Thesis on "Was the US Treasury 122 8 Billion Bailout of American International Group Justified?"

Thesis 7 pages (1844 words) Sources: 1+

[EXCERPT] . . . .

The American International Group Situation

Contents Table

Introduction

The following pages will focus on analyzing the American International

Group in the context of the current financial crisis that is affecting the

world, and on discussing whether the financial support received by the AIG

Group from the U.S. Treasury was justified or not.

In order better understand the reasons that led to this situation, it

is necessary to discuss the general causes of the financial crisis and its

chronology. The financial crisis began in 2006, when the United States real

estate market began to face the issue of declining prices.

In the spring of 2007, New Century Financial corporation decided to

stop granting new loans, like high risk mortgage loans to individuals that

did not normally qualify for this kind of loans. As a consequence, the U.S.

home mortgage market starts to weaken.[1]

A few months later, Wall Street is alarmed by Bear Stearns' situation

that shows bankruptcy signs because of extensive investments in mortgage-

backed securities. The U.S. defective real estate market starts to affect a

few German banks with bad investment policy. In the summer of 2007, the

U.S. government intended to intervene in the crisis, but the U.S. President

George W. Bush rejected the plan.

The rest of the year of 2007 was characterized by the following

aspects: the U.S. Federal Reserve influences the interest rate in order to

decrease, Bank of America acquires Countrywide Financial, interest rates

reach 3% after Fed intervention.

In 2008, the Lehman Brothers investment bank declares bankruptcy. The

AIG insurance group is bailed in September. In October, the U.S. Senate

adopts the massive bail-out plan.

Introduction to Subprime Mortgage Crisis

The subprime mortgage crisis is generally characterized by contracted

liquidity in global credit markets and banking systems. The main causes of

the subprime mortgage crisis are: housing market boom, speculation, high

risk mortgage loans policies, securitization practices, inaccurate credit

ratings, government policies, central banks policies, financial

institutions debt levels.[2]

The years before the crisis were characterized by low interest rates

and large inflows of foreign funds, which led to easy credit conditions,

further leading to the current financial crisis. The demand for housing

significantly increased, and so did the home ownership rate, reaching

69.2%.

The increasing demand obviously led to increasing prices and consumer

spending. Over the past decade, housing prices increased by 124%. However,

the household debt as a percentage of income increased by 130%. The boom

period was characterized by overbuilding, therefore increasing the supply,

causing inventory surplus and declining home prices. Prices are expected to

decrease in the next period also.

Markets are usually characterized by speculation. The real estate

market in the U.S. makes no exception, given the fact that 22% of the

houses bought during this period were bought for speculative reasons. All

this speculative borrowing had a significant impact on the subprime

mortgage crisis.

One of the causes of the subprime mortgage crisis listed above is

represented by inaccurate credit ratings. In other words, credit rating

agencies gave investment-grade ratings to CDOs based on subprime mortgage

loans.[3]

Although these higher ratings were considered to be justified at the

time, later analysis revealed that the rating process was a defective one,

and even more, rating agencies were perfectly aware of this fact at that

time. However, it is expected that the CDO market created by these rating

agencies will create similar financial problems in the future.

The situation on this market is not completely clear, as "the rise and

fall of nonprime mortgages has taken us into largely uncharted territory.

Past behavior, however, suggests that housing markets' adjustment to more

realistic lending standards is likely to be prolonged".[4]

Introduction to AIG

The American International Group was established in 1919 in Shanghai,

and had developed into the United States' largest insurance corporation.

Even more, in 2008 Forbes included AIG in the Global 2000 list as the 18th

largest company in the world.[5]

The company's international holdings include: Australia, Pakistan,

China, Hong Kong, India, Philippines, Singapore, United Kingdom, and

Indonesia.

Business holdings include: mortgage lending, aerospace, real estate,

telecommunications, ports, and skiing. The company's profits come from life

insurances and auto insurances mainly.

Regarding general insurance operations, AIG is the largest underwriter

of commercial and industrial insurance, also owning "the most extensive

international property-casualty network, a personal lines business with an

emphasis on auto insurance and high-net-worth clients, a mortgage guaranty

insurance operation and a leading international reinsurer".[6]

The most important strong points that characterize AIG are:

. Underwriting skill

. Innovative insurance solutions

. Financial strength

. Superior service

. Responsive claims handling

Regarding the financial services sector, AIG is mainly specialized in:

. Aircraft and equipment leasing

. Capital markets

. Consumer finance

. Insurance premium finance

AIG's operations regarding capital markets are conducted through AIG

Financial Products Corporation. The most important operations rely on

transactions, and providing clients with risk management solutions and

complex hedging and investment products in standard and customized

transactions regarding commodities, credit, currencies, energy, equities

and rates.

AIG also accounts for the most extensive network of life insurers. The

company's success in this is mainly due to AIG's concern for developing new

markets, expanding distribution channels, and expanding the range of

products.

The Asset Management businesses at AIG are mainly based on

institutional and individual asset management, broker-dealer services,

private banking, spread-based investment programs, and management of AIG

insurance invested assets.

Over the past decade, 2006 was the most profitable year for AIG. The

company's financial highlights are: net income: $6,200 in 2007 and $14,048

in 2006; adjusted net income: $9,308 in 2007 and $15,405 in 2006; net

income per common share: 2.39 in 2007 and 5.36 in 2006; revenues: $110,064

in 2007 and $113,387 in 2006; assets: $1,060,505 in 2007 and $979,410 in

2006; shareholders' equity: $95,801 in 2007 and $101,677 in 2006.[7] The

values are expressed in millions.

The mortgage crisis severely affected AIG. The financial highlights

after the second quarter of 2008 are revealed in the following table:

Table 1 - 2008 Second Quarter Financial Highlights

Note: the values are expressed in millions of dollars, except per

share data.

Source: AIG Second Quarter Reports, 2008.

Analysis on AIG

The financial context Of September 2008 for AIG consisted in the fact

that the company's share prices fell over 95%, reaching $1.25 on September

16, 2008, preceded by a 52 week high of $70.13. As a consequence, the

company's Financial Product division was forced to enter into credit

default swaps, in order to ensure $441 billion worth of securities.

Initially, these securities were rated AAA. The problem with these

securities was the fact that $57.8 billion of them were based on subprime

loans. Most financial specialists consider that this is one of the most

important factors that led to the financial crisis in the United States,

expanding it in the entire world.

On September 14, 2008 AIG made an announcement regarding the fact that

the company might sell the aircraft leasing division, in order to raise

capital and correct the mistakes that can be attributed to a defective

subprime mortgage policy.

On September 16, 2008, AIG's stocks dropped 60%. During this period,

The Federal Reserve officials were in discussions with Wall Street

investment firms in order to analyze AIG's situation, its impact on the

U.S. economy and what the Fed should further do.

However, on the same day, the Federal Reserve Bank of New York

announced the Federal Reserve bailout in AIG's case. The bailout took the

form of a $85 billion, based on a 24 month credit liquidity facility. The

interest rate was established at 850 basis points over the three month

London Interbank Offered Rate.[8]

The Federal Reserve bailout in the case of AIG was legally justified

by Section 13(3) of the Federal Reserve Act. The emergency loan reaches a

total of $122.8 billion.

Personal Analysis

As stated by several economic theories, the main purpose of any

company is to generate profits for its shareholders. However, in my

opinion, this is not entirely true, at least not in the case of financial

giants like the AIG. Some businesses are designed for profit purposes only,

and pthis is not necessarily a bad thing.

But in the case of financial corporations, like AIG, it is not allowed

to orient the corporation's policy towards profits only. The activity and

decisions of such corporations affect millions of people, they influence

the economic situation of the United States, and they can lead to global

economic disasters, like the current financial crisis.

In my opinion, not everyone should be able to buy a house if they lack

sufficient financial support. If financial companies would not give such

easy credit to practically anyone, we would not be in the situation that we

are in now.

It is quite probable that financial corporations will not change their

policies significantly after the general financial situation improves.

Therefore, it is necessary that the government implements a series of

regulations that limit such easy credit allowance, in order to prevent

future… READ MORE

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