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Aig Bailout

In: Business and Management

Submitted By celineyyy
Words 2738
Pages 11
Can We Expect A Regulated CDS Market?
Derivatives Project
Xilin Yang (Celine)

Introduction
The article introduces credit default swaps and explores the problems of the credit derivatives. By analyzing the AIG’s bailout, the article describes the regulation gap in the CDS market and states the regulation reform after the crisis. Part I is background, generally introduces the Wall Street crisis. How it happened? What consequence it has? Part II is mainly about AIG’s CDS business: how AIG got involved in the crisis and why the biggest world insurance company suddenly collapsed. Part III is about credit default swaps: definition, construction, and problems. Part IV is concerned on the regulation reform after AIG’s failure.

Wall Street Crisis
Speaking of the Wall Street crisis, people all know it proceed from subprime crisis. The relatively low interest rate prompts banks to issue large amount of housing loans. To transfer default risk embedded in those loans, investment banks package those loans and mortgages into student loans, car loans and credit card debt, which form the so-called collateralized debt obligation (CDOs). All these derivatives depend on the housing loans. In the era of low interest rates, house prices rise rapidly and promote the rapid development of the housing loans business. With steady stream of housing loans into financial derivatives products, different ranks of products are packaged to sale out. The good view of economy makes those potentially risky CDOs popular with retirement funds. Lenders didn’t care anymore about whether a borrower could repay; the investment banks earned more money on selling more CDOs; the rating agencies had no liability if their ratings of CDOs prove wrong. Everyone in this securitization food chain made money. Ever one was happy until the market for CDOs collapsed.
By 2008, home foreclosures were skyrocketing, and the securitization food chain imploded. In March 2008, the investment bank Bear Stearns ran out of cash, and was acquired for $2 a share by JPMorgan Chase. On September 7, 2008, Treasury Secretary Henry Paulson announced the federal takeover of Fannie Mas and Freddie Mac, giant lenders on the brink of collapse. On September 12, 2008, Lehman Brothers had run out of cash, and the entire investment-banking industry was sinking fast. Merrill Lynch was also on the brink of failure. Several major financial institutions failed during this tragedy. AIG is the only one insurance company.
AIG’s CDS Business * How AIG involved in financial crisis?
There is no problem with AIG’s insurance business. What pull AIG into the abyss is its subsidiary—AIG Financial Products Corporation (AIGFP). AIGFP issue a large number of credit default swaps (CDSs) on super senior tranches of multi-sector collateralized debt obligations (CDOs.)
For investors who own CDOs, credit default swaps work like an insurance policy. An investor who purchased a credit default swap pays AIG a quarterly premium. If no credit event occurs the protection seller retains the premium payment, while when the CDOs goes bad, AIG promises to pay the investor for their losses.
Selling CDS became a significant and profitable business for AIG. AIG’s Financial Products division in London issued $533 billion worth of credit default swaps at the year-end 2007, many of them for CDOs backed by subprime mortgages. Investors welcome CDS, since they didn’t need to worry about counterparty credit risk any more. Eventually they would get compensation no matter what happened. Banks are also interested in buying CDS to convert their assets into triple-A rate assets. Approximately $379 billion of AIGFP’s CDS were written to provide European financial institutions. Under regulation, European lenders, especially banks, have to set aside reserve to cover the potential losses on their loans. By owning CDS, they off-loaded the risk to AIG.
The so-called “free money” CDS turns out to be a nightmare of AIG. Due to the rapid increase in housing loan delinquencies, in early 2008, it was clear that AIG was trapped in a trouble. With the downgrade of AIG’s credit rating, borrowers began requesting returns of large amounts of collateral in September. By the end of August 2008, it had posted about $20 billion of additional collateral for this CDS portfolio. AIG also ran into major problems with the securities lending program of its life insurance subsidiaries, which had $69 billion of loans outstanding at the end of August. On September 17, 2008, AIG is taken over by the government.
The liquidity problems created by collateral calls for both programs were significantly exacerbated by the downgrades of AIG’s long-term debt ratings by S&P, Moody’s, and Fitch on September 15, 2008. * Why AIG fall down?
Liquidity strains
The large majority of AIGFP’s CDS product requires AIG to post collateral equal to the difference between the notional amount of specific CDS and the market value of the underlying securities. But as “AAA” Rate Company, AIG’s derivatives counterparties had not required AIG to post collateral on most of its derivatives. However, with the initial downgrade, along with the government takeovers of Fannie Mae and Freddie Mac and the Lehman’s bankruptcy, AIG has to post margin on those positions.
What amplified AIG’s liquidity strains was AIG’s securities lending program. Borrowers posted cash collateral with AIG in exchange for loans of securities owned by AIG’s insurance company subsidiaries. AIG could use those cash collaterals to do investment. AIG was supposed to invest in some highly liquid and short-term securities in case that the borrowers required the collaterals back. However, AIG invested those collaterals in subprime mortgage backed securities (MBS). When the borrowers returned the securities, AIG found that it was difficult to sell those MBS they had invested.
Oversight of regulation
Credit default swaps are typical over-the-counter market derivatives. Over-the-counter (OTC) market is a financial liberalization product: no fixed clearinghouse, no membership requirement, no strict and clear rules, and no limits on the trading products. Over-the-counter is down directly between 2 parties, without any supervision of an exchange.
The characteristics determine that the OTC market is lack of transparency. Nobody knew how many CDS contract AIG had written, and it was extremely difficult to realize AIG relied too much on its CDS business. The sweeping deregulation of over-the-counter market removed the margin requirement that would eliminate the likelihood of AIG’s failure. The difficulty to determine the market value, since most of the credit derivatives traded on the OTC market is illiquid, exacerbated the collateral disputes with AIG and its counterparty.
Speculators in CDS market
In insurance, you can only insure on something you really have. For instance, you are the only one who can insure your own house once. In derivatives universe, someone else can also insure your house, even though they don’t own the house. So if the house burns down, anyone who has insured the house can get compensation, making the number of losses in the system become proportionately large. Those people who don’t “own the house” are speculators. Speculators could also buy credit default swaps from AIG, in order to bet against CDOs they didn’t own.
The most prominent of AIG’s CDS is Goldman Sachs. Goldman Sachs purchased credit default swaps from AIG, bet against those CDOs they didn’t own, and earned money when CDOs failed. Goldman Sachs bought at least $22 billion credit default swaps. When AIG was taken over by the government, Goldman Sachs was paid by $61 billion dollars from AIG.
Credit Default Swaps: Definition, Pricing and Problems and Collateral Debt Obligation Construction * Definition
A Credit Default Swap (CDS) is a credit derivative contract in which the writer offers the buyer protection against a credit event in a reference name for a specified period of time in return for a premium payment. Credit default swaps allow one party to “buy” protection from another party for losses resulting from default by a specified reference credits. The “buyer” of protection pays a premium for the protection, while the “seller” of protection agrees to make a payment to compensate the buyer for losses. Credit default swap is credit insurance. If the buyer of CDS actually owns the underlying risky securities, CDS can be used as a hedge, while speculators may also buy the CDS to bet against the default. If the reference entity defaults, there are two types of compensation, cash or physical settlement. The “seller” of CDS can cay the difference between the par value and the market price, which is known as cash settlement. If the CDS provides for physical settlement, AIG has to buy at par value upon delivery. So when a credit event happens, even though the real value of underlying securities drops, AIG still Quarterly Payments of X basis points per annum
Quarterly Payments of X basis points per annum needs to pay par value.
Par value of bond
Par value of bond
Reference
Bond
Reference
Bond
Protection
Buyer
Protection
Buyer
Protection
Seller
Protection
Seller

Delivery of bond
Delivery of bond

Table 1: Credit Default Swap Structure (Physical settlement) * Pricing
The pricing procedure of credit default swap is complex. To put it simply, the price of credit default swap is based on the expected probability of default on the assets. The higher the default probability, the higher the CDS will be. AIG charges percentage of the notional value as premium for protection. The CDS notional value is given by bond notional value times (bond price-R)/(1-R). R is the recovery rate, which is calculated by actuary. * Construction
Collateralized debt obligations (CDOs) are structured financial instruments that purchase and pool financial assets such as the risker tranches of various mortgage-backed securities. The CDO manager and securities firm select and purchase assets, such as some of the lower-rated tranches of mortgage-backer securities, then the CDO manager and securities firm pool various assets in an attempt to get diversification benefits. Similar to mortgage-backed securities, the CDO issues securities in tranches that vary based on their place in the cash flow waterfalls. For those tranches, if the investors worry about the default risks, they will use credit default swap to hedge.

Table 2: CDO Structure

* Problems
Market Risk: The market for credit default swaps are OTC and unregulated, and contracts are often traded so much, it is difficult to know who is standing at each ends of a transaction. Leverage involved in many CDS transactions, and the likelihood that there may be a general downturn in the market could cause massive default risk and increased uncertainty.
Incentives for monitoring: For instance, the bank made a great amount of loans to a company and then bought a DS to protect itself. Since the bank will eventually get compensation, its incentives to monitor the loan would become less powerful. Same things happened on investors. Through buying a CDS, investors would change their attitude toward the reference company. When the company was in financial distress, the investors may prefer to drive the firm into bankruptcy, thus trigger payments under the credit default swaps.

Regulation reform
Even both are in crisis; AIG is much luckier than Lehman Brothers. After establishing a supposed hard line against bailouts over the weekend with Lehman Brothers, the government abruptly abandoned it Tuesday and announced a $185 billion Federal Reserve loan to insurance giant AIG. By reviewing the whole AIG crisis, we need to figure out who should pay for AIG’s bailout. I can say it definitely shouldn’t be taxpayers, who actually are the victims in this event.
How could regulators ignore what AIGFP was doing? Why didn’t regulators prevent the crisis? Perhaps some of them had realized that they have big problems, but they chose to turn a blind eye to the potential crisis: they are watching this tsunami coming, and supposing that which swimming costume you should put on. In any way, they still got wealthy by sacrificing other’s benefit.
A CDS has characters of a security, a contract of sale of a commodity for future delivery and an insurance contract. Securities are generally subject to regulation under the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act). Contracts of sale of a commodity for future delivery are generally subject to regulation under the Commodity Exchange Act (CEA). Insurance contracts are generally subject to regulation under state insurance laws. However, CDSs are expressly excluded from each of these regulatory schemes. Since credit default market was unregulated, AIG didn’t have to put aside any money to cover potential losses. There is nothing wrong with AIG’s insurance business. The insurance is a highly regulated industry. There is clear limit on the amount of insurers can take, while for CDS, AIGFP can issue as much as they want. CDS is similar to regular insurance but it can be regarded as insurance on systemic risk. It turns out that the AIG crisis was precipitated by the bursting of the real state bubble, and increases in actual and expected mortgage defaults.
Vice Chairman Kohn testified on March 5, 2009, before the Senate Banking Committee (Kohn, 2009) that AIGFP … is an unregulated entity that exploited a gap in the supervisory framework for insurance companies and was able to take on substantial risk using the credit rating that AIG received as a consequence of its strong regulated insurance subsidiaries.
Unsurprisingly, legislative bodies in the U.S have moved to increase regulation of the over-the-counter (OTC) derivatives market since AIG's collapse. Most prominent is the Restoring American Financial Stability Act of 2010, which has been singed into law by President Obama on July 21, 2010. This act combines the bills passed by the House of Representatives and the Senate, would require most derivatives to be traded on swap execution facilities (SEFs) or exchanges and be cleared through clearinghouses.
There are already plans for clearing houses for CDSs. The recommends require clearing of all standardized OTC derivatives through regulated central counterparties (CCP). In this proposal, CCPs are required to post margin requirements and other necessary risk controls. Had the contemplated CCP clearing requirement been in place, those margin and other risk control mechanisms would have prevented AIG from building such a large and uncollateralized CDS position and, therefore, perhaps prevented its collapse.
The proposal also calls for amendments to the CEA and securities laws to empower the Commodity Futures Trading Commission (CFTC) and SEC to impose recordkeeping and reporting requirements for OTC derivatives and to develop a system for timely reporting trades and prompt dissemination of prices and other trade information. Had mechanisms along these lines been in place, presumably the government would have been able to make a more informed decision concerning AIG’s bailout.
Besides, the rating agencies play critical role in the CDS market. The publisher of the Financial Crisis Inquiry Report (FCIR), concluded that the "failures" of the Big Three rating agencies were "essential cogs in the wheel of financial destruction" and "key enablers of the financial meltdown". Since investors relied on the rating so much, the misleading reports of securities produced by rating agencies directly cause the failure of the whole financial market.
The most severe problem of rating agencies is the conflict of interests. Rating agencies enjoyed their profitable income by providing their consumers high grade. SEC took actions after 2008 to address the interest conflicts between rating agency and issuers of structured securities. The rating agencies are prohibited from issuing the rating for a structured product unless information on assets underlying the product was available, structuring the same products that they have rated, and are required to disclosure the information they used to in rating procedure on a structured product.
On December 3, 2008, after ten-month investigation about the weakness in rating practices, the SEC approved measures to strengthen oversight of credit rating agencies, including conflicts of interest.

Reference
1. “SEC Proposes Comprehensive Reforms to Bring Increased Transparency to Credit Rating Process”. U.S. Securities and Exchange Commission. 2008. Retrieved 2008-07-2008
2. “SEC – Rating Agency Rules”. Sec.gov. 2008-12-03. Retrieved 2009-02-27.
3. “The AIG Bailout”, William K. Sjostrom, Jr.
4. “The Rise and Fall of AIG”. Richard Ivey School of Business, The University of Western Ontario
5. “The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation”. Scott E. Harrington, The Journal of Risk and Insurance, 2009, Vol. 76, No. 4, 785-819.
6. “Credit Default Swaps and the Credit Crisis”. Rene M. Stulz, Journal of Economic Perspectives, Vol.24, No.1, Winter 2010.…...

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...American International Group (AIG) bankruptcy The bankruptcy of the American International Group caused a large crash in the US economy after depression, since AIG are filing bankruptcy and are asking the help from the congress for the bailouts. AIG is considered one of the largest companies in the insurance market and it is almost bankrupt. It had already filed bankruptcy once before and still could not recover and need more money. One thing that can be obtained from the article is that there has to be some amount of transparency into the operations of the firms who are big like AIG, I think the major reason behind all this trouble was that the operations were not disclosed to the public and therefore the authorities got a chance to manipulate them. This way they covered up one time the problems in the form of first bailout, but because the problems were quite large and could not be solved, they went bankrupt again. I think this all would have not happened if the first bailout was disclosed to public and common stakeholders. I also somewhere think that the authorities misused their rights. I disagree with the way they handled the first bailout request. I feel that the authorities should have taken the legal actions and let the courts decide what to do. It is not acceptable for me ethically that some big issues are tried to be covered up. In addition to that, I also think that oligopoly may not be useful any more in the economy,......

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Aig Case Study

...Case Study: Coping with Financial and Ethical Risks at AIG Cesare Lucritzia Capella University In 2008-2009, AIG became one of the most controversial financial bailouts in U.S. history. AIG underwrites insurance risk coverage to insurance companies. If an insurance company acquires too much risk, they then go to AIG who is a reinsurance company. Reinsurance companies enable insurance companies the ability to sell more insurance policies and enable growth. Within AIG there was a division that was selling insurance on mortgage-backed securities that are known as credit default swaps. As the value of homes continued to rise in 2008, the contracts that AIG made with these credit default swaps expired and AIG pocketed the premiums. People were buying homes with zero money down. When the housing bubble burst and people started defaulting on their loans, AIG then had to buy a ton of bad mortgage backed securities that nobody else could afford to take on. Since AIG was the largest insurance company in the United States at that time, they simply could not afford to fail because this would create a domino effect on the entire U.S. financial system, so the United States government was forced to bail them out to keep the U.S. and the international financial system on its rails. AIG’s corporate culture played a large role in its downfall. For 38 years, Maurice Greenberg was AIG’s Chief Executive Officer and was the face of AIG and its evolving corporate culture. He was an......

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