Over the years, AIG built upon its premier global franchises in life and general insurance by expanding into a range of financial services businesses. One of these, created in 1987, was AIG Financial Products Corp. (AIGFP), a company that engaged as principal in a wide variety of financial transactions for a global client base. In 1998, AIGFP began to sell credit default swaps to other financial institutions to protect against the default of certain securities. At the time, many of these securities were rated AAA, the highest rating possible. However, in late 2007, as the U.S. residential mortgage market began to deteriorate, the valuation of these securities declined severely. As a result, AIG recorded significant unrealized market valuation losses, especially on AIGFP’s credit default swap portfolio, which led to substantial cash requirements.
At the same time, AIG reported large unrealized losses in its securities lending program. Through this program, AIG made short-term loans of certain securities it owned to generate revenues by investing in high-grade residential mortgage backed securities. These and other AIG real estate-related investments suffered sharp decline in fair value as well.
It is important to reiterate that throughout the crisis, AIG’s insurance businesses were—and continue to be—healthy and well capitalized. The losses that occurred as a result of AIGFP’s actions have no direct impact on AIG policyholders. AIG’s insurance companies are closely regulated, and their reserves are protected with adequate assets to meet policyholder obligations.
The collapse of respected financial institutions such as Bear Stearns and Lehman Brothers sent shock waves throughout the world economy. The crises at the U.S.-sponsored mortgage companies Fannie Mae and Freddie Mac added to the financial disruption. Credit markets deteriorated rapidly, making it virtually impossible to access capital. In September, AIG’s credit ratings were downgraded once again, triggering additional collateral calls and cash requirements in excess of $20 billion. Although solvent, AIG suddenly faced an acute liquidity crisis.
Because of its size and substantial interconnection with financial markets and institutions around the world, the government recognized that a failure of AIG would have had severe ramifications. In addition to being one of the world’s largest insurers, AIG was providing more than $400 billion of credit protection to banks and other clients around the world through its credit default swap business. AIG also is a major participant in foreign exchange and interest rate markets.
To stabilize AIG and prevent reverberations throughout the economy, the FRBNY extended to AIG a two-year emergency secured loan of up to $85 billion on September 16, 2008. The credit facility carried a rate of LIBOR (the London Interbank Offered Rate—a widely used benchmark to set short-term interest rates) plus 8.5 percent, a commitment fee of 2 percent on the loan principal and a fee on the undrawn portion of 8.5 percent. Additionally, the U.S. Treasury would be entitled to 79.9 percent equity ownership of AIG through preferred stock.
With the Federal Reserve Bank of New York (FRBNY) loan in place, the management team developed a plan to sell many of AIG's leading businesses around the world to pay back the FRBNY loan with interest. However, with this divestiture and restructuring plan in place, AIG still had to address its two principal liquidity issues: the multisector credit default swap portfolio and the securities lending program. On November 10, 2008, AIG and the FRBNY announced a comprehensive plan to address AIG’s liquidity issues and provide more time and greater flexibility to sell assets and repay the government. The plan included the creation by FRBNY of two financing entities, Maiden Lane II and Maiden Lane III, to acquire AIG’s securities lending assets and the multi-sector collateralized debt obligations that were guaranteed by AIGFP’s credit default swaps. The entities were funded primarily by the FRBNY, with a subordinated capital contribution by AIG. Under the terms of the agreements, the majority of any appreciation in the securities held by the entities would go to the FRBNY, but a portion would be retained by AIG.
In addition, the U.S. Department of the Treasury (U.S. Treasury) purchased, through the Troubled Asset Relief Program (TARP), $40 billion of newly issued AIG perpetual preferred shares. The proceeds were used to pay down a portion of amounts then-outstanding of the FRBNY loan. The perpetual preferred shares carried cumulative compound dividends at 10 percent per year.
Although Maiden Lane II and III and the government’s equity injection significantly relieved AIG’s liquidity pressures, the world economy in general and the financial industry in particular continued to falter. Asset valuations continued to decline and AIG’s losses increased through the end of the year, taking a heavy toll on fourth quarter results.