March 22, 2010 In this issue of The IRA, we feature a comment by Richard Alford. We first met Dick at the Federal Reserve Bank of New York, where he worked as an economist in the FRBNY's foreign department, contributing to the weekly report for the Federal Open Market Committee and helping to coordinate market intervention by the Fed's foreign exchange trading desk.
American International Group (AIG) is back in the news yet again as it has finally negotiated the sale of two significant operating units, the domestic underwriter ALICO and the Asia business operated under AIA. The length of time it took for AIG to find buyers for the two subsidiaries and the terms of the deals as presented in the newspapers are both telling. While the popular accounts and analyses of the crisis at AIG have largely focused AIG Financial Product's (AIGFP) book of credit default swaps, the problems at AIGFP involve more than the CDS book. AIG's financial difficulties overall reflected problems at the insurance subs as well as on the derivatives book. The problems at the insurance subsidiaries were not larger or more serious than the problems in AIGFP. However, some of the insurance subsidiaries would have experienced serious problems continuing as going concerns even under state conservatorship had the parent and AIGFP been allowed to fail. Given the fragility of the market post Lehman and the difficulties at Primary Reserve Fund during this same time frame, it is probable that the market would not have distinguished between the sound and unsound subsidiaries of AIG. But the problems at the insurance units have received far too little attention and, in turn, suggest motives for the rescue of AIG that are not commonly understood. A quick examination of how the bailout money was used supports the view that serious problems were more endemic than the popular accounts suggest. The $22.4 billion of bailout funds were used to make payments to AIGFP's CDS counterparties. However, AIGFP had significant losses other than in the CDS book. A total of $24.6 billion was used to make payments to meet non-CDS linked AIGFP obligations, e, g. $12.5 billion was used to retire maturing debt and $12.1 billion was used to make whole participants in Guaranteed Investment Agreements (GIAs) -largely municipality sponsored tax-advantaged employee savings plans. These numbers do not reflect fully reflect the losses from the various activities that AIGFP was engaged in, but rather are presented to make it clear that AIGFP incurred sizable losses in areas other than the CDS book. The non AIGFP parts of the AIG family, including the insurance subsidiaries, received $29.4 billion of bailout funds-less than the $52 billion AIGFP received- but still a considerable amount of aid. Of that $29.4 billion, $20.9 was reported as "Capital Contribution to Life Insurance Cos." If the life insurance companies were financial sound, then the scandal ought to be the needless transfer of $20.9 billion to the life insurers. As The IRA has noted in the past, the bailout of AIG was the first federal rescue of an insolvent insurer in modern times. Unfortunately, there are good reasons to believe that the transfer was necessary. The reported uses of the bailout funds indicate that a securities lending operation had cost AIG life insurers dearly. Were these transactions arm's length and were they suitable for a regulated insurer such as AIG? Which dealers were involved in these transactions? Some of the life insurers attempted to enhance returns by lending securities they held and then investing the collateral posted with them in residential mortgage-backed securities (RMBS) in effect leveraging up and running a maturity mismatch. As the RMBS they held declined in value, and securities lending counterparties return the borrowed securities for the cash they had placed with the life insurers, losses mounted and liquidity evaporated. The realized losses stemming from the securities lending operations were large relative to the surplus (surplus = assets-liabilities) of some of the life insurance subsidiaries. This has been brought to light by research of David J. Merkel of Finacorp Securities and the author of The Aleph Blog in a paper titled "To What Degree Were AIG's Operating Insurance Subsidiaries Sound?" Merkel based his analysis and conclusions on a review of regulatory filings made by AIG life insurance subsidiaries. The filings indicate that the realized security lending losses at six life insurance subsidiaries exceeded their reported surpluses. The average realized loss at twelve subsidiaries was 76% of the surpluses of those subsidiaries. The scale of the losses is also reflected in the fact that AIG used $36.7 billion of the bailout finds it received to pay securities lending counterparties. Merkel also makes it clear that there were other problems at AIG's life insurance subsidiaries, including the interlacing of the capital of the subsidiaries which allowed for greater leverage and cross guarantees as well as losses from investments apart from the securities lending operations, etc. For example, Sun American Life held securities of affiliated companies equal to 107% of its 2008 year end surplus. These cross holding of securities gave rise to unrealized capital losses. For example, ALICO reported unrealized capital losses of $3.9 billion as of yearend 2008. Merkel dug a little deeper: "…I found something unusual at ALICO. At the end of 2007, almost the entirety of their surplus assets were composed of AIG common stock…. For those less aware, holding affiliated stock of the subsidiary is capital stacking which raises leverage, but owning holding company stock is creating capital out of thin air." Merkel's analysis of the regulatory filings also revealed that in some cases the realized capital losses-excluding those arising from securities lending operations were substantial fractions of the subsidiary's surplus. These realized capital losses arose from investments in corporate bonds (including junk bonds), CMBS and nonconforming RMBS. Barofsky, of SIGTARP, charged that the Fed failed because it did not have a contingency plan in place deal with a problem at AIG (and presumably a contingency plan to deal with a failure at every other systemically important firm). This assumes, of course, that bailing out a financial firm is even a proper role for the central bank. I beg to differ. William Dudley, President of the Federal Reserve Bank of New York offered the best rebuttal when he said: the Fed was the contingency plan. Treasury, the other regulators, the President and Congress all avoided so much as proposing a plan to deal with failure of a large non-bank post Bear and the GSEs. The Fed picked up the financial and political tab. But why should we have expected the Treasury to make difficult decisions before a crisis, when the Fed could buy time to react after the crisis when the political cost to the DC crowd -- but not the economic costs to society -- would be lower. AIG has negotiated the sales of ALICO to MetLife and AIA to Prudential UK. In both cases the Fed will receive partial payment in stock of the acquirer. In other words, the Fed and the US taxpayers are still providing capital and taking risk to support the business activities of insurance subsidiaries of financially sound parent companies,) operating abroad, a year and a half after the crisis hit. If the life insurance subsidiaries of AIG were financially sound, how did we get here? Sadly, that key question about AIG -- how did we get here -- does not seem likely to be answered. Questions? Comments? info@institutionalriskanalytics.com About IRA Products and Services IRA offers advanced analytics for risk surveillance and investment research via subscription products such as the IRA Bank Monitor for Professionals covering the US banking industry and the IRA Corporate Monitor covering public companies. For a trial subscription or an on-line demonstration, please register here. IRA Advisory Services including our channel research and diligence support services are available to qualified clients. For more information, please contact our offices. IRA for Consumers IRA provides consumers easy to buy online reports to independently check on their banks via our How's My Bank? system. IRA on Web 2.0 For updates during the week please follow IRA www.twitter.com/IRABankMonitor. 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