(a) Background of the corporation or institution

American International Groups earliest root is from Asia and then branched out in a

series of acquisitions, fusions, and consolidations, building it up to the giant pot.

AIG first started out in Shanghai by a young American entrepreneur who is

Cornelius Vander Starr in 1919. He founded the AAU, or American Asiatic

Underwriters, which is a low, two-way, two-clerk insurance agency that represented a

few American insurance companies established in Shanghai. They offered fire and

marine coverage. Seven years later, which is in 1926, Starr founded the American

International Underwriters (AIU) in New York, his first office is in America. The AIU

wrote insurance policies for Americans working outside the United States. He made for

the representation of Pittsburgh, Pennsylvania, and the Globe & Rutgers Company into

his close up.

In 1939, Starr decided to move his company's headquarters to New York

permanently after unrest spread in China and East Asia and the onset of the Second

World War. AIU experienced a rapid expansion during the 1950s, as they expanded

across 75 countries, most notably in Western Europe, North Africa, Australia, and the

Middle East. In 1952, the company merged with several other insurance, and they

collectively became known as American Home. Besides that, Starr already expanded his

companys operations to British and Chinese businessmen and established the

International Assurance Company (INTASCO), and also towards the Central American

and Caribbean businesses. When Starr joined the American Home board, he named

Maurice R. Greenberg as president, and the company formed the American International

Assurance Company of New York.

With Greenberg the company focused on broker sales, which permitted the

company to establish its own policies and maintain underwriting control. They focused

on industrial and commercial risks, which gave them negotiated rates instead of the usual

state-controlled rates. This permitted them to develop reinsurance facilities that would

cover large parts of major hazards and also control insurance ratings. American Home,

avoided medical insurance, but the new marketing strategies worked. Most large

corporations thought American Home for insurance.

The American International Group, Inc. as known today was formed in the late

1960s, when American Home began to be an important commercial and industrial

property and casualty insurer. In 1967, AIRCO formed American International Group,

which heralded the start of corporate re-constitution. Its many acquisitions and mergers

allowed it to become ace of the mammoth insurance groups ever.

(b) Chain of the case

AIGs result in 2007 was clearly unsatisfactory, said by the Chief Executive Martin

Sullivan. During years 2007, AIG reported a US $5.29 billion fourth-quarter net loss,

versus net income of $3.44 billion. To date, this case has been viewed through the

inaccurate conclusion of AIGs failure on its credit default swaps portfolio. Some more,

AIGs financial difficulties can be viewed from few difference businesses fields and this

is due to the shortcomings of the AIGs risk management.

In September 2009, the US government had bailout the American International

Group, Inc. (AIG) total $ 85 billion and the size of bailout increased to $ 180 billion over

next few month. This fall down of AIGs group can be traced back to March 2005, the

company rating was decreased from AAA credit rating to AA+ when the resignation of

AIGs current CEO, Hank Greenberg. However, this downgrade result not only leads by

the fail of derivative but also the mismanagement of AIGs group in internal control,

corporate governance and culture.

With the downgrade of credit rating, the company needs to post the margin on

those positions. The severe deterioration of the derivatives underlying AIGs credit

default swap portfolio forced AIG to post increasing the amount of collateral up the safe

limits. In November 5, AIG have agreed to post a total of $ 39.9 billion in collateral. This

problem of liquidity strains which caused by margin calls against the credit default swap

was making larger from AIGs securities lending unit.

During the time 2004 to 2009, AIGs insurances provide almost 90% of AIGs net

revenue and owned about 230 countries around the world. Prior to the Global Financial

Crisis, the American insurance regulators believed that the AIGs core operation in

insurances is generally sound. However, in years 2005, AIG decide to change in

investment strategy. The collateral in cash form would no long invest in low risk

securities, instead, AIG choose to invest in residential Mortgage Backed Securities. Many

people was disagree with the action and that was not the time to investing in the

Mortgage Backed Securities. Even the AIG rating these lines of businesses was too risky,

at the end of 2005, AIGs decide to stop underwriting subprime debt securities.

In next two years, AIGs Securities Lending Program aggressively expanded its

investment in subprime debt. By late of 2007, AIGs Securities Lending Programs held

amount up to $ 76 billion in liabilities and 60% is from the Residential Mortgage Backed

Securities (RMBS). The total asset of AIGs life insurances companies was about $ 400

million; about 11% of the assets were invested in RMBS and this lead to mismatch in

asset-liability management.

According to the Boyd (2011), the AIG manage in Securities Lending Programs

did not have a good management in perspective about the change in asset allocation. The

fund managers simply change in the prospectus which giving the freedom to invest in the

risky assets. When happen the subprime crisis, the answer of AIG is just the reassuring

mean buy misleading about the excellence of the portfolios risk management controls.

However, during late year 2007 and 2008, the RMBS was increase the difficulty to join

sell off and the size of RMBS portfolio is US pool was decrease from $ 76 billion to $ 58

billion by September 2008.

The subprime debt crisis began affecting AIG seriously in 2007, this decline in

market values was affected the AIG financial product and AIGs securities Lending

Programs. However, the fall in collateralized Debt Obligation (CDOs) make the AIGs

counterparties start to make the collateral calls. Initially AIG did not expect to suffer any

losses due to the subprime debt crisis, because based on the AIGs model, these collateral

calls was unnecessary. But the counterparties have their own models, which rating the

CDOs and some market participants began to report losses. Therefore, in 2008, AIGs

group forced to write down the value of the portfolios, which is unrealized loss of $ 11.25

billion. At the same time, S&P put AIG with the negative watch. The losses in securities

began affect the AIGs credit rating again. In mid of 2008, the rating based on the S&P

was reduced to AA-. Rating downgrade was created the situation become more serious;

this created the liquidity problems for AIG. The collateral calls increased by billions of

dollars every month.

(c) Lessons learnt from the case

Initially, AIGs securities lending activities such as reinvesting the cash collateral in

short-term U.S. were regulated and approved by state insurance regulators. Treasury

securities ensuring there was no maturity mismatch. However, AIG got greedy and

changed the nature of their securities lending program as well as its size by reinvesting

the cash collateral in mortgage-backed securities with long maturity dates, thereby

creating maturity mismatches once the housing market heated up (Thomas, 2014). AIG

had issued a large amount of credit default swap contracts to investors. When its ratings

were downgraded, AIG was required to put up additional collateral requirements (Henry

et al., 2008).

In 2007, the fall in the market price of underlying debt security made seriously

effect to AIGs liquidity which was adversely affected by requirements to post collateral.

Certain of the credit default swaps written by AIGFP contain collateral posting

requirements. The amount of collateral required to be posted for most of these

transactions is determined based on the value of the security or loan referenced in the

documentation for the credit default swap (Vasudev, 2010). This makes default swaps

more risky and onerous than regular insurance contracts.

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 concern with these programs (Thomas, 2014).

Besides, the regulatory black holes in the financial system must be eradicated.

One black hole concerns regulation of financial derivatives the exotic instruments that

threw AIG into virtual insolvency. In 2000, Congress prohibited such regulation by law.

When regulation are finally adopted, as they almost certainly will be, they should prohibit

certain kinds of financial derivatives altogether and require that new ones prove their

safety and social value before being placed on the market (Robert, 2009).

In addition, renewed attention must be paid to corporate structure and prohibitions

on whole categories of activity. Insurance companies should be prohibited from operating

affiliates that function as de facto hedge funds. Commercial banks husbanding depositors

assets should be prohibited from operating securities firms or making securities firm-style

speculative bets (Robert, 2009).

Moreover, the unregulated use of credit default swaps and other high-risk

instruments by AIG Financial Products, a federally regulated noninsurance unit with

wildly insufficient reserves, caused AIG to stumble and threatened the financial system.

The essential lesson of AIG and of the broader crisis is the need to reform financial

regulation. And that reform should learn from state insurance regulation (Eric, 2010).

Furthermore, AIGs default swaps business was handled by its subsidiary, AIG Financial

Product Corp. (AIGFP), based in London, UK. Interestingly, AIG had a committee

specifically to deal with derivatives risk management which is the Derivatives Review

Committee. But, this was not a committee of directors. The Derivatives Review

Committee, which apparently consisted of company executives, did not look into the

credit derivatives business of AIGFP, which was treated as independent (Vasudev, 2010).

Last but not least, the lesson that should be kept in mind is that AIG should pay

serious attentions which in the monitoring of the default swap transactions, its potential

obligations and logistical issues such as valuation of securities (Vasudev, 2010). AIGFP

should be reporting all their derivatives transactions to committee that set up by AIG in

order providing convenient platform for them to monitor and examine their activities

regularly.

(d) Four (4) recommendations on how the problems could have been avoided

We suggest that stricter rules and regulations should be set on Credit Default Swap

(CDS) market. Calistru (2012) mentions that CDS markets are unregulated due to the

fact that this kind of derivative is traded OTC. Unlike exchanges, OTC market involves

less transparency and more counterparty risk (Stulz, 2010). First, standardization on

every credit derivatives contract must be as a precondition to enter into the market

(Calistru, 2012). Lack of clearing arrangements and standardization causes OTC market

to expose to systematic risks easily. Standardization ensures less risk of disputes from

both buyers and sellers, since quantity, quality, delivery date and other details from the

contract are revealed to both parties. As a result, all contracts are transparent to the parties,

and fewer risks would be incurred. Standardization also helps to reduce time for settling

the contract (Coudert & Gex, 2010). Second, disclosure requirement on credit derivatives

must be imposed (Archaya & Johnson, 2007; Calistru, 2012). Underestimation on risk

exposure might occur if no disclosure requirement. This makes company to take less

prudent approach in managing exposure risks in CDS market. This might be a reason

why AIGs Derivatives Review Committee overlooked their derivatives activities.

Disclosure requirement at least provides protection basic knowledge of contract and

counterparty for the trader, so that trader can take effective measures for overcoming

related risks. These regulations are so useful that they can help in suppressing any

misconduct in the financial markets, especially in CDS market.

Besides that, a party which acts as middleman should be available in CDS market

in order to reduce risks in the market. Centrally cleared market must exist in CDS

market (Calistru, 2012; Bolton & Oehmke, 2013). Many central clearing platforms (CCP)

are established as a consequence of subprime crisis 2007-2009. CCPs help in reducing

the counterparty risks by assuming the credit risk through credit risk mitigation method.

CCP must be an impartial party: it is independent from buyers and sellers, and cannot be

influenced by decision of buyers and sellers (Arora & Rathinam, 2011). As compared to a

normal OTC market, CDS market with CCP assure safer investment, as management of

counterparty risk can be run effectively, multilateral netting of exposures and payments

can be performed, centralized information on market activity and exposure can be

gathered by this party. Each party would not need to take more risks then since there is

mutualization of losses: CCP helps in assuming the counterparty and credit risks occur

in OTC market (Arora & Rathinam, 2011; Calistru, 2012; Hull, 2012; Bolton & Oehmke,

2013). Hull (2012) mentions that operations of CCPs should be regulated and monitored

well so that CCPs would not engage in risky investment activities. This ensures the

independent role of CCPs is carried out effectively. Presence of CCPs in CDS market

alleviates the financial integration in the market. Many companies, including AIG, could

reduce the costs of monitoring their credit derivatives activities in OTC market. Having

reduction on both risks (counterparty and credit risks) and costs (costs of monitoring) is

like killing two birds with one stone.

References