INTRO: Nobody
likes bailouts. The idea that rotting companies that exploit their customers,
their employees, the environment, and who knows what else are able to receive a bailout from tax
payer money just because the company is quote on quote “too big to fail” is disgusting. The
official reasoning for bailouts is that if these companies were to collapse, hundreds of thousands
of jobs would be lost and the subsequent economic shockwaves would be catastrophic.
But, maybe that’s actually better than keeping these parasitic corporations alive, but that’s
besides the point. The point is that bailouts have a terrible reputation and for good reason.
However, there have been a few bailouts in history that have actually played out surprisingly well.
You would think that this would be most likely to happen with a small company that’s nimble
and quick. But, this actually happened with the biggest bailout in history:
AIG. AIG was an insurance/finanical conglomerate that had suffered insane losses,
so the government came to their rescue with an appalling $182 billion. The bailout itself is
large enough to be world’s 60th largest company. Now, I don’t support this bailout, but the US
government did end up profiting from the bailout and things worked out surprisingly well. So,
here’s why a company even needed a $182 billion bailout and why the bailout actually kinda worked.
BUILT ON HARDSHIP: $182 billion is an insane amount of money, so
how did a company even end up in such a terrible position? Well, the answer is half a century worth
of terrible decisions that eventually caught up. AIG wasn’t always bad though. Like most companies,
AIG was started with good intentions by a man named Cornelius Vander Starr.
Cornelius was born to a Dutch family living in Fort Bragg California in 1892. Things started off
good for Cornelius when he was a baby. His father had a respectable job as a railroad engineer and
the family was able to comfortably get by. But, this didn’t last long as his father would pass
away when Cornelius was just two years old. This forced the family to take in boarders to get by.
If you don’t know what this is, it’s basically converting your house into a long term airbnb
to earn money. Considering this background, you would think that Cornelius would play things safe
when it came to his career, but he was more of a risk taker. He would drop out of UC Berkeley
after just one year and would try opening an ice cream shop. This was somewhat successful,
but nothing crazy, so he would end up joining the US army near the end of WW1. Cornelius never got
deployed but he could feel this urge to travel and see the world, so he would get a job as a
clerk at a Japanese office and move to Japan. From there, he would travel to Shanghai, China 1919,
and this where he would found AIG, though it wasn’t called AIG at the time. The young company
focused on providing western insurance products to the Asian market which proved to be quite popular.
Soon enough, Cornelius had operations across all of Southeast Asia along with the Philippines,
Indonesia, and Malaysia. It wasn’t until he had a strong presence in Asia that Cornelius even opened
an office in America. But, even after opening an American office, Cornelius didn’t really pursue
the American market. Maybe, he thought it was too competitive. His reasoning is not too clear,
but something that was clear was that AIG was phenomenal at attracting customers
in developing countries. So, naturally, Cornelius would turn his attention to Cuba
and Latin America. It wasn’t until WW2 hit that Cornelius finally shifted his focus to America.
You see, Cornelius saw an opportunity to provide insurance for military personnel
which turned out to be extremely popular. Moving past the war, Cornelius would spend his time
expanding across devastated European countries like France, Italy, Germany, and the UK. Clearly,
Cornelius was no saint. He built AIG on the backs of other people’s hardships. First,
he leveraged people from underdeveloped countries. Then, he leveraged military families. And finally,
he leveraged war stricken Europe. Cornelius was no doubt an opportunist, but something he wasn’t
was a fraud. When he was at the helm, AIG was sound financially. But, naturally, Cornelius
couldn’t run the company forever. So, he would end up handing the company over to a man named
Maurice R Greenberg also known as Hank in the 1960s, and this marked the beginning of the end.
FUNDAMENTAL COLLAPSE:
Ever since Hank joined AIG, he only had one goal which was to impress his superiors.
At first, this was Cornelius, and eventually, this would become the shareholders. Now, trying
to impress your superiors isn’t a bad goal per se, but the problem was that Hank was willing to
do almost anything and this was evident from the very beginning. When Hank was hired in 1960, he
was given the task of developing an international accident and health business. But, his approach to
doing so was completely different from what we saw with Cornerlius. Much of Cornelius’ success could
be attributed to his patience. He never forced an oppurtunity. He was willing to wait years if
not decades for the right opportunity. It doesn’t seem like Hank was a fan of this approach though
as he far preferred to create his own opportunity. And the way he accomplished this was by leveraging
insurance brokers instead of insurance agents. For most of you guys, these probably sound like
the same thing, but theres a small difference. You see, insurance agents are employed by the
insurance company meaning that their loyalty lies with the company. It is the agent’s best interest
to find the best clients to insure. Insurance brokers on the other hand are technically
supposed to be loyal to the customer, but really, the only thing their loyal to is the commission.
It’s in the broker’s best interest to complete as many transactions as possible. The quality of the
transactions doesn’t really matter to them. So, from the company’s perspective, in the long term,
it’s better to use agents than brokers because while agents are more expensive, they’ll secure
higher quality clients and protect the liquidity of the firm. But, Hank through all of that out the
window and went all in on brokers. He figured that even if sales went down, the company would be more
profitable thanks to the small commissions that brokers charged. In the short term,
this made him look his a genius as his departments grew faster than ever. But, what he was really
doing was gambling the financial integrity of the firm for more revenue and profits. At first,
Hank was simply cutting corners here and there to inflate the company’s profits, but eventually
he would turn to full on accounting fraud. In the early 2000s, Hank orchestrated multiple fraudulent
deals with offshore entities that made it seem like AIG’s reserves were larger than they truly
were. These deals also inflated AIG’s profits by nearly $4 billion. When these activities came to
light in 2005, Hank would be ousted from AIG after leading the company for 37 years. But the damage
had already been done. While Hank had succeeded in growing the company’s marketcap from a few
hundred million dollars to a few hundred billion dollars and made AIG the world’s largest insurance
company, he had also destroyed the company fundamentally. All it would take is one gust
of wind to blow over this house of cards, and that’s exactly what happened in 2008.
PUBLIC COLLAPSE:
In the end, it was two risky practices that did in AIG and these were credit default swaps and
securities lending. Credit default swaps are pretty complex financial instruments,
but for our purposes, we can just think of them as a type of insurance. If you have home insurance
and something terrible happens to your home, the insurance company would cover the damages right?
Well, it works the same way with credit default swaps, but instead of insuring your home,
they insure corporate debt. For example, let’s say GM needs money to build a new factory.
You as a lender are willing to lend GM this money. But you wanna make sure that even if GM can’t pay
back their debts, you get your money back. So, you get insurance on this debt called a credit default
swap. This way, even if GM collapses, AIG will pay you back a certain percentage or even the entire
loan based on the terms of the swap. But, the thing to note is that AIG doesn’t actually have
enough money to pay back all of these swaps. It’s unlikely that all of these corporations default
at the same time. So, AIG only has to carry a portion of the total amount they insure. Now,
this wouldn’t be a problem if these swaps were a small portion of their portfolio. But, AIG had
written swaps on $500 billion in assets. And as we now know, corporations would fall left and right
throughout 2008 meaning that AIG had start paying out massive checks. But, this wasn’t even what
screwed them over. What screwed them over was a downgrade in their credit rating on September 15,
2008. This downgrade meant that AIG had to put up significantly more collateral to back up their
credit default swaps, collateral they didn’t have. I think you can guess what happened next.
It wasn’t just credit default swaps that were screwing over the company though.
They were also getting burned with securities lending. As an insurance company, AIG owned
millions of shares of stock, bonds, options, futures, variable annuities and basically every
other security you can think of. Now, AIG could’ve just kept these securities for themselves. But AIG
wasn’t satisfied with the returns that these securities could offer by themselves. So, they
decided to lend out these securities in return for interest. This is a pretty common practice
amongst financial institutions, and it wouldn’t have been that bad if AIG stopped right here,
but they would take it to even the next level. You see, when someone borrows a security from AIG,
aside from paying interest on the security, they also have to give AIG cash collateral.
The borrower can pay back the security at any time and ask for their cash collateral back.
So, it’s in AIG’s best interest to keep the cash collateral as liquid as possible. But,
AIG decided that it would be a great idea to invest this cash into sub prime mortgages. When
the financial crisis hit, a lot of AIG’s borrowers were trying to raise cash for the recession.
So, they paid back their securities and asked AIG for their cash collateral.
But, you know this cash was invested in subprime mortgages which um completely collapsed,
yeah it was bad. At this point, it was just a matter of time until AIG needed a bailout.
THE BAILOUT:
AIG would go onto post some of the worst corporate quarters known to mankind. On this channel,
we often discuss market cap losses, but the losses that we’re about to discuss are not market cap
losses, they’re cash losses. In Q3 of 2008, AIG would report a net loss of $24.5 billion which
was 8th worst corporate quarter ever since. And that wasn’t even the worst of it. In Q4 of 2008,
AIG would lose $61.7 billion which is the worst corporate quarter ever reported to this day.
With these types of losses, even a $182 billion bailout would only last a few quarters
and that’s why they got such a massive bailout. The bailout didn’t come for free though.
The US government got a 79.9% stake in the company for the first $85 billion. And AIG had to pay back
the remaining bailout with interest. Fortunately, this was enough money to sustain their losses and
get them through the recession which is what AIG really needed. I mean, it’s not like AIG
was the next Radioshack or Sears. Their business model was still profitable. The problem was that
it only worked in bull markets, so they just had to get through the bear market, and that’s
exactly what the government helped them do. As the economy recovered, so did AIG’s bottom line,
and they would become profitable again in late 2010. This allowed them to pay off the bailout
with interest. At the same time, the treasury was slowly selling off AIG stock on the market.
And by the time everything was said and done, the US actually ended up profiting $22.7 billion.
Meanwhile, things have worked out pretty well for AIG as well.
They’ve downsized significantly since their peak, but they’re still worth over $40 billion,
so they’re still pretty big. Considering this happy ending, some have argued that bailouts don’t
have to be bad if done correctly. But in the end, I think it just comes down to a consent issue.
With such bailouts, the government is essentially making everyday Americans a shareholder in these
garbage companies which is something that taxpayers never consented to. Sometimes,
bailouts can work out like with AIG, but by definition, bailouts are handed out to companies
with the most liquidity risk. So, more times than not, it’s not gonna work out. But even if it did,
I’m still not a fan of bailouts given that they’re not approved by the people that are funding it.
Also, I think it’s probably best if such companies go under anyway. But that’s just what I think. Do
you think AIG should’ve been bailed out? Comment that down below. Also, drop a like if you’re not a
fan of bailouts either. And of course, consider checking out our discord community to suggest
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