Saturday, September 20, 2008

Where AIG Went Wrong

Where AIG Went Wrong

Amid all the debate about the long-term impact of an $85 billion federal loan to American International Group (AIG), one thing is clear: The world's most sophisticated insurer proved to be far from adept at managing its own risk. Despite $110 billion in annual sales and assets in excess of $1 trillion, AIG stood at the brink of bankruptcy on Sept. 16. As management persuaded New York regulators to waive insurance rules so it could essentially tap subsidiaries for cash and tried in vain to raise $75 billion from Wall Street, AIG's shares fell as low as 1.25 (down from a 52-week high of 70). The taxpayer-funded bailout, which gives Washington warrants for an 80% stake in the company, won't bring back the $184 billion, or 97% of shareholder capital, that has evaporated in less than a year.

How did this happen? One place to start is former Chief Executive Maurice R. "Hank" Greenberg, who built AIG into a global behemoth during his four-decade tenure, in part by expanding into complex lines of business and insuring risk that few would dare to touch. Although forced to step down in 2005 amid an accounting scandal, Greenberg remains AIG's largest individual shareholder and a harsh critic of how AIG was managed under Martin Sullivan and Robert Willumstad, who stepped into the CEO role in June. Under the federal deal, former Allstate chief Edward M. Liddy will replace Willumstad. AIG's board of directors issued a statement saying the federal loan will protect policyholders, address rating agency worries, and "give AIG the time necessary to conduct asset sales on an orderly basis."

Greenberg told BusinessWeek on Sept. 17 that the government went too far: wiping out average shareholders with a bailout when all that was needed was a short-term loan to cover AIG's obligations. And he insists things would have been different had he remained at the helm. "I would not have waited until it got to this point," says Greenberg. "We had very strict risk-management controls. Those were obviously not followed." Hours before the rescue package was announced, he led a group of investors who alerted the Securities & Exchange Commission that they were looking at buying AIG assets or even assuming control. But AIG says its financial woes stem from actions taken in 2005 and earlier, when Greenberg was still in charge. "He took a lot of risk," says David Shiff, editor of Shiff's Insurance Observer and a longtime AIG critic.


AIG got into derivatives in 1987. A decade later credit derivative swaps—contracts that transfer and, ideally, insure against credit risk—took off. AIG's superb credit rating helped it become a leading player. It often sold protection on other contracts, using its own sterling rating to essentially insure others' collateralized debt obligations (securities often backed by a pool of loans) against losses. Those promises would later haunt AIG. As Jamie Cawley, CEO of IDX Capital, explains: "They were able to monetize their credit rating [and] rent it."

AIG was exposed to the U.S. housing market on other fronts, too. It had a mortgage insurance business, United Guaranty, that started to rack up big losses in 2007. It also had invested in mortgage-backed securities that led to $12 billion in costs over the past year as their values plunged—money it owed to its insurance companies in order to maintain strictly regulated capital requirements. By early 2008 it was clear that the company's derivatives were eroding at a rapid clip. AIG's audit firm, PricewaterhouseCoopers, forced it to change how it was valuing the products. That caught the attention of Donn Vickrey, an analyst at Gradient Analytics, who began to question AIG's earnings quality. He went back into the company's SEC filings and chronicled the sharp declines in the valuation of its derivatives. The cumulative losses swelled from only $352 million as of Sept. 30, 2007, to $6 billion just two months later. (How big that figure is now, Vickrey says, is "unknown.")

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