NON-CORE BLOWS TO AIG'S HEART

By Gillian Tett and Andrea Felsted 2008-09-18
As American International Group fights for survival, the question on everyone's lips is how could what was once the world's biggest insurer get itself into such a mess?
The answer has its roots in a decision in the late 1980s to hire a group of derivatives specialists from Drexel Burnham Lambert.
These formed the basis of AIG Financial Products, which wrote billions of dollars of derivatives, which are now at the heart of AIG's woes and are a long way from the mainstream insurance business that continues to lie at AIG's core.

According to one person who knows AIG well, the explosion of this business was fuelled by the culture created by Maurice “Hank” Greenberg, who built up AIG over four decades before being ousted in 2005.
This culture was “innovation and entrepreneurship, and basically leveraging AIG's low cost of funding”, he says.
With a triple A rating, AIG was an attractive counterparty for swap transactions. “If you wanted to enter a long-term swap, AIG was the name,” he says.
Over the next decade the financial products division continued to expand, including into areas such as credit default swaps, which insure against the risk of default, as well as originating mortgages and consumer finance.
For many years the diversification paid off in the form of large profits.
But part of its expansion plan included insuring investors against defaults on collateralised debt obligations (CDOs), or pools of securities. It is this, as well as problems on similar securities that it held itself, that accounts for the bulk of the $41bn of write-downs that AIG has suffered in recent months.
Until recently, AIG believed that insurance against defaults on CDOs would be extremely unlikely to generate any losses because most related to so-called “super-senior” deals, which were previously deemed so safe by the rating agencies they they held a triple-A rating.
AIG first started becoming exposed to these super-senior securities almost a decade ago when it began to acquire this type of risk from groups such as JPMorgan, soon after the concept was first invented. Back then, most investors were reluctant to buy these instruments since they paid only a paltry return. However, AIG, as an insurance company, tended to prefer to hold triple A rated debt and these instruments did at least pay a return that was better than US treasuries. “They gobbled stuff up, they were a key player in the market,” one banker involved in selling such products recalls.
During the first seven years of this decade, AIGFP steadily increased its presence in this opaque, and esoteric, corner of finance and, when the credit crunch started in the summer of 2007, a significant portion of the insurance group's exposure to the structured credit world was in the form of super-senior debt.
When the credit crisis struck, the AIGFP management expressed little concern about these holdings. As a result, AIG announced on December 5 that its cumulative loss had been just $1.4bn.
However, one factor that forced AIG to conduct a U-turn in accounting terms at the end of 2007 and early 2008 was that banks came under intense pressure from auditors in the closing months of 2007 to revalue their super-senior holdings.
AIG's auditors then forced it to revise its super-senior losses from $1.5bn to $6bn, for the period ending November 30. Shortly, afterwards, it raised this estimate again to $11.5bn – and on May 8 2008 the company declared that the losses had swelled by an additional $9.1bn.
With the ABX derivatives index continuing to decline, some analysts fear that further writedowns could be needed.
Outside the financial products division, AIG continues to hold valuable insurance assets.
These businesses include the largest commercial and industrial insurer in the US, and a business offering mainly car insurance to individuals. AIG also owns 59 per cent of Transatlantic Holdings, a separately listed reinsurer. It is also one of the US's biggest life assurers, dominating, for example, the market for fixed annuities, a popular retirement savings product.

Abroad, it is particularly big in Asia. In addition, it owns one of the world's biggest aircraft leasing operations and a sizeable asset management business.
With such valuable assets, there should be no shortage of buyers for AIG's units.
Prudential, the UK life assurer, has been touted as a buyer for some of AIG's Asian assets, while Warren Buffett could also be interested in parts of AIG.
Michael Diekmann, chief executive of Allianz, said any interest on the part of the German insurer would depend on what assets might be available.
But Mr Diekmann said current talk seemed to focus on a potential sale of AIG's reinsurance, leasing and financial services businesses – none of which was of interest to Allianz. “If there is anything else we will look at the situation,” he said.
Nikolaus von Bomhard, chief executive of Munich Re, told Germany's Handelsblatt newspaper that the reinsurer could be interested in some parts of AIG's businesses.