AIG, which was the holding company of the many subsidiaries engaged in the insurance related businesses, showed tremendous growth during the last years of the 20th century, until it became the largest insurance group in the world in 2001. Although the company continued to grow at a very high rate until 2008, different scandals began to emerge 2002, that highlighted the weakness and inefficiencies of the corporate governance structure. However, the shareholders and other outside observers were so mesmerized by the impressive financial achievements of the company that they overlooked many grave inconsistencies on the part of the management of the company. However, inefficiencies in the risk management and the corporate governance structure of the company became self evident with the advent of sub-prime mortgage. The confidence of investors and the counterparties that had traded with AIG in the over the counter market was shaken when the company practically became insolvent. Lack of proper regulations of the activities of AIG in the derivatives market, greed of the top management of the company and the inefficient risk measurement and prediction mechanism were the chief reasons for the failure of AIG. Since the company was too big, effects of its failure were expected to spillover to other financial institutions and hence the whole economy was bound to suffer unless the company was bailed out. Hence, eventually a bailout package of $85 billion was announced by the US government initially to minimize the spillover effects of the insolvency of the company.
How did the Corporate Structure of AIG contribute to its failure?
There were many issues with the corporate structure of the company, as a result of which, many controversies began to emerge from 2002 onwards. One of the major problems was the oversight of the market conditions in pursuance of unrealistic goals. Compensation plans of the top executives were not being monitored by the compensation committee of the board. The stock options represented only a small proportion of the outstanding shares of the company and were far below the threshold of 15%.
Furthermore, by understating the risks of AIG-FP’s business in the derivative market, the top management was able to earn very high returns. Attractive prices coupled with AAA rating enabled the company to show tremendous growth in the beginning. However, due to risk-blindness of the top management, it continued to pursue same level of growth by inflating profits during a very competitive time period. The weakness of the corporate structure was evident from the recurring fraud and misrepresentation scandals that began to emerge from 2002 to 2007. From charges of bid rigging with the insurance brokers to the fraudulent accounting to inflate profits, the company’s top management, particularly Greenberg, began to give signs of a weak corporate system. It became clear from these scandals that the corporate culture of AIG laid more stress on business than on ethics. This mindset appeared to have trickled down from the top management of Greenberg. Use of the inefficient Gary Gorton’s model, exploiting non-regulation of Over-the-counter market and fraudulent financial reporting to fool the shareholders, all of these aspects showed that the top management was either too inefficient to understand the long-term consequences of these events or was willingly compromising on corporate ethics to reap short term benefits. The absence of the independent review and supervision of the compensation system posed a very serious conflict of interest for the top management to forego short term profits for the long term benefit of the company. Therefore, bad decision of the top management continued to go unchecked due to the lack of a strong, robust and independent internal review system in the company.
The fact that most of the bad and unethical decisions continued to go unchecked showed that those around him did not question him as independent executives should have. Another problem with the governance structure of AIG was the misalignment of the risks and compensation. The traders in the AIG-FP received very compensations when the profits were high, whereas, they shared very less in the losses that eventually occurred.
Describe how the regulatory environment contributed to market reliance on AIG and how that reliance exacerbated financial market problems?
Due to the deregulation of derivative market, AIG sold a lot of derivatives to all the big financial institutions at very attractive prices because AIG was the only one of the two companies that enjoyed AAA status. The company showed tremendous growth until 2001, when it became the largest insurance group in the world. The prices of these derivative instruments did not reflect the true risk borne by the company. The company was not incorporating risks assumed by going into the CDS market properly and hence, overall firm risk remained grossly understated. So, soon the company lost its AAA status and hence, the profitability of the company began to decline. The situation became even worse with the advent of Sub-prime mortgage crisis, which destroyed the CDS portfolio of the company. So, investment in the derivative market that seemed like a very profitable option became a huge liability for the company at once. The inter-dependences of the large commercial banks, investment banks and all big financial institutions over AIG were very high. The counterparty relationship created by the Credit default swaps and the mutual businesses of lending securities was so enormous that the possible failure of AIG created very serious Systematic risk. The failure of AIG would have resulted in the failure of the dependent financial institutions and hence, the whole financial system would have terribly collapsed. AIG had sold derivatives in very large numbers to almost all the major financial institutions in the world. It was estimated that the failure of AIG would cost its counterparties around $180 billion, and the spillover effect would have caused the failure of many of the counterparties in the derivative market.
Compare the operations of AIG-FP to that for insurance firms. Describe how the practices of AIG-FP contributed to its failure.
According to the report of the Government’s Crisis Inquiry Commission (GCIC), selection of a very weak regulator i.e. the Office of Thrift Supervision” was the major reason why AIG could not be adequately regulated and then eventually failed. Another reason for the failure of AIG was the deregulation of the over the counter derivatives like Credit Default Swaps (CDS). This derogation eliminated the need to maintain capital and margin requirements, which were mainly supervised by federal and state regulatory bodies. Consequently, the transactions between the counterparties of the over the counter markets were mostly controversial due to the lack of transparency. Also, Ineffective pricing of the products in the over the counter market led to disputes between AIG and its counterparts like Goldman Sachs. AIG tried to take advantage of the lack of regulation in the over the counter market by investing too much in the CDS market and by setting up a big chunk of business outside United States i.e. in London. These contracts in the over the counter market were not being included in the assessment of the firm risk. This led to serious understatement of the firm risk and gross mispricing of the insurance products. Therefore, in order to pursue higher returns in the short run, risks began to accumulate that eventually began to hamper the very survival of the company in the long run. AIG failed to incorporate Systematic risk, posed by going into the CDS market, in the firm risk. Therefore, in pursuit of higher return in the short term, AIG-FP began to exploit the deregulation of the over the counter market and made investments that were too risky for an insurance company.
Broadly describe regulations that a) would have prevented the financial market problems caused by AIG and b) can prevent a recurrence of these problems?
By going into the CDS market, AIG had exposed its business to three kinds of risks.
- Risk that the debt security may default.
- The risk that counterparties, that have bought Credit default Swaps from AIG may demand collateral back if the value of security, which is being insured by CDS, decreases.
- The risk that credit rating of the company may go down.
The problem for AIG was that it didn’t apply effective models for that could estimate these risks accurately. This, coupled with the deregulation of Over- the-Counter market, made the business of AIG more of a banking business than an insurance business. Therefore, lack of regulatory requirements regarding capital and margin requirements resulted in the failure of organization. Furthermore, corporate governance of the insurance group wasn’t also appropriately regulated. The credit rating agencies also failed to accurately quantify the risks associated with the sales of CDS by the company. A strong and effective supervision of the large financial companies can prevent the recurrence of such problems. Timely identification of the reckless risk-taking of the large financial institutions can prevent the problem to grow. Furthermore, risk weights for credit swaps should reflect the intrinsic risks borne by the players of this market. Regulatory requirements should include recurrent stress tests and liquidity tests to ensure the solvency of the company should any unexpected occur again.