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American International Group (AIG) — the insurance giant and poster child for the financial crisis — will once again sell its stock to the public in a “re-IPO” recently set for May. The firm, which was shaken by soured bets on mortgage derivatives, says it is recovering from its near collapse in 2008 and is now a leaner, healthier firm looking forward to a bright future.
American taxpayers, who shelled out $182 billion to prevent AIG’s crisis from sending a tidal wave through the financial markets, will be repaid in full, AIG chief executive Robert Benmosche has insisted recently. In January, the firm paid back $21 billion borrowed from the Federal Reserve of New York, and the series of stock sales starting this spring could reduce taxpayers’ holdings by two thirds by the end of the year if all goes well.
But can the firm ever return to its former glory, having sold some of its prime assets to repay debts? Does it make sense to keep AIG together rather than let its disparate operations go their separate ways? Most importantly: What has the AIG story told us about how well the government handled trouble at a huge financial services firm, whose missteps hurt so many innocent bystanders?
“I would not call [the bailout] a success,” says Wharton insurance professor Kent Smetters, “but the alternative is always hard to assess.” Even though the taxpayer may eventually not lose in this case, Smetters worries that the AIG bailout and other post-crisis government actions “have likely worsened the [too] big-to-fail problem” by signaling that the government will step in to help in a crisis involving a big firm connected to others, making it easier for companies to continue taking unsound risks.
“We all know this could all happen again,” adds Wharton finance professor Richard Marston. “Specifically, banks are far too large to ensure that the fear of failure will discipline them. Large banks know that they are too ‘systemically’ important for us to let them fail.” Executives heading large financial firms are sure to be cautious for a while, Marston adds, but “then they will be succeeded by new people who did not get burned last time.”
Though not a bank, AIG was a major player in the financial markets and was the biggest insurance company in the U.S. until disaster struck in September 2008 because of bad bets made by a London-based operation. Using derivatives called credit-default swaps, AIG had written insurance policies on mortgage-backed securities. When the housing bubble burst, the securities lost value and AIG was on the hook for enormous claims. Losses peaked at $25 billion for the third quarter of 2008. Worried that an AIG collapse would have a domino effect on other financial firms, creating upheaval in the financial markets and economy, the federal government stepped in with a series of bailouts that eventually totaled $182 billion, taking majority ownership of the firm in exchange.
Whether that was necessary is open to debate. The financial markets had been roiled by the September 15, 2008, bankruptcy of Lehman Brothers, a global financial services firm that had asked for government help but been denied, and many regulators and lawmakers were afraid that a bankruptcy by AIG shortly afterward would create havoc.
While it’s impossible to know what would have happened if AIG had fallen into bankruptcy, Wharton finance professor Richard J. Herring wonders whether the results would have been as bad as many predicted. “I still harbor doubts about whether the [AIG] bailout was necessary, since the one thing that went reasonably well in the Lehman Brothers fiasco was the settlement of the derivative contracts, including the credit default swaps,” he says. “People weren’t necessarily pleased with the prices they received, but there were no knock-on effects, and it was a very orderly process.” In the AIG case, he points out, it was only the derivatives business that appeared to pose a risk to other firms; the more mundane insurance operations were sound.
Many of the problems that ensued, like the credit crisis, were not so much a result of the troubles at Lehman and AIG as they were the result of a perception — based on the different treatment of the two firms — that the government “didn’t have a game plan or even consistent policy goals,” Herring notes. The AIG bailout “heightened the degree of moral hazard in the system more than any other event,” he adds, referring to the way risk-taking is encouraged by the belief that the government provides a safety net. “AIG had done everything it could to evade competent regulation and supervision, yet it was treated more generously than any other institution when its bets turned sour.”
U.S. taxpayers now own 92% of the company. To get free of that, AIG plans to sell those government-owned shares to the public, starting with an offering — expected to total $15 billion to $20 billion — in May. Before then, the company will conduct a series of “road shows” to convince potential investors that the stock is a good bet. Since the government’s stake is worth about $64 billion, depending on the share price, additional sales will be required to reduce the public’s stake to zero.
While the company is undeniably in better shape than it was in the depths of its crisis, it is far from out of the woods. As its reputation became tarnished, AIG’s customers and business partners deserted the otherwise healthy insurance units, a trend that has yet to be completely reversed. With the results of its divestments and gains and losses from restructuring set aside, AIG reported in late February a $2.2 billion operating loss for the most recent quarter, and an $898 million loss for 2010, results The Wall Street Journal called “messy.”
AIG shares were trading around $67 at the start of the year but are now around $37, though another $7 to $8 should be added for the value of warrants issued to shareholders in January. (Warrants are similar to long-term stock options allowing holders to purchase AIG stock at $45 a share in the future.) Adjusting for a reverse stock split that in mid-2009 provided one new share for every 20 old ones, AIG shares had traded above $1,400 early in 2008. While most of the decline is due to the company’s near collapse, many analysts say this year’s drop reflects continuing investor skepticism about AIG’s future.
Ratings agencies also have concerns. In January, Moody’s Investors Service, the ratings agency, lowered various AIG debt ratings by one notch. “The downgrades reflect Moody’s view that while the core insurance operations have stabilized over the past year, they have not yet improved sufficiently to justify the previous ratings in the absence of continued government support,” Moody’s said.
After selling many units to pay down debts, AIG now has two main lines of business: Chartis, an insurer specializing in property and casualty policies, and SunAmerica Financial Group, which sells life insurance and other financial products, such as 403(b) retirement plans for teachers. There is also an aircraft leasing unit that is operating in the red.
Investors were alarmed when Chartis recently announced a $4.2 billion charge to boost loss reserves, or money that may have to be paid out as policy holders file claims that are larger than the company had earlier forecast. An analyst at Nomura Securities pointed out that the charge was bigger than had been expected and was particularly noteworthy because “other insurers generally seem to be better reserved” and have reported excess in that category. Moody’s said Chartis’ “reserve volatility” offset the benefits the firm should enjoy from its “global footprint and diversified product set.”
At SunAmerica, fourth quarter operating income dropped 4% from the year-earlier period. Although SunAmerica has top-10 market share in many products, the premiums received from insurance policy holders and deposits from retirement investors “are down materially from pre-crisis levels,” Moody’s said, adding that SunAmerica’s “profitability remains weak relative to that of its peers.”
To rebuild and pay debts, AIG has sold many of its foreign operations. Late last year, for example, it raised $37 billion by selling much of its majority stake in AIA Group, a life insurer in Asia, a region where the company had its roots and had long done the lion’s share of its business. That money was used in January to pay its debt to the Federal Reserve Bank of New York. This and other sales reduced the company’s workforce to 63,000, from 96,000 a year ago.
On the bright side, the asset sales, plus the unwinding of most of the risky derivatives operations of AIG Financial Products, the unit that caused most of the trouble, have substantially reduced the firm’s risks, Moody’s said.
A Potential Break-up?
But some experts question how well AIG can do now that it is essentially reduced to its U.S. operations, primarily Chartis and SunAmerica. Among the concerns: Are there really any synergies between the property-casualty business and the life insurer, which is quite different? Many experts think there are not, and that each firm might do better operating on its own. In fact, many insurance companies focus on just one type of insurance –property-casualty or life — but not both.
Late in January, Harvey Golub, AIG’s chairman during 11 months in 2009 and 2010, said AIG should eventually be broken up because the two main businesses have “no strategic fit.” Smetters agrees that a breakup might make sense, as property-casualty and life insurance are very different businesses. “There really is very little rationale for keeping both businesses together under a common stock ticker,” Smetters says. “Any cross-marketing gains could be achieved just as efficiently through standard cross-marketing partnership agreements” between stand-alone companies. Nor is there any particular regulatory advantage to having the two types of insurer in one company, he adds.
“Academic studies have also found that bigger is usually not better for insurance firms due to increased complexity of decision making across multiple units,” Smetters notes. “A breakup would make the stock due diligence simpler for investors as well.”
The Government’s Role
Aside from questions about AIG’s future prospects, the firm offers a case study in government responses to catastrophe at a major financial services firm. With the benefit of hindsight, how well did the bailout work?
Marston believes the government was right to bail out AIG and other firms, as the financial crisis would otherwise have been worse, but he says regulators might have struck a harder bargain to assure that taxpayers would earn a profit when the firms recovered, compensating for the risk the public had taken. “We should have ‘owned’ enough of these institutions to reward us for the risk absorption.”
Going forward, Marston says, the government has two choices: to regulate financial services firms more heavily or to break up the mega-firms so they would do less damage if they fail. Currently, Washington does not seem to have much stomach for either approach, he notes, but better regulation could emerge. Reform efforts like the Dodd–Frank Wall Street Reform and Consumer Protection Act, signed into law last July, have prodded regulators to strengthen and revise rules, but in many respects that process is only in its early stages.
“I think the big problem with these large companies is that they tend to capture the regulators and politicians,” says Wharton finance professor Franklin Allen. “This is a big part of the too-big-to-fail problem, so in general I’m in favor of smaller financial companies. I think that would make it much more difficult for them to hold the country [hostage]…. I don’t think we employ the anti-trust laws nearly enough in the financial services industry. That’s one of the things the government could do which would be a serious improvement.”
The current system, where states rather than the federal government regulate insurance companies, is out of date given the global interconnectedness of financial services, Allen adds. “I think we should go to national regulations.” The Dodd-Frank Act sets up a Federal Insurance Office to monitor the industry, but leaves regulation to the states.
Even with new, stronger rules and oversight, it is difficult for regulators to keep up with financial innovation and efforts to get around the rules, Marston points out. “After all, the insurance industry is heavily regulated, yet AIG got around those restrictions by working in an uncharted area — default swaps — outside the purview of the traditional insurance regulators…. But since we are not about to break up [large financial firms], we ought to try regulation. Perhaps Congress will be sensible enough to let regulators regulate.”
The Dodd-Frank bill does address risks posed by exotic derivatives like default swaps, requiring that many be traded through exchanges, Smetters notes. Exchanges reduce systemic risk by using clearinghouses to guarantee payment on securities transactions even if one party defaults. Clearinghouses can also dampen risk by refusing to guarantee transactions they deem too hazardous. Exchanges make it easier to determine market prices for securities, so that firms and regulators can better assess risks. Wall Street, however, is pushing to exempt some types of derivatives from the exchange requirement, so it is unclear how much of the derivatives business eventually will be covered.
Looking back at the AIG bailout, a June 2010 report by a congressional panel concluded that the Federal Reserve Bank of New York had given too little consideration to alternatives. Critics said the government erred in allowing AIG’s counterparties, including banks that bought its mortgage derivatives, to recover all that they were owed by the firm.
The Federal Reserve has argued that it had no choice, as the alternative would have been too damaging to the financial markets and economy, but many critics think it is important that counterparties share the pain when bets go bad, so they will be more careful in making those bets in the first place. In return for the bailout, AIG had to forfeit its right to sue firms such as Goldman Sachs and Merrill Lynch over any misrepresentations they may have made about the health of the securities they insured through AIG, further sheltering those counterparties.
“You want sophisticated bondholders and counterparties to use better due diligence when it comes to credit and securitization,” says Smetters. “I would reserve government bailouts only for consumer protection as a very last resort, never for sophisticated counterparties.”