I read with interest Ms. Peirce’s article about the collapse of AIG (“AIG’s Collapse: The Part Nobody Likes to Talk About,” June 16).  State insurance regulators have always acknowledged that AIG’s insurance-based securities lending program grew too large and contributed to the liquidity issues at the firm.  However, to compare that activity with the actions of AIG’s Financial Product (AIGFP) division is misleading.

First, AIG’s securities lending activities were regulated and approved by state insurance regulators.  At the time of approval these programs were conservative; reinvesting the cash collateral in short-term U.S. Treasury securities ensuring there was no maturity mismatch.  As the housing market heated up, however, AIG got greedy and changed the nature of their securities lending program as well as its size, reinvesting the cash collateral in mortgage-backed securities with long maturity dates, thereby creating maturity mismatches.  While AIG was obligated to inform its home state regulator of this change, it failed to do so.  State regulators in Texas ultimately caught these changes as the result of an onsite examination and began a process of working with AIG to unwind these contracts and shrink the program.  As Ms. Peirce notes, the program had been cut almost in half from its late 2007 high water mark by the time the financial crisis hit just one year later.   It’s also worth noting that the states communicated this information to other involved regulators, including AIG’s consolidated regulator, the Office of Thrift Supervision, a now defunct federal agency.

Second, unlike AIGFP’s transactions, the securities lending transactions were backed by collateral and the securities being loaned to counterparties were primarily U.S Treasuries.  When AIG’s counterparties began asking for that collateral back, AIG chose to pay back in cash instead of defaulting.  While such a default is never a first choice, it would have resulted in AIG’s counterparties being left with a basket of U.S. Treasuries, among the only safe investments during the peak of the crisis.  AIGFP, on the other hand, was not loaning anything of value out, posting no collateral, and its credit default swap and other derivatives transactions were backed by nothing but AIG’s financial strength rating.

As a lesson learned from this situation, the state regulators, acting through the National Association of Insurance Commissioners, instituted new reporting requirements for securities lending activities so that now state insurance regulators can easily identify any maturity mismatch or other concerns with these programs and not have to rely upon the company to inform us of any changes.  We are also putting in place broader holding company authorities and ERM reporting to better understand the risks of complex firms outside the traditional insurance operations.

Ms. Peirce would be hard pressed to find a regulator, or for that matter a policymaker, mortgage underwriter, real estate appraiser, investment bank, ratings agency, derivatives trader, or global counterparty who didn’t make some mistakes that contributed to the financial crisis.  And Ms. Peirce is certainly entitled to her opinion on the merits of the federal bailout of AIG and the system at large.  But the conclusion that, because of missteps by one regulator or another, all regulation is unnecessary and all that is needed is market pressure is a dangerous fallacy.  To observe the effectiveness of a market devoid of regulation and subject primarily to the guiding hand of market pressure alone, one need not look further than the very market that AIGFP embraced with such catastrophic consequences.

Thomas B. Leonardi is the insurance commissioner for the state of Connecticut.