On September 16, 2008, exactly ten years ago this past Sunday, the Federal Reserve Bank of New York provided an emergency $85 billion loan to keep AIG, a global company with about $1 trillion in assets prior to the financial crisis, from a liquidity insolvency. When all was said and done, AIG lost $99 billion in 2008 and received over $180 billion in taxpayer funds to prevent its default.
AIG found itself in such dire financial straits through the activities of one division within the company, AIG Financial Products. That division wrote credit default swaps (CDS) on over $500 billion of assets, including $78 billion on collateralized debt obligations relating to residential mortgages of which $63 billion had exposure to subprime mortgages. When AIG established this directional CDS position, it did not post any initial margin with its counterparties or otherwise set aside capital for future potential losses. Instead, under the terms of these bilateral contracts, AIG was only required to post margin in the event the market value of the underlying mortgage-backed securities dropped, or if AIG itself suffered a credit downgrade. In fact, for an insurance company, AIG’s collateral situation was somewhat unique. Many of AIG’s competitors, including monoline financial guarantors, were not required to post any collateral until actual losses occurred.
In July 2007, after the credit ratings agencies downgraded their ratings of mortgage-backed securities, AIG received its first collateral call from Goldman Sachs. Surprisingly, up until these collateral calls, top AIG executives – including the CEO and Chief Risk Officer – were unaware of the collateral provisions in AIG’s CDS agreements that required AIG to post collateral if the market value of the underlying securities dropped. It soon became apparent that the Office of Thrift Supervision, which supervised AIG on a consolidated basis, also was not aware of the collateral provisions in these contracts.
From July 2007 onward, AIG disputed its requirements to post collateral with counterparties, arguing that AIG’s models showed no long-term losses on the underlying mortgage-backed securities. Counterparties countered that the contracts required AIG to post collateral if market value fell, regardless of the fact the losses were so far unrealized. And yet, even while these potentially crippling collateral disputes were ongoing, AIG’s CEO, Martin Sullivan, who would eventually step down as the company’s billion dollar losses mounted, continued to focus publicly on only the temporary capital effect of unrealized losses and the low probability of realized losses, describing the CDS contracts as so “carefully underwritten and structured … [that] we believe the probability that [the business] will sustain an economic loss is close to zero,” and stating in a November 2007 presentation that the underlying CDOs “would have to take losses that erode all of the tranches below the ‘Super Senior’ level before AIGFP would be at risk.”
What he did not describe, however, was AIG’s precarious liquidity position should margin calls be triggered by either mounting mark-to-market losses or a downgrade of the firm’s credit rating. This potential liquidity drain was further exacerbated by AIG’s securities lending activity, which invested a substantial portion of its cash collateral in illiquid mortgage-backed securities that became trapped in the credit freeze. Shockingly, despite that existential liquidity risk, AIG stated flatly in February 2008 that, “AIGFP…has the ability and intent to hold its positions until contract maturity or call by the counterparty.”
By June 2008, AIG had posted $13.2 billion of collateral with counterparties, causing a severe liquidity strain on the company. Then, on Monday, September 15, all three ratings agencies downgraded AIG, triggering an additional $13 billion in cash collateral calls. AIG was unable to meet these collateral calls, amassing a $12.4 billion unfunded exposure to its counterparties, and prompting the Federal Reserve to offer assistance.
If we want to avoid the next crisis, transparency is a must have.