The Bailout of AIG and the Securities Lending Business: A Double Death Spiral

The TARP Oversight Commission run by Elizabeth Warren has issued a report on the bailout of AIG back in June.   The Report did not get much attention but it is well worth the read (all 300 pages of it).  We thought we would mention a few interesting points that came out of the Report.

First, the crisis at AIG was likely precipitated by AIG Financial Products (AIGFP), the subsidiary responsible for writing the credit default swaps on the housing securities.  What is astounding is the relatively small number of contracts that brought down the company.  As the Report noted on p. 30:

• Only $149 billion, or 6 percent, of AIGFP's total derivatives portfolio in 2007 was classified as Arbitrage CDS, comprised of both the multi-sector CDO and corporate debt/CLO components.  Ultimately, these two portfolios accounted for 99 percent of AIGFP‟s unrealized valuation losses in 2007 and 2008.  AIGFP's multi-sector CDO subset of the Arbitrage portfolio, which represented approximately 3 percent of the notional value of AIGFP's total credit and non-credit derivatives exposure, accounted for over 90 percent of these losses. Ultimately, these losses were driven by just 125 of the roughly 44,000 contracts entered into by AIGFP.

In other words, AIG was brought to its knees by a portfolio representing only 3% of the national value of all derivatives and more specifically by only 125 out of 44,000 contracts entered into by AIGFP.  

Second, AIG was not just addressing the losses associated with the swaps written by AIGFP but was in a "double death spiral" as a result of its securities lending practices.  AIG lent out securities owned by its insurance subsidiaries.  The loans were done by a single subsidiary (AIG Securities Lending Corp), effectively centralizing the process.  As the Report notes, security lending is ordinarily a low risk proposition, with loans of stock collateralized with cash that is typically invested in liquid securities such as Treasuries.  

AIG's program, however, was, as the Report notes (p. 43), "unusual in two ways."  First, the collateral was increasingly invested in residential mortgage-backed securities (RMBS).   "At the height of AIG's securities lending program in 2007, the U.S. pool hled $76 billion in invested liabilities, 60 percent of which was in RMBS."  This was done, unsurprisingly, with the "intention of maximizing returns."

Second, AIG started to accept less collateral for the loans.  As the Report noted:

• In normal circumstances, securities lending counterparties would be required to post collateral of 100 to 102 percent of the market value of the securities they borrowed, as specified by state insurance regulators. But when unregulated companies started to lend securities under terms that included lower collateral requirements, AIG determined that lower collateral amounts were necessary to compete in the market, with the AIG parent company making up the difference and posting the collateral deficit up to 100 percent.

As the crisis at AIG deepened, customers began to insist on closing out their positions and obtaining a return of the collateral.  The Report notes that these demands reached $24 billion between Sept. 12 and Sept. 30, 2008.  AIG found itself in an increasingly illiquid market and with growing losses on the securities.

The cash demands from the obligations on the swap contracts and the closing of securities loan contracts created the double death spiral.  Moreover, once receiving government largess, a significant portion of the money ($20.9 billion) was funneled to insurance subsidiaries as capital contributions in part to help them meet their obligations under the securities lending program. 

The report suggests serious concern about securities lending operations and the need for regulation or at least disclosure.  The matter was primarily subject to state supervision since the securities came from the insurance subsidiaries.  State regulators could and did intervene in the lending practices associated with the subsidiaries in their jurisdiction.  Nonetheless, they lacked the means to supervise the problem on a company wide basis.  Moreover, while the securities lending problem was brought on in large part by the failing economic health of AIG due to the activities of AIGFP, its not hard to imagine other circumstances where spooked investors would lose confidence and seek a return of their collateral.