AIG’s securities lending program is just as critical to the story of its downfall. Through the securities lending program, AIG and its life insurance subsidiaries had massive exposure to residential mortgage-backed securities. At the height of the 2008 crisis, the program experienced a run, and AIG could not meet the massive repayment demands. The losses in the securities lending program were severe enough to imperil a number of AIG’s regulated life insurance subsidiaries. Before the bailout, AIG itself may have been insolvent.
The standard story is that all of the problems at AIG were caused by its credit default swaps. As those out-of-the-money options came closer to being in the money, their counterparties exercised rights to collateral calls, creating a liquidity crisis for AIG.
I have always accepted the standard story, and my view is that the way to handle it would have been to block the collateral calls. Make Goldman Sachs and DeutscheBank and everyone else wait to see how things play out.
Peirce says that in addition to the collateral calls on credit default swaps, AIG had exposure to mortgage securities through its regular insurance subsidiaries’ portfolios. Those securities lost market value during the crisis. For AIG, the problem became acute because of its securities-lending business. I don’t think I understand completely how this securities lending worked, but I think that the effect was to create a very significant maturity mismatch for AIG, so that it had a lot of short-term liabilities backed by long-term assets. When counterparties for a variety of reasons stopped providing short-term funding to AIG, it was faced with a need to sell long-term assets, and a lot of those assets were mortgage securities whose prices were depressed.
I came away from this analysis believing that the securities-lending program was important. However, I am less convinced that AIG was insolvent or that some of its subsidiaries were insolvent.
A finance guy should address this, but the way I remember the AIG story is that AIG lent securities it owned (e.g., to broker dealers for use in their customers’ short sales, etc.). AIG got cash collateral from the broker dealers. The usual thing is to invest the cash collateral in extremely safe securities (short Treasuries), but AIG invested in, what else, mortgage backed securities of various sorts. When the sales price of these securities collapsed, they were in double trouble.
Also, as I remember it, the Fed poured about as much money into this mess as it did into the CDS stuff.
Why would you want to block the collateral calls? The rules were agreed in the terms of the trades done between AIG and its counterparties. If AIG was unable to meet the collateral calls, why not allow the usual resolution mechanisms – bankruptcy, whatever?
A finance guy did, David Merkel and came to the conclusion it netted out to zero. Bankruptcy is the method of forestalling collateral calls.
Of course the costs of bankruptcy would have made it strongly negative.