Earlier this month, American International Group announced the departure of Robert Benmosche, the CEO who led the company through most of its recovery from the financial crisis. Now that the companys postcrisis chapter is underway, it is worth taking a fresh look at AIGs downfall and rescue and the implications for reform.
The standard AIG story lays all the blame for the companys problems on AIG Financial Productsan allegedly unregulated, irresponsible, derivatives dealer hiding within an otherwise solid insurance company.
Former Treasury Secretary Timothy Geithner repeats this traditional line in his recent book, where he recounts how an aggressive hedge fund-like subsidiary called AIG Financial Products brought the otherwise healthy insurance company to its knees and ultimately drove it into the Feds welcoming arms. Former Federal Reserve chairman Ben Bernanke made a similar claim when he told Congress how angry he was about AIGs Financial Products unita hedge fund attached [to] a large and stable insurance company. And former Commodity Futures Trading Commission Chairman Gary Gensler, with typical dramatic flair, explained that AIGs subsidiary, AIG Financial Products, operating out of London, brought down the company and nearly toppled the U.S. economy.
This widely repeated narrative ignores or downplays a critical aspect of AIGs downfallthe insurers securities lending program run for the benefit of its regulated life insurance subsidiaries.
An endnote in Geithners tome explains that securities lending was one of AIGs major liquidity needs at the time of its rescue. As I describe in a recent working paper, the company got itself into hot water by lending securities from its life insurance companies portfolios. AIG took the cash collateral it received for these short-term loans andin a departure from insurance industry practiceinvested much of it in longer term, illiquid residential mortgage-backed securities.
The securities lending program grew from about $10 billion at the end of 2001 to over $80 billion by the end of 2007. When borrowers stopped renewing the loans, returned their securities, and asking for their cash back, AIG was in a bindthe borrowers cash was tied up in reinvestments.
To meet borrowers demands, AIG lent more securities and used the cash collateral from new borrowers to return to existing borrowers. This solution only aggravated the problem. When CEO Robert Willumstad took the reins of AIG in June 2008, the cash drain from securities lending worried him more than AIG Financial Products liquidity needs.
Losses from the securities lending program threatened the viability of a number of AIGs regulated life insurance subsidiaries. To save them from falling below minimum capital requirements, AIG pumped billions of dollars into these units.
Government rescue money was critical to this recapitalization effort. Taxpayer funds were also critical in meeting securities borrowers demands for cash. Securities lending counterparties received $43.8 billion in the last quarter of 2008, comparable to $49.6 billion in collateral postings and payments to AIGs derivatives counterparties.
As consequential as it was to AIG in a time of crisis, nobody likes to tell the securities lending part of the story. First, it doesnt feed as nicely into the vilification of derivatives that laced crisis narratives and fueled calls for an intense derivatives regulatory regime. Second, the fact that heavily regulated insurance companies got into trouble does not support the call for greater reliance on government regulators. Finally, the rescue of a deeply troubled company is less defensible than the rescue of a healthy insurance company with a troubled derivatives subsidiary.
The Feds contention that its loan was adequately secured rested on the supposition that apart from the derivatives unit, AIG was sound. The banks that went in to AIG in September 2008 to assess whether it was worth rescuing concluded that it was not.
As one of the private bankers subsequently explained, The value of the company in its entirety was not necessarily sufficient to cover the liquidity need that the company had.
Geithner recounts in his book thatlooking for confirmation that a loan to AIG would comply with the legal requirement that the Fed can only lend against reasonably solid collateralhe asked Warren Buffett what he thought about the earning power of AIGs traditional insurance subsidiaries. Buffett was pretty positive about their underlying value, which made [Geithner] more confident that [the Fed] could meet the legal test of being secured to [its] satisfaction. Buffetts words of assurance to Geithner werent matched by a willingness to put his own money on the line; he refused AIGs overtures to invest during 2008.
AIG was on the verge of filing for bankruptcy when the Fed stepped in with a better deal for shareholders and creditors. The government subsequently re-rescued the company by devoting additional taxpayer funds to it and softening the lending terms. At any of these re-rescue points, the government could instead have let the company go through bankruptcy.
By continuing to prop up AIG, the government shielded the company from the toughest regulator of allthe markets. AIGs problems were not confined to one unregulated corner; problems also arose in full view of insurance regulators. Rather than assuming the Fed will be better than AIGs other regulators, we ought to allow the truly superior regulatorthe marketto do its job.
Hester Peirce is a senior research fellow with the Mercatus Center at George Mason University and author of the Mercatus Center working paper, Securities Lending and the Untold Story in the Collapse of AIG.