The Demise of AIG: Credit Default Swaps, Subprime Mortgages, and Financial Mismanagement

AIG's Writing of CDSs on Subprime Mortgages and its Descent into Financial Mismanagement

In 2005 AIG’s writing of CDSs continued at the same pace but the nature of debt being insured turned increasingly toward consumer debt. A significantly increasing percentage of consumer debt was subprime mortgages, which did not carry any guarantee from either Fannie Mae or Freddie Mac. Concerns were surfacing about the share of subprime mortgages in the overall portfolio of mortgage-backed securities that AIG protected by writing CDSs. In the spring of 2005, AIG lost its AAA credit rating pursuant to the discovery of earnings manipulation. The rating downgrade required AIG to post collateral for its CDS portfolio. Later that year, in the fall of 2005, housing prices showed a modest decline—AIG’s descent into the subprime abyss had started.

The AIG Financial Products Unit’s revenue (from insurance premiums) peaked in 2005 at $3.26 billion, with operating income accounting for 17.5 percent of the firm’s total operating income. Unlike its many siblings in the extended AIG family, AIG Financial Products did not believe in proper reserving and capitalizing of the insurance products it was selling. As the president of AIG Financial Products so eloquently remarked:

Because of its faulty business model, AIG Financial Products misled itself, its parent, and its investors, reporting a profit margin of 83 percent in 2005, and unsurprisingly it lavished on its employees outlandish salaries and bonuses:

Mr. Cassano and his colleagues minted tidy fortunes during these highcotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Overall, AIG Financial Products paid its employees $3.56 billion during the last seven years.3

Had credit default swaps written by AIG been fairly priced? Had AIG properly reserved for potential losses? Had AIG been misled by its CDS valuation models that consistently showed a minuscule risk of default?

KEY QUESTIONS

The questions are intended to be a guideline of the relevant issues in Case: The Demise of AIG.

1. What are credit default swaps? How do they differ from traditional bond insurance issued by American International Group (AIG)?

2. Describe each step of securitization discussed in the class. Which step was played by AIG in this process?

3. How did AIG use credit default swaps to credit-enhance mortgage-backed securities? Discuss AIG’s role in the success of securitization.