Note that I obtained the facts mentioned in the following lines from different credible sources and all I that have done is paraphrased the content and broken it into categories. I guess the jargon will be too much for some of you so shoot any questions that you have.
The following post is about investigating the reasons behind AIG's fallout:
Why did CDS contracts almost provoke the bankruptcy of AIG?
AIG had been a successful insurance provider until, seemingly, it started to venture out in the business of writing Credit Default Swaps. It began insuring debt obligations of lenders against a risk of counterparty default, thereby taking the credit risk of the counterparty on itself. At one stage, of the $60 trillion CDS market, AIG owned about $440 billion of notional, an enormous amount compared to its peak market value of about $240 billion, with the portfolio contributing over a quarter of AIG’s profits.
The problem was that CDS was designed in such a way that it didn’t require any capital requirements and hence it attracted pension funds, insurers, hedge funds and banks for they could reap on the credit risk without any capital to lend. Furthermore, the demand for such instruments rose as they added on to the profits on the income statements without a mention of the risk involved.
Most of these CDS were on asset backed securities pools, primarily mortgages, and when the housing market collapsed these mortgages that AIG had “indirectly” insured started falling in value. The losses began accruing in 2006 and by 2008 AIG had less equity than it needed to fulfill its obligations. This trapped it into a vicious cycle as its credit rating was downgraded and hence it was required to post an additional margin that further put strain on its financial resources.
Hence we see that AIG, due to its good credit rating and the nature of CDS, was able to stack up large quantities of such insurance on its books with being questioned about the risk involved. Since the notional value of these contracts exceeded the market value of AIG, the possibility of the underlying assets going sour raised a possibility of bankruptcy for AIG.
http://www.economist.com/node/12274070
http://www.economist.com/node/12552204
What saved AIG from bankruptcy?
AIG is one of the biggest insurance companies in US and during the crisis it held a huge amount of credit risk on its books. It started getting calls on that risk when the underlying assets began degrading in value but its capital stash was not enough to meet all the requirements. To avoid a contagion across those who had insured their risks as well as to avoid the mess that AIG’s default would create in its other space such as life insurance and annuities, the government decided to bail it out with taxpayer’s money.
When AIG reported the biggest quarterly loss of any company in American history, of $61.7 billion, the government proposed a bailout package of $85 billion and took a 79.9% stake in the company in return. It further provided up to $37.8 billion in capital and removed the coupon on a $40 billion equity that was injected by the government in Nov 2008. Although AIG quickly used up about $90 billion of the ~$120 billion credit line awarded, it was able to stabilize its margin requirements on its contracts and was able to fulfill its obligations
http://www.economist.com/blogs/freeexchange/2009/03/government_and_aig_together_fo
http://www.economist.com/blogs/freeexchange/2009/04/did_we_need_to_bail_out_aig
http://www.economist.com/node/13213322
What could be done, in terms of reorganizing the CDS market in order to diminish the impact of situations like the one that almost doomed AIG?
There seem to be quite a few fundamental flaws with the way a CDS contract is designed:
- With the exception of capital requirements, a CDS contract allowed smaller firms, such as hedge funds, which did not have huge capital to lend, to be able to take on the credit risk of a counterparty’s portfolio in exchange of insurance premium.
- The accounting policies did not require such companies to reflect such transactions on their financial statements and hence the risk of such instruments went unnoticed and what appeared on the balance sheets were the profits.
- Depending on their credit rating, the companies had to put aside minimal margin, relative to the loan, to cushion against possible defaults.
- The CDS contracts allowed speculative positions to be held in the market. Hence the CDS market was over inflated and peaked at about $62 trillion when the value of the underlying debt was just about $5 trillion. This in turn had an effect on the ability of a company to take on debt as its CDS spread in the market would determine its credit strength.
- The voting power that comes with a debt stays with the debt holder even when the risk has been passed on. This can result in a clash between the intentions of the lender and the insurer regarding the default of the borrower as the lender might not agree to a debt restructuring.
It seems that with a proper understanding of CDS and its implications its abuse, and hence what followed, could have been avoided.
- The regulations around CDS can be more stringent to provide evidence of “credit risk” against which the insurance is sought. This will avoid speculative positions that can overburden the market with possibility of a multiple losses over a single debt.
- The accounting regulations also need to be strengthened so that such risks are portrayed on the balance sheet and hence are accounted for in assessing the financial health of a firm.
- The firm selling such contracts should be required to reserve certain capital in the event it needs to meet its obligations under the contract. This would help restrict the amount of CDS a company can write based on its capital cushion and credit rating.
- The voting power that comes with taking on debt should be somehow shared with the CDS seller so they have a say in the debt restructuring of the defaulting firm.
http://moneymorning.com/2009/04/23/ban-credit-default-swaps/
http://moneymorning.com/2008/09/22/credit-default-swaps-2/
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