Origins
AIG was transformed from a traditional insurance company into a global financial behemoth by Maurice “Hank” Greenberg, who built the firm’s prestige on a triple-A credit rating and aggressive risk-taking. In 1987, Greenberg backed the creation of AIG Financial Products (AIG-FP), a division designed to trade complex derivatives like interest rate and currency swaps. While the parent was a regulated insurer, FP was a lightly regulated unit based in Wilton, Connecticut, and London.
The division exploited AIG’s massive balance sheet to enter into long-dated contracts that competitors with lower ratings could not match. For years, this “joint venture” was spectacularly profitable, with FP’s traders and executives claiming 38% of the unit’s profits as personal compensation. The primary problem AIG-FP solved for Wall Street was the need for an extremely high-credit-rated counterparty to take the other side of complex derivatives trades.
Structure & Function
Under the leadership of Joseph Cassano, AIG-FP moved into credit default swaps (CDS)—contracts that functioned as insurance policies against borrower defaults. They specialized in the “super-senior” tranches of collateralized debt obligations (CDOs), which were supposedly safer than even the highest-rated traditional securities. These swaps allowed major banks to move risk off their balance sheets and significantly reduce their capital requirements.
AIG-FP’s models suggested a 99.85% probability that the firm would never have to pay a single penny on these contracts, which led them to forgo the expensive “hedging” that other market participants employed. The firm’s fatal flaw was a series of “collateral triggers” embedded in its contracts. If AIG’s credit rating fell or the market value of the underlying subprime mortgages declined, AIG was contractually obligated to post billions of dollars in cash collateral to its counterparties—most notably Goldman Sachs.
Historical Significance
AIG’s legacy is the ultimate case study in systemic interconnectedness. Because virtually every major financial institution in the world was a client of AIG-FP, its default would have triggered a global chain reaction of failures. This forced the U.S. government to provide an initial $85 billion bailout on September 16, 2008—just one day after Lehman Brothers’ bankruptcy—to prevent its default on $500 billion of credit default swaps from causing global contagion.
The bailout eventually grew to over $180 billion, making it the largest corporate rescue in history. AIG’s near-collapse demonstrated that systemic risk could originate not just in traditional banks but in any highly interconnected financial institution. It also exposed the dangers of derivatives trading occurring outside the regulated banking system, contributing to the passage of the Dodd-Frank Act’s derivatives reforms.
Key Developments
- 1919: Cornelius Vander Starr founds the company in Shanghai.
- 1968: Hank Greenberg becomes CEO and begins aggressive expansion.
- 1987: AIG Financial Products (AIG-FP) is created.
- c. 1998: AIG-FP begins writing credit default swaps.
- 2001: Joseph Cassano becomes head of AIG-FP.
- c. 2004: AIG-FP begins selling protection on multisector CDOs stuffed with subprime mortgages.
- 2005: Hank Greenberg is forced out amid accounting scandals; AIG’s credit rating is downgraded.
- 2007 (July): Goldman Sachs issues the first massive $1.8 billion collateral call to AIG-FP.
- 2007 (August): Cassano tells investors that AIG-FP’s subprime exposure “could not see…losses.”
- 2008 (February): AIG discloses $11 billion in unrealized losses on its CDS portfolio.
- 2008 (September 15): Lehman Brothers files for bankruptcy; pressure mounts on AIG.
- 2008 (September 16): The U.S. government provides an initial $85 billion bailout to prevent systemic collapse.
- 2008 (November): Bailout is restructured and expanded.
- 2012: U.S. Treasury sells its final AIG shares, ending government ownership.