What led to American International Group’s fall?

MUMBAI: The House Oversight and Government Reform Committee is examining the events that led to the financial crisis in the US and now plaguing countries in Europe. The panel is looking into the financial excesses and regulatory slip-ups that now haunt the stock and financial markets and raised the threat of a global recession.

Three ex-chief executive officers of American International Group, including its largest individual shareholder, Maurice Greenberg, are to testify before the committee on Tuesday.

The US government rescued the insurance giant on Sep. 16 with the $85 billion loan, a day after Lehman Brothers filed for bankruptcy.

The fall of AIG followed its downgrade the earlier day by all the major credit-rating agencies, as its credit default swap losses soared even higher than Fannie Mae and Freddie Mac to $87 billion.

What led to AIG���s fall?

Banks around the world must comply with Basel II regulations, which determine how much capital a bank must maintain as reserves. The rules are based on the quality of the bank's loan book. The riskier the loans, the more capital it must keep in reserve.

AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps--designed to transfer the credit exposure of fixed income products between parties.

Under default credit swaps, the buyer of a swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral --as long as it maintained AAA credit rating. There was no real capital cost to selling these swaps.

AIG never built any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were AAA rated have ended up being worth less than $0.15 on the dollar.

This had a domino effect on other investment firms like Lehman Brothers. Merrill Lynch was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly selloff of its assets for over 79 per cent equity.

AIG's largest trading partner is said to be European investment bank Goldman Sachs. Goldman hedged its exposure via credit default swaps with AIG to the tune of $20 billion, according to sources.

Thus, Goldman had to mark down the value of its assets by $20 billion after AIG���s downgrade.

However, Goldman was quick enough to seek $5 billion help from Warren Buffet. This, in turn, helped it raise another $5 billion via a public offering.

The collapse of the credit default swap market also meant the investment banks had no way to borrow money, because no one would insure their obligations. The global credit derivatives market is about $62 trillion, about 30 per cent more than the mortgage market.

To fund their daily operations, they've become totally reliant on the Federal Reserve, making them commercial banks. To date, banks, insurance firms, and investment banks have borrowed around $350 billion from the Fed. Things are so bad that the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman to use equities as collateral for these loans.

One must understand that without the government's action, the collapse of AIG could have caused every major bank in the world to fail. But for the huge fraud perpetrated by AIG, the mortgage bubble would never have grown as large.