How AIG Impacts The World

Let's not pretend anymore, many people don't know how or why the demise of AIG affects the financial world. Let's try and cut to the chase.

Why: Its right at the epicenter of the financial troubles. Investment banks have been forced to take back a lot of CDOs and related papers onto their books. These banks have been writing down these papers religiously and has affected their profits for the past 2-3 quarters and probably another couple of quarters ahead. Many corporate bonds and CDOs have a sub market called credit default swaps (CDS). These are basically to insure in case the bond is not repaid in full. Guess where the bulk of these CDS end up. That's right, AIG. In other words, the provision of default insurance on mortgage-backed securities through a range of derivative contracts is what AIG is in trouble for. When you book the premium (insurance) and the stuff hits the fan, you have to pay up. Right now, AIG still has a lot of cash, but investors are now calculating how the company is going to pay these CDS.

What Is AIG: It is the world's largest insurer by premium income, with a franchise that includes the best China exposure; owns the world's biggest aircraft leasing company with a fleet worth almost $US50 billion; is a crucial debt market insurer; and is a significant US general insurer, with major market share in workers compensation and car insurance.

How It Came About: AIG shares traded at a 12 month high of US$59. Last Friday it closed at US$12.14. On Monday, it opened at US$7.12 (oops) and closed at US$5.15. Today it has lost another 36% from yesterday's close. The triggers were the Lehman's collapse and Merrill's move to be absorbed, plus the downgrading by 3 research teams: Citigroup, Merrill Lynch and S&P. This was thought to be a precursor to major ratings firms downgrading AIG's debt in the near term. Following that, S&P, A.M. Best and Fitch have all downgraded AIG's credit ratings. Moody's has just followed suit.

Recent Results: AIG has suffered US$18.5bn in losses in the past three quarters. AIG will now have to sell its Transatlantic Holdings reinsurance group, its consumer finance group, its financial products division, and a leasing unit. Medicine: New York’s governor David Patterson announced, in a relaxation of insurance regulations, that the giant insurer AIG will be able to tap its own subsidiaries for a US$20 billion loan, or about half of what most observers believe the company needs to salvage itself. Much of its exposure is related to credit default swaps, insurancelike contracts tied to corporate defaults. AIG's counterparties on these instruments include Wall Street firms, which may have an incentive not to immediately demand more collateral so as not to trigger a wider panic. AIG has been scrambling to raise as much as US$75 billion to weather the crisis, and people close to the situation said that if the insurer doesn't secure fresh funding by Wednesday, it may have no choice but to opt for a bankruptcy-court filing. JP Morgan and Goldman Sachs are stepping up to help round up the shortfall from international lenders. Chances are good that they will succeed.

How Bad: As at June 30, AIG had US$20 billion of subprime mortgages marked at 69c in the dollar and US$24 billion in Alt-A mortgages (the next step up from subprime), valued at 67c in the dollar. Days before its holding company filed for bankruptcy on Monday, Lehman told its shareholders that it was valuing similar subprime and Alt-A exposure at 34c and 29c in the dollar respectively. The gap between AIG's valuations and Lehman's is worth almost US$14 billion to AIG.
Thats just subprime mortgages, AIG also has collateralised debt obligation (CDO) assets that AIG values at US$58 billion. If you take a 50% whack at that, that's another US$29 billion. Total impairment potential: US$43 billion and counting.

Why Not The Fed: The company I am sure would have seeked help from the Federal Reserve, but the Fed is seen as having limited authority to help AIG, which is not regulated by the Fed. The fact that Paulson and Bernanke have allowed Lehman to file for bankruptcy and Merrill giving up the notion of trying to stay afloat independently, shows clearly that the Treasury and Fed have drawn a line on bailouts - which is bad news for AIG, but economically correct medicine for a capitalist market place.

How Bad (Really): If AIG is to fail, it poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds. AIG touches every single sector of the financial spectrum. Funds and investors who bought these CDS, who thought they had insurance (and now needs it because the chances of these mortgage-backed securities failing is very high), will now be faced themselves with no insurance. Its like insuring your home fo fire, paying the premium and your house getting burnt down and the insurance firm went belly up. So if AIG collapses, which means their assets cannot serve their overall liabilities, you'd be staring at getting only a small fraction of what was covered. If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.’s credit default swaps may be unable to collect on their trades. More failures, particularly of hedge funds, could follow.

Ramifications: AIG is a huge employer, about 30,000 staff. Other funds which are badly affected may then be forced to sell down other "good assets" such as emerging market shares, commodity exposure, etc. resulting in what we now call collateral damage. CDS - Derivates like futures, options and swaps were developed to allow investors hedge risks in financial markets - in effect buy insurance against market movements. However, when firms take them onto their books and ignore their leveraged effects, derivatives can decimate even the biggest insurance firm. The profits and losses from derivates deals are booked straight away, even though no actual money changes hand. In many cases the real costs hit companies only many years later.

Unlikely Hero: I expect Warren Buffett to step in soon to take a huge stake in AIG. He is likely to do so AFTER the US$75 billion lending facility has been secured. Buffett is an investor and also knows that he may have to play a special role to help the US and global economy to stave off a major crisis. He will have to get AIG at a very good price and need to know that the full extent of CDS are properly covered. He also knows that his entry will bring back the confidence that has been shattered in financials. Sometimes its more than just making a buck. This time, he can make a buck and also be regarded as a hero of sorts - I cannot see him not participating. He knows insurance very well, he likes that sector, he wants a decent exposure into China insurance, AIG is #1 in the world, he knows value, and he has been at talks a couple of times over the last few days with AIG people and the big guys as well. He should be acting soon.

Final Word: Though it looks bad, I see a very good chance of JP Morgan and Goldman Sachs in coming up with the funds to lend to AIG. AIG shares are still falling, and will continue to fall until the funds are secured and/or a hero-buyer like Buffett emerges. Right now, AIG shares is dominated by day traders and short sellers, hence it will be volatile with a downward bias. The rippling pessimism will continue till the air clears for AIG. This will be a volatile week, but I think markets will turn positive by Thursday and Friday. Of course, if the funds do not arrive, AIG will be in bankruptcy mode by tomorrow, and the downside for all markets will be very severe. We will be looking at a severe global recession then. This has a minor chance of happening, but we should at least know how bad it can get if it happens.

p/s photos: Vivian Hsu & Vivian Chow