Poor old Martin Sullivan and AIG

AIG is primarily a collection of life and property and causality companies. They are highly regulated. The issues that took over AIG stemmed from providing what are called credit default swaps. These are like an insurance policy that guarantees to pay an agreed amount if a company or financial structure fails to perform as expected. AIG wrote a great deal of these guarantees supporting the housing market. There was tremendous amount money (trillions) that supported and provided the cash for all the US home equity loans and new home loans over the last 10 years that were packaged up and sold to investors. AIG wrote these guarantees or default swaps on a large number of mortgage backed loans so that investors would feel safer in buying them. Everything worked well.

Housing can't be outsourced to India and since a big portion of everything you and I buy now comes from China, it was about the only major commerce being done in the US. Everybody took cash out of their house (refi) or borrowed up to the hilt to buy all those nice things the Chinese wanted to ship over, (Aqua Dots). Financial institutions are like all companies and they wanted to grow so they started doing sub-prime lending when the market got saturated and the prime market didn’t grow as fast. The government saw this as good for the people and kept interest rates low to prime the pump. The Wall Street firms figured out a way to package these sub prime loans as well and AIG put a credit default wrapper around them and off they went to be sold to investor’s world wide. The rating agencies liked the fees so they bought off on some highly structured financial engineering and gave the bonds a AAA or AA rating. AIG was OK as long as there was secondary market for their guarantees. With out a secondary market AIG couldn't value the contracts they held on their books. When the government took over the extremely highly leveraged Fannie Mae and Freddy the world financial markets became very nervous and the flow of money between institutions dried up. This caused the secondary market for credit default swaps to halt. Proper accounting required AIG to write the value to zero. That caused a paper loss. It wasn't cash. When AIG took the write downs on their books the rating agencies down graded AIG which triggered a collateral call on all the guarantees AIG had issued to investors in the mortgage loans so that someone could put a pool in and buy a plasma TV made in China. AIG is a huge company with lots of cash flow from its business but the severity of the collateral calls out stripped their ability to continue to post the required collateral. They were about to file bankruptcy when the government agreed to loan them $85 billion for two years at 11.5% interest. If they had failed many other companies would have failed in a row just like a line of dominoes. As it is about 100,000 employees will probably lose their jobs at AIG and if it had failed it would have been 10 times this number.

So why did AIG take on so much risk? First the financial engineers thought they could out smart dumb lending decisions. The country was hungry for growth and refinancing home equity loans propelled consumer demand. The Fed kept interest rates low and every body was happy. But guess what, the financial engineers were wrong and defaults started percolating in the sub prime assets. The bonds starting having trouble. AIG was writing a great deal of this because they thought they could trade out the risks and the brilliant quants had it all figured out. They get bonuses on trades and they snookered poor old dumb Martin Sullivan. He was a property man and couldn’t tell a good trade from a bad one. He had no clue but he was determined to prove he could run AIG and make money like Greenberg. Traders need to be held on a tight rein and he didn’t get it. He let them do their magic so he could show profits. The problem with these financial market guys is given a free hand they will bet the house every time. The CFO was just a guilty and that is why they relieved him of his position but interestingly they didn’t let him go. I am only guessing but he probably tried to act like he knew what was going on and took the side of the quants against the auditors. I am still guessing but he probably needed to be removed because the auditors couldn’t work with such an inept and weak CFO in a cheap suit.