The American International Group Situation

The American International Group Situation Contents Table Introduction The following pages will focus on analyzing the American International Group in the context of the current financial crisis that is affecting the world, and on discussing whether the financial support received by the AIG Group from the U.S. Treasury was justified or not. In order better understand the reasons that led to this situation, it is necessary to discuss the general causes of the financial crisis and its chronology. The financial crisis began in 2006, when the United States real estate market began to face the issue of declining prices. In the spring of 2007, New Century Financial corporation decided to stop granting new loans, like high risk mortgage loans to individuals that did not normally qualify for this kind of loans. As a consequence, the U.S. home mortgage market starts to weaken.[1] A few months later, Wall Street is alarmed by Bear Stearns' situation that shows bankruptcy signs because of extensive investments in mortgage- backed securities. The U.S. defective real estate market starts to affect a few German banks with bad investment policy. In the summer of 2007, the U.S. government intended to intervene in the crisis, but the U.S. President George W. Bush rejected the plan. The rest of the year of 2007 was characterized by the following aspects: the U.S. Federal Reserve influences the interest rate in order to decrease, Bank of America acquires Countrywide Financial, interest rates reach 3% after Fed intervention. In 2008, the Lehman Brothers investment bank declares bankruptcy. The AIG insurance group is bailed in September. In October, the U.S. Senate adopts the massive bail-out plan. Introduction to Subprime Mortgage Crisis The subprime mortgage crisis is generally characterized by contracted liquidity in global credit markets and banking systems. The main causes of the subprime mortgage crisis are: housing market boom, speculation, high risk mortgage loans policies, securitization practices, inaccurate credit ratings, government policies, central banks policies, financial institutions debt levels.[2] The years before the crisis were characterized by low interest rates and large inflows of foreign funds, which led to easy credit conditions, further leading to the current financial crisis. The demand for housing significantly increased, and so did the home ownership rate, reaching 69.2%. The increasing demand obviously led to increasing prices and consumer spending. Over the past decade, housing prices increased by 124%. However, the household debt as a percentage of income increased by 130%. The boom period was characterized by overbuilding, therefore increasing the supply, causing inventory surplus and declining home prices. Prices are expected to decrease in the next period also. Markets are usually characterized by speculation. The real estate market in the U.S. makes no exception, given the fact that 22% of the houses bought during this period were bought for speculative reasons. All this speculative borrowing had a significant impact on the subprime mortgage crisis. One of the causes of the subprime mortgage crisis listed above is represented by inaccurate credit ratings. In other words, credit rating agencies gave investment-grade ratings to CDOs based on subprime mortgage loans.[3] Although these higher ratings were considered to be justified at the time, later analysis revealed that the rating process was a defective one, and even more, rating agencies were perfectly aware of this fact at that time. However, it is expected that the CDO market created by these rating agencies will create similar financial problems in the future. The situation on this market is not completely clear, as "the rise and fall of nonprime mortgages has taken us into largely uncharted territory. Past behavior, however, suggests that housing markets' adjustment to more realistic lending standards is likely to be prolonged".[4] Introduction to AIG The American International Group was established in 1919 in Shanghai, and had developed into the United States' largest insurance corporation. Even more, in 2008 Forbes included AIG in the Global 2000 list as the 18th largest company in the world.[5] The company's international holdings include: Australia, Pakistan, China, Hong Kong, India, Philippines, Singapore, United Kingdom, and Indonesia. Business holdings include: mortgage lending, aerospace, real estate, telecommunications, ports, and skiing. The company's profits come from life insurances and auto insurances mainly. Regarding general insurance operations, AIG is the largest underwriter of commercial and industrial insurance, also owning "the most extensive international property-casualty network, a personal lines business with an emphasis on auto insurance and high-net-worth clients, a mortgage guaranty insurance operation and a leading international reinsurer".[6] The most important strong points that characterize AIG are: . Underwriting skill . Innovative insurance solutions . Financial strength . Superior service . Responsive claims handling

Regarding the financial services sector, AIG is mainly specialized in: . Aircraft and equipment leasing . Capital markets . Consumer finance . Insurance premium finance

AIG's operations regarding capital markets are conducted through AIG Financial Products Corporation. The most important operations rely on transactions, and providing clients with risk management solutions and complex hedging and investment products in standard and customized transactions regarding commodities, credit, currencies, energy, equities and rates. AIG also accounts for the most extensive network of life insurers. The company's success in this is mainly due to AIG's concern for developing new markets, expanding distribution channels, and expanding the range of products. The Asset Management businesses at AIG are mainly based on institutional and individual asset management, broker-dealer services, private banking, spread-based investment programs, and management of AIG insurance invested assets. Over the past decade, 2006 was the most profitable year for AIG. The company's financial highlights are: net income: $6,200 in 2007 and $14,048 in 2006; adjusted net income: $9,308 in 2007 and $15,405 in 2006; net income per common share: 2.39 in 2007 and 5.36 in 2006; revenues: $110,064 in 2007 and $113,387 in 2006; assets: $1,060,505 in 2007 and $979,410 in 2006; shareholders' equity: $95,801 in 2007 and $101,677 in 2006.[7] The values are expressed in millions. The mortgage crisis severely affected AIG. The financial highlights after the second quarter of 2008 are revealed in the following table: Table 1 - 2008 Second Quarter Financial Highlights Note: the values are expressed in millions of dollars, except per share data. Source: AIG Second Quarter Reports, 2008.

Analysis on AIG The financial context Of September 2008 for AIG consisted in the fact that the company's share prices fell over 95%, reaching $1.25 on September 16, 2008, preceded by a 52 week high of $70.13. As a consequence, the company's Financial Product division was forced to enter into credit default swaps, in order to ensure $441 billion worth of securities. Initially, these securities were rated AAA. The problem with these securities was the fact that $57.8 billion of them were based on subprime loans. Most financial specialists consider that this is one of the most important factors that led to the financial crisis in the United States, expanding it in the entire world. On September 14, 2008 AIG made an announcement regarding the fact that the company might sell the aircraft leasing division, in order to raise capital and correct the mistakes that can be attributed to a defective subprime mortgage policy. On September 16, 2008, AIG's stocks dropped 60%. During this period, The Federal Reserve officials were in discussions with Wall Street investment firms in order to analyze AIG's situation, its impact on the U.S. economy and what the Fed should further do. However, on the same day, the Federal Reserve Bank of New York announced the Federal Reserve bailout in AIG's case. The bailout took the form of a $85 billion, based on a 24 month credit liquidity facility. The interest rate was established at 850 basis points over the three month London Interbank Offered Rate.[8] The Federal Reserve bailout in the case of AIG was legally justified by Section 13(3) of the Federal Reserve Act. The emergency loan reaches a total of $122.8 billion.

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