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Company History1
AIG was founded in Shanghai in 1919 when an American entrepreneur named Cornelius Vander Starr formed American Asiatic Underwriters (AAU) to represent American insurance companies that were providing insurance coverage in China. Shortly thereafter, Starr started the Asia Life Insurance Company, the first Western firm to provide life insurance to the Chinese people.
In 1926, Starr established American International Underwriters (AIU) in New York City to provide insurance to Americans outside the country. It was his first office within the United States and became his company’s headquarters in 1939 due to political unrest in China. Starr closed his Shanghai office in 1950 due to the rise of Communism.
In 1945, after World War II, AIU established operations in Germany and Japan to provide insurance to American troops. In the postwar period, European insurers had little capital and could not provide enough policies or products to suit customers’ needs. AIU took advantage of these weakened European insurers and the global expansion of American businesses in the 1950s to grow across Europe, North Africa, the Middle East, and Australia.
In 1952, AIU made an aggressive move in the U.S. insurance market; it acquired a majority interest in the Globe & Rutgers Fire Insurance Company and its subsidiaries, including American Home Assurance Company. But by 1962, its U.S. operations were struggling, and Starr appointed Maurice R. “Hank” Greenberg to turn the company around. The company took a new direction; it sold off American Home Assurance’s agency business, established an independent brokerage model, and shifted the subsidiary’s focus from personal insurance to the high-margin commercial insurance business. Greenberg established reinsurance2 policies, which allowed AIU to take on larger numbers of policies and thus have more control over pricing. He also established numerous product and service innovations such as deductibles. Within several years, Greenberg had turned AIU’s operations around and had begun to acquire many of the companies that, in 2009, made up AIG’s Domestic Brokerage Group.
In 1967, American International Group was founded as a holding company for many of the firm’s U.S. businesses. Hank Greenberg became president and CEO of AIG, and in 1969, he took AIG public. By 1970, AIU and most of its associated organizations became subsidiaries of AIG. AIG experienced periods of strong growth in the 1970s and 1980s as it established itself as a major international player, developed specialized services for numerous market segments, and
1 Information in this section comes primarily from “American International Group, Inc.” Funding Universe,
http://www.fundinguniverse.com/company-histories/American-International-Group-Inc-Company-History.html (accessed May 24, 2011).
2 Reinsurance, sometimes referred as insurance for insurers, occurs when an insurance company transfers a portion of its risk to another insurance company called a reinsurer. The reinsurer obtains a fraction of the potential obligation in exchange for a fee. This transaction reduces the original insurer’s risk and allows the company to write additional policies without raising additional capital.
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expanded comprehensive technical expertise. During this time, AIG began a financing arm and entered into oil and gas drilling rig insurance, pension fund management, health care services, residential mortgage insurance, and aviation insurance.
In 1987, AIG formed its Financial Services segment, which consolidated specialized financial units and grew business throughout the 1990s in fields such as investment management, venture capital, aircraft leasing, and risk management. AIG also expanded or entered into foreign countries such as China, India, Pakistan, and Russia during this time. By 1994, 52% of AIG’s revenue came from outside the United States.
Beginning in 1999, AIG entered into the Retirement Savings and Investment Management field by acquiring SunAmerica Inc. for $18.3 billion. In 2001, it made its largest acquisition of American General Corporation for $23 billion. Both firms provided AIG with a dominant position in fixed and variable annuities and mutual funds.
Greenberg’s impressive run, however, came to an abrupt end in 2005 when he and other AIG executives were charged by the New York State Attorney General’s office with inflating reserves by $500 million through fraudulent reinsurance deals with General Re Corporation.3 In March 2005, Greenberg was removed as CEO through a deal between AIG’s board and the State Attorney General. Greenberg was replaced by Martin J. Sullivan as CEO. In 2006, AIG paid $1.6 billion to settle the civil case by the New York State Attorney General.4 Company Description5
In December 2008, AIG had 116,000 employees and operated in 130 countries. It was organized into four principal business segments: General Insurance, Life Insurance and Retirement Services, Asset Management, and Financial Services. Exhibit 1 shows a simplified organizational structure of the company. Exhibit 2 provides financial details for each of these four segments.
The General Insurance segment consisted of multiple companies that provided a wide range of commercial and personal lines of insurance. These included commercial and industrial property insurance, personal auto insurance, coverage for high-net-worth individuals, mortgage guaranty insurance, and international reinsurance. From 2003 to 2006, the General Insurance segment accounted for, on average, 43% of AIG’s total revenues and 31% of its total profits. The Life Insurance and Retirement Services segment primarily offered individual and group life insurance policies, fixed and variable annuities, endowment policies, and accidental and health
3 Amir Efrati, “Greenberg Role Seen In AIG-Gen Re Case,” Wall Street Journal, May 20, 2008. 4 James Freeman, “Eliot Spitzer and the Decline of AIG,” Wall Street Journal, May 16, 2008. 5 Information in this section comes primarily from AIG’s 10-Ks for the fiscal years ended December 31, 2008,
December 31, 2007, and December 31, 2006.
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policies. This segment averaged 45% of AIG’s revenues and 55% of profits from 2003 to 2006. The Asset Management segment provided investment-related products and services to both institutional and individual clients. It accounted for an average of 4% of AIG’s revenues and 11% of profits from 2003 to 2006. Finally, the Financial Services segment was engaged in a variety of markets including aircraft leasing, consumer finance, and capital markets. It accounted for an average of 8% of AIG’s revenues and 14% of profits from 2003 to 2006.
Financial Services segment6
The Financial Services segment was divided into three diverse units: Aircraft Leasing, Consumer Finance, and Capital Markets. Exhibit 3 provides financial details for each of the units within Financial Services. The Aircraft Leasing unit operated as the International Lease Finance Corporation and had a fleet of over 900 aircraft. Revenues in this unit were primarily generated through leasing contracts with foreign and domestic airlines, fleet management, and remarketing7 of its aircraft. The Consumer Finance unit operated globally and derived its revenues from finance charges by providing real estate and non-real estate loans and retail sales finance receivables. The Capital Markets unit included only the AIG Financial Products (AIGFP) group. AIGFP participated in a wide variety of financial transactions to provide clients with risk management products and hedging and investment opportunities. AIGFP operated in a broad range of markets, including commodities, credit, currencies, equities, and interest rates. It was AIGFP’s involvement in credit protection—particularly credit default swaps—that caused most of the $40.8 billion operating loss within Financial Services in 2008.
Financial Products group8
Started in 1987, AIGFP was the brainchild of three employees at Drexel Burnham Lambert (Drexel), a Wall Street firm well known for its aggressive involvement in the high-risk, high-yield “junk” bonds market. Outside of Drexel, however, Howard Sosin, a “finance scholar,” Randy Rackson, a “computer wizard,” and Barry Goldman, a “genius for constructing financial transactions,”9 had developed a business plan to provide a vast array of long-term derivative contracts. At the time, deals typically lasted a few years, but Sosin, Rackson, and Goldman envisioned deals that would last decades. They sought out AIG because they wanted to work under an AAA-rated institution, which would provide a source of cheap credit, financial backing, and confidence for potential clients. In negotiations with Hank Greenberg, they set up AIGFP like a hedge fund; AIGFP would keep 38% of profits, and AIG would take 62%. Sosin also requested operating independence, which was rarely granted by AIG’s CEO. In return, Greenberg insisted on assurances that AIG’s AAA credit rating would stay intact. After striking
6 Information in this section comes primarily from AIG’s 10-Ks for the fiscal year ended December 31, 2008. 7 Remarketing aircraft includes leasing excess capacity or selling aircraft. 8 Information from this section comes primarily from Robert O’Harrow Jr. and Brady Dennis, “Wall Street’s
Beautiful Machine: Origins of the Crash,” Washington Post, January 4, 2009. 9 O’Harrow and Dennis, “Wall Street’s Beautiful Machine: Origins of the Crash.”
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a deal, the trio left Drexel with a handful of colleagues, including Joseph J. Cassano, who would later lead AIGFP and be identified by Time magazine as one of the top people to blame for the financial crisis.10
It took six months for the group to develop computer models they referred to as “the system” that could value a variety of asset classes—bonds, equities, loans, and all their derivatives—that other firms tended to treat separately. The group initially provided long-term derivative contracts for clients to mitigate the effect of pricing fluctuations in markets such as commodities and interest rates. These contracts were meticulously hedged to diminish risk and insulate AIGFP from changes in the market. The group also wanted to create a “culture of skepticism” and “set up a committee to examine all transactions at the end of each workday, searching for flaws in logic, pricing, and hedging.”11 Tom Savage, a mathematician who had been among those employees who moved from Drexel to AIG said, “It was everybody’s job to criticize and double-check other people’s opinions about what was appropriate business and what wasn’t.”12
Despite the success of AIGFP over the next several years, Greenberg never felt comfortable with Sosin or the agreements they had made. One particular point of dissatisfaction was that AIGFP received its profits immediately after conducting a transaction regardless of how long the contract lasted. Greenberg’s uneasiness led to mistrust, and after one sour deal, he was ready to change the terms of their agreement. Sosin refused and left the company with a settlement worth over $150 million, of which his colleague Rackson later received a portion.
Savage, who started at AIG in 1988, replaced Sosin as head of AIGFP. Savage was known for his strong quantitative skills and was committed to Sosin’s procedures for risk reduction and a culture of skepticism. The agreement with Greenberg, however, was different. AIGPF now kept 30% of its profits, providing 70% to AIG, and the group’s employees had to defer their compensation over several years. Greenberg also insisted that Savage and his group had to take more direction from him and reiterated, “You guys at FP ever do anything to my Triple A rating, and I’m coming after you with a pitchfork.”13
While Savage continued operating AIGFP using an approach similar to Sosin’s, other firms were entering the market and challenging AIGFP’s profit margins. Savage started to push the group into new products, markets, and services. The group responded, providing more complicated deals and new products such as guaranteed investment contracts, wherein AIGFP would borrow money from municipalities, pay a higher rate of interest than treasury bonds or bank accounts, and, in turn, use the capital for larger deals.
10 “25 People to Blame for the Financial Crisis,” Time magazine online,
http://www.time.com/time/specials/packages/completelist/0,29569,1877351,00.html (accessed May 24, 2011). 11 O’Harrow and Dennis, “Wall Street’s Beautiful Machine: Origins of the Crash.” 12 O’Harrow and Dennis, “Wall Street’s Beautiful Machine: Origins of the Crash.” 13 O’Harrow and Dennis, “Wall Street’s Beautiful Machine: Origins of the Crash.”
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Joseph Cassano, at this time, was head of the Transaction Development Group, whose deals involved corporate debt, which gave him considerable voice in the company’s debate on whether to enter into a new product called a credit default swap (CDS).14 Cassano was one of the biggest supporters of CDSs, but ultimately, Savage, Greenberg, and AIG’s board allowed AIGFP to enter into the deals. AIGFP continued to increase its business in CDSs during Savage’s tenure, which lasted until he retired at the end of 2001. During that time, Cassano was making the firm a substantial amount of money and rose to COO of AIGFP. Cassano was chosen by the board to replace Savage based on a recommendation from Savage and the strong positive impression he had made on Greenberg. Cassano was ambitious and had a “strong drive to make money in the derivatives field.” Greenberg also saw some of his own qualities in Cassano—an intense personal investment in AIG, a hot temper, and a dislike of criticism. But above all, he followed direction from Greenberg.15
Despite Cassano’s approval from above, his new subordinates were not as complementary. Cassano, unlike his predecessors, spent most of his career in back-office operations and did not have a strong background in analytics. Many employees thought he did not fully understand the models AIGFP used and therefore were unsure if he could manage the group effectively. He also did not welcome the skepticism and debates that were held in such high regard by Sosin and Savage. A trader working at AIGFP who refused to provide his identity was quoted saying, “The culture changed, the fear level was so high that when we had these morning meetings you presented what you did [in order] not to upset him. And if you were critical of the organization, all hell would break loose.”16 Credit Default Swaps
In 1998, J.P. Morgan approached AIGFP to help it sell a new offering. J.P. Morgan was selling diverse vehicles of debt on its balance sheet, including loans, bonds, and securities, by repackaging them into a security similar to a bond. These securities would be layered into various classes, where the top layer would be the least risky and paid first if a default occurred. Conversely, the bottom class was the most risky but paid the highest rates. These types of products evolved into collateralized debt obligations (CDOs).17 See Exhibit 4 for a description of CDOs. Ultimately, J.P. Morgan wanted AIG to provide an insurance-type product to provide additional confidence to potential clients for its top-tier securities. In response, AIGFP crafted a CDS; for a periodic fee, AIGFP would guarantee payment if the security defaulted.
14 A CDS is a type of credit derivative known as a swap contract. For a fee, the contract provides protection in
case the underlying credit defaults. The purchaser of a CDS pays the seller periodic payments, and the seller provides a payoff if defaults occur.
15 Brady Dennis and Robert O’Harrow Jr., “A Crack in the System,” Washington Post, December 30, 2008. 16 Michael Lewis, “The Man Who Crashed the World,” Vanity Fair, August 2009. 17 CDOs are products where individual loans, such as corporate debt or car loans, are repackaged into one
instrument. They are divided into tiers, rated by agencies, and sold to investors on a secondary market. CDOs are typically collateralized or backed by some form of asset, such as a home or corporate property or inventory.
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Originally, the CDOs created by J.P. Morgan and other banks were written primarily against corporate debt, such as bonds or short-term notes. AIG provided CDSs against these securities with confidence because there was a considerable amount of data on corporate bonds that could be used to assess the risk of the CDOs. It was also considered highly unlikely that investment-grade companies all over the world spanning different industries would default simultaneously. CDOs, however, were not publicly traded and thus were not regulated. This allowed the loans to be financed with greater amounts of debt.
By around 2003, the composition of CDOs was beginning to change dramatically. Banks started packaging consumer debt such as mortgages, credit-card debt, and car loans into these securities. Despite consumer loans being drastically different from corporate debt, AIGFP seemed to apply the same rationale to it—that consumer debt was substantially diverse and chances of mass default were small.
As the housing boom ensued, mortgages began to make up a larger portion of CDOs and became known as “mortgage-backed securities,” which were collateralized by real estate. There was considerable demand for these mortgage-backed securities, and institutions were hedging them with CDSs. AIGFP’s revenue soared from $737 million in 1999 to $3.26 billion in 2005.18 In 2007, Cassano, who had led AIGFP since 2002, called his group’s clients:
A broad global swath of mostly high-grade institutions, mostly high-grade entities around the world, and it includes banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities, and sovereigns and super nationals.19
The CDSs provided a sense of security and fueled these clients to purchase even more
CDOs. European banks could even use CDSs as a form of collateral to free up capital that would have normally been reserved in case of default.20
AIGFP was also able to avoid any regulation of its CDSs. Derivatives, as a result of the Commodity Futures Modernization Act of 2000, were not regulated. Numerous government officials concluded that regulation would stifle economic growth and that the market had enough safeguards to correct itself if necessary.21 Because AIGFP was not considered an insurance company, it did not have to answer to state insurance regulators for its CDSs.22
AIG seemed to consider CDSs to be low risk. While speaking to investors in 2007, Andy Forster, head of global credit trading at AIG, explained, “Given the conservatism that we’ve built
18 Gretchen Morgenson, “Behind Insurer’s Crisis, Blind Eye to a Web of Risk,” New York Times, September 28, 2008.
19 Robert O’Harrow Jr. and Brady Dennis, “Downgrades and Downfall,” Washington Post, December 31, 2008. 20 O’Harrow and Dennis, “Downgrades and Downfall.” 21 Dennis and O’Harrow, “A Crack in the System.” 22 AIGFP was reviewed by a federal regulator, the U.S. Office of Thrift Supervision.
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[into] these portfolios, we haven’t had to do a huge amount of hedging over the years.”23 AIG only sold CDSs for the highest tier of CDOs and put each through an extensive review process, essentially selecting those that were the least risky. The company also viewed the mortgage- backed CDOs as safe because they were geographically diverse.
What AIG failed to realize was that during this time, subprime mortgages began to make up a large portion of the CDOs it was insuring. In 2004, interest rates began to rise, which conventionally causes consumer loans to decrease. Prime mortgages, for example, decreased by half from June 2004 to June 2005. Subprime mortgages, however, did the opposite—they increased24 (Exhibit 5).
One possible explanation for the dramatic increase in subprime mortgages came from an unnamed trader inside AIGFP. He believed Wall Street was so eager to purchase these subprime mortgage-backed securities because AIG was just as eager to insure them and thus assume the risk: “I’m convinced that our input into the system led to a substantial portion of the increase in housing prices in the U.S. We facilitated a trillion dollars in mortgages. Just us.”25
Unfortunately for AIG, Cassano had offered his clients different terms for CDSs on subprime-mortgage CDOs than it had previously offered for CDSs. For instance, if the value of these CDOs happened to drop, AIG would have to post collateral, and the counterparty—not AIG—would determine the value of the security. In previous agreements with purchasers of CDSs, counterparties had to accept AIG’s AAA rating as sufficient evidence that the company could make any payments should they be necessary. But Cassano now agreed to post collateral if AIG’s AAA rating was downgraded. Sure enough, in March 2005, Fitch downgraded AIG to AA as a result of Greenberg’s alleged involvement in an accounting scandal and his resignation.26 AIG was forced to post $1.16 billion in collateral for these deals.27
Toward the end of 2005, Eugene Park, who had worked at AIGFP in the corporate credit- derivative portfolio, was asked to replace a marketing executive within AIGFP’s CDS business.28 Park, who had an analytical background and a deep understanding of securities, decided to investigate before accepting. Park discovered that subprime mortgages made up approximately 95% of the consumer loans AIGFP had insured. Understandably, Park declined the offer and spoke with his colleagues working in the CDS group. According to Park, Yale professor Gary Gorton, who had helped create the model that was used to price the CDSs, estimated subprime mortgages made up no more than 10% of the CDOs insured; a risk analyst in the group estimated 20%; and Al Frost, whom Park had been asked to replace, had no idea. The fact that AIGFP was insuring primarily subprime mortgages rather than general consumer debt “was irrelevant [to
23 O’Harrow and Dennis, “Downgrades and Downfall.” 24 Lewis, “The Man Who Crashed the World.” 25 Lewis, “The Man Who Crashed the World.” 26 Lewis, “The Man Who Crashed the World.” 27 O’Harrow and Dennis, “Downgrades and Downfall.” 28 O’Harrow and Dennis, “Downgrades and Downfall.”
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Cassano]: for the bonds to default, U.S. house prices had to fall, and Cassano didn’t believe house prices could ever fall everywhere in the country at once. After all, Moody’s and S&P still rated this stuff AAA!”29
Over the next several weeks, Park and Cassano worked with executives at AIGFP and researchers at investment banks that were counterparties to some of the AIGFP transactions. Executives were surprised to learn how little analysis went into the subprime mortgage securities and that it was based on such a simple belief—that housing prices would not fall simultaneously across the country. Furthermore, the fact remained that the loan-origination process for subprime mortgages was inadequate and the AAA ratings of these securities were highly questionable. Cassano finally relented, and at the end of 2005, AIGFP stopped issuing CDSs.
Despite AIGFP’s abrupt exit from the CDS market, another division of AIG was simultaneously aggressively investing in this market. AIG’s Investments unit lent securities, typically long-term corporate bonds held by AIG’s Retirement Services and Insurance subsidiaries, to banks and brokers in exchange for cash collateral. The investment unit was then investing the resulting cash in mortgage-backed securities instead of a low-risk security such as a treasury bond, which was typical for most lending security businesses. This resulted in additional subprime exposure for AIG in an area completely unrelated to AIGFP.30 Housing Market Cools
In early 2007, the unthinkable began to happen—the housing market was cooling, borrowers were defaulting on loans throughout the United States, and as a result, rating agencies were beginning to downgrade mortgage-backed CDOs.
Goldman Sachs, one of AIG’s largest counterparties of CDSs,31 was the first to demand collateral from AIG as part of its CDS contract.32 Despite the request for $1.5 billion, AIG agreed to post $450 million of collateral in August of 2007. Another request in late October from Goldman resulted in AIG posting a total of $1.5 billion in collateral. Due to changes in U.S. SEC requirements, AIG was also forced to value its CDSs on a mark-to-market basis,33 and as a result,
29 Lewis, “The Man Who Crashed the World.” 30 Serena Ng and Liam Pleven, “An AIG Unit’s Quest to Juice Profit,” Wall Street Journal, February 5, 2009. 31 “AIG Discloses Counterparties to CDS, GIA, and Security Lending Transactions,” AIG press release, March
15, 2009, http://media.corporate-ir.net/media_files/irol/76/76115/releases/031509.pdf (accessed May 26, 2011). 32 Collateral was typically required to prove an institution had funds available to cover in case of default. There
are two reasons a firm would have to post collateral for a CDS: a reduced or low credit rating or a reduction in value of the securities or assets the CDS was covering. With a high credit rating, AIG was believed to have access to inexpensive financing or have sufficient means to pay if necessary.
33 As the value of the security that a CDS covered declined, the value of the CDS had to be decreased as well.
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in the third quarter of 2007, AIG posted its first unrealized loss of $352 million from its swap portfolio.34
In its end-of-year filing on February 28, 2008, AIG disclosed that it had recorded a total unrealized loss on CDSs of $11.5 billion in 2007 and that it had posted $5.3 billion in collateral. The following day, the company announced the resignation of Joseph Cassano; however, it did not mention he would continue working for AIG as a consultant for roughly $1 million per month.35 By June 2008, CEO Martin Sullivan resigned as well and was replaced by AIG Chairman Robert B. Willumstad.36
In August, AIG disclosed in its second-quarter filing for 2008 that the total loss in the CDS business amounted to $26.2 billion and that AIG had posted a total of $16.5 billion in collateral. On September 15, Fitch, S&P, and Moody’s all downgraded AIG’s credit rating, forcing it to post an additional $14.5 billion in collateral.37 At this point, AIG had sold $441 billion worth of coverage through its CDSs, which backed $57.8 billion worth of subprime mortgages.38
Although AIG had profitable businesses to sell to cover the collateral, the economic crisis was preventing quick sales. These lucrative businesses were unrelated to AIGFP and normally would have been valued at a premium; however, they were now substantially undervalued. In addition, potential buyers were having trouble securing the funding required for purchase. The Bailouts
After failing to secure a loan through a consortium of private banks, AIG received a loan for $85 billion from the U.S. Federal Reserve Bank on September 16, 2008, a day after the downgrade of its credit rating. In exchange for the loan, the U.S. government received a 79.9% equity stake in AIG. Federal Reserve Chairman Ben Bernanke, New York Federal Reserve President Timothy Geithner, and U.S. Treasury Secretary Henry Paulson determined that a declaration of bankruptcy by AIG would cause catastrophic events throughout the banking industry, from investment banks to money market funds. Accordingly, they enacted a rarely used Federal Reserve Act to lend money to nonbanks during an “unusual and exigent” time and also stipulated that in order to receive the funds, Willumstad had to step down as CEO. He was
34 Paul Kiel, “AIG’s Spiral Downward: A Timeline,” ProPublica, November 14, 2008,
http://www.propublica.org/article/article-aigs-downward-spiral-1114 (accessed May 26, 2011). 35 http://www.propublica.org/article/article-aigs-downward-spiral-1114. 36 Lilla Zuill, “AIG Chief Sullivan Resigns Amid Subprime Losses,” Reuters, June 15, 2008
http://www.reuters.com/article/2008/06/15/us-aig-sullivan-newsmaker-idUSN1335612520080615 (accessed May 26, 2011).
37 http://www.propublica.org/article/article-aigs-downward-spiral-1114. 38 Mark Pittman, “Goldman, Merrill Collect Billions After Fed’s AIG Bailout Loans,” Bloomberg, September
29, 2008.
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replaced by Edward Liddy, a former CEO of Allstate Corporation who had experience in divestures at Sears Roebuck and Co.39
By the beginning of October, AIG had already drawn down $61 billion of the $85 billion loan, and it was clear that AIG would need more. The Federal Reserve, on October 8, provided an additional $37.8 billion in exchange for fixed-income securities from AIG’s regulated life insurance businesses.40
On November 10, AIG announced its total losses for the CDSs had increased to $33.2 billion. As a result, the Federal Reserve revealed that it had restructured its original $85 billion loan and provided additional lines of credit and equity investments to AIG. In particular, the Federal Reserve purchased $40 billion in preferred shares through the Troubled Asset Relief Program and reduced the $85 billion loan to $60 billion with reduced interest rates and lengthened terms. It also provided $22.5 billion to purchase mortgage-backed securities from its securities lending business41 and $30 billion to purchase CDOs covered by AIG’s CDSs. Both transactions occurred under the Federal Reserve Act and resulted in a total rescue package of $152.5 billion.42
The bleeding continued. On March 2, 2009, AIG reported a $62 billion fourth-quarter loss in 2008, the largest of any company in history. Credit rating agencies were preparing to drastically reduce AIG’s credit rating, which would inhibit AIG’s ability to pay its debts and increase capital calls; it would likely force bankruptcy.43 In response, the Federal Reserve once again provided an additional $30 billion in capital in exchange for noncumulative preferred shares, and for the second time, restructured the outstanding loans. The Federal Reserve eliminated the dividend payments on its $40 billion preferred shares, reduced the interest rate on the $60 billion loan, and reduced the principal of the loan to “no less than $25 billion” in exchange for shares of two AIG life insurance subsidiaries in Asia valued at up to $26 billion. It
39 Matthew Karnitschnig, Deborah Solomon, Liam Pleven, and Jon E. Hilsenrath, “U.S. to Take Over AIG in
$85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up,” Wall Street Journal, September 16, 2008. 40 Barry Meier and Mary Williams Walsh, “A.I.G. to Get Additional $37.8 Billion,” New York Times, October
9, 2008. 41 When parties were returning securities to AIG’s Investments unit, AIG could not pay its required
commitment because the mortgage-backed securities had substantially declined in value and AIG was unable to sell them to generate sufficient funds.
42 Federal Reserve Board, press release, November 10, 2008, http://www.federalreserve.gov/newsevents/press/other/20081110a.htm (accessed May 26, 2011).
43 Andrew Ross Sorkin and Mary Williams Walsh, “U.S. Is Said to Offer Another $30 Billion in Funds to A.I.G.,” New York Times, March 2, 2009.
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also made available an $8.5 billion loan to AIG’s life insurance subsidiaries.44 The resulting package was estimated to be as high as $182 billion.45 The Bonuses
By March 16, 2009, two weeks after the government provided its fourth bailout package to AIG, the company set off a firestorm after it was revealed that it had paid $165 million in retention bonuses to employees within the Financial Products group. The $165 million retention payments were made to 418 people and ranged from $1,000 to $6.4 million. Seventy-three employees received payments greater than $1 million, and 52 individuals who had left the firm received a combined total of $33.6 million.46,47
AIG had entered into the retention contracts with the Financial Products group employees in the spring of 2008, just after AIG announced the $11.5 billion unrealized loss for 2007. These contracts guaranteed retention bonuses for 2008 and 2009 equal to the 2007 total bonus levels for nonsenior management employees and 75% of 2007 total bonus levels for senior managers. The retention payments were not tied to performance of the division, and payment was only forfeited if the employee resigned without good reason or was terminated for just cause (such as fraud, dishonesty, or conviction of a criminal offense). Additionally, if an employee was dismissed in 2008 for performance reasons, he or she would still receive the 2008 retention bonus; however, the 2009 bonus would be terminated.48 See Exhibit 6 for more details on the bonus contract. In total, these awards for 2008 and 2009 were valued at $450 million; $55 million was paid in December 2008, $165 million was paid in March 2009, and $230 million was reserved for work completed in 2009.
The media later speculated that at the time AIG signed the bonus contract, it knew a
significant economic downturn was imminent due to the mortgage crisis. AIG believed, however, that the key to surviving the crisis was retaining the employees who were most knowledgeable about the derivative positions and could unwind them most efficiently.
Although Liddy was not employed at AIG when the contracts were created, he had to defend them. Liddy addressed Treasury Secretary Geithner in a letter providing two main
44 “U.S. Treasury and Federal Reserve Board Announce Participation in AIG Restructuring Plan,” Joint press release, March 2, 2009, http://www.federalreserve.gov/newsevents/press/other/20090302a.htm (accessed May 26, 2011).
45 David Goldman, “CNNMoney.com’s Bailout Tracker,” CNNMoney, August 8, 2009, http://money.cnn.com/news/storysupplement/economy/bailouttracker/ (accessed May 26, 2011).
46 Andrew Cuomo’s letter to Barney Frank (chairman of the House Committee on Financial Services), March 17, 2009.
47 Edmund L. Andrews and Peter Baker, “Bonus Money at Troubled A.I.G. Draws Heavy Criticism,” New York Times, March 16, 2009.
48 “AIG Financial Products Corp. 2008 Employee Retention Plan,” AIG, http://www.house.gov/apps/list/press/financialsvcs_dem/employeeretentionplan.pdf, (accessed May 26, 2011).
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arguments for the disbursements: honoring contractual commitments and retaining knowledgeable employees to unwind the contracts. With advice from outside counsel, Liddy emphasized that “AIG’s hands are tied,” and “these are legal, binding obligations of AIG, and there are serious legal, as well as business, consequences for not paying.”49 It was estimated that AIG could face $330 million in payments and lawsuits, double the cost of the bonuses, if they did not honor the contracts.50 He also stressed that the bonuses were crucial to retaining key individuals that would ultimately ensure repayment of the government loans.
Additionally, Liddy outlined the steps AIG had taken to reduce future payments and bonuses to employees. He promised to reduce retention payments for 2009 by at least 30%. He reduced salaries for the highest 25 contractual employees to $1 and salaries for the remaining officers at AIG by 10%. Finally, he indicated that AIG was in the process of changing 2008 corporate bonus proposals in keeping with the company’s restructuring efforts and need to repay the government.51
49 Edward Liddy’s letter to Treasury Secretary Timothy Geithner, March 14, 2009. 50 Alice Gomstyn and Lauren Pearle, “Could AIG Bonus Mess Balloon to $330M,” abc NEWS, September 8,
2009. 51 Liddy’s letter to Geithner, March 14, 2009.
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Exhibit 1
AMERICAN INTERNATIONAL GROUP, INC.—THE FINANCIAL CRISIS
AIG Abbreviated Organizational Structure
Source: Created by case writer based on information in AIG’s 10-K for the fiscal year ended December 31, 2008.
AIG Financial Products
Aircraft Leasing
Consumer Finance
Capital Markets
General Insurance Life Insurance &
Retirement Services
Financial Services
Asset Management
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Exhibit 2
AMERICAN INTERNATIONAL GROUP, INC.—THE FINANCIAL CRISIS
Selected Financial Information by Operating Segment (in millions of U.S. dollars)
Operating Segments
General Insurance
Life Insurance & Retirement
Services
Financial Services
Asset Management
Other Total Consolidation
and Eliminations
Consolidated
2008 Total Revenues $44,676 $3,054 $(31,095) $(4,526) $(81) $12,028 $(924) $11,104 Other-than-temporary impairment charges 4,533 38,731 127 7,276 138 50,805 - 50,805 Operating income (loss) before minority interest (5,746) (37,446) (40,821) (9,187) (15,055) (108,255) (506) (108,761) Year-end identifiable assets $165,947 $489,646 $167,061 $46,850 $168,762 $1,038,266 $(177,848) $860,418 2007 Total Revenues $51,708 $53,570 $(1,309) $5,625 $457 $110,051 $13 $110,064 Other-than-temporary impairment charges 276 2,798 650 835 156 4,715 - 4,715 Operating income (loss) before minority interest 10,526 8,186 (9,515) 1,164 (2,140) 8,221 722 8,943 Year-end identifiable assets $181,708 $613,161 $193,975 $77,274 $126,874 $1,192,992 $(144,631) $1,048,361 2006 Total Revenues $49,206 $50,878 $7,777 $4,543 $483 $112,887 $500 $113,387 Other-than-temporary impairment charges 77 641 1 225 - 944 - 944 Operating income (loss) before minority interest 10,412 10,121 383 1,538 (1,435) 21,019 668 21,687 Year-end identifiable assets $167,004 $550,957 $202,485 $78,275 $107,517 $1,106,238 $(126,828) $979,410
Source: Created by case writer based on information in AIG’s 10-K for the fiscal year ended December 31, 2008.
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Exhibit 3
AMERICAN INTERNATIONAL GROUP, INC.—THE FINANCIAL CRISIS
Selected Financial Information of Financial Products Group by Operating Segment (in millions of U.S. dollars)
Aircraft Leasing
Capital Markets
Consumer Finance
Other Total
Reportable Segment
Consolidation and
Eliminations
Total Financial Services
2008 Total Revenues $5,075 $(40,333) $3,849 $323 $(31,086) $(9) $(31,095) Operating income (loss) 1,116 (40,471) (1,261) (205) (40,821) - (40,821) Year-end identifiable assets $47,426 $77,846 $34,525 $(2,354) $57,443 $9,618 $167,061 2007 Total Revenues $4,694 $(9,979) $3,655 $1,471 $(159) $(1,150) $(1,309) Operating income (loss) 873 (10,557) 171 (2) (9,515) - (9,515) Year-end identifiable assets $44,970 $105,568 $36,822 $17,357 $204,717 $(10,742) $193,975 2006 Total Revenues $4,082 $(186) $3,587 $320 $7,803 $(26) $7,777 Operating income (loss) 578 (873) 668 10 383 - 383 Year-end identifiable assets 41,975 121,243 32,702 12,368 $208,288 (5,803) $202,485
Source: Created by case writer based on information in AIG’s 10-K for the fiscal year ended December 31, 2008.
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Exhibit 4
AMERICAN INTERNATIONAL GROUP, INC.—THE FINANCIAL CRISIS
Collateralized Debt Obligations
CDOs are products where individual loans, such as corporate debt or car loans, are repackaged into one instrument. They are divided into tiers, rated by agencies, and sold to investors on a secondary market. CDOs are typically collateralized or backed by some form of asset, such as a home or corporate property or inventory.
Source: Created by case writer.
Super-Senior Debt (usually rated
AAA)
Mezzanine-Level Debt
Lowest-Level or Equity-Level Debt (usually not rated)
In tr
o d u ct
io n o
f C
D O
c o n te
n ts
o v er
t im
e
Pooling of Debt
(Typically under a Special Purpose Vehicle, SPV)
Corporate Debt
Subprime Mortgages
2005
1998
Consumer Debt
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1
Center for Respon
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Total Su
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ubprime Mortga
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Exhibit 5
ROUP, INC.—
ages Originated
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—THE FINANC
(1998–2006)1
RL Issue Paper No.
CIAL CRISIS
14, March 27. 200
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VA-C-2322
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Exhibit 6
AMERICAN INTERNATIONAL GROUP, INC.—THE FINANCIAL CRISIS
Summary of “AIG Financial Products Corp. 2008 Employee Retention Plan” This document sets forth the terms of “AIG Financial Products Corp. 2008 Employee Retention
Plan,” effective December 1, 2007. The Plan sets out the 2008 and 2009 Guaranteed Retention Awards to be provided hereunder to certain employees and consultants of AIG-FP (which term includes subsidiaries).
The objectives of the plans are:
1. To provide incentives for AIG-FP’s employees and consultants to continue developing, promoting, and executing AIG-FP’s business;
2. To recognize the uncertainty that the unrealized market valuation losses in AIG-FP’s super senior credit derivatives and originally rated AAA cash CDO portfolios have created for AIG-FP’s employees and consultants;
3. To ensure that AIG-FP’s and its employees’ and consultants’ interests continue to be aligned with those of AIG and AIG’s shareholders;
4. To continue to build and maintain the formation of capital to AIG-FP; and 5. To show the support by AIG of the on-going business of AIG-FP by implementing a
meaningful employee retention plan. 2008 and 2009 Retention Awards.
1. Covered persons who are not members of the Senior Management Team for the 2008 and 2009 Compensation Year, shall be awarded a Guaranteed Retention Award for each of those Compensation Years equal to 100% of such Covered Person’s 2007 Total Economic Award.
2. Covered Persons who are members of the Senior Management Team for the 2008 and 2009 Compensation Year, shall be awarded a Guaranteed Retention Award for each of those Compensation years equal to 75% of such Covered Person’s 2007 Total Economic Award.
Effect on Bonus Pool of Mark-to-Market and Realized Losses.
1. The Bonus Pool for any Compensation Year beginning with the 2008 Compensation Year will not be affected by the incurrence of any mark-to-market losses (or gains) or impairment charges (or reversals thereof) arising from (i) the CDO portfolio or (ii) super senior credit derivative transactions that are not part of the CDO Portfolio.
2. The Bonus Pool for any Compensation Year beginning with the 2008 Compensation Year will not be affected by the incurrence of any Realized Losses (or gains) arising from any source, subject to limitations set forth in Section 3.07.
Source: Created by case writer based on “AIG Financial Products Corp. 2008 Employee Retention Plan,” http://www.house.gov/apps/list/press/financialsvcs_dem/employeeretentionplan.pdf (accessed May 26, 2011).
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m er
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D re
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- L
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s.
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