Why AIG collapsed

Why the collapse of AIG
The best explanation on how and why giant New York-based insurer AIG collapsed comes from David Paul of The Huffington Post. In his article, “Credit Default Swaps, the Collapse of AIG and Addressing the Crisis of Confidence” of Oct. 18, 2008, David explains what happened to AIG and why it is now being broken up and sold to pay for huge debts. AIG overexposed itself in so-called credit default swaps (CDS).
David says “credit default swaps are financial products that allows for the transfer of the default risk related to owning a corporate bond from one party to another.”
For example, he explains, “imagine that before the current market meltdown, CalPERS -- the large California public pension fund -- owned $100 million of IBM bonds, but wanted to insure against the risk of a bond default. CalPERS could accomplish this by negotiating a $100 million, five-year credit default swap with AIG -- which up until a month ago was a global, triple-A rated financial institution.”
“Under the terms of the swap, CalPERS would make an annual swap payment to AIG equal to -- for example – one percent of the $100 million swap notional amount. In return, AIG would pay CalPERS the amount of any losses that CalPERS realized in the event of a default by IBM. For example, if IBM went bankrupt during the contract period, and bondholders were only repaid twenty cents on the dollar, AIG would pay CalPERS $80 million. And to secure AIG's obligations, the swap contract would require that if AIG were downgraded from triple-A level to below double-A, AIG would post collateral equal to 20 percent of the notional amount of the swap contract, or $20 million.”
Then came the AIG collapse.
David says the AIG collapse “was a direct consequence of AIG's CDS exposure. Four weeks ago, AIG was a triple-A rated insurance company. Today, it is being dismantled. If AIG had large investment losses in mortgage-backed securities, but no CDS exposure, AIG would still be in business today.”
David says AIG's collapse came as a result of the following sequence of events:
“1. In the wake of the decline in real estate prices, the market value of mortgage-backed securities declined.
2. Under accounting rules that were established after the downfall of Enron -- implemented to require rapid disclosure of investment losses -- AIG marked down the value of its mortgage-backed securities portfolio.
3. These investment losses resulted in a reduction of AIG's capital reserves -- the core measure of its financial strength. 
4. As a result of the decline in AIG's capital reserves, Standard & Poor's and Moody's Investors Service downgraded AIG from triple-A to the single-A level.
5. These rating downgrades to the single-A level triggered collateralization requirements under AIG's CDS contracts. 
6. The amount of the collateral that AIG had to produce under its estimated $450 billion of CDS contracts approximated $100 billion.
“And AIG did not have $100 billion in available funds.
“This was the explosive event that destroyed AIG. It was not the market losses on its investments in mortgage-backed securities. It was not payouts on CDS contracts where default events had actually occurred. It was a collateral call.
“The AIG story illustrates two important aspects of the current crisis of confidence within the financial markets. First, AIG's collapse in a matter of days resulted from the collateral requirements under the terms of contracts that are opaque, unregulated and difficult to track on corporate financial statements. As Buffett and others have suggested, the risk in the AIG derivatives portfolio was explosive -- and ignored until it was too late.
“Second, the AIG story illustrates how a collateral call under a CDS contract can have the effect of positioning the CDS counterparty -- the institution on the other side that claims rights to the collateral -- senior to the AIG policy holders and bondholders.
“As US and European central bankers are working to define a collective strategy to rebuild confidence in the financial system and to reinvigorate inter-bank lending, the destabilizing impact of the CDS market remains one of the central problems to be addressed.
“The problem seems straightforward. After the AIG collapse, how does one institution trust its exposure to another? If CitiBank seeks a loan from JPMorgan, how does JPMorgan know whether some event might be looming that will result in a collateral call under some of the myriad derivatives contracts to which CitiBank is a party, a collateral call that in a matter of hours could bring Citibank to its knees.”

Now, my good friend Joey Cuisia insists AIG didn’t go bankrupt. AIG’s Philippine subsidiary, Philamlife, also did not go bankrupt, he asserts. I leave it to my readers to make their own conclusions.


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