability of derivative financial tools, others are busy investing in tangible assets which have lesser disadvantages compared to the securities.

Works Cited

Adam, Davidson. How AIG fell apart. Routledge, 2008, Pp. 43-57

Amerman, Daniel. “AIG’s Dangerous Collapse & A Credit Derivatives Risk Primer.” Prentice Hall, 2010, Pp. 45-63

Faber, David. And then the roof caved in: how Wall Street’s greed and stupidity brought capitalism to its knees. John Wiley and Sons, 2009, Pp. 7-26

Gilbert, Mark. Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable. Bloomberg Press, 2010, Pp. 161-170

Jeannine, Aversa. AIG collapse too awful to contemplate. New York Times. September 18, 2008

Lewitt, Michael.The Collapse of AIG. New York Times. September 17, 2008

Peter, D. Schiff. “Crash Proof: How to Profit from the Coming Economic Collapse,” New York Times, September 16, 2006

Saporito, Bill. How AIG Became Too Big to Fail. Time Magazine (Thursday, March 19, 2009)

Shelp, Ronald Kent. Fallen Giant: The Amazing Story of Hank Greenberg and the History of AIG. Hoboken, New Jersey: Wiley, 2006

Skeel, David & Cohan, D. William. The New Financial Deal: Understanding the Dodd-Frank Act. John Wiley and Sons, 2010, Pp. 24-47

Warren, Elizabeth. AIG Rescue, Its Impact on Markets, and the Government’s Exit Strategy. DIANE Publishing, 2010, Pp. 287-301

Warren, Elizabeth. Reviving Lending to Small Business and Families and the Impact of the TALF. DIANE Publishing, 2010, Pp. 141-156

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