Corporate Failure and Forensic Accounting - Assignment Example

1.0 Overview Largest insurer across the globe, with market value of US$172.24 billion in 20091. AIG is engaged in general insurance, life insurance and retirement services operations and also provides financial services and asset management services (Datamonitor, 2009). Its financial services business includes commercial aircraft and equipment leasing, capital markets operations and consumer financing (www.globalmarketsdirect.com). In 2008, AIG witnessed liquidity concerns due to higher than anticipated capital losses in multi-sector credit default swaps. The company suffered capital losses of US$30,482 million during the first three quarter of the fiscal year ending 2008 (www.globalmarketsdirect.com). The high capital loss has worsened AIG’s capital position and the company, in order to regain its market position, had to seek a bailout program from the US Treasury and the Federal Reserve to resolve its capital issues through a bridge loan of US$85 billion (Datamonitor, 2009). £ in millions 2008 2007 2006 2005 2004 CAGR Net Premiums Earned 45072.1 39626.2 40271.8 38632.3 36367 5.51% Total Premiums Earned 45072.1 39626.2 40271.8 38632.3 36367 5.51% Net Investment Income 6596.9 14300.6 14146.9 12408.9 10079 -10.05% Realized Gains (Losses) (45386) (7527.3) 57.5 187.4 24 n.d Total Revenue 5993.4 54997.6 61529.6 59770.4 53310.6 -42.10% Net Income (53592) 3098.1 7623.2 5756.7 5370.6 n.d Basic Normalized EPS (258.66) 39.18 61.06 44.33 42.13 n.d Total Debt 134379 88440.2 76064.7 64094.9 50574.5 27.67% Total Liabilities 561786 478529 448475 446620 375786 10.58% Long Term Debt Issued 61262.5 51572.8 38543.4 36847.1 17187.6 37.40% Source: OneSource The net debt for AIG in 2008 stood at £134.3 billion, with CAGR of 27.67% (2004-2008). The company recorded total revenue of US$11,104 million in the fiscal 2008, against US$110,064 million in the previous year, representing a decrease of 90% year on year (Datamonitor, 2009). Further, the company incurred a net loss of US$99,289 million in 2008 compared with a net profit of US$6,200 million a year ago (Annual Report, 2008). The weak performance was due to the unexpected loss in net investment income, net realized capital gains and unrealized market valuation losses (Annual Report, 2008). Fall of AIG was the biggest failure of corporate governance and business losses in a decade’s time. Higher credit default swaps exposure for AIG hampered its long-term sustainability in 2008. US$ in billions Credit Default Swaps Equity derivative outstanding Currency outstanding 2001 69,207.30 918.87 0 2002 101,318.49 2,191.57 2,455.29 2003 142,306.92 3,779.40 3,444.08 2004 183,583.27 8,422.26 4,151.29 2005 213,194.58 17,096.14 5,553.97 2006 285,728.14 34,422.80 7,178.48 2007 382,302.71 62,173.20 9,995.71 2008 403,072.81 38,563.82 8,733.03 CAGR 34.92% 88.75% n.d Source: www.isda.org Bottom line: The total credit default swap market grew to US$403,072 billion, with CAGR of 35% in 2001-2008. Credit default swap was the second fastest growing segment in United States. In 2008, the segment stood at ten times of equity derivate outstanding (www.isda.org). In 2008, AIG sold credit default swaps worth US$527 billion i.e. 1.3% of total marketspace (www.isda.org). High credit default swap exposure was the primary cause for AIG’s fall and one of the biggest corporate failures in 2007-2009. 2.0 Research Question How to prevent corporate failures such as AIG in future? In our case study we would highlight the following: Cause-Effect analysis of credit default swaps trap Lapse of financial regulations Propositions to reduce corporate failures such as AIG in future 3.0 Cause-Effect Analysis According to Basel II regulations for global banking industry every financial institution should maintain particular capital reserves depending upon bank's loan book (Stansberry, 2008). The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits (Stansberry, 2008). AIG used to offer banks a way to get around the Basel rules via unregulated insurance contracts, known as credit default swaps (Stansberry, 2008). Thus it could be termed as lapse in financial regulations across United States and globally. Another issue with AIG’s insurance contracts or credit default swaps was unregulated by U.S treasury. The unregulated credit default swaps weren’t required by AIG to put up any capital as collateral as long as it maintained a triple-A credit rating (Annual Report, 2008). Further AIG’s shareholders were trapped due to mark-to-market accounting standards due to which the company reported net profits, based on expected default rates. It could be seen that net profit of AIG increased to £7.6 billion, with CAGR of 18.9% (2004-2006)2. AIG never had capital to back up the insurance sold and default rates of mortgage backed securities increased higher than expectations thus reducing the competitive advantage of the company in 2007-2008. In September 2008, majority of credit rating agencies downgraded AIG than required triple-A and the defaults in credit swaps increased due to sub-prime mortgage losses. The company was unable to raise capital in collateral and thus filed for Chapter 11 (September 2008). Bottom line: Financial institutions defaulted Basel II regulatory framework and enhanced exposure to credit default swaps. AIG was the core insurer of providing credit default swaps. On the other hand, mark-to-market financial accounting system provided illusive net profits for AIG thus repeating the bottleneck year-on-year basis. The fraud of AIG selling credit default swap without collateral was the primary cause-effect of Chapter 11 bankruptcy in September 2008. 4.0 Lapse of financial regulation AIG’s downturn has been attributed to financial accounting and regulatory lapse in United States and worldwide. The other macro economic frauds related to AIG due to lapse in regulations and stringent policies are as follows (Tatom, 2008): Frauds in Asset Management business: The Company has a significant asset management business which may be negatively impacted by a decrease in confidence in asset managers (www.globalmarketsdirect.com). This has been caused by major asset value declines in 2008 and accentuated by frauds. The most high profile of these was fraud in Bernard Madoff’s scheme where investors all over the World lost around US$50 billion (www.globalmarketsdirect.com). Auto Insurance Frauds: During the recession, incidents of auto insurance frauds are increasing in the US. It led to excess auto insurance payments of over US$6 billion per year (www.globalmarketsdirect.com). In Hawaii, the convictions for auto insurance fraud increased by 61% from 2007 to 2008. Car give-ups increased by almost 33% in 2008 in New York (www.globalmarketsdirect.com). In Pennsylvania, insurance fraud and related crimes recorded a rise of 30% in 2008, compared to 2007, with 46% of car insurance fraud in the total fraudulent claims (www.globalmarketsdirect.com). Bottom line: Although U.S government has offered bail out package of US$85 billion to AIG, the lapse in financial regulations such as credit default swaps, frauds in auto insurance and asset management activities will hamper positive growth for the corporation on long-term basis. There is aggressive need to restructuring regulatory framework by U.S treasury in order to reduce future shocks such as AIG fall and vice versa. 5.0 Futuristic approach Post downfall of giant such as AIG in September 2008, the three core pitfalls registered are as follows: Global Learning best practices from Financial Services Authority (www.group30.org). Importance of a federal role in regulating insurers, which are currently regulated by the states (Kuttner, 2009). Fed to expand its credit to the private sector (www.group30.org). AIG and sub-prime mortgage losses (total losses stood at US$8.3 trillion) triggered heavy debate on financial institution regulations worldwide. The potential change management in financial institution regulatory framework is as follows: Globally the activities of government-insured deposit-taking institutions should be subject to prudential regulation and supervision by a single regulator (www.group30.org). The credit default swaps weren’t regulated causing AIG trap. Banking institutions should be restricted in undertaking proprietary activities that present particularly high risks and serious conflicts of interest (www.group30.org). AIG offered unregulated insurance for risky loans offered by financial institutions and no restriction was pinpointed. Government-insured deposit-taking institutions should not be owned and controlled by unregulated non-financial organizations (www.group30.org). AIG controlled credit default swaps worth US$527 billion i.e. 1.3% of total marketspace (2009). Single regulator for large investment banks and broker-dealers that are not organized as bank holding companies (www.group30.org). Bernard Madoff’s fraud was worth US$50 billion further enhancing global economic downturn in 2008 and 20093. Change of mark-to-market to fair value accounting standards: The fair value accounting standards will enhance dealing with less liquid instruments and distressed markets (Kennen, 2008). AIG was ignorant about the pitfall of credit default swaps due to mark-to-market accounting standards. The new accounting standard will grasp liquid instruments and distressed market conditions in realistic manner. National regulatory authorities and finance ministers are strongly encouraged to adapt and enhance existing mechanisms for international regulatory and supervisory coordination (www.group30.org). AIG operated in United States, Far East, and European marketspaces. Higher global co-ordination will reduce crises on long-term basis. Adequate transparency as to transaction volumes and holdings across all products, and that both credit and leverage elements of each product be thoroughly understood and monitored (www.group30.org). As credit default swaps was unregulated thus volume transactions weren’t reported for AIG. 6.0 Propositions Post analysis of AIG’s historical and current status has provided the following propositions on prevention of future large corporate failure: AIG failed due to poor regulatory framework and lapse of financial accounting post 2001. On the other hand, growth of credit default swaps was due to bottlenecks in unregulated insurance contracts offered by AIG to financial institutions related to risky loans. Thus enhancing regulations across the globe will reduce corporate governance frauds and failures on long-term basis as determined by AIG case note. On the other hand, change in financial accounting to fair value and regulated rules & policies such as single regulator for large investment banks etc will enhance global GDP growth on long-term basis. Thus it could be seen on broader basis that frauds and corporate failures in financial institutions can be enhanced via: Global transparency in regulations Change in financial accounting from time-to-time 7.0 References www.isda.org Datamonitor www.globalmarketsdirect.com Tatom, John A., “The Fed’s New Front in the Financial Crisis,” Networks Financial Institute Research Buzz, Volume 4, Issue 8, (October 2008b), pp. 1-9. Kuttner, Kenneth N., “The Federal Reserve as a Lender of Last Resort during the Panic of 2008,” The Committee on Capital Markets Regulation, January 13, 2009. Stransberry, Porter., “How AIG's Collapse Began a Global Run on the Banks”, Stock House, October 2008. Working Group on Financial Reform, Financial Reform: A Framework for Financial Stability, (Washington D.C.: Group of Thirty, January 15, 2009). www.group30.org/pubs/recommendations.pdf Read More