Direct answer: AIG's near-failure resulted from its Financial Products (AIGFP) division selling credit default swaps on mortgage-backed CDOs without holding adequate capital against those positions. AIGFP earned premiums for providing credit protection on $440 billion in securities, treating this as near-riskless insurance income because AAA-rated CDOs had never previously experienced widespread losses. When CDO values fell in 2007-2008, AIG faced collateral calls from counterparties it could not meet. The U.S. government provided $182 billion in assistance (subsequently mostly recovered) to prevent AIG's failure from triggering cascading losses at Goldman Sachs, Deutsche Bank, Societe Generale, and dozens of other institutions that held AIG credit protection.
AIG 2008 Investment Autopsy: What Actually Went Wrong?
The investment
Category: Financial Crisis Failure
Era: 2005-2008
Primary failure mechanism: credit default swap exposure / AIG FP / counterparty risk
What investors believed
AIG Financial Products earned premiums for writing credit protection on AAA-rated securities. Historical default rates on such securities were near zero, making the business appear risk-free.
What broke
Ratings on CDOs were wrong. Correlation between underlying mortgages was higher than models assumed. When housing prices fell nationally, even AAA tranches defaulted.
Warning signals that were visible
- AIG FP's income growing rapidly through 2005-2007 indicating expanding exposure
- Academic research questioning CDO correlation assumptions published before the crisis
- AIG's own risk models showing low but non-zero probability of the scenarios that actually occurred
- Rating agencies simultaneously downgrading CDOs holding assets that had not changed their underlying quality
Transferable lessons
- Insurance against tail risks that have never historically materialized is not risk-free; it is an unpriced tail risk
- Correlation in models determines how much protection a senior tranche provides; if correlation assumptions are wrong, the protection is wrong
- AIG's balance sheet provided visible systemic counterparty risk to financial institutions that regulators should have required to be disclosed
- Government bailout of insurance companies, not banks, is possible when the systemic linkage is sufficiently large
Frequently Asked Questions
How did credit default swaps work in AIG's case?
A credit default swap (CDS) is a contract where one party (the protection seller, AIG) agrees to compensate another party (the protection buyer, a bank) if a specified credit instrument defaults. AIG charged premiums for promising to pay if CDOs backed by mortgage securities experienced losses. Because the CDOs held AAA-rated tranches, AIG's models showed minimal probability of having to pay out. AIG also did not initially post collateral because counterparties agreed to release collateral requirements based on AIG's own AAA rating. When AIG's credit rating was downgraded and CDO values fell simultaneously in September 2008, collateral calls from dozens of counterparties simultaneously demanded billions in margin that AIG did not have.
Who benefited from the AIG bailout?
The government's $182 billion rescue of AIG directly benefited AIG's counterparties who held credit default swaps. The Federal Reserve's Maiden Lane III vehicle purchased approximately $27 billion in CDOs from AIG's counterparties at 100 cents on the dollar, including Goldman Sachs ($14 billion), Societe Generale ($4.1 billion), Deutsche Bank ($2.6 billion), and Merrill Lynch ($1.8 billion). Critics noted that these payments at full value rather than negotiated discounts represented a windfall to sophisticated institutions that had conducted risk management business with AIG. Treasury Secretary Paulson, who previously led Goldman Sachs, recused himself from the specific decision about AIG's counterparty payments while remaining involved in the broader rescue.
How much did taxpayers recover from the AIG bailout?
The U.S. government ultimately recovered more than it invested in AIG. The Federal Reserve loans were repaid with interest. Treasury sold its equity stake in AIG at prices above cost as AIG's financial condition improved. The total government investment of approximately $182 billion was recovered in full plus a profit by 2012. This recovery was unusual among financial crisis interventions. AIG survived as a functioning insurance company and remains one of the largest insurers in the world, though significantly smaller and more conservatively managed than before 2008.