The taxpayer bailout of giant American International Group (AIG) became necessary largely because of AIG’s poor risk management of its financial products and because deregulation of over-the-counter derivatives, including credit default swaps, let the company get away with its risky behavior.
That’s according the final report by the government’s Financial Crisis Inquiry Commission.
The report also cites AIG’s success in setting up its financial products unit in London and selecting a weak U.S. regulator, the Office of Thrift Supervision, as contributing to the firms’ failure.
Because of the deregulation, state regulators were barred from regulating AIG’s credit default swaps, even though they were similar to insurance contracts. If that deregulation, which began under the Clinton Administration, had not happened, the commission suggests that events might have been different.
“If they had been regulated as insurance contracts, AIG would have been required to maintain adequate capital reserves, would not have been able to enter into contracts requiring the posting of collateral, and would not have been able to provide default protection to speculators; thus AIG would have been prevented from acting in such a risky manner,” the commission concluded.
Here are the final conclusions of the commission with regard to the federal bailout of American International Group in full:
The Commission concludes AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure—a profound failure in corporate governance, particularly its risk management practices.
AIG’s failure was possible because of the sweeping deregulation of over-the-counter (OTC) derivatives, including credit default swaps, which effectively eliminated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG’s failure. The OTC derivatives market’s lack of transparency and of effective price discovery exacerbated the collateral disputes of AIG and Goldman Sachs and similar disputes between other derivatives counterparties. AIG engaged in regulatory arbitrage by setting up a major business in this unregulated product, locating much of the business in London, and selecting a weak federal regulator, the Office of Thrift Supervision (OTS).
The OTS failed to effectively exercise its authority over AIG and its affiliates: it lacked the capability to supervise an institution of the size and complexity of AIG, did not recognize the risks inherent in AIG’s sales of credit default swaps, and did not understand its responsibility to oversee the entire company, including AIG Financial Products. Furthermore, because of the deregulation of OTC derivatives, state insurance supervisors were barred from regulating AIG’s sale of credit default swaps even though they were similar in effect to insurance contracts. If they had been regulated as insurance contracts, AIG would have been required to maintain adequate capital reserves, would not have been able to enter into contracts requiring the posting of collateral, and would not have been able to provide default protection to speculators; thus AIG would have been prevented from acting in such a risky manner.
AIG was so interconnected with many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships on credit default swaps and other activities such as securities lending that its potential failure created systemic risk. The government concluded AIG was too big to fail and committed more than billion to its rescue. Without the bailout, AIG’s default and collapse could have brought down its counterparties, causing cascading losses and collapses throughout the financial system.