The Collapse of American International Group - Case Study Example

The collapse of AIG The fall of AIG was the start of a recession that catapulted the world into a global financial crisis. AIG had sold credit fortification through a London unit in the structure of Credit default swaps often referred to as CDSs. The main cause of AIG’s collapse was actually its credit default swap portfolio. Initially, the swap was essentially insurance contracts on different and diverse securities, and this was for a fee. AIG decided to guarantee the security’s value, however, the problem was that the prices of the securities collapsed and consequently AIG was on the hook. However, because the portions of the securities which AIG had guaranteed were judged to be almost risk free, there was not much thought that had been given to the scenario. At the end of the year 2007, through the different swaps, AIG had covered around $61 billion in securities with exposure to the different subprime mortgages. There are several prominent people that were involved in the fall of AIG, the most prominent was Martin J. Sullivan who at the time was the CEO of the company. Sullivan was blamed on taking on tens of millions of risk that was associated with the mortgages. Sullivan did not purchase any reinsurance on the risk as it was the norm Robert Willumstad, the chairperson of AIG Board of directors was also another prominent person involved in the fall of AIG. Joseph Cassano who was the AIG financial production division was accused of insuring to more than $441 billion value of securities that were in the first place rated AAA. Several companies were associated with the fall of 2008, they included the European Investment bank referred to as Goldman Sachs. Morgan Stanley and Merrill were also involved in the mess that came with the fall of AIG. AIG credit default swaps were insurance contracts that were unregulated, therefore, AIG did not put anything any capital as collateral and consequently it maintained what can be described as an AAA credit rating. Further, the company did not build any capital to back the insurance that they had sold and the profits it booked in any way never materialized. The default rates that were on mortgage securities were underwritten in the year 2006, and the year 2007. The underwritten securities increased in their worth and the by the last part of the year 2007, the securities that were in the banks which they claimed were AAA rated ended up being worth around $0.15 on the dollar. In the year 2008, there was the collapse of the credit default swap market which also meant that most investment banks had no way to borrow money as there was no one who would insure their obligations. Therefore, with the fall of the credit default swap market and with no re-insurance, the company that is AIG went under. There are several things that led to the collapse of the company AIG. The first truism is that ‘most people in the United States want to do the right thing, and they want others to do the right thing (Crews 1). However, individuals have different values, priorities and attributes which often guide their behavior and decisions. It is imperative to understand that taken to an extreme, almost any personal attribute, value and priority can be an ethical breach. AIG and its business at the time were highly complex; however, the business was understood by those who had built it such as Hank Greenberg. However, the successors lacked the essential tools that were needed to run the company safely. The two companies both AIG and AIGFP companies often ran in a complicated way, neither the board of directors nor even the regulators in the company understood the entire operation process. Consequently, the more complicated the operations were run, the more weak the financial system became (Case Business school 22). There was no one in the company that was familiar with the operating process as the AIG creator of the swaps, Hank Greenberg. However, he did not give information about its working and consequently the company was on the path to financial ruins. Greenberg controlled Cassano, and every decision that Cassano made was from Greenberg, therefore, when Greenberg left it was very difficult for Cassano to understand what was happening as he was not qualified for the job (Lewis 10). Therefore, the power control that came with Greenberg and the fact that he was not willing to transfer his work details to anyone meant that when he left, AIG Company would not be able to run regular operations. “There are some organizations that are simply more ethical than others” (Crews 9). It is imperative to understand that the main internal factor which eventually led to AIG collapse was the credit default swaps (CDCs) which were sold by the AIG financial products corp referred to as the AIGFP. The sales of the credit default swaps were made without the putting of any initial collateral, or even setting aside any capital reserves. Further, there was no hedging of the exposure. This in turn was an immense failure in the governance of the company, In particular, the risk management practices of the company were very extremely bad (Harrington, 2009). Sjostrum(2009) argued that the securities lending activities as well as investment in mortgage backed securities were the causes of failure of AIG (Baranoff 248).The reason as to why the AIG company collapsed in the financial crisis was mainly because of the fact that the AIGFP did not have sufficient experience when it came to the credit default swap management exercises. They violated different rules of the credit default swaps by the company abandoning capital reserves as well as not hedging exposure with the initial collateral (Baranoff 248).The CDs were interconnected with many players in the market and this did little to ensure substitutability. AIG was recognized as too big to fail and it added systematic risk which led to its eventual collapse. Greenberg team was joined by Karen Webster who tried to clear the name of Greenberg, however, the plans on how to increase the company’s became a subject for the Boston Globe much to the embarrassment of everyone. Greenberg wanted to have a good reputation in public, however, he refused to pay for the services and this behavior affected his reputation in the business area. In order to ensure ethical behavior, reward systems must reward good and ethical behavior as well as penalize bad and unethical behavior. (Crews 9, F). The AAA- rated AIG can be said to run a complex business. This is because its CEO Hank Greenberg had put up a basic business model which was 15% revenue growth, 15% return on equity and 15% profit growth. Those that were unable to deliver the model were immediately blown up. In the year 2005, it merged that AIG had hidden a lot of significant underwriting losses by the use of creative reinsurance. AIG was therefore forced to restate more than 4 years earning. Greenberg at the time was forced to resign following the allegations of fraudulent accounting and consequently AIG lost its AAA rating. The company continued with the credit default swaps despite the fact that the person who had initiated them was not available. The Credit default swaps exemplified the contradictions that often exist in modern finance. This is because they allowed companies to free untold amounts of capital that could have been tied up as collateral loans. The credit default swaps were sold both to reduce risk and in some cases to give clients room to take in more risk. However, neither the buyers nor even the sellers understood the enormous risk which they were creating. The less regulation ensures that credit default swaps in companies would use large amount of money without information and therefore, increase the risks (Brady and OHarrow). The system of credit default swaps act like a gamble system, where both the salesman as well as the buyer cannot be able to predict the huge risk associated just like in gambling. Safeguard ensurance cannot be in any way promised in the system as the fundamental concept of credit default swaps often focuses on the short term prefits as compared to the lone term strategy. Cassano was a bully in the company and followed his rules and did not listen to advice. It is common knowledge that behaviors of a leader often have direct impact on their employees, for this reason, people often prefer to get basic respect as compared to compensation through money. Management should play a key factor in the maintenance of a stable operation in a given company (Cohan). Board of directors are often easy to manipulate when the executive hold important information. The board members in many cases often lack the expertise, the incentives and the accurate information that is often needed to hold the executives accountable for their actions (Crews 11, F). Directors of AIG was forced to fire Greenberg mainly because SEC and Splitzer were threatening criminal indictment. The board of governors expelled Greenberg who then decided to break down all connections with AIG and swore never to contribute to the board again (Cohan).Spitzer at the time held large amounts of AIG information and as a result had the control of the Board of directors. The Board of directors on the other hand was very low on experience as well as accurate information against Spitzer. This is the weakness that was utilized; this shows that regulation defects contribute to ethics scandals. Financial advisors from the E.U were dependent on the monitoring of the U.S office of Thrift supervision (OTS) in AIG. Therefore, the information which related to the decision makings of the government in AIG was not in any exposed to the public. The entire regulation of the whole OTS that existed under the AMercan government as well as foreign banking can be blamed for the unsuccessful management. There were two main dereliction of duties that existed with the managers of federal banking, they include the fact that large amount of credit limitation existed within the AIG, and another was the fact that federal banks offered enormous securities lending collateral when it came to AIG (Harrington 800). OTS did not have sufficient resources as well as capabilities to regulate all parts in AIGFP. The U.S government as well as foreign banks did not pay sufficient attention in the entire regulation of the OTS. For this reason, the lack of supervision as well as too much reliance on the OTD eventually contributed to the negative influence in the collapse of AIG. One might wonder how AIG was able to live so dangerously for so long; the answer is that the company was able to befriend politicians with campaign cash. It provided $9.3 million that was divided evenly between both Republicans and Democrats from the year 1990 to the year 2008. In fact, people from the company bribed government officials with more than 70 million dollars as they tried to get a shortcut in the regulation department. This is what eventually stimulated the financial risk that led to the collapse of AIG. There several important stakeholders that were affected by the collapse of AIG. The first was the government which suffered a large financial loss of around $85 billion by bailing out the company. This was money that could have otherwise gone into other useful projects. The second were three stockholders who owned around 4% of the exceptional supply of AIG the three were key stakeholders in the company and therefore, went a large financial loss as they were not repaid all the money that they have invested in the company. These stockholders were angry to the extent that they wrote a letter to the Wall street journal which was later deemed as a public spat that existed between the management and the company’s board of directors as well as key stakeholders and Hank Greenberg. Other stakeholder included persons that had taken insurance with the firm, their insurance were cancelled and they did not have any reimbursements for the same. Those with insurances in affiliate insurance companies such as Taiwanese life insurance company, and American Life Insurance company. The sale of these companies to other MetLife stock meant that some of the people whose cover was not documented properly suffered the entire financial loss because of the collapse of the company. Another stakeholder that felt the collapse of the Company financially was the individual taxpayer, this is because the Federal government used a lot of money to bail out the company. This was money that was raised from the taxpayer and consequently, the taxpayers felt the heat when the company collapsed. There are several lessons that can be learnt from the collapse of AIG in the year 2008. The first is the fact that there is a need for diversification in an organization where there will be information sharing in the way in which a system can work. Secondly, there is a need for companies to study market patterns and take essential risk management techniques in a bid to ensure that the company is well protected from different unseen financial risks. Thirdly, there is a need for companies to have leaders that have insight and are knowledgeable in the field that they deal with. This will ensure that they know what they are doing and realize the best way on how to do it. Works Cited Bandler, James, Roddy Boyd, and Doris Burke.  "Hanks Last Stand."  Fortune.  158, 7 (2008): 112-131. Baranoff, Etti.  "An Analysis of the AIG Case: Understanding System Risk and Its Relation to Insurance."  Journal of Insurance Regulation.  (2012): 243-270. Brady, Dennis and Rober OHarrow Jr.  "A Crack in the System."  Washington Post.  30 December 2008: A1. Cass Business School.  "Roads to Ruin: The Analysis."  15 January 2014.  http://www.airmic.com/roads-ruin-study-major-risk-events-their-origins-impacts-and-implications. Cohan, William D.  "Collapse of the House of Hank." Institutional Investor.  44, 3 (2010): 40-84. Harrington, Scott.  "The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation."  The Journal of Risk and Insurance.  76, 4 (2009): 785-819. Lewis, Michael.  "The Man Who Crashed the World." 2009. 15 January 2014.  http://haraldhau.com/The_Man_Who_Crashed_the_World.pdf.  Saporito, Bill, Massimo Calabresi, Michael Duffy, Jay Newton-Small, Michael Scherer, Mark Thompson, Michael Weisskopf, and Adam Zagorin.  "How AIG Became Too Big to Fail."  Time.  173, 12 (2009): 24-30. Read More