The Global Credit Crisis - Essay Example

?4.2 Background On September 16, 2007, American International Group’s (AIG) share price was $63.44 per share. In its quarterly report released later that month, AIG reported assets of $1.07 trillion and 9-month net income of over $3 billion (AIG annual report, 2007). Exactly one year later, its stock price had fallen by 94% to $3.75. At the onset, United States federal officials and additional regulators attempted to access the capital markets to alleviate the liquidity crisis. Afterward, the Federal Reserve Bank’s Board of Governors declared a bailout plan to rescue AIG from a looming collapse because it feared that AIG’s collapse would be a threat to the overall state of the economy. In regard to the bailout, AIG was presented with access to a $85 billion credit facility. In exchange, the United States government was presented with warrants for a 79.9% equity stake in AIG and the power to expel dividend payments to shareholders. AIG’s misfortunes started in a unit known as AIG Financial Products, which traded in credit default swap (CDS). A CDS acts as a safeguard against a default on assets that are connected to corporate debt and mortgage securities. The losses to AIG’s portfolio of CDSs were prompted by the disintegration of the subprime mortgage1 market. A groundbreaking amount of defaults by subprime borrowers with adjustable rate mortgages initiated the current catastrophe in the global financial markets in 2008. Most of these began in 2005 and 2006 when lenders remarkably loosened up on underwriting standards. Figure 4.2: Subprime mortgage originations Source: Bradford (2008) ‘The Subprime Mortgage Meltdown, the Global CreditCrisis and the D&O Market.’ Advisen : Productivity&insight for insurance professionals. The assumption was that homeowners would refinance prior to the monthly payments being readjusted, but decreasing real estate prices made it inaccessible for the majority of subprime borrowers who had hardly any or no equity in their houses to refinance. As they were incapable of paying the increased monthly payments, many borrowers had no choice but to default. Defaults in U.S. mortgages rose beyond record levels in the second quarter of 2007, and the fallout rapidly expanded all through the financial markets. The subprime mortgage debacle immediately brought forth the worldwide credit crisis. AIG is one of the financial institutions with credit default swaps business that was also affected during these circumstances. From then on, many CDSs were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis. As those mortgage-backed securities2 and collateralized debt obligations3 became more or less valueless, abruptly that reputedly low risk event saw an actual bond default occurring on a daily basis. AIG sold CDSs were no longer taking in free cash. It had to pay out a large amount of money. The crisis at AIG is a “question of liquidity, not of capital”, according to ROB Schimek, EVP and CFO of AIG Property Casualty Group. Despite the fact that there have been a small amount of losses paid under the CDSs, contract provisions demand of AIG to post collateral in cash if the value of the assets underlying a CDS declines. At the parent level, AIG has approximately $80 billion in shareholder equity, though the majority of that is secured in the company’s insurance operations and cannot be converted to meet the collateral calls of the financial products unit. Since it did not have enough cash to meet the collateral demands, the company faced a liquidity crisis and bankruptcy protection. 4.3 What AIG actual did leaded the company go down 4.3.1 The undoing of AIG liquidity crisis AIG reported “an unrealized market valuation loss of $11.5 billion on [the] super senior credit default swap (CDS) portfolio” held by its subsidiary, AIG Financial Products in the annual report for 2007. The definition of CDSs was discussed in chapter 2.2. This initiated a drastic downfall and ended AIG’s career as an independent and triumphant corporation. The section to follow offers an overview of how CDSs are the defeat of AIG- an analytical account of the AIG development of credit derivatives business from 2003 until 2007. It looks at how the company invested and managed its default swaps. 2002 AIG’s default swaps4 were the nature of the transaction which providing protection against credit risk. In 2002, AIG was alive to the risk in the default swaps sold by the Financial Products unit. It stated that: AIGFP is exposed to credit risk. If its securities available for the CDSs were to suffer significant default and the collateral held declined significantly in value with no replacement or the credit default swap counter-party failed to perform, AIG could have a liquidity strain. But interestingly, AIG identified the credit risk it might have, and it had a committee specifically to deal with derivatives risk management named the Derivatives Review Committee. There was not a committee of directors. The derivatives Review Committee did not look into the credit derivatives business of AIGFP. It performed practically no function. Though AIG identified the credit risk of selling default swaps, but they underestimated them. In the theory, which was mentioned in chapter 2.2.4, derivative swaps can serve as very effective risk management tools, and they can also expose AIG to market risk, liquidity risk, legal risk and operational risk. Because effective risk management is essential to the long-term success of AIG, the company must consider and ultimately control all relevant risk parameters. Secondly, like a watchdog, the director is responsible for identifying the problems of the company. The task of the director (which mentioned in chapter 2.4.2) is to estimate the long-term consequences of corporate actions, and when to bring matters directly to the attention of the shareholders. The director plays a significant role on the committee. As a risk management department without a director, it means the Derivatives Review Committee is useless, and the risk of derivatives cannot be known by a top management team of AIG in due time. When AIG decided to invest in the highly risky products (CDS), there was no soundly risk management team available to estimate the risk. It would be the original undoing of the AIG future liquidity crisis. 2003 AIG formed the Capital Markets unit in 2003, and the credit derivatives business5 became implemented with this component. Originally, AIG reported a $1845 million profit and a $1086 million profit from its Capital Markets unit. The following account emulated the mood in the corporation about this business component: “Capital Market activities were the primary reason for the growth in operating income in 2003 and to a lesser extent in 2002 (Form 10-K, 2003).” Notably, AIG supplied an ample amount of information in regard to non-credit derivatives that included “all interest rate, currency, commodity and equity swaps, options, swaps and forward commitments, futures and forward contracts.” The disclosures on non-credit derivatives were more extensive and their standard was greater than those for credit derivatives. AIG appraised the “fair value” of the non-credit derivatives portfolio at $17.38 billion for 2002 and $21.6 billion for 2003, and noted that these totals displayed “the maximum potential loss” to the company. There are references to the practice of “evaluating the creditworthiness of its counter-parties” and attaining approval from the Credit Risk Committee for “particularly credit intensive transactions.” AIG then presented the credit ratings breakdown of the counter-parties for non-credit derivatives. However, similar details were not provided for credit derivatives. AIG seemingly made no attempts to assess the maximum potential loss from the credit derivatives segment. Similarly, there is also no reference to processes like pursuing approval from the Credit Risk Committee or examining of risk by the Derivatives Review Committee. AIG invested in a non-credit derivatives portfolio totaling $38.98 billin within two years. The big amount of capital invested in “the maximum potential loss” and expansive products led AIG to lose a large amount of liquidity funds, so that these funds cannot be used for aiding AIG in the liquidity crisis in 2008. As most of financial institutions, AIG also used internal credit risk models to manage its credit risk. CreditMetrics model (which discussed in chapter 2.3.3.2) is using available data on counter-parties’ credit rating, and the probability that the rating will change over the next year will calculate the assumption in order to help the company estimate credit risk. A downgrade of borrowers’ means that their ability to repay their debt has been declined. AIG uses CreditMetrics to make sure the repayment of debt ability of its counter-parties still looks well, then they invested a large amount of funds to non-credit derivatives. However, credit rating breakdown of the counter-parties for non-credit derivatives can reach the conclusion that AIG relies too much on the credit risk model, but considered less about the shortcomings of the model. In the theory mentioned in chapter 2.3.4, the CreditMetrics model has been hindered by data availability and implementation problems. It also asked users to set a judgmental basis on implementing the model. Every mistake in the data collection may lead to wrong results with the credit risk model. Regardless of whether or not AIG can get the right results by using CreditMetric, the company still cannot over rely on the theory result due to the theory always going away from reality. Failure to use the credit risk model made AIG misjudge the credit rating changed by its counter-parties. It virtually increased the risk of investing in non-credit derivatives. 2004 The basic tone of disclosures about credit derivatives in 2004 is very much alike to the previous two years, except for the following: AIG confessed that some of the credit derivative transactions were not rated by credit rating agencies, but added that it “applies the same risk criteria for setting the threshold level for its obligations (Form 10-K, 2005).” As was the case in 2003, the counter-party and the credit rating breakdowns for counter-parties were only administered for non-credit derivatives. Continued for two years, AIG provided nothing about the credit rating downgrade of counter-parties in its credit derivatives business. With the national amount for the credit derivatives segment at $203 billion, AIG should put the details about credit derivatives on its annual report or Form 10-K, so that it can give more available information to investors who want to invest in AIG derivatives. 2005 This was the most victorious year for the Capital markets unit, which dealt with AIG’s credit derivatives business. In 2005, the unit’s income grew to $2.66 billion from $662 million in 2004 (AIG annual 2006). There is no compelling alternative in the disclosures on credit derivatives except that the company noted once more, after a break of one year, that “it has never had a payment obligation under these derivative transactions.” 2006 There are no material variations in AIG’s disclosures on credit derivatives for 2006, a year in which the Capital Markets business lost $873 million. The statements on concerns such as management structure, the nature of the credit risk and management of risk persisted along the same lines of previous years, except that AIG kept mum on whether it made any payments during 2006 towards the default swaps it sold. Allegedly, the loss did not make a noticeable effect on AIG’s management. In 2006, AIG finished five years of reporting on the default swaps business. In the following year, the business noted a loss of $11.5 billion in this business, setting off the crisis. The disclosures made in the five years from 2002 to 2006 were very unobjectionable. They barely touched the surface on the consequences and risks of credit derivatives, which brought the company to the edge of its life. If these disclosures were to lead investors, it is uncertain how far they could have been forewarned about the occurrences that took place in the following years 2007 and 2008 in which investors nearly lost their investments. 2007 This was the eminent year for the default swaps business of AIG. In 2007, the company reported a total loss of $11.5 billion from the default swaps business. In its filing for 2007, AIG explained the situation arising from its obligation to post collateral (AIG annual report, 2007): AIG’s liquidity may be adversely affected by requirements to post collateral. Certain of the credit default swaps written by AIGFP contain collateral posting requirements. The amount of collateral required to be posted for most of these transactions is determined based on the value of the security or loan referenced in the documentation for the credit default swap. Continued declines in the values of these referenced securities or loans will increase the amount of collateral AIGFP must post which could impair AIG’s liquidity. The swap seller must supply collateral when the market value of the debt portfolio decrease. It makes default swaps more chancy and difficult than normal insurance contracts. Facing the huge losses in 2007, AIG made the following statements about risk management (AIG annual report, note 40, 2007): AIG is exposed to a number of significant risks, and AIG’s risk management processes and controls may not be fully effective in mitigating AIG’s risk exposures in all market conditions and to all types of risk. The major risks to which AIG is exposed include: credit risk, market risk, operational risk, liquidity risk and insurance risk. AIG has devoted significant resources to the development and implementation of risk management processes and controls across AIG’s operations, including by establishing review and oversight committees to monitor risks, setting limits and identifying risk mitigating strategies and techniques. Nonetheless, these procedures may not be fully effective in mitigating risk exposure in all market conditions, some of which change rapidly and severely. AIG accepted hefty risk in its default swaps business. Eventually, the risk proved to be uncontrollable. Overviewing the previous years default swaps business in AIG, it is not hard to arrive at the conclusion that the unsound risk management strategies of AIG are the undoing of the AIG liquidity crisis in 2008. 4.3.2 The liquidity crisis of AIG in 2008 29 February 2008 AIG announced a $11.1 billion unrealized loss on their super senior CDS portfolio. Its share price fell by 7%. Source: Anthony Asher and Curtis Heaser (2008) AIG, as the protection seller (which mentioned in chapter 2.2.3) in the CDSs business, provided the cover to the banks who lent to subprime borrowers, and took on the default risk of the reference entity. With the U.S. subprime mortgage crisis across 2007-2009, the meanings of selling CDS for AIG can be seen as the risk of a direction loan to the subprime borrowers. It is not difficult to understand how risky AIG was by staying in. The huge losses at the beginning of 2008 with falling share prices should have sounded an alarm for AIG. 12 May 2008 AIG downgraded by Standard & Poor’s6 (S&P) from AA to AA-. It is really bad news for AIG. Credit rating agencies (which was discussed in chapter 2.3.2) regularly produce information about the credit standing of borrowers, which significantly influences the cost of their credit. The company with the highest credit ratings were able to enter swaps business (include CDSs) without depositing collateral with their trading counter-parties. Nevertheless, when its credit rating was declined like AIG, the company was demanded to post further collateral with its trading counter-parties. The decline of AIG led the company to need to put over $10 billion into collateral, which was similar to the loss of $10 billion for AIG, who were in danger of liquidity strain. 15 June 2008 AIG CEO Martin Sullivan is replaced by the chairman, Robert Willumstad, who came from outside of AIG. According to the theory, which was discussed in chapter 2.4.4, the chairman is the heart of the board, the person with the ultimate responsibility for the organisation’s governance. All objectives and criteria for chairman performance should be linked to the strategy of the company, the company performance, and the board performance. It can be made sure that the basic criteria of voting in a chairman is that the chairman must have a solid understanding of the company’s performance and must be experienced enough so that he can function efficiently in the role. AIG’s chairman came from outside of AIG with less understanding of AIG businesses and less experience of managing this group. It is hard to imagine that Robert can turn assisting company to contribute as incisively as possible to the work of the board. There is a loophole of AIG’s corporate governance, especially for AIG, who was in a very critical period. 6 August 2008 AIG announced a further $5.6 billion unrealized loss on their super senior CDS portfolio in the first quarter. AIG could take default risk (which was discussed in chapter 2.2.4) by both reference entity and their counter-party. However, they can earn money from the periodic payment from their counter-parties during the term of the CDS and do not have to make any payments unless a specified credit event occurs. The motivations of AIG were to benefit from a higher yield, which is offered by protection buyers in CDSs. After losing big money, AIG announced for a second time in 2008, that it indicted that AIG underestimated the risk of CDSs, and they traded CDSs business over focus on the benefit of gaining exposure to a credit that is not otherwise available. However, the top manager team of risk management in AIG still did nothing to aid the company, who was going down. It exposed the shortcomings of risk management in AIG. 12-15 September 2008 S&P lowers their rating from AA- to A- (A three level drop) based on ‘reduced flexibility in meeting additional collateral needs and concerns over additional residential mortgage related losses’. The impact of S&P and other ratings agencies declined, triggering clauses requiring AIG to find a further $10 - $15 billion of collateral. AIG share prices fall by 31% during a single day. Source: Asher and Heaser (2008) Standard & Poor’s lowers AIG’s credit rating again due to the combination of reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses. The downgrade forces AIG to raise an additional $14.5 billion in collateral to meet its obligations to counter-parties. Unable to do so, AIG faced a liquidity crisis. Credit ratings dropped three levels; also, this is the main reason that led to AIG’s share price falling rapidly. 16 September 2008 The Federal Reserve Bank of New York lent up to $85 billion to the American International Group (AIG), in a plan aimed at saving the insurer from a "disorderly failure" that could damage the global economy. As part of the deal, the government received a 79.9 percent equity interest in AIG. AIG share price fell 21%, and the company suffered a liquidity crisis. Source: Anthony Asher and Curtis Heaser (2008) 4.4 An exploration of AIG enterprise risk management According to the ISDA7 (2009) report, the accepted insight concerning the near?collapse of AIG is that the company's financial issues were greatly due to its use of credit default swaps. These issues could have been prevented if only its derivatives endeavors had been properly managed. In fact, AIG's financial difficulties can be attributed to serious shortcomings in risk management. The following part will focus on the AIG enterprise risk management. AIG notes on the company’s 2007 10-K that its “major risks are addressed at the corporate level through enterprise risk management, which is headed by AIG’s Chief Risk Officer” Martin Sullivan8 states that there are four components of enterprise risk management at AIG, which were credit, market, operational, and liquidity. 4.4.1 Oversight by CEO/Senior management According to the annual report (2007), there were many statements that demonstrated an awareness of an AIG liquidity crisis: “AIG’s liquidity may be adversely affected by requirements to post collateral. Certain of the credit default swaps written by AIGFP contain collateral posting requirements.” “Certain OTC derivatives trade in less liquid markets… and the determination of fair value for these derivatives is inherently more difficult.” “If AIGFP sells or closes out its derivative transactions prior to maturity, the effect could be significant to AIG’s overall liquidity.” However, the Credit Risk Committee or the monitoring of risk by the Derivatives Review Committee did not heed to the presented risks. They underestimated the extreme events that would be the crucial reason that led to AIG suffering in the liquidity crisis. Secondly, AIG risk management committees either did not foresee or did not clearly communicate the possibility that the unrealized losses on the CDS lead to a liquidity crisis. Lastly, AIG’s corporate governance (which was mentioned in chapter 2.4) was weak. Boards of AIG had a task to identify the types and degrees of risk that AIG was willing to accept in pursuit of its goals. There are three functions of boards, which are: control function, service function and source dependence function. CEOs and boards exercised near-complete control over AIG; however, AIG’s boards did not implement their function, which can be seen as intangible factors that led to AIG going down. 4.4.2 Underestimate risk As CDSs are the risky insurance products, most banks and hedge funds would buy CDS protection and then sell CDS protection to someone else at the same time. When a bond defaulted, the banks might have to pay some money out, but they would also be getting money back in, so that they netted out. According to ISDA, “AIG was unique among large CDS participants in that it ran a “one way” book consisting almost entirely of sold protection, in contrast, maintain ‘matched books’ that balance sold with bought protection so net exposure is low.” According to the theory, which was cited in chapter 2.2, the one fundamental reality of CDSs is that they cannot eliminate risk for protection buyers; they merely shift it around. As a result, when the credit cycle turns and default rates rise like in the U.S. subprime mortgage crisis, AIG must lose money. AIG risk management should have known these before they invested huge funds into CDSs market. Unfortunately, AIG was overconfident that their CDS they invested could bring quick profits to the company, due to AIG’s risk management team underestimating the risks of CDS. AIG was on one side of these trades only: they sold CDS, but never bought them. As a result, AIG lost the opportunities to find a trade-off measure to decline the risk of doing CDSs business. Credit risk can be seen as the most important risk of trading CDS for AIG. As a protection seller, AIG has to face both the risk of loss due to the default of a reference credit asset and risk of loss due to failure by the counter-party to a CDS contract. It is risky enough for AIG in CDSs business. It is necessary to AIG to do both sides of the CDS trade, and also to use the appropriate risk management approaches to estimate their risk of CDSs. 4.4.3 Avoiding credit risk relied on credit risk models When AIG invested in the risky products-CDSs, internal credit risk models were used by AIG’s risk management team to control its credit/default risks, which included CreditMetrics, KMV Porfolio Manager™ (KMV), Credit Portfolio View™ (CPV) and CreditRisk+™. The discussion about these four credit risk models were in chapter 2.3.3. AIG credit risk modeling is an important building block of the internal economic capital framework. The company believes that credit risk modeling will allow them in the coming years to increase the risk adjusted performance on their investment portfolios. As risk modeling is a centerpiece of enterprise risk management, it is necessary for AIG to employ models they feel are most suitable for a given level of risk. In theory, AIG used the four internal credit risk models exactly. Because using credit risk models can lead to risk, managers are being more able at identifying areas that are contributing to credit risk. Using comparisons of credit risk models founded on standard portfolios, it seems that models can be considered a reasonable internal tool to asses. Compared to CreditMetric, CreditRisk+ and Credit Portfolio View, it was concluded that these models were built on common grounds. The main factor that led to result differentiation was the parameterization of the default behavior among different assets. However, according to the theory from 2.3.4, there are many limitations or shortcomings in the four models. These models have been hindered by data availability and implementation problems. It is difficult to set on a judgmental basis by AIG. It is a big challenge for AIG to implement the credit risk models and get accurate results. When the results came out, AIG should not have used them in investment portfolios as soon as they had. Due to the results from credit risk models theory results, there are many distances from reality. AIG chose to make a bad investment decision by relying too much on a credit risk modeling to expose itself to mortgages that went sour. The acute liquidity crunch, triggered by AIG's credit rating downgrade, which ultimately led to AIG's bailout is attributable to AIG's failure to assess the risks of CDSs. Seemingly enough, AIG put too much dependency on a credit risk model that did not sufficiently account for both the decrease in the mortgage market and a downgrade of AIG's credit rating. 4.5 Chapter summary This chapter has presented findings and analysis that were provided from the method laid out. Analysis of the finding results has been carried out with academic theory and practical results together via critical evaluation of American International Group. Read More