Thursday, January 1, 2009

Video Lesson: How AIG Collapse?

All in a sudden I have an interest to explore the in-depth of finance & blog about it. After all being an economist, I feel that I shouldn’t just restrict myself to the boundary of economics. To some extent subjects like finance, economics & even accounting are inter-related. Think about this. What causes the stock market boom towards late 1990s in America which creates mass of wealth & consumption? Which firms that emerged to become 7th largest in America? It’s non-other than Enron with its largest accounting frauds in history. Enron is no more than a loss-making company, but with its revenue being inflated by creating accounting

How about AIG? It stirs curiosity on how a large insurer with such strong branding & long run supernormal profit is on the brink of collapse. This is challenging the principle of monopoly & the wisdom of free market (Unit 4 & Unit 1). AIG is not the only one. We have others like Lehman Brothers, Bear Sterns earlier, the Big 3 etc

AIG’s near-to-collapse has much to do with its interest in flirting around with CDS (credit default swap), something that the Great Sage of Omaha, Warren Buffet called “financial weapon of mass destruction”

What is CDS?

Referring to a contract between 2 counterparties, whereby the buyer will make a periodic payment to the seller & in the event of default, it will receive one-off payment from the seller. Another way to look at this is insuring against risk

Let’s me simplify a real situation (It could be difficult to Econs students than Finance students)
Say, we have the followings (You seriously need a pencil & paper):

1 company called C1
1 pension fund, called P1
1 hedge fund called H1
1 insurer called AIG

Say C1 which was given a bad rating, say BB from Moody’s (rating agency) & is desperately in need of cash. Thereby it issues a bond worth $10m with periodic 10% interest payment & this is taken up by P1. Feeling insecure, P1 decides to insured against the risk with AIG which was highly rated by Moody’s, say AA. AIG in return would command for a premium say 1% ($ 100k) from a P1. Notice that AIG is in a very profitable position to do so. This is because, there could be many other firms that seek credit default protection from it & as such receiving premiums all over

Now, to make things interesting say a hedge fund, H1 would like to take a huge bet, say $100m that C1 will have high chance of default. Here H1 is not going to lend C1 any money but would like to buy a credit default swap from AIG. The hedge fund is now getting larger insurance for more than what C1 actually borrowed from. H1 is willing to pay 5% per annum to AIG

AIG begins to think that the deal is interesting since they can get $5m per annum from H1. On the other hand, H1 thinks that the company is more likely to default & thereby they will be getting those $100m. Now, say C1 really went into default after the second year. AIG will therefore need to compensate H1 the full amount of $100m. Paying such a huge sum of losses may attract the attention of Moody’s. Moody’s may now need to lower down the rating of AIG, say to B+ since now it is under-capitalised.

But don’t forget AIG does insured against other’s debt such as P1. Now that insurance of the pension fund is no longer worth AA but B+. This prompt P1 to wind it’s transaction & causing further liquidity problem to AIG

What happen then?

This has a serious chain-effect. Liquidity crisis & huge drop in rating, cause AIG share price to plunge from its 52-weeks high of $70.13 to $1.25 in 16th September. Its financial product head, Joseph Cassano was being labeled as the “10 most wanted culprits” of the financial collapse. Earlier it ran into financial panic, after nearly disposing of its aircraft leasing division called International Lease Finance Corporation, to raise capital

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