AIG's 2003-2007 Behavior Was An Expression of Bad Monetary Policy

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In October 1998, just as the mania was frothing into the dot-com bubble, a company named BrightPoint had the unenviable task of reporting an expected one-time charge of between $13 and $18 million in one of its British units. Concerned about how that would affect the stock price, BrightPoint management began to seek out "financial" advice. That December, it was learned the loss in the UK might be actually closer to $29 or $30 million, so senior corporate managers enlisted the services of the National Union Fire Insurance Company of Pittsburgh.

At the Loss Mitigation Unit (LMU) of National Union Fire, BrightPoint obtained $15 million of "retroactive" insurance that covered all of the additional UK losses. At the same time, the LMU and BrightPoint opened a "fidelity coverage" policy which was designed to avoid scrutiny with auditors. BrightPoint would pay monthly premiums on the policy that would total the expected loss payout on the retroactive insurance. As a result, BrightPoint booked an $11.9 million insurance receivable in the fourth quarter of 1998, reducing its UK losses back to the previous estimate.

Of course, this was an improper transaction amounting to nothing more than a cash loan from the LMU to "smooth" earnings. BrightPoint would still have to take its loss, but now in the form of monthly "premiums" rather than all at once. For its trouble in fronting the money, National Union Fire obtained a fee. What was really a loan took advantage of accounting conventions to fool investors and regulators.

In October 2001, BrightPoint became the subject of an inquiry from the SEC that directed auditors to more closely scrutinize this "insurance" arrangement. By January 2002, BrightPoint was restating its results to reflect that insurance premiums paid on the retroactive policy were only deposits that were eventually returned in full. The corporate parent of the "guilty" (they never admitted guilt, but paid a $10 million fine) insurer was AIG.

Only a few years later, AIG was back in the sights of the SEC enforcement division, this time related to financial advice given to PNC Bank. AIG, through its Financial Products division, had developed and marketed Contributed Guaranteed Alternative Investment Trust Securities (C-GAITS), catching the interest of PNC's Financial Services Group. AIG would collect a fee to create a Special Purpose Entity (SPE) to "purchase" volatile or troubled assets. AIG represented that the SPE would not have to be consolidated under GAAP rules, and thus would spare PNC any losses or charges to income statements.

As AIG set it up, PNC would receive preferred shares in the SPE in exchange for the "bad" assets plus some cash. AIG would then take the cash and purchase a 30-year zero coupon note paying an amount equal to the original PNC investment. AIG would then receive separate preferred and voting shares in the SPE, and the cash AIG contributed would be used to buy highly-rated securities. AIG would keep all the dividends and interest on those purchased instruments through a dividend paid by the SPE to AIG. Further, AIG would receive a management fee.

Since this amounted to a structured pass-through (AIG was simply receiving the same exact compensation it would have if it invested its cash "capital contribution" itself) there was no basis for treating the SPE as a nonconsolidated entity. PNC entered into three of these C-GAITS, sheltering $762 million in assets improperly off its balance sheet. AIG received $39.82 million in fees in the three transactions.

In 2004, AIG would pay $126 million in penalties and disgorgements.

Around the same time AIG was peddling C-GAITS, it was engaged in re-insurance "scams" with General Re. Reinsurance is a common occurrence in the insurance business as a means of spreading risk beyond a single insurer structure. It creates economic opportunities for one insurer to "earn" fees on its credit ratings, and allows another insurer to better manage its risk profile or portfolio.

Reinsurance business has evolved into several specialty products, including something called "finite" insurance. Here, the insurer "buys" a finite policy from a reinsurer for a very large premium, typically an amount equal to the payout value of the policy, spread over several years. The reinsurer gains premiums large enough that there is no real risk, and the insurer gets to spread the premiums out over several years and thus any potential losses. The insurer gets its premiums back at the end of the contract, making it more like a loan than an insurance policy. But in terms of "capital" treatment, it makes a huge difference.

There are legitimate uses for finite insurance, but in the General Re/AIG policy in 2000 and 2001 the setup was reversed. AIG took over the obligations on $500 million in finite insurance bundles while at the same time General Re transferred $500 million in premiums (and got a $5 million fee for the transfer). This was unusual because, in the finite insurance setup, AIG would have to repay $500 million back to General Re to close out the policies.

But AIG accounted for this loan as revenue (it was insurance premiums, after all), and applied the funds to its loss reserves. Stock analysts had been questioning AIG's reserve balances and the stock had sold off in light of those concerns. The finite insurance setup allowed AIG to turn a loan of cash and transfer of policy obligations into "capital".

From 2001 to 2003, AIG subsidiaries were also selling in-the-money covered calls on municipal bonds in their investment portfolios. Since these bonds had unrealized appreciation, AIG's subs would use forwards and swaps to reacquire any bonds that were called away. This allowed the company to recognize net investment income rather than capital gains. During those same years, AIG sold muni bonds at market value to third party brokers, who turned around and sold the same bonds to a trust established by the broker. The trust would then issue debt instruments to third parties to pay for this swap, with AIG holding an option to return them. The trust should have been consolidated but was not.

The common theme throughout all of these deals, and a great deal more that I haven't the time nor space to detail, was "capital" management. In some cases AIG was reducing the risk it showed to outside perceptions, and in others it was gaining a fee for allowing third parties to rent its capital or ratings strength.

There was another form of this type of activity that was common in the insurance business, called "side letters". The setup was largely the same as finite insurance in terms of a reinsurance arrangement, except here the insurer would provide a side letter to the reinsurer stating that they will never have to pay. The reinsurer has to book the policy and take the liability or capital charge, but it does so in the knowledge that is the worst outcome since the side letter alleviates any further loss liability. For its trouble, the reinsurer is paid a fee, and the insurer gets to present a more fortified balance sheet.

In essence, the insurer is renting capital or balance sheet strength from the reinsurer. It is entirely devious, but the "loan fee" is a good enough spread to take the regulator risk.

Right around the time AIG was receiving these repeated wrist slaps, without ever denying wrongdoing, AIG's Financial Products division decided to lead the evolving finance system into a new age. The unit had already been at the leading edge of derivatives trading, but there was, in the bustle of a forming housing bubble, opportunity to turn their experience in the nascent credit default swap business into much larger "capital".

There was a huge potential market for this type of derivative, particularly from European banks participating in eurodollar markets. The credit default swap, from AIG's perspective, was really nothing more than reinsurance with a side letter. Given the modeled expectations of risk, AIG was collecting premiums on swaps it thought would never pay out. The CDS was essentially renting AIG's ratings strength in volume, leaving the other nickel and dime scams behind in the legitimacy of London trading operations.

By 2005, the trading unit's revenue had more than quadrupled to $3.3 billion. Profit margins were an unbelievable 83% that year, and the client base of the CDS traders included pretty much every megabank and pension fund in the burgeoning mortgage bond market. They paid a nice fee to "control" their risk through "insurance" written on the strength of AIG's insurance business and capital structure. And none of it was on the balance sheet, except, of course, the positive "capital" of those CDS premiums AIG collected through London.

At the same time, AIG also transformed itself into a major securities dealer where it could also take advantage of the insurance subsidiaries' conservative appearances. In 2001, AIG lent $10.6 billion in securities belonging to its two insurance subsidiaries into the marketplace. In consideration for those lent securities, mostly corporate bonds, AIG would receive 102% in cash collateral. It would then, through its Global Investment Group, invest the cash collateral in some kind of highly liquid structure. The collateral lending service earned a small spread, increasing the insurance company portfolio's return efficiency.

By 2004, AIG was engaged in about $50 billion in securities lending. However, returns on simple and liquid reinvestment of cash collateral received were paltry, at best, thanks to the Fed's then-record low interest rate policy. In response, cash collateral was increasingly reinvested in residential mortgage bonds and other structured products. In other words, it was turning the conservative investments of the insurance units into the means to borrow very short-term funds with the intent on earning the "low risk", relatively high returns of the RMBS market. In short, it was another way to replicate the approach of the default swap business.

By the end of 2007, the cracks had already appeared in the façade. Securities lending had risen to more than $80 billion (on the books), but the value of the collateral investments (those mortgage bonds) had fallen to $76 billion despite the overcollateralization. In other words, the Global Investment unit had lent out $82 billion in insurance-owned bonds, but only had $75.7 billion (at then-market values) in securities to sell to pay back the loans.

It spent much of early 2008 trying to get out from under both the securities lending mismatch and the credit default swap mess. The collateral calls on the default swaps were pressuring every unit, yet the Global Investment Unit was increasingly behind in freeing collateral already used to build the RMBS portfolio. By the end of the second quarter of 2008, AIG had reduced its security lending line to $75 billion, but now only $59 billion in were left invested against it.

Moving into September 2008, at the very same time Lehman was wrestling with insolvency, AIG was hit with collateral calls it could no longer meet. Counterparties were shunning not just AIG's regular financing channels (the company was rejected repeatedly in attempts at selling commercial paper through both the parent and some of the subs) they were also unwilling to even hold the collateral lent out from the insurance portfolios. Banks normally very friendly suddenly began returning the securities and asking for their cash back; since the cash was invested in largely illiquid securities at that point there was no hope but the Federal Reserve.

There is a tendency, as we review these events of five years ago, to limit the scope to the proximate problems at these firms like AIG. It was credit default swaps and securities lending hubris that should have destroyed AIG in the end (but for the Fed it was not the end of AIG), however there are bigger considerations that are perhaps more important. We have to account for the processes at work that would turn AIG from a true insurance company into such a gambler. In 2007, the company had 116,000 employees, yet it would be defined in total by the 377 at the Financial Products division in London.

This is beyond even the artificial imprints of interest rate targeting. There is no doubt that the Fed's stimulation attempts in the first housing bubble of 2003-07 played a direct role in both this AIG transformation and the larger imbalance of financialization. AIG's behavior in searching for yield is a direct result of rate suppression, leading to a growth in securities lending and then a change in collateral investment. Neither would have taken place, or at least would have occurred at far smaller scales, had risk been accurately priced for decent and matching returns on "boring" investments.

What is perhaps less obvious are the exchanges in the insurance business that established the means and structure for all of this to take place. AIG was renting "capital" to other banks (and businesses) because "capital" was a fuzzy notion, a product of accounting rules and conventions. There was no money in any meaningful sense anywhere to be found. AIG could make PNC look less risky because capital wasn't really capital.

Under a true monetary standard, these gimmicks are drastically reduced (though they can never be entirely eliminated) because they are comparatively uneconomical. AIG could not (warning, I am engaging in counterfactuals) have written $500 billion in credit default swaps based on nothing more than its rating. At some point the market, in a real monetary standard, would have seen the massive disparity between promises to pay and the ability to pay based on real reserves.

In reality, there will always be bad actors, but the fact that this kind of behavior became systemic is important. This is not just romanticizing about the past. AIG stopped being an insurance company, at the margins, providing a societal "good", and started being a hedge fund for its own good. Proprietary trading is the inevitable result of a moneyless system because incentives all skew in that direction. AIG, the insurance company, certainly acted in its own self-interest as an insurance company, but that impulse is at least closely aligned with the goals of the real economy because capital was scarce and real. In other words, it had remained an insurance company because there was no other option for the same profitability - returns on investing real money in a straightforward manner were more than enough.

This is not just the lack of transparency, it is a lack of understanding about what "money" has become. The flood of paper in the past forty years opened financial markets to this kind of comportment, even encouraging it as the expression of monetary policy. AIG stepped out of the sleepy insurance role because the opportunity cost had grown high enough to engage in other kinds of businesses.

Financialization has been the overriding goal of monetary policy since before money was banished to history. Firms, even stodgy insurance concerns, will respond to incentives. If those incentives produce tragic results, we should at least evaluate whether the incentive system was properly engaged in the first place. We surely find AIG's behavior in the past fifteen years to be abhorrent, but it has hardly been an outlier.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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