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Slide 1: C as e S tudy: L ehman and AIG F inancial Reg ulation C las s Ts ing hua Univers ity Andrew S heng Adjunct P rofes s or, S E M 1
Slide 2: L ehman’s B ankruptcy 2
Slide 3: C ompany P rofiles • Headqua rters in New York, • Opera ting in North America, As ia-P acific and E urope, employed more than 25,000 people • Lea ding g lobal equity and fixed income s ales , trading and res ea rch, • F ourth larges t inves tment banking and s ecurities firm, • One of the la rg es t private inves tment management, as s et mana gement and private equity. • On S eptember 15, 2008, Lehman filed a voluntary petition in the US B ankruptcy C ourt. 3
Slide 4: S hareholders Jun 30,2008 4
Slide 5: E xecutives Name Richard S . F uld Ja s jit S. Bh a tta l Erin M Ca lla n . Sc o tt J. Fre id h e im Da v e Go ld fa rb Jo s e p h M Gre g o ry . Je re m y M I a a c s .s Th e o d o re P. Ja n u lis P rofiles C hairman and C hief E xecutive Officer Ch ie f Exe c u tiv e Offic e r, As ia -Pa c ific Ch ie f Fin a n c ia l Offic e r Co -Ch ie f Ad m in is tra tiv e Offic e r Glo b a l He a d o f Stra te g ic Pa rtn e rs h ip s , Prin c ip a l I v e s tin g a n d Ris k n Pre s id e n t a n d Ch ie f Op e ra tin g Offic e r Ch ie f Exe c u tiv e Offic e r, Eu ro p e , M d le Ea s t id a n d As ia -Pa c ific Glo b a l He a d o f M rtg a g e Ca p ita l o 5
Slide 6: B us ines s and P erformance 6
Slide 7: L ehman vs Major C ompetitors Sep 18,2008 C ompany Le h m a n Bro th e rs Go ld m a n Sa c h s M rrill Lyn c h e M rg a n Sta n le y o No m u ra CI C CS TI JPM rg a n Ch a s e o Market Revenu Net E P S ($ cap e Income ) 1 4 8 .2 M 5 5 .5 5 B 4 5 .1 8 B 3 0 .1 8 B 2 4 .8 1 B 1 8 .9 B 1 6 1 .7 1 B 3 5 .9 0 B 3 4 .5 4 B -6 .9 9 B 2 2 .3 4 B 5 .0 6 B 1 .6 B 1 1 6 .4 B -5 .6 3 B 7 .4 9 B -8 .7 0 1 6 .6 4 P/ E ratio n /a 7 .8 n /a 6 1 .7 0 n /a 1 3 .7 1 5 .4 7 Debt/ E mployee E quity 2 3 .3 3 8 .9 4 1 4 .1 7 1 2 .9 7 8 .6 3 .3 1 1 .6 2 8 ,6 0 0 3 7 ,4 7 8 6 4 ,9 0 0 4 6 ,3 9 0 1 8 ,9 9 5 1 ,3 9 6 1 9 5 ,5 9 4 -1 9 .8 4 B -2 1 .3 7 0 .4 B -2 .0 7 B 0 .6 9 B 1 0 .6 3 B 0 .4 4 -1 .0 8 0 .1 1 3 .0 4 7
Slide 8: Revenues by B us ines s S egment Items (millions $) Eq uity Fixe d I c o m e n C apital Market Glo b a l Fin a n c e Ad v is o ry Se rv ic e s Inves tment B ank Inves tment Manag ement 2003 4 ,3 9 1 1 ,6 2 7 6 ,0 1 8 1 ,3 4 3 379 1 ,7 2 2 907 2004 5 ,7 3 9 1 ,9 5 5 7 ,6 9 4 2005 7 ,3 3 4 2 ,4 7 3 2006 8 ,4 4 7 3 ,5 5 9 2007 2 rd Q,08 3 rd Q,08 454 (4 ,6 0 2 ) (4,148) 380 231 61 1 634 5 ,9 7 7 6 0 1 6 ,2 8 0 (2 ,9 7 5 ) 9 ,8 0 7 1 2 ,0 0 6 1 2 ,2 5 7 (2,374) 2 ,2 3 9 921 3 ,1 6 0 2 ,4 1 7 2 ,5 6 6 1 ,3 3 7 61 8 2 40 1 ,5 6 2 2 ,1 2 8 626 2 ,1 8 8 1 ,6 9 4 766 2 ,8 9 4 1 ,9 2 9 3 ,9 0 3 8 5 8 3 ,0 9 7 8 4 8 Total bus ines s 8 ,6 4 7 1 1 ,5 7 6 1 4 ,6 3 0 1 7 ,5 8 3 1 9,2 5 7 (6 68 ) (2,90 3) 8
Slide 9: B ankruptcy Review 9
Slide 10: L ehman His tory Founded in Montgomery, Alabama in 1850 as a cotton broker In the 1860s, after civil war, Lehman moved to New York Beginning venture beyond cotton to other commodities and securities In 1887 it became member of the New York Stock Exchange In the 1930s, Lehman became a securities firm under Glass-Steagall Act Post-War prosperity fueled the growth of Lehman Opened offices in Paris in 1960, London 1972 and Tokyo 1973 1984 American Express acquiring the Firm and merged it with Shearson 1994 The Firm became independent through a IPO on the NYSE 1998 Lehman Brothers joins the S&P 500 Index 2002 moved into its new global headquarters in Midtown Manhattan 2005 achieved record revenues, net income and earnings per share Sep 15, 2008, Lehman filed bankruptcy protection with total debts of $613 bn 10
Slide 11: B ankruptcy P roces s June 10,2008 June 16,2008 Aug 16,2008 Aug 21,2008 Aug 23,2008 Aug 26,2008 Aug 27,2008 Sep 3,2008 Sep 4,2008 Sep 8,2008 Sep 9,2008 Sep 10,2008 The firm reported $2.87bn 2nd quarter loss It raised $6bn capital from pension funds, hedge funds and investors. Lehman was in talks to sell $40bn real estate portfolio Began talks with KDB and China CITIC for stake sale PE firms expressed interested in Lehman’s asset management division Korean FSA expressed cautious attitude on KDB’s takeover of Lehman. Lehman tells KKR and Hellman they remain in running for unit KDB confirmed ongoing talks over taking stake in Lehman Ospraie, a hedge fund under Lehman, collapsed suddenly Lehman replace 3 top men, including COO Announced expected 3rd quarter $3.9 bn loss or -$5.92 Per Share. Share fall 45% 11
Slide 12: B ankruptcy P roces s Sep 11,2008 Lehman’s months-long talks with KDB broke down. JP Morgan asked Lehman for additional $5bn collateral Lehman disclosed plan of spin-off its commercial real estate about $30bn and disposal of a 55% stake in its asset management unit. Shares plunged 40% and investors, customers and counterparties signalled deep concern CDS cost on Lehman reach record high of 790 basis points Rating Agencies warned Downgrade of Lehman’s rating. Sep 12,2008 Sep 13,2008 Share price closes at $3.83 down 93% from Sep 1,2007 Bank of America with JC Flowers, CIC and Barclays are contacting Lehman for possible takeover Paulsen,Treasury Secretary, refused financial support for Lehman’s take over. Sep 15,2008 Top Wall Street executives and regulators failed to agree a rescue plan for the Lehman’s troubled assets. Lehman filed bankruptcy with debts of $613bn including $128bn bonds 12
Slide 13: S tock Quote During C ris is Sep 9,10,11 share plunged 13
Slide 14: C DS Quote Sep 9,2008 14
Slide 15: S ys temic Ramifications of L ehmans 1. 2. 3. 4. 5. 6. 7. Operates in major markets around US , E U and As ia. Total bala nce s heet s ize of $639 bn at end May 2008. E quity of $2 9 bn. Uns ecured bond is s ue of $180 bn. One-eig hth market s hare in F ixed Income in US , 14% of trading in equities in L S E , 24% of G lobal M&A. As s ets under manag ement of $277 bn. B elow the line derivatives of $738 bn. Key prime broker to Hedg e funds and as s et managers . P os s ible L os s or As s ets frozen to market counterparties : C rude es timate due to B ankruptcy: Uns ecured bonds + derivative expos ure + as s ets under ma nag ement (frozen until unwound) = $1,654 bn [2+4+5 ] G ros s OTC contracts have to be 15
Slide 16: L ehmans Domino effect • • • • • • • • • Ma jor opera tor in F ixed Income markets , pa rticula rly S a murai ma rket, s hut down inter-ba nk ma rket, beca us e counterparty fa ilure E very domes tic ba nk tha t borrows from g loba l interba nk market ca nnot g et liquidity, s o C DS s preads g o up. As C DS s prea ds g o up, colla tera l calls on debt ris es , s queezing liquidity more Widening s preads = falling as s et prices , mea ning decline in s olvency of ba nks as as s et are MTM. B a nks will not lend to each other. L a rg e foreig n banks withdra w dolla rs from their la rg e facilities abroa d, eg g Mexico, Hong Kong etc. F a ilure of Icelandic banks etc hurt other banks Hedg e funds hurt, Money Market F unds hurt, s o hug e redemptions AIG expos ed to C DS ma rket, s o $ 1 trillion ins urer ma y fa il. 16
Slide 17: B ankruptcy Analys is 17
Slide 18: B ankruptcy Reas ons • • • • • • M rk e t turm o il s in c e s u b p rim e c ris is a Bu s in e s s m o d e l M s s iv e re a l e s ta te a s s e ts a Sp e c ula tio n a n d m a rk e t fe a rs Se n io r m a n a g e m e n t m is ta k e s No g o v e rn m e n t re s c u e 18
Slide 19: Market Turmoil • S ince May 2007, global financial market crunch. • Lehma n wrote down $13.8bn after the cris is unfolded. • Lehma n had mortgage portfolio and as s et backed portfolio worth $72.5bn including $20.6bn level 3 as s ets clos e to its equity as of May 31,2008. • The credit crunch pervaded all markets including inter-ba nk, equity, bonds , mortg age and cons umer credit. • Ris k avers ion and credit crunch led to hig her-cos t funding . 19
Slide 20: US Hous ing P rice Index August 26, 2008 20
Slide 21: Ted S pread AIG Rescue Bear Stearns Collapse Source: Bloomberg 21
Slide 22: B us ines s Model • B roker-dea ler model has no backs top of liquidity, while univers a l banks with retail depos it-taking activities a nd their inves tment banking have more s table funding bas e; • S tand-alone inves tment banks face two fundamental challenges : capital and liquidity. • Inves tment banking depend crucially on the s hortterm Repo market for s ecured funding . 22
Slide 23: B alance S heet (in Millions USD) C ash and cash equivale n t s Cash an d securities f o r regulatory purpose Financ ial instrument s Securit ies purchased t o resell Securities borrowed R eceivables Goodwil l & Intangible s , To tal Assets 2004 5,440 4,085 2005 4,900 5,744 2 00 6 5 ,9 8 7 6 ,0 9 1 2007 7,286 12,743 May 3 1, 2 00 8 6 ,5 1 3 13,031 2 69 , 40 9 1 69 , 68 4 1 24 , 84 2 41,721 4 ,1 0 1 6 39 , 43 2 1 4 4 , 4 6 8 1 7 7 , 4 3 8 2 26 , 59 6 3 1 3 , 1 2 9 9 5 , 5 3 5 1 0 6 , 2 0 9 1 17 , 49 0 1 6 2 , 6 3 5 7 4 , 2 9 4 7 8 , 4 5 5 1 07 , 66 6 1 3 8 , 5 9 9 18,763 22,643 27,971 43,277 3,284 3,256 3 ,3 6 2 4,127 3 5 7 , 1 6 8 4 1 0 , 0 6 3 5 03 , 54 5 6 9 1 , 0 6 3 2,857 2,941 20,638 28,066 9 6 , 2 8 1 1 1 0 , 5 7 7 1 25 , 96 0 1 4 9 , 6 1 7 1 3 1 , 7 3 5 1 5 2 , 4 2 5 1 76 , 55 7 2 5 8 , 0 3 1 Short Term Borrowing s Financ ial instrument s Sold to repurchase C ollater alized financi n g s 35,302 1 41 , 50 7 2 07 , 92 2 23
Slide 24: L iquidity Items Financial instruments Total assets Per cent of total assets Short term financing 2 0 04 218,762 357,168 61% 230,873 20 0 5 255,893 410,063 62% 265,943 68% 62,309 16% 2 00 6 334,262 503,545 66% 323,155 67% 81,178 17% 2 00 7 691,063 65% 435,714 65% 123,150 18% 2 ndQ.0 8 639,432 62% 384,731 63% 128,182 21% 451,728 394,251 Per cent of the total debts 67% Long term borrowing Per cent of the total debts 56,486 17% Lehman’s liquidity relied heavily on its short term financing including Short Term Borrowings, Repo and collateral financing. 24
Slide 25: L everag e Ratios Items To ta l a s s e ts To ta l e q u ity G ros s Leverage ratio Ne t a s s e ts Ta n g ib le e q u ity c a p ita l Ne t le v e ra g e ra tio 20 0 3 2 0 04 2 0 05 2 00 6 20 0 7 6 9 1 ,0 6 3 2 2 ,4 9 0 30.7 3 7 2 ,9 5 9 2 3 ,1 0 3 1 6 .1 2 ndQ.0 8 6 0 0 ,0 0 0 2 8 ,4 4 3 21.1 3 1 0 ,9 1 5 2 9 ,2 7 7 1 0 .6 3 rd Q.0 8 6 0 0 ,0 0 0 2 8 ,4 4 3 21.1 3 1 0 ,9 1 5 2 9 ,2 7 7 1 0 .6 3 1 2 ,0 6 1 3 5 7 ,1 6 8 4 1 0 ,0 6 3 5 0 3 ,5 4 5 1 3 ,1 7 4 23.7 1 4 ,9 2 0 23.9 1 6 ,7 9 4 24.4 1 9 ,1 9 1 26.2 1 6 3 ,1 8 2 1 7 5 ,2 2 1 2 1 1 ,4 2 4 2 6 8 ,9 3 6 1 0 ,6 8 1 1 5 .3 1 2 ,6 3 6 1 3 .9 1 5 ,5 6 4 1 3 .6 1 8 ,5 6 7 1 4 .5 We calculate net assets by excluding from total assets: (i) cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements; and (iii) identifiable intangible assets and goodwill. 25
Slide 26: VaR Methods underes timated Ris ks • Levels 1 - 3 : – (1 ) Va R ba s ed on Quoted Market P rices for Identical As s ets or L iabilities in Active Ma rkets – (2 ) Inputs a re Obs erva ble Market B a s ed or Unobs erva ble Inputs C orroborated B y Market Da ta – (3 ) Inputs to Determine the F a ir Value Is E s tima ted B as ed on Interna lly Developed Models or Methodolog ies L es s Rea dily Obs ervable from Objective S ources 26
Slide 27: Off B alance Arrang ements 27
Slide 28: C ommitments and G uarantees 28
Slide 29: B orrow S hort – Inves t Long - real es tate as s ets • On M y 2 9 2 0 0 7 , Le h m a n , a b a n k w ith a little m o re th a n $ 2 0 b n a (€1 4 b n , £1 1 b n ) in e q u ity, jo in e d a v e n tu re to s p e n d $ 1 5 b n fo r Arc h s to n e -Sm ith Tru s t, a p ro p e rty in v e s tm e n t c o m p a n y th a t o w n e d a g ia n t p o rtfo lio o f a p a rtm e n t in U c itie s . S • L ehman s till had martg a g e portfolio a nd as s et ba ck portfolio worth $ 72 .5bn including $2 0 .6 bn level 3 as s ets clos e to its equity a s of Ma y 31 ,2 00 8 . • With le s s c a p ita l th a n riv a ls s u c h a s Go ld m a n Sa c h s a n d M rg a n o Sta n le y, Le h m a n w a s k n o w n fo r p u n c h in g a b o v e its w e ig h t a n d b e in g q u ic k e r th a n o th e rs to s e ize o p p o rtu n itie s . • I $ 3 3 b n p o rtfo lio o f tro u b le d c o m m e rc ia l p ro p e rty lo a n s h a s b e e n ts la rg e ly re s p o n s ib le fo r h e a v y lo s s e s in th e p a s t tw o q u a rte rs . • U c e rta in ty a b o u t th e tru e v a lu e o f th o s e lo a n s u n d e rm in e d th e n b a n k 's s h a re p ric e a n d s c a re d o ff p o te n tia l n e w in v e s to rs . 29
Slide 30: S peculation and Market F ears • Aug 2 6 20 08 , S outh Korea n reg ula tor expres s ed caution on KDB ’s takeover of L ehma n. L ehman s ha res fa ll 6 .9 %. • S ep 1 0 20 08 , L ehman s ha res fa ll 4 5% va lued on fea rs about its a bility to ra is e ca pital s pa rked by a report tha t KDB decided a g ains t inves ting in L ehman. • S ep 1 1 20 08 S ha res plung e 40 % and inves tors , cus tomers and counterpa rties s ig nal deep concerns • Hedg e fund mana g ers s uch a s David E inhorn of G reenlig ht C a pital repea tedly ques tioned whether the bank's problems were deeper than many thoug ht. • Analys ts were pa rticularly s ceptica l a bout Archs tone, a rg uing that it s hould be marked down by 30 per cent. 30
Slide 31: Manag ement Mis s ed S teps • Le h m a n d id n ’t s e ll q u ic k ly its re a l e s ta te a s s e ts a n d re c a p ita lize d a fte r Be a r Ste a rn s ta k e o v e r; • I to o k a lo n g tim e fo r its s ta k e s a le a n d Le h m a n t a s k e d to o m u c h o n th e p ric e a n d te rm . • Se n io r m a n a g e m e n t u n d e re s tim a te d th e s e rio u s s itu a tio n o f m a rk e t c ris is . 31
Slide 32: B ehind the S cenes of a C ollaps e • • • • • • • • Tw o ye a rs a g o , Le h m a n h e ld a d v a n c e d ta lk s o v e r a d e a l w ith in s u re r AI G. Afte r Be a r Ste a rn s ' c o lla p s e , Le h m a n s o u g h t o u t p a rtn e rs ra n g in g fro m Ge n e ra l Ele c tric to HSBC a n d M rg a n Sta n le y. o Ab u Dh a b i I v e s tm e n t w e re re v ie w in g Le h m a n 's b o o k s b u t fin a lly n q u it; No m u ra a ls o e xp re s s e d in te re s t, b u t w ith th e tw o b a n k s ' te a m s o n o p p o s ite s id e s o f th e w o rld a n d No m u ra u n c o m fo rta b le o v e r th e s c a le o f Le h m a n 's lia b ilitie s , a b id w a s ru le d o u t. Le h m a n s ta rte d its fin a l w e e k e n d w ith its fa te tie d to tw o s u ito rs Ba rc la ys a n d Ba n k o f Am e ric a . By e a rly Sa tu rd a y Ba rc la ys a g re e d to b u y Le h m a n b u t U re g u la to r K d id n ’t a p p ro v e th e d e a l w ith o u t Fe d ’s b a c k in g . I Ju ly Le h m a n fa ile d to g e t a p p ro v a l o f Fe d to c o n v e rt to a n tra d itio n a l b a n k h o ld in g c o m p a n y a n d to e xte n d th e typ e s o f c o lla te ra l. Tw o m o n th s la te r, Fe d a p p ro v e d Go ld m a n a n d M rg a n Sta n le y to o b e c o m e Ba n k Ho ld in g Co m p a n ie s . 32
Slide 33: Why Res cue B ear and F annie and F reddie? • Why F annie a nd F reddie Mac? – Th e y a c c o u n t fo r a b o u t th re e -q u a rte rs o f a ll n e w U S m o rtg a g e s ; – Th e ir h yb rid s tru c tu re a s “g o v e rn m e n t-s p o n s o re d ” p riv a te c o m p a n ie s • Why g uarantee B ear S tearns in March? – Be a r’s fa ilu re w o u ld c re a te s ys te m ic ris k s , a s Be a r w a s im p o rta n t p la ye r in fixe d in c o m e m a rk e t – Be a r Ste a rn s is h ig h ly in v o lv e d in th e s ys te m ic a lly im p o rta n t c re d it d e fa u lt s w a p s m a rk e t, 33
Slide 34: Why no res cue for L ehman? • Le h m a n is le s s in v o lv e d in th e v u ln e ra b le c re d it d e fa u lt s w a p s m a rk e t th a n Be a r Ste a rn s ; • M rk e ts s h o u ld h a v e tim e to p re p a re fo r th e p o s s ib ility o f a Le h m a n ’s b a n k ru p tc y; • A n e w Fe d fa c ility e n s u re s th a t it c a n n o t s u d d e n ly ru n o u t o f liq u id ity; • M ra l h a za rd to re s c u e Le h m a n w ith p u b lic fu n d . o • Oth e r Wa ll Stre e t e xe c u tiv e s h o ld th a t th e ir e ffo rts a n d re s o u rc e s w o u ld o n ly b e n e fit a riv a l, e n a b lin g Bo fA o r Ba rc la ys to a c q u ire Le h m a n ’s s till-p o w e rfu l in v e s tm e n t b a n k in g fra n c h is e . 34
Slide 35: US Inves tment B ank balance s heet end 2007 = US $ 4.27 trillion, E quity $2 00.3 bn, L everage of Bear S Lehman Merrill B L C ash an d c ash eq uiv al e nt s 2 1 , 4 0 6 7 , 2 8 6 41,346 Cash and securitie s f o r 1 2 , 8 9 0 1 2 , 7 4 3 2 2 , 9 9 9 reg ula tor y p u rp o se Fin anc ial in str u me n ts 1 3 8 , 2 4 2 3 1 3 , 1 2 4 1 2 , 1 9 3 9 Securities purchas e d t o 2 7 , 8 7 8 1 6 2 , 6 3 2 2 1 , 6 1 7 r es e ll 5 S ecu rit ies bo rr o we d 8 2 , 2 4 5 1 3 8 , 5 9 1 3 3 , 1 4 0 9 Receiv a b l e s 5 3 , 5 2 2 4 3 , 2 7 7 1 2 6 , 8 4 9 S ecu rit ies re cei ve d a s 1 5 , 5 9 9 4 , 1 2 7 5,091 c oll at e ra l T ota l A ss e ts 3 9 5 , 3 6 2 6 9 1 , 0 6 1 , 0 2 0 , 0 5 3 0 S hor t T erm Bo rro win gs an d 1 6 , 6 0 0 2 8 , 0 6 6 1 2 8 , 9 0 1 Dep o s i t s Financial instruments S o l d 4 3 , 8 0 0 1 4 9 , 6 1 1 2 3 , 5 8 8 Data source: 2007 annual reports 7 (in Millions USD) 21.3x M o r g a n S G ol d ma n S 25,598 11,882 6 1 , 6 0 8 1 19 , 93 9 374,963 126,887 239,994 112,312 4,071 4 52 , 59 5 85,717 2 77 , 41 3 1 48 , 18 3 5 ,0 9 2 1 , 0 4 5 , 4 0 1 ,1 1 9, 7 9 9 6 65,674 134,341 86,927 2 15 , 02 3 35
Slide 36: US Inves tment bank Off-B alance L iabilities = US $17.8 trillion, additional leverage of 88.8 times Company C ommitments Le n d in g re la te d I v e s tin g in n Co n d uit,e tc U d e rw ritin g n Co m m e rc ia l a n d Re s id e n tia l Le tte rs o f Cre d it Oth e r G uarantees De riv a tiv e s Oth e r Total 17,784,380 Bear S 7 ,2 1 9 729 652 2 ,8 2 8 2 ,7 4 9 1 70 2 ,5 1 5 ,9 6 5 4 ,4 5 2 2 ,5 3 4 ,7 6 4 Lehman B Merrill L 3 8 ,0 5 9 1 1 ,6 9 4 1 9 ,9 7 9 7 ,4 4 9 1 ,6 9 0 1 2 5 ,8 5 9 7 3 7 ,9 3 7 6 ,9 0 2 9 4 9 ,5 6 9 7 8 ,2 3 2 n n 8 ,1 3 2 4 5 ,1 7 7 6 6 ,4 3 4 Morgan S Goldman S 7 3 ,9 5 8 1 ,3 1 1 1 1 ,6 2 0 5 ,6 8 0 1 6 ,0 4 9 988 8 ,7 4 7 4 3 ,5 2 8 2 ,0 4 5 ,3 4 1 2 9 ,5 2 5 8 2 ,7 4 7 1 7 ,7 5 8 88 n 4 ,5 6 2 ,8 8 3 7 ,1 2 0 ,3 8 0 4 4 ,6 7 0 4 ,8 0 5 ,5 2 8 3 6 ,7 9 9 7 ,2 6 6 ,7 8 5 2 ,2 2 7 ,7 3 4 Data source: 2007 annual reports 36
Slide 37: AIG B ail-out 37
Slide 38: AIG P rofile • • • • • • • A lea ding interna tional ins ura nce org anization with opera tions in more tha n 1 30 countries and juris dictions ;  F ounded in S ha ng ha i P roviding the mos t extens ive worldwide property-cas ua lty a nd life ins urance networks of a ny ins urer;  C overing commercial, ins titutional a nd individua l cus tomers ; A lea ding provider of retirement s ervices , fina ncia l s ervices and a s s et manag ement to 7 0 million clients .  L is ted on the New York S tock E xcha ng e, as well a s the s tock excha ng es in P aris and Tokyo; AIG (F Y 20 07 ) had $ 1,0 60 bn in a s s ets , equity of $ 96 bn, ma de $1 4 bn in a nnua l net profits and employed 1 0 6,0 0 0 people. 38
Slide 39: How AIG 2007 Annual Report disclosed CDS exposure “Included in 2007 net income and adjusted net income was a charge of $11.47 billion pretax ($7.46 billion after tax) for unrealized market valuation losses related to the AIG Financial Products Corp. (AIGFP) super senior credit default swap portfolio. Based upon its most current analysis, AIG believes any losses that are realized over time on the super senior credit default swap portfolio of AIGFP will not be material to AIG’s overall financial condition, although it is possible that realized losses could be material to AIG’s consolidated results of operations for an individual reporting period.” 39
Slide 40: AIG Res cue Sep 11,2008 Lehman share plunged 40% and fears spreaded to AIG, WaMu,etc Share price dropped more than 30 per cent amid concerns over its business of writing insurance against defaults on mortgage bonds. Sep 15,2008 Sep 16,2008 AIG was seeking to raise $10bn-$20bn in equity from buy-out investors including KKR, TPGroup and JC Flowers,but failed finally. New York State insurance regulators allows the company to access $20bn of its own subsidiaries in a desperate attempt to stave off a liquidity crisis and credit downgrades. Federal Reserve extended a two-year, $85 billion credit facility at a penal rate with a 79.9% stake in the company in return. Rating agencies downgraded its debt, forcing it to post more than $13 billion of extra collateral with trading partners Sep 17,2008 Eric Dinallo, New York’s insurance regulator, vouched for the solvency of AIG’s insurance subsidiaries but was more circumspect on the company overall. 40 Sep 16,2008
Slide 41: S tock Quote Sep 16,Fed extended $85 billion credit facility 41
Slide 42: Why bail out AIG ? • At its p e a k AI w a s th e w o rld ’ la rg e s t in s u re r w ith a m a rk e t v a lu e o f G $ 2 3 9 b illio n ; 7 4 m illio n c u s to m e rs , 7 0 0 ,0 0 0 a g e n ts a n d 1 1 6 ,0 0 0 s ta ff. • I w ro te c re d it d e fa u lt s w a p s (CDSs ), w ith a n o tio n a l e xp o s u re o f t $ 4 4 1 b illio n a s o f Ju n e 2 0 0 8 . Of th is , $ 5 8 b illio n w a s e xp o s e d to s u b p rim e s e c u ritie s ; • I w a s e xp o s e d to $ 3 0 7 b illio n o f c o n tra c ts w ritte n o n in s tru m e n ts t o w n e d b y b a n k s in Am e ric a a n d Eu ro p e a n d d e s ig n e d to g u a ra n te e th e b a n k s ’ a s s e t q u a lity, th e re b y h e lp in g th e ir re g u la to ry c a p ita l; • With tota l derivative expos ure $ 44 1 bn AIG would incur ma s s ive los s es and would require more ca pita l. • Ha d AI g o n e b u s t, its m illio n s o f c u s to m e rs w o u ld h a v e b e e n le ft G w o n d e rin g if th e ir c a r a n d h o m e in s u ra n c e p o lic ie s w e re s till v a lid , a t a tim e w h e n c o n s u m e rs a re a lre a d y tw itc h y a b o u t th e s a fe ty o f th e ir42 b a n k d e p o s its .
Slide 43: Why AIG had to be res cued • Th e c o m b in a tio n o f a n e p o c h a l fin a n c ia l c ris is , o u ts ize d b e ts o n e xo tic s e c u ritie s , in a d e q u a te in te rn a l c o n tro ls a n d p o o r re g u la to ry s u p e rv is io n fo rc e d AI la s t m o n th to a c c e p t a n $ 8 5 b n lo a n fro m th e G Fe d e ra l Re s e rv e th a t p la c e s it in g o v e rn m e n t h a n d s ; • AI h a s m o re th a n 4 ,3 0 0 le g a l e n titie s s c a tte re d a ro u n d th e w o rld , a G s e t-u p th a t m a d e b o th in te rn a l c o -o rd in a tio n a n d o u ts id e s c ru tin y v e ry d iffic u lt. • M re th a n o th e r in s u re rs , AI h a s s ig n ific a n t e xp o s u re in re a l e s ta te o G a n d CDS m a rk e t, b o th c ru s h e d in th e p a s t ye a r b y th e o v e ra ll d e c lin e in a s s e t p ric e s . • It pla ys a central role in the C DS ma rket and in s tructured finance a nd was one of the firs t ins titutions to s ta rt buying “s uper-s enior” C DOs a lmos t a deca de a g o. 43
Slide 44: AIG Financial Products (London) “A key attribute that differentiates AIGFP from its peers is its ability to commit significant amounts of its own capital - depending on the opportunity arising from a particular investment—at different levels of a company’s debt and equity capital structure. AIGFP has demonstrated this capability in its energy and infrastructure investments, both as a single investor and in partnership with other investors. The firm is also a major investor in a wide array of debt and equity securities. As an innovator in the commodity and commodity index markets, AIGFP played an instrumental role in attracting the investing public’s interest in commodities as an alternative asset class. As a result of the severe disruption in the U.S. residential mortgage and credit markets that accelerated during the fourth quarter of 2007, AIGFP recognized unrealized market valuation losses of more than $11 billion on its credit default swap portfolio written principally on the super senior tranches of multisector collateralized debt obligations.44
Slide 45: AIG Annual Report 2007 explanation of CDS exposure [pg 121] “Approximately $379 billion (consisting of the corporate loans and prime residential mortgages) of the $527 billion in notional exposure of AIGFP’s super senior credit default swap portfolio as of December 31, 2007 represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation. In exchange for a minimum guaranteed fee, the counterparties receive credit protection in respect of diversified loan portfolios they own, thus improving their regulatory capital position. These derivatives are generally expected to terminate at no additional cost to the counterparty upon the counterparty’s adoption of models compliant with the Basel II Accord. AIG expects that the majority of these transactions will be terminated within the next 12 to 18 months by AIGFP’s counterparties as they implement models compliant with the new Basel II Accord. As of February 26, 2008, $54 billion in notional exposures have either been terminated or are in the process of being terminated.” 45
Slide 46: Notional amounts by remaining maturity of AIGFP’s interest rate, credit default and currency swaps and swaptions derivatives portfolio at December 31, 2007 and 2006: Remaining Life of Notional Amount* Interest rate swaps Credit default swaps Currency swaps Swaptions, equity and commodity swaps Total One Year Two Through Five Years $ 554,917 286,069 Six Through Ten Years (in $ millions) After Ten Years Total 2007 Total 2006 $441,801 184,924 $156,634 85,792 $ 1 4 ,1 1 2 5,028 $1,167,464 561,813 $1,058,279 483,648 38,384 57,709 135,187 62,849 41,675 35,270 9,029 23,139 224,275 178,967 218,091 180,040 $722,818 $1,039,022 $319,371 $51,308 $2,132,519 $1,940,058 •Notional amount is not representative of either market risk or credit risk and is not recorded in the consolidated balance sheet. 46
Slide 47: AIGFP’s CDS Commitments At December 31, 2007: Notional Amount (in billions) Corporate loans(a) $230 Prime residential mortgages(a) 149 Corporate Debt/CLOs 70 Multi-sector CDO(b) 78 Total $527 Unrealized Market Valuation Loss (in millions) 226 11,246 $11,472 (a) Predominantly represent transactions written to facilitate capital relief (b) Approximately $61.4 billion in notional amount of the multi-sector pools include some exposure to U.S. subprime mortgages. SOURCE: AIG 2007 ANNUAL REPORT, FORM 10-K, PAGE 122 47
Slide 48: Why AIG had to be res cued • AI h a d ra c k e d u p a b o u t $ 2 5 b n o f c u m u la tiv e lo s s e s o n its c re d it G d e fa u lt p ro te c tio n a n d ha d taken $ 18 .5 bn in los s es over the pa s t three quarters . • Th e Le h m a n b a n k ru p tc y w a s n o t th e o n ly c a u s e b u t it s h re d d e d th e re m n a n ts o f c o n fid e n c e o n AI G; • Ad ju s te d fu lly fo r m a rk -to -m a rk e t lo s s e s a n d s trip p in g o u t g o o d w ill a n d h yb rid c a p ita l, e v e n a t th e e n d o f Ju n e AI m ig h t h a v e h a d G a b o u t $ 2 4 b illio n le s s b o o k e q u ity th a n s a fe ly c a p ita lis e d . • C DS on AIG lea pt to record levels that to protect $ 10 m of AIG bonds for five years would ha ve to pa y $1 .2 5 m per year; • Th e fin a l b lo w c a m e w h e n AI G's d e b t w a s d o w n g ra d e d , m e a n in g c o u n te rp a rtie s c o u ld d e m a n d $ 1 4 .5 b n in c o lla te ra l; 48
Slide 49: “S uper S enior” C redit Derivatives 49
Slide 50: AIG Inves tment P ortfolio As of Jun 30,2008 Items S ubP rime ALT-A Other RMB S Amount ($bn) 20 2 0 .2 3 7 .3 77.5 4.1 391.4 473 50 Total RMB S C DO Other Total Inves tment
Slide 51: C DS MTM Valuation L os s es As of Jun 30,2008 51
Slide 52: Importance of Ma cro-P rudentia l P olicy • • • • Need to watch out for As s et B ubble, particularly real es tate Need to monitor exces s leverag e in any s ector, hous eholds , corporate, g overnment and financial ins titutions C ons olidate S P V or S IV into balance s heets of banks , s o that true leverag e is revealed. C entralize OTC trading into org anized exchang es with central clearing and counterparty to monitor leverag e, s olvency and improve trans parency Remove procyclicality of Accounting and Reg ulatory s tandards . C oordinate with monetary, fis cal and g overnment authorities to us e different policies to tackle as s et bubbles Us e L TV and collateral ratios proactively Have dynamic provis ioning for banks • • • • 52
Slide 53: P os s ible C ris is Ma na g ement a nd Res olution Tools • “C ris is is an event; C ris is Mana g ement a nd B ank Res olution is a P roces s ” • P roblem rea lly is s peed of delevera g ing - Revers ion ba ck to mea n a fter bubble • Injection of L iquidity [its not liquidity, s tupid; it’s fear of ins olvency of counter-party!] • Is ola te Ins olvent P layer （ C a rve out ） • Inject capita l into banks • G ua rantee of Depos its and B a nk Debts • F orbea ra nce - s us pens ion of Ma rk-to-Ma rket accounting etc • L ower interes t ra tes • F is cal P rime-pumping • C rea te Res olution Trus t C ompa ny （ RTC ） to dea l with ba nks or borrowers (e.g . homeowners ) 53
Slide 54: F inancial C ris is = P olitical B acklas h • AFL-CI U io n Le a d e r, Jo h n Sw e e n e y s a id , “On e th in g On is c e rta in . No o n e - n o p o litic ia n , n o in v e s tm e n t b a n k e r, n o te le v is io n c o m m e n ta to r, n o e c o n o m is t – s h o u ld b e a b le to s a y a g a in w ith a s tra ig h t fa c e th a t h e re in th e U ite d Sta te s w e ju s t le t th e m a rk e ts d o w h a te v e r n m a rk e ts d o a n d e v e ryth in g w o rk s o u t fo r th e b e s t.” 54
Slide 55: C onclus ion • • • • • • • Mas s ive mortg ag e rela ted pos itions a nd written C DS led to larg e los s under credit crunch; Hig h fina ncia l levera g e ratio g ave ris e to fra g ile confidence on the compa ny’s liquidity a nd ca pita l; Ins ufficient reg ula tion and lack of s ys tem-wide s upervis ion; F a ir va lue a ccounting Valuation of F inancia l ins truments ,es pecia lly Ma rk to Model, C omplexity of derivatives led to difficulty of pricing and liquidation under ma rket turmoil. S enior ma nag ement underes tima ted market difficulties ; US g overnment did not rea lize complexity of s itua tion a nd could only rea ct under with cris is . 55
Slide 56: Thank You Questions to as@andrewsheng.net 56