Robert McDonald and Anna Paulson explain the financial picture behind the scenes in "AIG in Hindsight" in the Spring 2015 issue of the Journal of Economic Perspectives. Their explanation bears remembering in the light of the decision by the US Court of Federal Claims earlier this week that the federal government actions in taking over AIG were unconstitutional. Judge Thomas Wheeler's full decision is available here. For news coverage summarizing the decision, a Washington Post story is here and a New York Times story is here.
In passing, I'll just mention that this same Spring 2015 issue of JEP includes articles about the other main bailouts, too. If you want a perspective on what happened in the car bailouts, Austan D. Goolsbee and Alan B. Krueger, who were working in the Obama administration at the time, offer "A Retrospective Look at Rescuing and Restructuring General Motors and Chrysler." (I offered my own perspective on "The GM and Chrysler Bailouts" back in May 2012.) W. Scott Frame, Andreas Fuster, Joseph Tracy, and James Vickery discuss "The Rescue of Fannie Mae and Freddie Mac." Calomiris, Charles W. Calomiris, and Urooj Khan offer"An Assessment of TARP Assistance to Financial Institutions." Phillip Swagel reviews "Legal, Political, and Institutional Constraints on the Financial Crisis Policy Response."
In the case of AIG, McDonald and Paulson lay out how an insurance company got connected to the fall in housing prices. There were two main channels, both of which will require some explanation for the uninitiated.
There's a financial activity called "securities lending." It works like this. An insurance company needs to hold reserves, so that it will have funds when the time comes to pay out claims. Those reserves are invested in financial securities, like bonds and stocks, so that the insurance company can earn a return on the reserves. However, the insurance company can also lend out these financial securities. For example, perhaps a financial firm has a customer to purchase a specific corporate bond, but the firm can't get a supply of the bond immediately. The financial firm can then borrow the bond from an insurance company like AIG, AIG continues to be the legal owner of the bond, and to receive all interest payments due on the bond. But the borrower of the bond deposits cash as collateral with the lender, in this case AIG. AIG can then also invest this cash and earn an additional return. When the borrower of the financial security returns it to AIG, then AIG has to return the cash collateral.
Securities lending is a normal everyday business for insurance companies, but AIG went took a step that looks crazy. The usual practice is to take the cash received as collateral in securities lending and invest it in something very safe and liquid--perhaps Treasury bonds. After all, you're going to have to give that cash back! But AIG took 65% of the cash it had received as collateral for its securities lending, and invested it in assets linked to subprime mortgages! McDonald and Paulson write: "At the end of 2007, 65 percent of AIG’s securities lending collateral was invested in securities that were
sensitive either directly or indirectly to home prices and mortgage defaults." Indeed, AIG became so desperate to generate more cash through additional securities lending that instead of requiring cash collateral for the loans of 102%--the standard value--it was requiring collateral of less than 100%.
When securities lending arrangements are stable, they may just be renewed for months at a time. But when those who had borrowed securities from AIG recognized what AIG was doing with their cash collateral, they started returning the securities they had borrowed and demanding their cash back. "On Monday, September 15, 2008, alone, AIG experienced returns under its securities lending programs that led to cash payments of $5.2 billion. ... Ultimately, AIG reported losses from securities lending in excess of $20 billion in 2008." Without the infusion of a government cash bailout, all the people owning life insurance policies through AIG would have been at risk. Insurance companies in the US are regulated primarily at the state level. Not all the state regulations are the same, and it's not clear what the state-level life insurance regulators would have or could have done.
The other main issue that linked insurance company AIG to the housing price meltdown was its portfolio of "credit default swaps." The easiest way to think about a credit default swap is as a kind of insurance against the value of a financial security dropping. Say that a bank or big financial institution owns a bunch of mortgage-backed securities, and it's worried that they might drop in value. It then buys a credit default swap from a seller like AIG. If a "credit event" happens--roughly, you can think of this as a default--then the company that sold the credit default swap needs to cover those losses. AIG had sold credit default swaps on corporate loans, corporate debt, mortgage-backed securities backed by prime loans, and mortgage-backed securities backed by subprime loans. (For a discussion of the role of credit default swaps in the financial crisis, Rene M. Stulz wrote on "Credit Default Swaps and the Credit Crisis" in the Winter 2010 issue of the Journal of Economic Perspectives (24:1, pp. 73-92).)
Obviously, any company that sold a lot of credit default swaps before the decline in housing prices was going to take big losses. But here's the real kicker. Say that an actual "credit event" or default hasn't happened yet, but the risk of a credit default is rising. Because credit default swaps are bought and sold, an increase in risk can be observed in how their prices change. When the risk of a default on credit default swaps rises, AIG was required by its contracts to pay "collateral" to the companies that had bought the credit default swaps. If the risks had changed back in the other direction, the collateral would have been paid back. But that didn't happen. By September 12, 2008, AIG had already posted about $20 billion in collateral based on the expected future losses from it credit default swaps on securities based on subprime mortgages. On September 15, prices of these securities shifted again and AIG found on that day that it owed another $8.6 billion in collateral.
In short, in September 2008, the insurance company AIG had tied its fortunes to the price of subprime mortgages. As a result, AIG was going to fail to meet its financial obligations. It needed literally billions of dollars to cover the collateral for its securities lending and for its credit default swaps. Moreover, in the belly of the financial crisis at that time, no private party was going to lend AIG the billions or tens of billion of dollars it needed. Without a government bailout that according to McDonald and Paulson amounted to $182.3 billion, the firm would not have survived.
This discussion should help to clarify the issues with AIG, and also to raise a larger issue. For AIG, Judge Wheeler wrote that the Federal Reserve “possessed the authority in a time of crisis to make emergency loans to distressed entities such as AIG, but they did not have the legal right to become the owner of AIG. There is no law permitting the Federal Reserve to take over a company and run its business in the commercial world (in exchange) for a loan.” Thus, Wheeler ruled that the government action was an unconstitutional taking of property.
Ultimately, several years later when housing prices had first stabilized and then recovered, the Federal Reserve and the US government have been able to sell off the mortgage-backed securities that were owned or backed by AIG in a way which more than repaid the bailout funds. In the lawsuit, AIG used this fact to argue that the government rescue wasn't really needed. However, when it came to damages, Wheeler pointed out that without the government bailout, the shareholders of AIG would have lost everything anyway when the firm went bankrupt in fall 2008. Thus, he awarded damages of zero. Judge Wheeler's decision earlier this week is unlikely to be the final word in the AIG case. By deciding that the government had acted unconstitutionally, but that no damages would be paid, he has probably created a situation in which both side will appeal.
I find it hard to second-guess decisions made in the very worst days of the financial crisis in September 2008. One often hears the federal government damned for not doing enough to rescue Lehmann Brothers, and then also damned for bailing out other firms. But actions in the middle of a financial crisis are so difficult. MIT economist Ricardo Caballero said a few years back: ""I still recall politicians and economists calling for the need to teach lessons (in a punitive sense) to the financial system in the middle of the crisis. In fact, I think Lehman happened to a large extent due to the political pressures stemming from this view. What timing! ... I draw an analogy between panics and sudden cardiac arrest. We all understand that it’s very important to have a good diet and good exercise in order to prevent cardiac arrest. But once you’re in a seizure, that’s a totally secondary issue. You’re not going to solve the crisis by improving the diet of the patient. You don’t have time for that. You need a financial defibrillator, not a lecture."
Whatever the outcome of the legal battle, there is a broader issue here about the complexity and interconnectedness of modern finance. For example, it's not clear that state life insurance regulators were looking with skepticism at the AIG securities lending operation. It's not clear that bank regulators, checking to see if banks were protected against risk, were checking on whether AIG could actually make good on the credit default swaps it had sold. When the crisis hit, both private and public sector were unprepared. No one wanted the need for a bailout to arise back in 2008, and no one wants a future bailout. But it isn't clear to me that financial regulation in the last few years has found a way to make future AIG situations impossible, or even much less likely.
