11 years ago, the world saw the most serious economic collapse since the Great Depression.
The waves of this collapse went around the world, touching every continent and every
country.
Then, when all was said and done, the finger pointing began to see who was to blame and
who should pay the price for this crash.
In this video, we’ll see how the insurance company AIG largely avoided taking the blame,
despite ultimately being the single largest cause of the Great Recession.
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To understand AIG’s role, we first have to grasp what happened in 2008 and the events
that led up to the crash.
During the late 1990s, America was getting a huge flow of foreign funds from Russia and
many Asian countries which were beset by financial crisis at the time.
American banks naturally did not want that money just lying around earning no interest,
so they made it easier to get mortgages as a way to lend out this cash.
Americans who would normally not get home loans found it very easy to get the mortgages
they needed to buy houses.
After all, this was the “American Dream”.
Banks made it easier and easier to get a loan, creating adjustable rate mortgages with low
early payments and accepting people with low credit scores.
These less-than-ideal loans were called subprime mortgages.
Now, what banks usually do as a way to make more money, is to bundle thousands of mortgages
together as a single bond, known as a CDO, and then to sell these bonds to other parties,
like pension funds, insurance companies or other banks.
However, since subprime mortgages were riskier, many of the funds that would normally buy
these CDOs could not afford the risk to buy them … unless the banks employed a little
bit of financial trickery.
You see, if you bought an insurance policy protecting you from the CDO failing, then
you could buy it much more freely and this is where AIG comes in.
AIG was at the time the largest insurance company in America with branches and offices
in over 80 different countries.
They’ve been in business since 1919 and have been declared America’s largest underwriter
for insurance across many industries.
In 2008 they had hundreds of billions of dollars in assets and were in fact well on their way
to becoming the first company in the world to achieve a trillion dollar market cap.
Here’s what this huge company did to transform very risky CDOs into much safer products.
In a little office in London, AIG was performing financial alchemy.
They were selling insurance on CDOs that had a very poor credit rating, effectively swapping
it with the rating of AIG itself, a very solid and highly-rated company.
This insurance policy was known as a Credit Default Swap and it literally swapped the
bad credit rating of the CDO with the great credit rating of the big insurance company.
You were still buying these horribly rated CDO bonds from the banks, but since AIG was
willing to pay you off if that bond failed, well then what was the risk?
AIG loved the credit default swap and so did the fund companies.
In the 5 short years after introducing it, that little office in London, known as the
Financial Products division, saw its revenues quadruple to over $3 billion dollars per year.
Every time AIG sold another credit default swap, they were making free money in the premiums
being paid to them.
It was almost too easy.
But AIG got greedy.
Normally, if an insurance company insures you for a million dollars, they should have
a million in assets around to pay it, just in case.
Instead of having the capital, however, AIG were relying on the statistical probability
that the housing market would not fall.
This strategy worked until it didn’t, and in 2007, the housing market crashed.
All those subprime mortgages increased their adjustable rates and thus millions of Americans
that should never have had mortgages saw their monthly repayments increase.
When those mortgages weren’t getting paid, the bonds filled with these mortgages, the
CDOs, also started collapsing.
But the banks and funds weren’t concerned yet, and rightfully so because they had an
insurance policy, these credit default swaps.
The banks were relying on AIG to honor their end of the bargain, but when the time came,
AIG realized it had insured far too many CDOs to possibly pay up.
As soon as AIG’s coffers ran dry, all the banks it had insured also started going down.
The speed of the collapse was incredible: AIG ran out of money on September 15th, 2008
and later that same day, one of America’s oldest and largest banks, Lehman Brothers,
was forced into bankruptcy.
That day served as a wake up call for the government.
Up until then, the Federal Reserve was taking a hardline stance against government buyouts,
hoping to teach Wall Street a lesson.
AIG, however, was no small insurance agency and the Fed realized that if AIG failed, the
entire world was in trouble.
Virtually all banks and insurance companies had stock and policies held with AIG.
Everything was too connected.
Thus, AIG was deemed “too big to fail” and on September 16, 2008, just one day after
the US Treasury said there would be no more government bailouts, the government bailed
them out.
In return for a massive cash loan to pay out these credit default swaps, the Federal Reserve
took an 80% equity stake in AIG, allowing the government to change the leadership of
the company, which they did.
They installed a new CEO, hired at a salary of just $1, who would be in charge of undoing
the complex financial maze AIG had created.
AIG then used $165 million of the bailout money to pay executive bonuses, not for good
performance, but for incentives to help undo years of bad financial practice.
In total, AIG received a bailout of $182 billion dollars and in March 2009, they reported the
single greatest loss in corporate history.
As a result of that announcement, the Dow closed at the lowest level it had been since
1997, and at just 50% of it’s record high in Oct 2007.
AIG also settled a lawsuit brought against them, paying off nearly a billion dollars
to investors who were clearly misled.
As a result, AIG reduced its staff to less than half its 2008 numbers just to remain
profitable.
Interestingly enough, once the dust had settled and AIG’s business had stabilized, the government’s
stake in the business actually became a profitable trade.
In 2012, the Federal Reserve sold their shares of AIG to make a $22 billion profit, a truly
unprecedented result considering the size of the bailout.
It took another 5 years before the government considered AIG safe enough to remove it from
the “too big to fail” list and ever since, it’s been back to the good old boring days
of insurance.
AIG never caught the same backlash as banks like Lehman Brothers, who were arguably victims
in all of this, since they relied on fraudulent insurance.
Thus, it is worth remembering just how close AIG got to crashing the entire global economy
and if you wanna read more about the inside story of AIG’s collapse from the people
in the meeting rooms, you should listen to Fatal Risk on Audible.
Using the personal notes of men like AIG’s former CEO, you’ll learn the full story
from the perspective of its key players and you can listen to it for free right now if
you register for a free trial of Audible by visiting audible.com/businesscasual or by
texting “businesscasual” to 500500.
Not only will you get a free audiobook to go along with your free trial, you’ll also
receive two Audible Originals that you can’t hear anywhere else.
Now, I hope you enjoyed this video and I’d like to thank you for watching it.
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You can expect my next video in two weeks, and until then: stay smart.