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May 1, 2008updated 13 Apr 2017 8:58am

Enquiry exposes AIG’s house of cards

AIG was a disaster waiting to happen, is the clear message that emerged from a Congressional hearing into its near-bankruptcy However, while AIGs former CEO Hank Greenberg strongly implied that blame lay with his successors, a corporate governance expert does not believe Greenberg himself is blameless Born out of insurance agency CV Starr & Company established in Shanghai, China in 1919 by Cornelius van der Starr, American International Group (AIG) grew to become the worlds largest insurer

By LII editorial

AIG was a disaster waiting to happen, is the clear message that emerged from a Congressional hearing into its near-bankruptcy. However, while AIG’s former CEO Hank Greenberg strongly implied that blame lay with his successors, a corporate governance expert does not believe Greenberg himself is blameless.

Born out of insurance agency CV Starr & Company established in Shanghai, China in 1919 by Cornelius van der Starr, American International Group (AIG) grew to become the world’s largest insurer. As recently as 2007 AIG ranked as the US’ 10th-largest company and until May 2008 boasted an AA rating from Standard & Poor’s.

That is all history now, with AIG the subject of a of $123 billion federal rescue package which has left it 79.9 percent owned by the government and preparing to sell major chunks of its vast business interests.

At the heart of AIG’s woes were credit default swap (CDS) derivatives, a form of insurance offering protection against default of credit instruments. When the financial crisis burst, AIG found itself grossly over-exposed to risk related to CDS’ written by its AIG Financial Products (AIGFP) unit.

How could things have gone so wrong? The best insight so far came out of a House of Representatives’ Oversight Committee enquiry into AIG’s downfall held in October.

One of those testifying was Maurice Greenberg, who joined CV Starr in 1960 and went on to become AIG’s first CEO, a position he held until his ousting from AIG in March 2005.

“Its [AIG’s] market capitalisation increased 40,000 percent between 1969, when AIG went public, and 2004, my last full year as CEO,” he proclaimed in his opening remarks. “Today, the company we built up over almost four decades has been virtually destroyed.”

Blame does not lie with AIG’s insurance units – which are sound – but with AIGFP, which was formed in 1987 to diversify AIG’s earnings without incurring undue risk he stressed.

“From the beginning, AIG’s policy was that AIGFP conduct its business on a hedged basis – that is, its net profit should stem from the differences between the profit earned from the client and the cost of offsetting or hedging the risk in the market,” stressed Greenberg.“

AIGFP would therefore not be exposed to directional changes in the fixed income, foreign exchange or equity markets.”

While he was CEO, Greenberg said AIGFP was subject to internal risk controls, including credit risk monitoring by independent units of AIG, review of transactions by outside auditors and consultants, and scrutiny by AIGFP’s and AIG’s boards of directors.

He added that every new type of transaction or any transaction of size, including most CDS’ was reviewed by AIG’s chief credit officer. AIGFP began selling credit default insurance in 1998.

Following his departure from AIG, the volume of credit default swaps written by AIGFP “exploded,” said Greenberg. He noted that AIGFP reportedly wrote as many credit default swaps on collateralised debt obligations (CDO) in the nine months following his departure as it had written in the previous seven years combined.

He added that based on information published by AIG, AIG’s net notional exposure to CDOs at 30 June 2008 was $80.3 billion, of which $57.8 billion contained subprime mortgage collateral. The mark-to-market loss on this portfolio at that date totalled $24.8 billion, of which $21 billion related to securities containing sub-prime mortgage collateral.

Putting forward possible reasons for AIG’s problems, Greenberg said: “I was not there, so I cannot answer that question with precision. But reports indicate that the risk controls my team and I put in place were weakened or eliminated after my retirement. For example, it is my understanding that the weekly meetings we used to conduct to review all AIG’s investments and risks were eliminated.”

He added that earlier this year, AIG’s external auditors found AIG to have a material weakness in its internal controls relating to AIGFP’s portfolio of credit default swaps.

“It also appears to be the case that the problem created by the additional risk AIG had taken on through these new credit default swaps may have been aggravated by the fact that the new exposure appears to have been entirely or substantially unhedged,” he said.

Another view

A very insightful assessment of AIG was provided by Nell Minow who heads The Corporate Library (TCL), a research firm specialising in corporate governance.

“One of our most popular products is our rating of board effectiveness,” said Minow. ”We rate boards like bonds – A through F.”

During Greenberg’s tenure TCL had given AIG’s board a D rating in June 2002 which it downgraded to an F in February 2005. Following Greenberg’s departure, TCL upgraded AIG’s board to a D rating in May 2005 and in February 2006 to a C rating.

In its February 2006 assessment of AIG, TCL commented: “We are increasingly confident in the new board’s willingness and ability to move the company forward in the best interests of all its shareholders.”

That was the last upgrade and in November 2007 AIG’s board was downgraded to a D rating. Minow said that at the time of the downgrade, AIG’s board continued to reflect Greenberg’s influence and could not seem to solve or prevent accounting problems. In addition, the downgrade reflected what TCLs analysts at the time said were their “very high concerns over executive compensation.”

Minow continued that TCL’s most recent analysis again raised concerns related to AIG’s internal controls and then-CEO Martin Sullivan’s remuneration. In 2007 Sullivan’s compensation was $43.9 million, the bulk of which comprised a $36.5 million annual bonus and a $5.6 million non-equity incentive bonus. His annual salary was $1 million.

Problems were inevitable

Summing up, Minow said: “Neither of the CEOs that followed Greenberg sought to implement significant change, nor did the reconstituted board apply pressure on them to do so. One interpretation might be they simply weren’t up to it; a more cynical, but probably more accurate, interpretation would be the house of cards constructed by Greenberg in the first place was already too fragile and too far gone for such efforts to work.”

She concluded: “Certainly it is no accident that AIG was among the first of the giants to be toppled by the mounting credit crisis – the seeds of its destruction had been sown by Mr Greenberg, and endorsed by the AIG board, several years before.”

AIG was a disaster waiting to happen, is the clear message that emerged from a Congressional hearing into its near-bankruptcy. However, while AIG’s former CEO Hank Greenberg strongly implied that blame lay with his successors, a corporate governance expert does not believe Greenberg himself is blameless

Born out of insurance agency CV Starr & Company established in Shanghai, China in 1919 by Cornelius van der Starr, American International Group (AIG) grew to become the world’s largest insurer. As recently as 2007 AIG ranked as the US’ 10th-largest company and until May 2008 boasted an AA rating from Standard & Poor’s.

That is all history now, with AIG the subject of a of $123 billion federal rescue package which has left it 79.9 percent owned by the government and preparing to sell major chunks of its vast business interests.

At the heart of AIG’s woes were credit default swap (CDS) derivatives, a form of insurance offering protection against default of credit instruments. When the financial crisis burst, AIG found itself grossly over-exposed to risk related to CDS’ written by its AIG Financial Products (AIGFP) unit.

How could things have gone so wrong? The best insight so far came out of a House of Representatives’ Oversight Committee enquiry into AIG’s downfall held in October.

One of those testifying was Maurice Greenberg, who joined CV Starr in 1960 and went on to become AIG’s first CEO, a position he held until his ousting from AIG in March 2005.

“Its [AIG’s] market capitalisation increased 40,000 percent between 1969, when AIG went public, and 2004, my last full year as CEO,” he proclaimed in his opening remarks. “Today, the company we built up over almost four decades has been virtually destroyed.”

Blame does not lie with AIG’s insurance units – which are sound – but with AIGFP, which was formed in 1987 to diversify AIG’s earnings without incurring undue risk he stressed.

“From the beginning, AIG’s policy was that AIGFP conduct its business on a hedged basis – that is, its net profit should stem from the differences between the profit earned from the client and the cost of offsetting or hedging the risk in the market,” stressed Greenberg.“

AIGFP would therefore not be exposed to directional changes in the fixed income, foreign exchange or equity markets.”

While he was CEO, Greenberg said AIGFP was subject to internal risk controls, including credit risk monitoring by independent units of AIG, review of transactions by outside auditors and consultants, and scrutiny by AIGFP’s and AIG’s boards of directors.

He added that every new type of transaction or any transaction of size, including most CDS’ was reviewed by AIG’s chief credit officer. AIGFP began selling credit default insurance in 1998.

Following his departure from AIG, the volume of credit default swaps written by AIGFP “exploded,” said Greenberg. He noted that AIGFP reportedly wrote as many credit default swaps on collateralised debt obligations (CDO) in the nine months following his departure as it had written in the previous seven years combined.

He added that based on information published by AIG, AIG’s net notional exposure to CDOs at 30 June 2008 was $80.3 billion, of which $57.8 billion contained subprime mortgage collateral. The mark-to-market loss on this portfolio at that date totalled $24.8 billion, of which $21 billion related to securities containing sub-prime mortgage collateral.

Putting forward possible reasons for AIG’s problems, Greenberg said: “I was not there, so I cannot answer that question with precision. But reports indicate that the risk controls my team and I put in place were weakened or eliminated after my retirement. For example, it is my understanding that the weekly meetings we used to conduct to review all AIG’s investments and risks were eliminated.”

He added that earlier this year, AIG’s external auditors found AIG to have a material weakness in its internal controls relating to AIGFP’s portfolio of credit default swaps.

“It also appears to be the case that the problem created by the additional risk AIG had taken on through these new credit default swaps may have been aggravated by the fact that the new exposure appears to have been entirely or substantially unhedged,” he said.

Another view

A very insightful assessment of AIG was provided by Nell Minow who heads The Corporate Library (TCL), a research firm specialising in corporate governance.

“One of our most popular products is our rating of board effectiveness,” said Minow. ”We rate boards like bonds – A through F.”

During Greenberg’s tenure TCL had given AIG’s board a D rating in June 2002 which it downgraded to an F in February 2005. Following Greenberg’s departure, TCL upgraded AIG’s board to a D rating in May 2005 and in February 2006 to a C rating.

In its February 2006 assessment of AIG, TCL commented: “We are increasingly confident in the new board’s willingness and ability to move the company forward in the best interests of all its shareholders.”

That was the last upgrade and in November 2007 AIG’s board was downgraded to a D rating. Minow said that at the time of the downgrade, AIG’s board continued to reflect Greenberg’s influence and could not seem to solve or prevent accounting problems. In addition, the downgrade reflected what TCLs analysts at the time said were their “very high concerns over executive compensation.”

Minow continued that TCL’s most recent analysis again raised concerns related to AIG’s internal controls and then-CEO Martin Sullivan’s remuneration. In 2007 Sullivan’s compensation was $43.9 million, the bulk of which comprised a $36.5 million annual bonus and a $5.6 million non-equity incentive bonus. His annual salary was $1 million.

Problems were inevitable

Summing up, Minow said: “Neither of the CEOs that followed Greenberg sought to implement significant change, nor did the reconstituted board apply pressure on them to do so. One interpretation might be they simply weren’t up to it; a more cynical, but probably more accurate, interpretation would be the house of cards constructed by Greenberg in the first place was already too fragile and too far gone for such efforts to work.”

She concluded: “Certainly it is no accident that AIG was among the first of the giants to be toppled by the mounting credit crisis – the seeds of its destruction had been sown by Mr Greenberg, and endorsed by the AIG board, several years before.”

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