Associated Press

Why Did the Fed Prop Up AIG?

September 19, 2008 01:15 PM
by Anne Szustek
The Federal Reserve gave American Insurance Group an $85 billion loan this week, largely because of its importance to the market. But concerns over foreign trade may have also played a part.

U.S. Government Won’t Let AIG Take Down Global Markets

The Federal Reserve gave this rationale for injecting AIG with liquidity while letting Lehman fend for itself: Lehman had contingency plans in the works, whereas AIG’s fall took them by surprise.

As an insurance company, AIG falls under state, rather than federal regulation. And, in a move to keep the company afloat, New York state had pledged $20 billion in cash to AIG earlier this week. But after the Fed announced its $85 billion bailout, “The asset swap will not now take place,” said David Neustadt, director of public information for the New York State Insurance Department.

As of Sept. 22, AIG will no longer be included in the Dow Jones Industrials Average, replaced by Northfield, Ill.-based conglomerate Kraft, on the grounds that the Fed’s bailout is tantamount to “effective nationalization.”

Observers at home and abroad have perceived incongruities between the laissez-faire economic ideals championed in the United States and its lifelines to AIG and others. “We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have been doing in its wildest dreams,” American financial historian Ron Chernow told The New York Times.

The March emergency Fed loan to Bear Stearns and the government’s subsuming of Fannie Mae and Freddie Mac are not really parallel situations to AIG’s. Fannie and Freddie were already backed by the government, and Bear Stearns was government-regulated. AIG, in addition to offering insurance policies, was also involved in derivatives trading. Those largely fall out of regulators’ scope and are not backed by the FDIC. But, contrary to the justification given for the Fed’s bailout, AIG’s looming financial abyss was in plain sight.

Background: Fingerpointing at AIG

On June 15, AIG announced that CEO Martin Sullivan had resigned and had been succeeded by Robert Willumstad, a former Citigroup executive who has served as Chairman of the Board of Directors of AIG since 2006. The company also appointed Stephen Bollenbach, a current director, as its lead director. Willumstad was forced to step aside on Wednesday in favor of Edward M. Liddy.

Eli Broad, billionaire philanthropist and former director of AIG subsidiary SunAmerica, along with fund managers Bill Miller and Shelby Davis, who together control 100 million shares—or 4 percent—of AIG, sent the insurance conglomerate a letter June 12 demanding that CEO Martin Sullivan be swapped out with a stand-in chair selected from AIG’s board while a search is launched for a permanent replacement.

Exactly two months earlier and two days before AIG’s annual shareholder meeting, those three major shareholders sent a letter to its board of directors that assailed AIG’s financial practices, saying that the company had experienced a “staggering breakdown of risk controls and an unequivocal loss of investor confidence.”

Under Sullivan’s tenure, AIG made $14 billion in profits in 2006. However, in the past two financial quarters, the company has announced $13 billion in losses and $20 billion in write-downs, prompting a need for capital injections—$20.3 billion worth.

But despite the influx of capital, Citigroup analyst Joshua Shanker wrote in a May 27 report that the billions put in may not be enough to keep AIG’s credit rating, which was already downgraded earlier that month, from slumping further.

Maurice “Hank” Greenberg, who was pushed out as CEO three years ago, remains a significant shareholder in the company and has also fiercely criticized its practices. Greenberg himself continues to be under fire, however. In May, the SEC gave him a Wells notice—essentially a warning of a pending indictment—for possible accounting impropriety in dealings between AIG and General Re, a reinsurer owned by Warren Buffett’s conglomerate, Berkshire Hathaway. The transaction in question resulted in an extra $500 million appearing on AIG’s balance sheets.

Earlier this week, the three major credit agencies downgraded AIG’s credit rating: Fitch down two notches from AA-minus to A; Moody’s down two notches to A2 from Aa3; and S&P down three grades to A-minus from AA-minus.

And on the eve of the Fed’s $85 billion cash injection, former AIG chair—as well as, through various holdings, the insurer’s top shareholder—Hank Greenberg filed a 13-D with the SEC stating that the company he chairs, C.V. Starr, may seek control of AIG, put a member on the board of directors, or do a “take-private.” A take-private is when an entity that is not a listed company buys a listed company, often taking its stock off of capital markets. An attorney for Greenberg did not comment.

Opinion & Analysis: Propping up the dominoes at home and abroad

AIG, despite its name, was founded in China—in Shanghai in 1919, to be exact, by Cornelius VanderStarr—from which Greenberg’s C.V. Starr gets its name. AIG has a large employee base there and owns nearly 20 percent of the stock of state-owned People’s Insurance Company of China. Given that Asian financial holdings have been a fundamental source of foreign direct investment (FDI) in the United States, it makes financial and diplomatic sense to shore up a company that plays a key role in Asian confidence in American companies in general.

“When the dust settles, I think Asia will come out ahead of the U.S.,” Henry Lee, the managing director of a Hong Kong investment advisory firm told The New York Times. Financial analysts see Asian markets bouncing back more quickly from the current economic lull than America’s, for one. China’s 2007 economic expansion of 23 percent in dollar terms is testament to this. True, double-digit growth is common among emerging markets.

But tiger economies are not to be overlooked—especially when they start pulling securities out of developed ones, like those of the United States. According to statistics cited by The New York Times, central banks, many of which were Asian, bought up $18.2 billion of U.S. securities in July, compared to a monthly average of $22.3 billion during first-half 2008. China’s central bank controls some $1.8 billion in reserves, “grew $280.6 billion in the first half of this year—a pace of $64 million an hour,” writes the Times.

Market consternation over AIG fallout has played into a weaker U.S. dollar. As of Wednesday, the greenback had fallen back against the euro, the Swiss franc and the British pound. Forex expert Grace Cheng writes, “Apparently, many people, particularly retail investors, are scared that there might be more worms lurking beneath the carpet.”

Conversely, the weak dollar could also entice FDI into the United States. German insurers Allianz and Munich Re are looking to make inroads into American markets, and cheaper acquisitions may just be the ticket.

“I don’t think you can reach satisfactory growth numbers if you are not a substantial player in the US,” Michael Diekmann, Allianz’s Board of Management Chair, was quoted as saying by German newsmagazine Der Spiegel. “From what I see of some of our competitors in the US, this is not a bad time to look at the US market.”

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