what to make of the unusually low level of capital available to cover losses on the derivatives

TO BE NOTED: From the FT:

"Genesis of the debt disaster

By Gillian Tett

Published: May 1 2009 19:16 | Last updated: May 1 2009 19:16

In the 1990s, a young team at Wall Street investment bank JP Morgan pioneered a new way of making money – credit derivatives. Within a decade, the market for these exotic securities had exploded to more than $12,000bn – and some people later blamed them for fuelling the global financial fiasco. In the first of two extracts from her book, Fool’s Gold, the FT’s Gillian Tett reveals how the innovation genie was first let out of the bottle – and eventually devoured the system, to the horror of its creators. The first sign that there might be a structural problem with the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up emerged in the second half of 1998. In the preceding months, Blythe Masters and Bill Demchak – key members of JP Morgan’s credit derivatives team – had been pestering financial regulators. They believed that by using the new credit derivative products they had helped create, JP Morgan could better manage the risks in its portfolio of loans to companies, and thereby reduce the amount of capital it needed to put aside to cover possible defaults. The question was by how much. (Though these bundles of credit derivatives later went under other names, such as collateralised debt obligations [CDOs], at that time these pioneering structures were known as “Bistro” deals, short for Broad Index Secured Trust Offering). Masters and Demchak had done the first couple of Bistro deals on behalf of their own bank without knowing the answer to their question for sure. But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.

The regulators weren’t sure. When officials at the Office of the Comptroller of the Currency and the Federal Reserve had first heard about credit derivatives and CDOs, they had warmed to the idea that banks were trying to manage their risk. But they were also uneasy because the new derivatives didn’t fit neatly under any existing regulations. And they were particularly uncertain over what to make of the unusually low level of capital available to cover losses on the derivatives.

When the team did their first Bistro deal, they pooled more than 300 of JP Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans. The lure of the idea was clear: the team had calculated that they only needed to set aside $700m – a strikingly small sum – against the risk of defaults among the 300-plus loans. After much debate, the credit rating agencies had agreed with the team’s assessment of the risks, and the deal had gone ahead on the basis that if financial Armageddon wiped out the $700m funding cushion, JP Morgan would absorb the additional losses itself. To Masters and Demchak, the chance that losses would ever eat through $700m were minuscule.

That argument didn’t wash with European regulators, and some of their US counterparts were uneasy, too. Christine Cumming, a senior Fed official, indicated to Masters and Demchak that JP Morgan should look for a way to insure the rest of the risk – the “missing” $9bn in their original Bistro scheme – if the bank wanted to gain approval to cut its capital reserves. So Masters and her team set out to find a solution. They started by giving the bundle of “uninsured” risk a name. Masters liked to refer to it as “more than triple-A”, since it was deemed even safer than triple A-rated securities. But that was too clumsy to market, so they came up with “super-senior”. The next step was to explore who, if anyone, might want to buy or insure it.

The task did not look easy. As far as JP Morgan was concerned, this risk was not really risky at all, so there was no point paying anything other than a token amount to insure it. On top of that, whoever stepped up to acquire or insure the super-senior risk had to be brave enough to step into an unfamiliar world.

. . .

The seeds of AIG’s destruction

Masters eventually spotted one solution to the super-senior headache. In the past, one of JP Morgan’s longstanding blue-chip clients had been the mighty insurance company American International Group. Like JP Morgan, AIG was a pillar of the American financial establishment. It had risen to prominence by building a formidable franchise in the Asian markets during the early-20th century. That business was later extended to the US, making the company a powerful force in the American economy after the second world war. AIG was considered a weighty and utterly reliable market player, and like JP Morgan, it basked in the sun of a triple-A credit rating.

But within AIG, an upstart entrepreneurial subsidiary was booming. In the late 1980s the company hired a group of traders who had previously worked for Drexel Burnham Lambert, the infamous – and now defunct – champion of the junk-bond business under Michael Milken in the mid-1980s. These traders had developed a capital markets business, known as AIG Financial Products and based in London, where the regulatory regime was less restrictive. It was run by Joseph Cassano, a tough-talking trader from Brooklyn. Cassano was creative, bold and highly ambitious. More important, he knew that, as an insurance company, AIG was not subject to the same burdensome rules on capital reserves as banks. That meant it would not need to set aside anything but a tiny sliver of capital – at most – if it insured the super-senior risk. Nor was the insurer likely to face hard questions from its own regulators because AIG Financial Products had largely fallen through the cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose officials had scant expertise in the field of cutting-edge financial products.

Masters pitched to Cassano that AIG take over JP Morgan’s super-senior risk, and Cassano happily agreed. It was a “watershed” event, or so Cassano later observed. “JP Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what they called Bistro trades [which] were the precursors to what [became] the CDO market,” he explained. It seemed good business for AIG.

AIG would earn a relatively paltry fee for providing this service – just 0.02 cents per dollar insured per year. But if 0.02 cents is multiplied a few billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a “win–win” solution. Only many years later did it become clear that Cassano’s trade had set AIG on the path to ruin.

With the AIG deal in hand, the JP Morgan team returned to the regulators and pointed out that a way had been found to remove the rest of the credit risk from their Bistro deals. They started plotting other sales of super-senior risk to other insurance and reinsurance companies, which snapped it up, not just from JP Morgan but from other banks too.

Then, ironically, just as this business was taking off, the US regulators weighed in again. Officials at the Office of the Comptroller of the Currency and the Fed indicated to JP Morgan that after due reflection they thought that banks did not need to remove super-senior risk from their books after all. The lobbying by Masters and others had seemingly paid off. The regulators were not willing to let the banks get off scot-free. If they held the super-senior risk on their books, they would need to post reserves one-fifth the size of the usual amount (20 per cent of 8 per cent, meaning $1.60 for every $100 that lay on the books). There were also some conditions. Banks could only cut their capital reserves in this way if they could prove that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a Bistro-style structure carried a triple A credit rating from a “nationally recognised credit rating agency”. Those were strict terms, but JP Morgan was meeting them.

The implications were huge. Banks had typically been forced to hold $800m reserves for every $10bn of corporate loans on their books. Now that sum could fall to just $160m. The Bistro concept had pulled off a dance around the international banking rules.( NB DON )

For a while, Demchak’s team stopped transferring super-senior risk from JP Morgan’s books. But then Demchak became uneasy. The super-senior risk was ballooning to a staggering figure, because when the bank arranged these credit derivatives transactions for clients, it typically put the super-senior risk in the deal on its own balance sheet. In theory, there was no reason to worry. But by 1999, the total pipeline of future deals had swelled towards $100bn. Something about that mountain of risk started to offend Demchak’s common sense. “If you have got $60bn, $100bn or however many billions of something on your balance sheet, that is a very big number,” he remarked to his team. “I don’t think you should ignore a big number, no matter what it is.”

. . .

The problem with correlation

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody’s had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody’s had rated so many of these securities triple-A.

The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn’t want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.

That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.

. . .

The mortgage time bomb

Around the same time, the JP Morgan team stumbled on a second, potentially bigger problem. As the innovation cycle turned and earnings declined from the early Bistro deals based on pools of corporate loans, Demchak asked his team to explore new uses for Bistro-style deals, either by modifying the structure or by putting new kinds of loans or other assets into the mix. They decided to experiment with mortgages. Terri Duhon was at the heart of the endeavour. Only 10 years earlier, Duhon had been a high-school student in Louisiana. When she told her relatives she was going to work in a bank, they had assumed she was going to be a teller. Now she was managing tens of billions of dollars. She was trained as a mathematician, and she thrived on adrenaline, riding motorbikes in her spare time. Even so, she found the thought of being in charge of all those zeros awe-inspiring. “It was just an extraordinary, intense experience,” she later recalled.

A year after Duhon took on the post, she got word that Bayerische Landesbank, a large German bank, wanted to use the credit derivatives structure to remove the risk from $14bn of US mortgage loans it had extended. She debated with her team whether to accept the assignment; working with mortgage debt wasn’t a natural move for JP Morgan. But Duhon knew that some of the bank’s rivals were starting to conduct credit derivatives deals with mortgage risk, so the team decided to take it on.

As soon as Duhon talked to the quantitative analysts, she encountered a problem. When JP Morgan had offered the first Bistro deals in late 1997, it had access to extensive data about all the loans it had pooled together. So did the investors who bought the resulting credit derivatives, since the bank had deliberately named all of the 307 companies whose loans were included. In addition, many of these companies had been in business for decades, so extensive data were available on how they had performed over many business cycles. That gave JP Morgan’s statisticians, and investors, great confidence in predicting the likelihood of defaults. But the mortgage world was very different. For one thing, when banks sold bundles of mortgage loans to outside investors, they almost never revealed the names and credit histories of the individual borrowers. Worse, when Duhon went looking for data to track mortgage defaults over several business cycles, she discovered it was in short supply.

While America’s corporate world had suffered several booms and recessions in the later 20th century, the housing market had followed a steady path of growth. Some specific regions had suffered downturns: prices in Texas, for example, fell during the Savings and Loans debacle of the late 1980s. But since the second world war, there had never been a nationwide house-price slump. The last time house prices had fallen significantly en masse, in fact, was way back in the 1930s, during the Great Depression. The lack of data made Duhon nervous. When bankers assembled models to predict defaults, they wanted data on what normally happened in both booms and busts. Without that, it was impossible to know whether defaults tended to be correlated or not, in what circumstances they were isolated to particular urban centres or regions, and when they might go national. Duhon could see no way to obtain such information for mortgages. That meant she would either have to rely on data from just one region and extrapolate it across the US, or make even more assumptions than normal about how defaults were correlated. She discussed what to do with Krishna Varikooty and the other quantitative experts. Varikooty was renowned on the team for taking a sober approach to risk. He was a stickler for detail and that scrupulousness sometimes infuriated colleagues who were itching to make deals. But Demchak always defended Varikooty. His judgment on the mortgage debt was clear: he could not see a way to track the potential correlation of defaults with any confidence. Without that, he declared, no precise estimate could be made of the risks of default in a pool of mortgages. If defaults on mortgages were uncorrelated, then the Bistro structure should be safe for mortgage risk, but if they were highly correlated, it might be catastrophically dangerous. Nobody could know.

Duhon and her colleagues were reluctant simply to turn down Bayerische Landesbank’s request. The German bank was keen to go ahead, even after the uncertainty in the modelling was explained, and so Duhon came up with the best estimates she could to structure the deal. To cope with the uncertainties the team stipulated that a bigger-than-normal funding cushion be raised, which made the deal less lucrative for JP Morgan. The bank also hedged its risk. That was the only prudent thing to do, and Duhon couldn’t see herself doing many more such deals. Mortgage risk was just too uncharted. “We just could not get comfortable,” Masters later said.

In subsequent months, Duhon heard through the grapevine that other banks were starting to do credit derivatives deals with mortgage debt, and she wondered how they had coped with the lack of data that so worried her and Varikooty. Had they found a better way to track the correlation issue? Did they have more experience of dealing with mortgages? She had no way of finding out. Because the credit derivatives market was unregulated, details of the deals weren’t available.

The team at JP Morgan did only one more Bistro deal with mortgage debt, a few months later, worth $10bn. Then, as other banks ramped up their mortgage-backed business, JP Morgan largely dropped out. Eight years later, the unquantified mortgage risk that had frightened off Duhon, Varikooty and the JP Morgan team had reached vast proportions. And it was spread throughout the western world’s financial system.

Gillian Tett is an assistant editor at the FT. In March, she was named Journalist of the Year at the British Press Awards

This is an edited extract from ‘Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe’ by Gillian Tett. It is published this week by Little, Brown, £12.99, and in mid-May by Simon & Schuster in the US. To buy the book at 20 per cent discount, call the FT ordering service on 0870 429 5884 or go to www.ft.com/bookshop

Go to FT.com/tettinterview for a video interview of Gillian Tett by Andrew Davis, FT Weekend editor

Copyright The Financial Times Limited 2009"

industry’s uncertain outlook, tough funding markets and AIG’s need to unload assets to repay $100bn in debt and equity to the US government

TO BE NOTED: From the FT:

"Cut-price bids made for AIG’s aircraft unit

By Justin Baer and Francesco Guerrera in New York

Published: April 27 2009 00:12 | Last updated: April 27 2009 00:12

International Lease Finance Corp has drawn a step closer towards separation from its troubled parent, insurer AIG, with three investment groups submitting bids to acquire the aircraft lessor for less than $5bn.

People close to the situation said one consortium was led by Thomas H. Lee Partners and Carlyle Group, while Onex and Greenbriar Equity Group headlined a second group. The third bidder’s identity could not be determined.

While the three bids may be considered to be low given ILFC’s book value of $7.6bn, they reflect the industry’s uncertain outlook, tough funding markets and AIG’s need to unload assets to repay $100bn in debt and equity to the US government. Nevertheless, the sale of ILFC, one of the most successful businesses in AIG’s sprawling portfolio, would represent the biggest disposal by the insurer since it was first bailed out by the US government last September.

AIG is likely to negotiate with the three groups for several weeks before presenting the winning bid to the New York Federal Reserve and US Treasury, which hold a stake of about 80 per cent in the insurer. AIG, the bidders and ILFC declined to comment.

The insurer’s near-collapse last September has limited ILFC’s access to cheap funding, which is considered critical for large lessors such as GE Capital, General Electric’s finance arm.

AIG has pledged to support ILFC until its sale. But the division’s efforts to raise several billion dollars through a new credit facility have met with tepid demand from European banks and other traditional sources of aviation finance, people familiar with the matter said.

Additional funding may come from the Fed, which has been in talks with ILFC to extend the company a $5bn loan, and from key aerospace manufacturers that have come to rely on ILFC.

The sources of capital have been viewed as vital to the sale process to assure would-be buyers that ILFC can endure the credit crisis and a brutal downturn in demand for air travel.

People familiar with the matter said that other banks might be willing to participate in the credit facility once a buyer emerges from the auction.

ILFC has ordered 168 aircraft worth $16.7bn from Boeing and Airbus.

The aircraft are scheduled to be bought during the next 10 years, with 49 of them – worth about $3bn – set to be delivered this year.

Copyright The Financial Times Limited 2009"

Treasury is going to have to take some TARP money and reimburse the Fed

TO BE NOTED: From Bloomberg:

"Bear, AIG Dumped $74 Billion in Subprime, CDOs on Fed (Update1)

Share | Email | Print | A A A

By Mark Pittman

April 24 (Bloomberg) -- The Federal Reserve took on more than $74 billion in subprime mortgages, depreciating commercial leases and other assets after Bear Stearns Cos. and American International Group Inc. collapsed.

In its biggest disclosure of the securities accepted to stabilize capital markets, the Fed said yesterday it had unrealized losses of $9.6 billion on the assets as of Dec. 31. The bonds, swaps and notes were taken in from Bear Stearns, once the fifth-biggest Wall Street firm by capitalization, and AIG, which had been the world’s largest insurer.

The losses on securities backed by assets such as home loans in Florida and California signal that U.S. taxpayers may be forced to reimburse the central bank through the Troubled Asset Relief Program, according to Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics.

“The numbers basically confirm that Treasury is going to have to take some TARP money and reimburse the Fed,” said Whalen, whose financial-services research company analyzes banks for investors. “It is essentially up to the Treasury to get the Fed out of this.”

The central bank lent $2 trillion to financial institutions and hasn’t disclosed information about most of the collateral backing those loans.

Treasury spokesman Andrew Williams declined to comment.

Pressure to Disclose

The Fed report follows requests from lawmakers to identify the collateral and a lawsuit by Bloomberg News. Fed Chairman Ben S. Bernanke pledged to expand disclosure, assigning Vice Chairman Donald Kohn to lead the effort.

The central bank has refused to name the borrowers, the amounts of loans or the assets banks put up as collateral under most of its programs, arguing that doing so might set off a run by depositors and unsettle shareholders. That would be less of a concern for New York-based AIG, now 80 percent owned by the federal government, and Bear Stearns, taken over by New York- based JPMorgan Chase & Co. a year ago.

Bloomberg, the New York-based company majority-owned by New York Mayor Michael Bloomberg, sued Nov. 7 under the Freedom of Information Act on behalf of its Bloomberg News unit. The public is an “involuntary investor” in the nation’s banks, according to an April 15 court filing by Bloomberg.

Maiden Lanes

In the report, the Fed detailed its assets in three limited liability corporations, all called Maiden Lane, after a street in Lower Manhattan that runs past the New York Fed.

The $9.6 billion in losses are unrealized because they represent the difference between the fair value of the security under accounting rules and the amount outstanding. The losses become real if the principal isn’t returned.

Maiden Lane I is a $25.7 billion portfolio of Bear Stearns securities related to commercial and residential mortgages. JPMorgan refused to buy them when it acquired Bear Stearns to avert the firm’s bankruptcy.

The Fed’s losses included writing down the value of commercial-mortgage holdings by 28 percent to $5.6 billion and residential loans by 38 percent to $937 million as of Dec. 31, the central bank said. Properties in California and Florida accounted for 45 percent of outstanding principal of the residential mortgages.

AIG Counterparties

Maiden Lane II contains almost $11 billion of outstanding subprime mortgage-backed securities from the AIG transaction that the Fed said lost $180 million so far. The fund also contains $6.2 billion of Alt/A adjustable-rate mortgage-backed securities that the report said has $936 million of unrealized losses. The Fed values $11.4 billion of assets in Maiden Lane II with mathematical modeling, the same methods used by banks and AIG itself.

About 19 percent of the mortgage-backed securities are rated speculative grade, or BB+ at Standard & Poor’s, according to the Fed. About 40 percent are given the top rating of AAA.

Maiden Lane III has lost $2.6 billion after being created Oct. 31 to buy collateralized debt obligations from AIG counterparties, according to the Fed. CDOs in this unit include three parts of a high-grade asset-backed security known as TRIAX 2006-2A, totaling about $3.2 billion. Maiden Lane III also has two parts of a commercial mortgage-backed CDO called MAX 2007-1 A-1 with a face value totaling $7.5 billion. The fair value of those two is less than half that much, or $3.3 billion, according to the central bank.

A third of the amount outstanding in the Maiden Lane III CDOs are speculative grade, or deemed by ratings companies as having a greater chance of default. Another 27 percent are rated AA+ to AA-, the second-highest tier of S&P’s scale, the Fed said in its report. All but $155 million of the $26.8 billion in CDOs are classified as Level 3 assets, or those valued with mathematical models instead of market prices.

The case is Bloomberg LP v. Board of Governors of the Federal Reserve System, 08-CV-9595, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net."

bondholders who have purchased CDS on this debt have little incentive to negotiate or play ball

From Clusterstock:

"The AIG Bailout Is Pushing Other Companies Into Bankruptcy

Joe Weisenthal|Apr. 17, 2009, 8:14 AM|8

Print

Tags: Economy, Bankruptcy, Holiday Season, Bailout, AIG, Financial Crisis

This week, mall operator General Growth Partners (GGP) and newsprint maker AbitibiBowater both filed for bankruptcy, after failing to persuade bondholders to restructure voluntarily.

Now lawyers involved in these bankruptcy proceedings tell the Financial Times that the credit default swaps are the problem -- mainly, bondholders who have purchased CDS on this debt have little incentive to negotiate or play ball, since the CDS, if the counterparty honors the agreement, makes them whole.

FT: Some creditors, including Citigroup, which held a small exposure to AbitibiBowater, hedged themselves in the CDS market, meaning their economic interest in the deal was different to lenders who had not bought credit insurance, according to people familiar with the matter. Citigroup declined to comment.

Lawyers say CDS holdings were also a factor in the default and filing for Chapter 11 protection of General Growth Properties this week. Restructuring advisers expect many more such cases involving so-called fallen angels, or firms originally investment grade, since CDS was widely sold on such names.

Now just take a wild guess. What firm is most likely to be on the other end of Citi's CDS purchase? AIG maybe?

If it is AIG, it means our bailout is pushing companies into bankruptcy that might otherwise be able to restructure.

Note that this has been alleged before, though previously with GM's ongoing failure to get its bondholders to exchange debt for equity. Now those involved in actual bankruptcies are citing it as a problem."

Me:

Don the libertarian Democrat (URL) said:

Apr. 17, 10:36 AM

"hedged themselves in the CDS market"

This makes sense. They insured themselves against a loss in their bonds. Consequently, they will be paid something either way, and are simply trying to figure out the best deal. What's the problem? Wouldn't you do that? The other creditors took a risk by not buying CDS insurance. What am I missing?

So far it has sold 12 businesses for more than $4 billion.

TO BE NOTED: From Reuters:

1 of 1Full Size

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By Paritosh Bansal

NEW YORK (Reuters) - American International Group Inc agreed to sell its U.S. auto insurance business to Zurich Financial Services for $1.9 billion, marking the largest asset sale by the insurer since its September rescue.

Separately, Zurich said on Thursday that it expects first-quarter results will be materially in line with recent quarters and its regulatory solvency ratio will remain strong, following a finalized year-end 2008 figure of 160 percent.

Zurich had a business operating profit of $1.0 billion and net income after tax attributable to shareholders of $205 million in the fourth quarter.

It said the deal with AIG would boost its earnings per share immediately, and create the third-largest U.S. personal lines insurer. But the company wants to increase its market share in the business further and would look at other operations, said Paul Hopkins, chief executive of Zurich Americas.

Hopkins did not rule out other deals with AIG and more acquisitions in general.

"We look at AIG as an excellent insurance company," he told Reuters in an interview. "So if there were other assets that met our strategic and financial thresholds that were run by AIG or any other group, we would certainly look at them positively."

Zurich shares, which are down 15 percent this year, closed 3.4 percent higher on Thursday at 198.70 Swiss francs. AIG shares closed up 9 cents, or 5.6 percent, at $1.69 on the New York Stock Exchange.

DEAL TERMS

Zurich's Farmers Group Inc will acquire AIG's 21st Century Insurance Group in exchange for $1.5 billion cash and $400 million in notes backed by Zurich Insurance Co.

Farmers Group will also assume 21st Century's outstanding debt of $100 million.

Zurich plans to immediately sell the regulated insurance entities for $1.4 billion in cash to Farmers Exchanges, which it manages but does not own.

Farmers Exchanges are three reciprocal insurers, which are owned by their policy holders. Zurich manages them through Farmers Group, a management and holding company.

Zurich will also provide increased underwriting capacity to the Farmers Exchanges.

Zurich, the fourth-largest European insurer, will sell ordinary shares to raise $1.1 billion to help meet increased capital needs to support the acquisition and the additional business assumed. It said it will immediately launch the sale of shares to a limited number of institutional investors.

AIG bought out the minority shareholders in 21st Century in 2007 in a deal that valued the business, at that time, at about $2 billion.

Zurich had made an offer for the auto insurance business in February in the range of $2 billion to $2.5 billion, but market volatility kept a deal from coming together, a source familiar with the deal said.

US insurer MetLife Inc had been interested in the AIG business as well at one point, another source familiar with the matter said.

MetLife was not immediately available for comment. The sources did not want to be identified because the information was not public.

BROADER BASE

The business being sold includes the former AIG Direct and Agency Auto businesses. It operates in 49 states and Washington, D.C. In 2008, 21st Century reported total premiums of $3.6 billion.

The deal adds about 1.5 million direct auto customers and an estimated 500,000 new customers per year to Farmers' personal lines operations. It also broadens its geographic base, particularly in the eastern United States.

It also gives Farmers 21st Century's platform to sell insurance directly to people.

"We realized that customer shopping behavior is changing and more people are starting to shop online," Hopkins said.

The deal excludes AIG's Private Client Group, which provides property and casualty insurance to high net worth individuals.

The transaction is expected to close by the third quarter.

U.S. taxpayers have taken a roughly 80 percent stake in AIG, once the world's largest insurer, in exchange for providing up to $180 billion in financial support.

The company is trying to ditch assets in a bid to pay back the government but has struggled to find buyers for big-ticket assets.

So far it has sold 12 businesses for more than $4 billion.

Banc of America Securities acted as financial adviser and Sidley Austin as legal counsel to AIG. Blackstone Advisory Services is advising AIG on its global restructuring program. Farmers Group was given financial advise by UBS. Willkie Farr & Gallagher was Farmers Group's legal counsel, while Skadden, Arps, Slate, Meagher & Flom advised UBS.

(Reporting by Paritosh Bansal and Megan Davies in New York, Victoria Howley in London, and Sven Egenter in Zurich; Editing by Andre Grenon, Gunna Dickson and John Wallace)"

The company is trying to sell off assets in a bid to pay back the government, but it has struggled to find buyers for big-ticket items.

TO BE NOTED: From Reuters:

1 of 1Full Size

By Paritosh Bansal

NEW YORK (Reuters) - American International Group Inc is close to a deal to sell its U.S. auto insurance business to Swiss insurer Zurich Financial Services for roughly $1.5 billion, a source familiar with the matter said on Wednesday.

A deal could be announced soon, the source said, but added that it had not been finalized and things could still fall apart.

If a sale does happen, it would be the largest for the insurer since its rescue by the U.S. government in September.

The unit being sold includes the 21st Century Insurance business, which AIG took over in 2007 when it bought out the minority stakeholders.

The auto insurance business is part of AIG's U.S. personal lines unit, which also includes selling products to high net-worth individuals through its AIG Private Client division. AIG Chief Executive Edward Liddy has previously said that the private client division is not being sold.

U.S. taxpayers have taken a roughly 80 percent stake in AIG, once the world's largest insurer, in exchange for providing up to $180 billion in financial support.

The company is trying to sell off assets in a bid to pay back the government, but it has struggled to find buyers for big-ticket items.

Last week Liddy said AIG had reached agreements to sell 10 businesses, "despite the most challenging market environment in memory."

These include the sale of HSB Group to German reinsurer Munich Re for $742 million and its Canadian life insurance unit to Bank of Montreal for about C$375 million.

AIG and Zurich declined to comment.

(Reporting by Paritosh Bansal, Editing by Ian Geoghegan)"

If reasonable lending practices had been followed, much of this crisis quite simply would not have occurred.

TO BE NOTED:

"United States Congress
House of Representatives
Committee on Oversight and Government Reform
2154 Rayburn House Office Building
Testimony of
Lynn E Turner
October 7, 2008
Thank you Chairman Waxman and Ranking Member Davis for the opportunity to testify before the Committee today. I applaud each of you and the committee members for holding this hearing on the regulatory mistakes and financial excesses that led to the collapse and federal rescue of AIG and what it means for the United States Economy. I ask that my written statement be included in the record.
By way of background, I formerly served as the chief accountant of the Securities and Exchange Commission. Before that, I was an audit partner in the international accounting firm now known as PricewaterhouseCoopers, where I worked on troubled financial institutions during the savings and loan crisis. I also have served as a vice president and chief financial officer of an international semiconductor company, and the vice president and managing director of research of the internationally recognized proxy governance and financial research firm, Glass Lewis. In addition, I currently serve as a trustee on the board of a mutual fund and a public pension fund. I have also served on the boards of publicly listed companies, having chaired their audit committees. More recently I was appointed by Secretary Paulson to the Treasury Committee on the Auditing Profession.
American International Group (“AIG”) serves as a reminder and an unfortunate but excellent example of what is wrong with our financial system today. While there are many capital market participants that operate within ethical and legal boundaries, there have been far too many that have not. We began the decade with names such as Enron and Worldcom, followed by the revelations regarding Wall Street analysts misleading investors, then on to the mutual fund late trading and market timing scandal, then the stock option back dating at companies such as United Health, and now we find ourselves in the midst of the biggest and most destructive crisis of all—the subprime fiasco. This is a crisis that could have, and should have, been averted before it cost American taxpayers what appears may be in excess of a trillion dollars before all is said and done.
There is plenty of blame to go around for this current crisis which is resulting in hundreds of thousands of Main Street Americans losing their jobs. This includes:
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Executives engaging in unsound, if not illegal, business practices when they made loans that had a high risk of not being repaid. Predatory lending practices and the making of loans in which lenders fail to determine if the borrowers have sufficient income to repay the loan, are not what American capitalism is about. If reasonable lending practices had been followed, much of this crisis quite simply would not have occurred.
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Incentives designed to pay executives hundreds of times what their average employees made as they engaged in business that would eventually cripple the businesses they ran, placing employees jobs at risk. But some business executives got paid both coming and going as they walked away from the equivalent of a train wreck with huge severance packages their corporate boards had agreed to.
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Credit rating agencies that appear to have been more interested in satisfying the companies who paid them, and facilitating Wall Street’s greed, than in protecting investors who clearly relied on them but mistakenly trusted them.
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The accounting standard setters who failed to require that companies provide investors and the capital markets with transparency that might have provided the free markets with the ability and insight to provide discipline that would have reined in abusive and uneconomic practices. And without such standards, companies viewed existing rules as a “ceiling” rather than the “floor.” At the same time, as FASB Chairman Herz has noted in a letter to the Chairman of the Senate Securities subcommittee, it appears some accounting and disclosure rules were violated by some public companies.
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The due diligence required of investment banks underwriting securities, including securitizations, appears to have been deficient especially in light of problems in the auction rate securities market.
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“Cheap” debt fueled by low interest rates, which led to higher leverage and debt in this country. And when debt is cheap and easy to get, some business executives tend to take on excessively high levels of short term debt or significant liquidity risks. Unfortunately, as these risks became more significant as evidenced by what was a $62 trillion credit derivative market, the transparency surrounding the market failed to keep pace.
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Regulation also failed to keep pace. At the Securities and Exchange Commission (“SEC”), the Office of Risk management had been reduced to an office of one by February of this year. From 2005, the number of SEC enforcement division personnel was cut by 146 from 1338 to 1192 in 2007. In 2004, the SEC reduced the capital requirements for the largest Wall Street investment banks. The SEC was given insufficient oversight authority over the credit rating agencies when Congress adopted the Credit Rating Agencies Reform Act of 2006. And as Chairman Cox has recently and correctly testified, Congress also failed to give the SEC adequate supervisory powers over Wall Street Investment Bank Holding companies with the passage of the Gramm Leach Bliley Act. Congress also has failed to regulate the credit and other derivative instruments which in some instances are “Toxic Waste” to the financial system.
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Meanwhile, the Federal Reserve and banking regulators examinations failed to identify and rectify unsound lending and banking practices at institutions such as IndyMac, Washington Mutual (“WaMu”), Countrywide, and Citigroup. Often these practices developed as lenders sold loans they had originated, or were able to protect against credit risks through credit derivatives, thereby eliminating any “skin in the game.” As these unsound practices grew, the regulators also failed to ensure there was adequate capital in financial institutions that had taken on and retained excessive risks.
Investor confidence is paramount to the success of any capital market. It is indeed the life blood of a capital system. When people believe they can no longer trust those with whom they invest their money, they withdraw it quickly and find safer havens for it. And when they demand their money back from a financial institution for fear of losing it, it can cause a serious liquidity crisis
and failure as we have seen at Bear Stearns, Lehman and others. As the money dries up and the demand for investment in the stock of these institutions falls, so does their stock price making capital difficult, if not impossible, to raise.
A Lack of Timely Transparency
Trust and confidence in markets and any company begins with, and ends with, transparency. Transparency that ensures investors can fully understand and assess the risks and rewards of investing in a company. Yet time and time again AIG has failed to provide the requisite transparency to its investors.
In the first part of this decade, AIG’s reported numbers were grossly in error leading to a May 2005 restatement of its financial statements for each of the years 2000 through 2004. The company disclosed it had inadequate internal controls and the errors had overstated income by approximately $3.9 billion. Such a huge restatement raises questions about the legitimacy of the value of the stock during these periods. As noted in Exhibit A, the company’s stock price went into a sharp decline, losing approximately $8.5 billion in market value as the restatement unfolded.
The restatement was in the wake of settlements with the SEC regarding Brightpoint, inc. and PNC Financial Services (“PNC”) and investigations by the SEC, Department of Justice (“DOJ”), and New York Attorney General. The SEC alleged that AIG had failed to produce large quantities of requested documents and failed to provide key documents when requested. AIG also was charged by the SEC and DOJ for its part in assisting PNC allegedly improper shift of $762 million of under-performing loans and volatile venture capital investments to three off-balance sheet structures that had been arranged with the help of AIG Financial Products Group (“AIGFP”).1
AIG’s 2005 Form 10-K was troubling for investors, as it disclosed “In many cases these transactions or entries appear to have had the purpose of achieving an accounting result that would enhance measures believed to be important to the financial community and may have involved documentation that did not accurately reflect the true nature of the arrangements.” This is hardly a situation or disclosure that instills confidence or trust.
Subsequent to such serious shortcomings in financial reporting, one would expect the company to “clean up” its act and become more transparent. But in 2006 and 2007, the company continued to report “out of period adjustments” – another way of saying it continued to have errors in its financial statements. It also reported a material weakness in its internal controls in 2006. Then in its 2007 annual report on Form 10-K, AIG reported that internal “…controls over the AIGFP super senior credit default swap portfolio valuation process and oversight thereof were not effective. AIG had dedicated insufficient resources to design and carry out effective
1 American International Group, Inc. Proxy Paper. Eric Crawley. Glass Lewis. July 22, 2005.
controls to prevent or detect errors and to determine appropriate disclosures on a timely basis with respect to the processes and models introduced in the fourth quarter of 2007.”
Such a disclosure immediately raises a question as to the values the company is reporting throughout its financial statements. If a company does not have adequate internal controls to even figure out if its valuation of assets is proper, then how can the company expect to ensure accurate, complete and transparent information is supplied to investors on a timely basis. Yet in August 2007, a former AIG executive, Joseph J. Cassano, had said “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”2 I had also heard a similar response.
If one follows the disclosures made by the company, they also raise questions. For example, in AIG’s June 30, 2007 quarterly filing, the company disclosed:
“…a downgrade of AIG’s long-term senior debt ratings to ‘Aa3’ by Moody’s or ‘AA-’ by S&P would permit counterparties to call for approximately $847 million of collateral. Further, additional downgrades could result in requirements for substantial additional collateral, which could have a material effect on how AIGFP manages its liquidity. The actual amount of additional collateral that AIGFP would be required to post to counterparties in the event of such downgrades depends on market conditions, the fair value of the outstanding affected transactions and other factors prevailing at the time of the downgrade. Additional obligations to post collateral would increase the demand on AIGFP’s liquidity.”
But just six months later in its annual report, the company disclosed:
“As of February 26, 2008, AIGFP had received collateral calls from counterparties in respect of certain super senior credit default swaps (including those entered into by counterparties for regulatory capital relief purposes and those in respect of corporate debt/CLOs). AIG is aware that valuation estimates made by certain of the counterparties with respect to certain super senior credit default swaps or the underlying reference CDO securities, for purposes of determining the amount of collateral required to be posted by AIGFP in connection with such instruments, differ significantly from AIGFP’s estimates. AIGFP has been able to successfully resolve some of the differences, including in certain cases entering into compromise collateral arrangements, some of which are for specified periods of time. AIGFP is also in discussions with other counterparties to resolve such valuation differences. As of February 26, 2008, AIGFP had posted collateral (or had received collateral, where offsetting exposures on other transactions resulted in the counterparty posting to AIGFP) based on exposures, calculated in respect of super senior default swaps, in an aggregate amount of approximately $5.3 billion. Valuation estimates made by
2 Behind Insurer’s Crisis, Blind Eye to a Web of Risk. Gretchen Morgenson. New York Times. September 28, 2008.
counterparties for collateral purposes were considered in the determination of the fair value estimates of AIGFP’s super senior credit default swap portfolio.”
In this disclosure, the accuracy of the early statement is seriously called into question as the company discloses (1) that counter parties have questioned the company’s valuations and (2) required $5.3 billion in collateral, as opposed to the $847 million amount disclosed earlier. The company did not disclose any information with respect to who the counter parties were. For example, if one of the counter parties was Goldman Sachs, a firm that has a reputation for excellence in valuation models, it might even further call into questions the amounts reported by the company.
Six months later, AIG disclosed in its June 30, 2008 quarterly report:
“ As of July 31, 2008, AIGFP had received collateral calls from counterparties in respect of certain super senior credit default swaps (including those entered into by counterparties for regulatory capital relief purposes and those in respect of corporate debt/CLOs). At times, valuation estimates made by certain of the counterparties with respect to certain super senior credit default swaps or the underlying reference CDO securities, for purposes of determining the amount of collateral required to be posted by AIGFP in connection with such instruments, have differed significantly from AIGFP’s estimates. AIG is unable to assess the effect, if any, that recent transactions involving sales of large portfolios of CDOs will have on collateral posting requirements. In almost all cases, AIGFP has been able to successfully resolve the differences or otherwise reach an accommodation with respect to collateral posting levels, including in certain cases by entering into compromise collateral arrangements, some of which are for specified periods of time. Due to the ongoing nature of these collateral calls, AIGFP may engage in discussions with one or more counterparties in respect of these differences at any time. As of July 31, 2008, AIGFP had posted collateral (or had received collateral, where offsetting exposures on other transactions resulted in the counterparty posting to AIGFP) based on exposures, calculated in respect of super senior credit default swaps, in an aggregate net amount of $16.5 billion. Valuation estimates made by counterparties for collateral purposes were considered in the determination of the fair value estimates of AIGFP’s super senior credit default swap portfolio.
The unrealized market valuation losses of $26.1 billion recorded on AIGFP’s super senior multi-sector CDO credit default swap portfolio represents the cumulative change in fair value of these derivatives, which represents AIG’s best estimate of the amount it would need to pay to a willing, able and knowledgeable third party to assume the obligations under AIGFP’s super senior multi-sector credit default swap portfolio as of June 30, 2008.”
A recent analyst’s report highlights the concerns with the lack of timely transparent disclosures to investors, which have weighed on the valuation of the stock as it has plummeted. The report states:
“According the company’s 10-Q, AIG had already posted $16.5 billion of collateral and was required to post an additional $14.5 billion following a downgrade by Moody’s and S&P to the mid-A level, bringing total collateral posting requirements to $31 billion if AIG was rated mid-A by both agencies…With S&P taking the company to low-A, AIG faces significant additional collateral posting requirements that it has not disclosed.”3 [emphasis supplied]
In one year, the disclosures from the company had gone from not losing a dollar to over $26 billion in valuation losses and counter parties that to this day have not been disclosed demanding over $16 billion in collateral. And on October 3, 2008 the Company disclosed that at the end of September it had borrowed $61 billion from the federal government due to the liquidity crisis such calls on collateral had placed on AIG. Clearly it would seem that in light of this, the company had failed to provide investors with a clear view of the magnitude of the potential demands for collateral. No doubt some investors may question if the SEC’s disclosures rules for Management’s Discussion and Analysis (“MD&A”) have been complied with. In a release in December 2003, the SEC stated:
“The purpose of MD&A is not complicated. It is to provide readers information "necessary to an understanding of [a company's] financial condition, changes in financial condition and results of operations." .The MD&A requirements are intended to satisfy three principal objectives:
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o provide a narrative explanation of a company's financial statements that enables investors to see the company through the eyes of management;
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o enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
to provide information about the quality of, and potential variability of, a company's earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
MD&A should be a discussion and analysis of a company's business as seen through the eyes of those who manage that business.”4 [footnotes omitted]
The Financial Accounting Standards Board has recently adopted new disclosure rules that should enhance transparency with respect to credit derivatives. However, it appears additional disclosures may be warranted by companies with respect to credit derivative notional amounts, a
3 AIG: Debt reduction and Asset Coverage Analysis. Credit Sights. September 30, 2008.
4 Interpretation: Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations. SEC. December 19, 2003.
roll forward of notional amounts as well as fair values of the derivatives, the terms and conditions that can result in a call for collateral, the weighted average duration of such contracts, and information regarding the counter party risk involved.
In addition, in light of recent events, it appears serious consideration needs to be given to further regulation of these instruments, and the market for them. I wholeheartedly support SEC Chairman Cox’s recent call for such regulation. It should include the appropriate mechanisms to increase transparency including transparency with respect to risk exposures, pricing, processing of transactions including timely clearing and settlement with appropriate documentation. Consideration should also be given to whether greater standardization of the market might enhance liquidity. In addition, banking regulators need to give greater consideration to how credit derivatives have contributed to banks being lax on credit risks and lending standards as they can now off lay credit risks with derivatives.
Management and the Corporate Board
The 2005 restatements of AIG’s financial statements also raise questions regarding the integrity of management and the competency of the Board. This led to the ouster of Hank Greenberg as CEO and Chairman of the Board. In that year, Glass Lewis recommended a vote against 10 of the 15 members up for election to the Board.5
Glass Lewis also raised questions were also raised regarding the newly appointed CEO, Martin J. Sullivan, and the new Chairman of the Board, Frank Zarb. Mr. Zarb had been on the board and a member of the audit committee during the years the misleading financial statements had been prepared. In addition, the Board had quickly appointed Mr. Sullivan, previously the vice chairman of the company and co-chief operating office under Greenberg as the new CEO. The Board did not consider other candidates or do an outside search of potential candidates.
Six of those directors who were at the company during the early years involved with the initial restatement and troubling transactions that gave rise to investigations, remained on the board through the end of 2007. One of these board members served on at least seven public company boards, a number considered excessive by most corporate governance experts. Other directors served as executives at not for profit organizations who had beneficiaries of significant contributions from AIG or its affiliates. Mr. Zarb had indicated in the 2005 proxy that he would step down as interim chair at the end of 2005. However, after getting reelected in 2005, Mr. Zarb remained as chairman until age limits required him to step down in 2008. I believe the board should have gone through a complete and thorough overhaul when the first restatement and law enforcement agency investigations arose.
In addition, the board had also approved a severance package for Mr. Sullivan who stepped down as CEO on July1, 2008. Despite investors suffering significant declines in stock value,
5 American International Group, Inc. Proxy Paper. Eric Crawley. Glass Lewis. July 22, 2005.
Mr. Sullivan’s arrangements include severance of $15 million, a pro rata bonus of $4 million and the continued vesting of outstanding equity and long-term cash awards valued at approximately $28 million. One must question why such a package would have been agreed to, especially when the CEO was hired just three years earlier without an executive search having been performed. In essence, Mr. Sullivan received what many on Main Street would consider a lot of money for very little if any performance.
The competency of the board in overseeing management was also called into question earlier this year when some investors and a former director called for a change in management. When an insider, the chairman of the board, was anointed as the new CEO, an analyst’s report stated:
“Increasingly, investors have lost confidence in AIG’s business model and current management…Until AIG is able to regain investor confidence in its business model, we expect to see weakness in spreads.
…We were hoping for an outside appointment of someone who could take an unbiased view of AIG’s portfolio of companies. Although we are negative on the appointment, we would note that Willumstad is a highly capable financial services executive. We simply do not see him as a good fit for the company at this moment in its history.”6
Clearly a question remains regarding the competency of this board to carry out its responsibility on behalf of investors.
Another issue that calls into question the decisions of the board is its selection of auditors. As part of the settlement with the New York Attorney General, AIG agreed to go through a proposal process for selection of an auditor. PWC has been the auditor for AIG for many, many years, and yet despite its knowledge of the company had not caught and reported the errors leading up to the 2005 restatement. During this time period it has been reported that there was a change in audit partners that was challenged by AIG management, and at their request a different audit partner assigned. The CFO was also a former PWC employee. In addition, there has continued to be constant reporting of “new” material weaknesses and errors – out of period adjustments – that call into question how one can have confidence and trust in the financial statements. To PWC’s credit, they have appropriately challenged management and highlighted the shortcomings. But one wonders if they have been constantly behind the curve in surfacing problems. I believe the board would have enhanced shareholder confidence by bringing in a “fresh set of eyes” and a new independent auditor.
The Role of Lax Regulation
6 AIG 2Q08: Brutalized by Super Senior Swaps. Credit Sights. August 7, 2008.
I believe one of the significant contributing factors that allowed management to engage in their unsound business practices was lax regulation. For example, banking regulators have recently taken actions with respect to mortgage lending standards. One must ask why now, why not several years ago when such loans could have been prevented. Certainly the banking regulators did periodic examinations at institutions they did oversee such as Countrywide and WaMu, and must have been aware of the unsound lending practices that were being engaged in.
Yet the lack of action by the Federal Reserve raises a question that should be considered further when the structure of the regulatory system is revisited. If the Fed, as the central bank responsible for setting monetary policy decides on a policy of increasing the monetary supply, and cheap debt, should it also be responsible for the examination of the lending practices of banks to assess if they are conservative enough? It would appear the most recent crisis would seem to support legislation introduced in 1994 that would have transferred the responsibility for examinations and the accompanying supervision of financial institutions to a single agency, consolidating responsibilities that are now split among the Federal Reserve, Office of the Comptroller and Office of Thrift Supervision.
Likewise, there clearly was a lack of transparency as a result of inadequate disclosure standards for off balance sheet financings, credit derivatives and risks associated with lending activities. These shortcomings have contributed to investors questioning the financial stability and liquidity of companies when investors were unable to get sufficient information as to make informed decisions. As a result, if the FASB is unable to act quickly and responsibly to remedy these shortcomings, the SEC should act before further damage is done to the capital markets.
The SEC also needs to take actions to shore up confidence in the agency which I believe has been seriously eroded as a result of the current crisis. For example, the Office of Risk Management should be adequately staffed to allow the agency on a proactive basis to identify risks in the market place such as those created by excessive leverage, or new financial instruments that carry significant system risks such as credit derivatives. Once identified, a plan for promptly and appropriately addressing regulatory and public policy issues should be formulated and an action plan established on a proactive basis before, not after, the train wreck has occurred.
In addition, the SEC needs to once again establish itself as the investors’ advocate and a watchdog rather than a lap dog. Constraints put on its enforcement division under the current chairman should be removed immediately. And reductions in staffing should be reversed.
Likewise, Congress should also provide the SEC with necessary regulatory authority to supervise credit rating agencies as well as credit derivatives in a meaningful fashion. Congress failed to give the SEC the statutory authority necessary to properly regulate investment banks holding companies which it failed to do when passing the Gramm Leach Bliley act. In 2004 this contributed to the SEC making a fatal and flawed decision to reduce the capital requirements for
the largest Wall Street investment banks, yet failing to provide adequate oversight or supervision subsequently to evaluate the extent of the leverage and consequent risks being taken on. To prevent further such occurrences, Congress should fill a gaping hole created by the Gramm Leach Bliley act which failed to give regulatory agencies including the SEC, the authority to regulate and set standards for conflicts that arise when banking and securities activities occur within the same financial institution. While it may not be immediately apparent, an objective of safety and soundness is not always consistent with protecting investors
Mark to Market Accounting – Don’t Shoot the Messenger
I would also be remiss if I did not address today a question which the staff of the Committee has raised with me regarding the use of what has been referred to as fair value or mark to market accounting. I agree with the Federal Reserve Chairman, the Secretary of the Treasury and former SEC Chairman Levitt that it would be a poor decision to permit banks to have a moratorium from market value accounting.
Perhaps a vivid reminder of what happens when banks are allowed to stray from reporting fair values and losses is highlighted in the General Accounting Office report titled “Failed Banks – Accounting and Auditing Reforms Urgently Needed” issued in April 1991. In citing problems that led to the costly taxpayer funded bailout of the banking and S&L industry, the Comptroller General, Charles Bowsher stated that call reports of failed institutions often failed to reflect timely asset devaluations “...resulting in continued operation and losses by unsafe and unsound banks, at considerable cost to the Bank Insurance Fund.” He noted that banking examinations at the time often reflected dramatically lower values than the failed banks had reported. The report states “...we believe that market value accounting should be adopted now for debt investment securities held by financial institutions.” The costly lessons cited in the GAO report should be avoided or the cost of the current bailout would likely grow due to a lack of accountability.
But regardless of whether we have fair value accounting, we would still have the current financial crisis. The crisis is brought on by the fact the banks and investment banks have leveraged up, having borrowed many times more than the typical business, and have run out of cash - a liquidity crisis as some say. Think of it this way. If you go out and make a $100 loan but the borrower can only repay say $60, then you have got something worth less than a $100. But if you do that hundreds of thousands of times, as was done by the banking industry and Wall Street, it doesn't take a rocket scientist to figure out that sooner or later one runs out of cash. You can't just keep paying out more than you collect without running out of cash and eventually going bankrupt.
In the crisis at hand, too many bad loans were made and put on the books at $100. But they weren't worth that despite credit rating agencies giving them a AAA rating on paper. In addition, because so often the money used to make the $100 loan with was borrowed, but only $60 was repaid, there also wasn't enough money left over to repay those from whom money was borrowed to make the loan in the first place.
Unfortunately, not all the banks and those on Wall Street told everyone, including investors, what they had been up to. And certainly they didn't at first tell them the loans were not worth
$100. But as liquidity and cash ran short, the losses became apparent and some institutions began to report losses. (Some such as Goldman Sachs had been much more transparent reporting fair values and losses much more timely, and have proven to be more astute and successful managers.)
Unfortunately, when investors of companies such as Bear Stearns and Lehman began to doubt the value of the assets that were reported in their balance sheets, uncertainty and a lack of trust developed. Investors chose to move their money and investments elsewhere. In the case of Lehman, investors had already lost money and been burned on their investments in Bear Stearns. As a result, institutions sold shares in Lehman before they incurred the types of losses that had occurred by holding the investments in Bear Stearns until the bitter end. This left a market for the Lehman stock where there were a lot more sellers than buyers, and as anyone who has taken Econ 101 knows that results in the price of the stock going down - quickly. In fact, much quicker than if just short sellers were to be blamed.
While this had occurred, others (like AIG) had agreed to provide credit protections on these loans. As people found out that the loans were only worth $60, investors also began to wonder what the credit protection was going to cost those who agreed to provide it. With trillions in credit protection granted through contracts that had to be honored, an agreement that could call for collateral or cash if the insurer's own credit worthiness was called into question was now a serious risk to the insurers. And of course, as the subprime loans did not pay off, then the insurance would kick in, and someone would have to pay up for the shortfall in the original $100 loan or put up collateral.
As we have seen with all the foreclosures and defaults, the subprime loans predictably did not pay off - (that is why they are called subprime). People or financial institutions who put up the money for the loans were not receiving payments equal to what they had paid out, thereby creating a shortfall that was insured. And the insurers ran short when called upon to make good on their insurance. So regardless of whether one used fair value accounting or not, the lack of cash and liquidity crisis would have occurred.
But if institutions were allowed to continue to report the value of their loans as worth a $100 when only $60 was being repaid, this is just flat out misleading, if not lying to those who own the company or might be buying the company's stock. It certainly results in less accountability.
Only by reporting the loans or investments at what they are worth, does the market and investors learn of the fact managers were making loans they shouldn't have been, and permit the market to discipline them early on when loans first start going bad. With that information in the public domain, investors will pay less for the stock and challenge management. Informed decisions are an aspect of market discipline that works, but only works when there is transparency, not a shroud of secrecy. On the other hand, if this is all done without disclosure, management is able to get away with such unsound business practices for much longer. Especially when there is lax oversight or a void in regulatory authority as certainly has occurred in recent years.
The poor transparency that investors have been experiencing is very similar to what happened during the savings and loan (“S&L”) crisis when reporting of bad loans was delayed. It also
occurred with Enron, when so much off balance sheet debt was hidden from investors and the markets. Now after these instances, we are seeing a repeat performance yet again. The question is: how often is Congress going to permit this to occur, each time at great cost to the individual American. The S&L bailout cost taxpayers somewhere between half a trillion and trillion depending on whose estimates one uses. During the Enron corporate scandals, the capital markets bottomed out after losing around $7 trillion in market capitalization, and today, the Nasdaq index is still less than half of what it was in 2000. Now Americans are facing a price tab that some predict could reach one and half trillion dollars. At some point, Americans will lose faith in their government if this continues.
Nonetheless, bankers are once again asking for a suspension of accounting that requires them to report to investors and depositors at a minimum four times a year what their assets are worth including any declines in values during the period. This comes at a time when the International Monetary Fund and Bridgewater Associates have reported mortgage related losses will balloon to between $945 billion and $1.6 trillion. But with institutions only reporting a little more than $500 billion in losses to date, it is apparent that more losses should be forthcoming if data from the banks is reliable. To suspend further reporting of these losses to investors and depositors is akin to a student asking for suspension of a report card when a failing grade is coming.
I note the banks are requesting a moratorium on their fair value report card. But they are also requesting $700 billion of American’s money to bail them out for the bad loans they made. And they want both. But if the problem was as they assert, fair value accounting, a moratorium on it should solve the problem without the need for a bailout. Yet they are still asking for ALL the cash. A true red herring: the problem isn’t fair value accounting at all, but rather a lack of cash in the banks themselves because they spent more on assets bought or created than they are subsequently getting paid back on. Ultimately, it is no different than someone who spends more than their paycheck each month. Sooner or later you end up in foreclosure, just as we are seeing with the banks themselves.
And the voice of those who create the problem always becomes loudest when there is a downturn in the markets. We seldom hear such loud screaming and complaining when the markets are rising and gains, not losses, are being recorded under fair value accounting. But when the values of assets have become impaired, managers often don't want to tell their investors that the assets under their stewardship have lost values. That information raises questions about what investors are receiving in return for the compensation being paid, as well as questions about the decisions and competency of management. Instead, companies would just as soon report higher inflated values, even to those who rely on credible financial statements to buy the stock. Companies argue that the stock market will turn around and they will recover the values of their assets. I think that is an argument I have heard AIG saying - that they would not incur losses. Reality has shown that argument and approach does not always work out for investors, like the pension funds who did not and will not recover their investments.
Others argue that you can't value these loans and securities, especially those for which there are illiquid markets. These, however, are not the vast majority of investments, that is investments for which prices are readily available. But for those in illiquid markets, one can look to the expected cash flows, using historical data informed by recent market transactions as a guiding
light, to determine what cash is expected to be paid, which is ultimately always the determining factor in setting valuations. Of course values are often adjusted down to reflect the risk a willing buyer takes on in purchasing the assets, and the return that will compensate the buyer sufficiently to entice one to take on those risks. Keep in mind there was a reason some institutions chose not to buy subprime securities in the volumes others did, and whose management these day are getting credit for looking a lot smarter than others. While markets are illiquid at times, as with a thinly traded stock, that is no reason to simply ignore the best estimate of a market value or a calculation of a fair value. The reason markets are sometimes illiquid is there is no one who is willing to pay the price the seller wants because that price provides any buyer an insufficient return on their investment. And while that may be a depressing price, it is not a depressed price – it is just what the market says it is worth. If the price is lowered to a number that provides an adequate return, more buyers will enter into the bidding for the investment.
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At the same time it is relevant that key indices on housing prices continue to decline. Ultimately, it is either the payments on the mortgage or the underlying value of the house which serves as collateral that determines the value of a mortgage loan, or related security instrument. Of the 55 million homes financed with residential mortgages, it is thought that perhaps 12-13 million are now “underwater.” And sales that have occurred in the market place have come at significantly reduced prices, such as sales by E-Trade or Merrill Lynch. Similarly we saw Wachovia received offers that would pay only cents on the dollar compared to its $75 billion net book value.
If the cash payments for a security or loan cannot be determined, one must ask why it is being sold into the public markets or being bought by a bank with depositor’s money in the first place. I don't recall seeing a prospectus or offering memorandum with disclosure to the prospective investor saying the seller of the subprime loans didn't have any idea about what the cash repayment streams would be. Of course such a disclosure would have been a red flag to investors and certainly would not have resulted in a AAA credit rating from the credit rating agency, as many of these investments were rated.
Some say we are experiencing a “distressed” market with abnormally low and unjustified prices that will in time return to higher values. That is like saying the market in some years is up, and some years is down, but we will ignore the down years and only use the prices in the up years. I never have heard anyone say you shouldn’t use inflated bubble level prices because certainly they will fall when the crash comes. I do think prices currently are “distressing” but then they always are when they are not rising. But that doesn’t mean we should give an exemption to companies permitting them to go out and say the markets and the values of their assets are up, when in fact they are not.
Finally, some people don't understand what FASB standard No. 157 is all about and their lack of an informed understanding shows. They often want a moratorium on that standard. But the reality is that it is a standard which in addition to greatly enhancing transparency in the current crisis accomplishes two things. However, one of them is not a requirement for using fair value accounting. That requirement actually rests in other standards.
The two things FASB No. 157 does is that it (1) tells accountants how to do fair value accounting when it is required by another standard, and (2) requires some very excellent disclosures on the
fair values that have been determined. In fact, this is the standard that requires a company or financial institution to put their investments into three buckets depending on how "hard" or "soft" or independently verifiable those valuations may be. The company must then tell investors how much is in each bucket, so one can understand with greater confidence the nature and types of investments and where greater judgments are required to come up with good and solid valuations. Without such a standard, as we saw during the S&L and banking crisis of the late 1980's accounting sleight of hand is all too common when assets are reported at much more than they are/were worth. To that end, investors can thank the FASB for greatly improving the disclosures.
Closing
In closing, transparency – the ability to get information needed to make fully informed investment decisions – is critical to gaining investors trust in markets. Unless that information is accurate and reliable, investors will not trust it. When investors are provided misleading or incomplete information, they rightfully steer clear of investing in the markets because all too often it leads to losses, as we saw with Enron and more recently, financial institutions. To bring back investors to the markets, they must once again be convinced they are getting reliable information upon which to base informed, not misinformed decisions. Until then, they may prefer Las Vegas where at least the word “Casino” appears on the entrance.
Thank you and I would be happy to take any questions committee members might have.
EXHIBIT A
AIG Stock Charts – As of close of business on October 3, 2008
Stock Price $ 3.86
AIG Year To Date stock chart as of 10/03/08
Intraday 1 Mo 2 Mo 3 Mo 6 Mo 9 Mo YTD 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr
AIG 2 year stock chart as of 10/03/08
Intraday 1 Mo 2 Mo 3 Mo 6 Mo 9 Mo YTD 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr
EXHIBIT A
AIG Stock Charts – As of close of business on October 3, 2008
AIG 5 year stock chart as of 10/03/08
Intraday 1 Mo 2 Mo 3 Mo 6 Mo 9 Mo YTD 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr
AIG 10 year stock chart as of 10/03/08
Intraday 1 Mo 2 Mo 3 Mo 6 Mo 9 Mo YTD 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr

Goldman Sachs recorded a gain “over time” on the value of the hedges it bought to guard against a default on AIG

TO BE NOTED: From Bloomberg:

"Goldman Sachs’s Viniar ‘Mystified’ by Interest in AIG (Update1)

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By Christine Harper

April 14 (Bloomberg) -- David Viniar, Goldman Sachs Group Inc.’s chief financial officer, said he’s “mystified” by the interest investors and government officials have shown in the bank’s trading relationship with American International Group Inc.

“They’re one of thousands and thousands and thousands of counterparties and the results of any trading with AIG are completely immaterial to what we do,” Viniar said today in an interview. “I am mystified by this fascination with AIG.”

Goldman Sachs, the most-profitable securities firm before converting to a bank last year, received more cash from AIG after the Federal Reserve rescued it last year than any other counterparty. The company has said it was insured against any losses from AIG and it didn’t benefit from the government’s rescue of the New York-based insurer. The Treasury Department’s chief watchdog for the financial rescue program is investigating whether AIG paid more than necessary to banks.

Viniar told analysts today that any profits related to AIG in the January-to-March quarter “rounded to zero,” as most of the transactions were unwound before the end of the year. In an interview, he also said profits in December weren’t significant.

‘Rounded to Zero’

“I would never tell you that we didn’t book any profit, I don’t even know,” he said. “I couldn’t tell you with any counterparty that we booked zero, but I could tell you it rounded to zero.”

After AIG was rescued by the U.S. from collapse last year, banks that bought credit-default swaps got $22.4 billion in collateral and $27.1 billion in payments to retire contracts, the insurer said last month.

Neil Barofsky, special inspector general for the government’s Troubled Asset Relief Program, began an audit two weeks ago into whether there were attempts by AIG or the government to reduce the payments, according to an April 3 letter to Representative Elijah Cummings. The Maryland Democrat requested the probe last month along with 26 other members of Congress.

Lawmakers, frustrated with the cost of an AIG bailout that has expanded three times, have asked why about $50 billion was paid after the initial September rescue to banks that bought credit-default swaps from the firm. The audit will reveal who made “critical decisions” regarding the payments and provide an explanation for the actions, Barofsky said.

‘Misperceptions’

Viniar held a conference call on March 20 to answer questions about the firm’s trading relationship with AIG and to “clarify certain misperceptions.”

When AIG was rescued, Goldman Sachs had $10 billion of exposure to the insurance company that was offset with $7.5 billion of collateral as well as credit-default swaps that would have paid off in the event of an AIG bankruptcy, Viniar said on the March 20 call.

He also said on the call that Goldman Sachs recorded a gain “over time” on the value of the hedges it bought to guard against a default on AIG, even though the government enabled the insurer to honor its obligations. In today’s interview, he said those gains were booked “from 2006 to now” and that any gains booked in the first quarter “would have been very, very small.”

Goldman Sachs reported late yesterday that it earned $1.81 billion, or $3.39 per share, in the first quarter on record revenue from trading fixed-income, currencies and commodities. The firm also raised $5 billion by selling stock at $123 per share, a 5.5 percent discount from yesterday’s closing price.

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net."