Dawn September 22, 2008

Financial Earthquake and the AIG Nationalization

By Moin M. Fudda

Lehman Brothers bankruptcy on September 15, 2008 caused “The Mother of all Mondays” as called by the Wall Street Journal. The US financial earthquake triggered the world and so much so that Moscow Stock Exchange had to shut down for four days.

Perhaps the Russians were not aware of Karachi bourse action of freezing its thermostat to 9144 prior to this tsunami; otherwise they could have followed suit!

On September 16, AIG’s share melted from one year high of $80 to intra-day low of $1.25, whereas for the same period, market capitalization of its stock dropped from $185 billion to merely $5.5 billion. Worried with insurers non-ability to honor the financial commitments it had made through millions of contracts and its massive worldwide implications, on September 17 the Federal Reserve nationalized the largest insurer in the world by injecting $85 billion in exchange for 79.9 per cent stake.

At the root cause of this crisis were the sub-prime mortgages which carried the highest default risk. According to professor Wachter, at the Wharton School of Management, the looser credit standards brought a mortgage boom in 2005 when sub-prime mortgages made up 22 per cent of new loans compared to eight per cent in 2003.

Many lenders purchased credit insurance from institutions such as AIG and after keeping a portion passed the risk on to investors around the world who bought these mortgages backed securities for greed of higher yields than those offered by safer investment such as Treasury Bonds. The sub-prime market mushroomed from $240 billion in 2003 to $912 billion in 2005 of which AIG alone had a $441 billion notional exposure of its super senior credit default swap portfolio as of June 30, 2008.

To a layman, when you satisfy the greed of people to buy homes with as little as $2500 down, it should not have been a surprise that many of these borrowers would walk away from their obligation when they lost jobs or ran out of business. Senior Policy Advisor of the Federal Reserve Bank of Dallas, Duca reported that in early 2007, investors and lenders began to realize the ramifications of credit-standard easing.

Delinquency rates for 6-month-old sub-prime underwritten in 2006 were far higher than those of the same age originated in 2004. Lenders reacted to these signs by tightening credit standards more on riskier mortgages. Foreclosures added to downward pressures on home prices by raising the supply of houses on the market. And after peaking in September 2005, home sales fell in September 2007 to their lowest level since January 1998.

On August 14, 2007, the paralysis in the capital markets led three investment funds to halt redemptions because they couldn’t reasonably calculate the prices at which their shares could be valued. This event triggered widespread concern about the pricing of variety of new instruments, calling into question many financial firms’ market values and disrupting the normal workings of the financial markets. Initially it started with Citi Bank and later took the Wall Street and some of the European and Asian markets by surprise until the triggers of this financial earthquake were felt worldwide on September 16, 2008.

In my view there are four parties to this crisis, the borrower, lender, insurer and the regulator. While in first and second, as explained above there is a common element of greed which caused this crisis, but the role of third one being insurer, by nature has to be prudent — and finally, what regulator was doing when all this was happening?

This reminds me of 1980 when AIG group CEO Hank Greenberg played a key role in founding US Pakistan Business Council in New York and in 1984 played host to the late President Zia ul Haq at AIG’s Head Office in New York. The subject was grievance against 1973 nationalisation of American Life Insurance and its re-entry into Pakistan. But when following this visit, ALICO’s President called on the then Finance Minister, late Ghulam Ishaq Khan, he was categorically told that ALICO had received fair compensation of $3.5 million and that government will not open its life insurance business to foreign entities. However, Prime Minister Moeen Qureshi, a member of AIG’s international Advisory Board, in 1995 passed an order for issuance of license to ALICO with 51 per cent equity which India has still restricted to 26 per cent as seen in AIG’s 2007 report. Irony is that after 35 years of ALICO’s nationalisation in Pakistan, the whole Group required nationalisation.

In 2007 with 245 companies and a trillion dollars in assets, presence in 130 countries, 106,000 employees and 69 million customers, it was by far the world’s largest insurer. Besides underwriting traditional lines of business, it was heavily engaged from aircraft leasing, mortgage financing and credit insurance to asset management businesses. Sadly, in getting bigger and bigger, it deviated from the profit-centered approach on which it was founded.

In case of sub-prime mortgage, in the absence of data, the risk was greater and required careful underwriting, yet the company accepted the business at cheap rates which is evident from its annual reports that it could only reinsure less than 20 per cent of the business and could not create enough reserves from the premium it received to meet the claims. Thus, instead of being prudent, it ended up with aggressive underwriting strategy which resulted in accumulation of risks instead of spreading it through sound reinsurance approach.

In response to CNBC’s Maria Bartiromo’s question, on September 16, 2008, what do you think went wrong? Greenberg said, “I think several things; risk management controls either disappeared or were weakened. There was no attention being paid to the accumulation of risk. There was a determination to grow without the right controls in the financial sector of the business. It’s a tragedy, it did not have to happen.”

Now finally to the role of regulators. In response to a question on BBC news on September 17 that “where were the regulators when all this was happening”? Sir Howard Davies, former Chairman of the Financial Services Authority of UK said that there were no regulators to monitor the Group. According to him, it is a weakness in American system that each company files its report to each of the state and unlike Financial Regulatory Authority (FSA) there is n’t any super body to oversee the Group’s operation.

Additionally, AIG’s Annual Report became so complex that to examine it, each of the 50 states needed to employ a team of experts and an actuary, which perhaps they could not afford and were happy to receive increasing amount of annual fee which was linked to the premiums. However, as reported in the Business Week issue of April 11, 2005, AIG faced an investigation into two reinsurance transactions which the company acknowledged as improper accounting, inflating reserves up to $1.7 billion. In early 2005, the Group was served with subpoenas by state and federal regulators which caused decline in its stock by 22 per cent as well as downgrade in rating by S&P in fall of 2004, the insurer paid $126 million in fines to the SEC for deals it structured for outside clients that allegedly violated insurance accounting rules.

AIG also came under the glare of New York Attorney General for its role in a bid rigging with broker Marsh & McLennan. In the back drop of all this development, finally AIG Board, that was notoriously chubby and close to Greenberg, says Patrick McGurn of Institutional Shareholder Services, came under shareholders’ pressure resulting in ouster of Greenberg. But perhaps with his political connections, he managed a safe exit.

The matter should not have been allowed to rest on departure of Greenberg and merely on collecting of fines, rather had the New York Governor, who on September 16, offered $20 billion worth of state assets to bail out the insurer, intervened in March 2005 to team up with regulators to install independent directors and demanded from the Board to clean up the mess and make the Group cash rich before the close of 2005, the current bail out could have been avoided.

The writer is ex- Managing Director of the Karachi Stock Exchange and former Country Chief of Commercial Union Insurance.