Witch Hunt at AIG; While Lloyd’s Sees ‘Flight to Quality’

The witch hunt that has engulfed AIG needs to be toned down. If for no other reason than it’s making the problem worse, not better. It also reduces the likelihood that U.S. taxpayers will get back any of the money the government has put into it.

People from President Obama on down are perhaps properly outraged that a company, which lost $58 billion in one quarter and has been taken over by the government for $130 billion, paid its executives, some of whom caused the mess, $160 million in bonuses.

However, the outrage over AIG paying off its other obligations — notably to “foreign banks” and Goldman Sachs — is a bit misplaced. As Chris Boggs, associate editor of MyNewMarkets.com pointed out, credit default swaps worldwide total $58 trillion (See: https://www.insurancejournal.com/news/national/2009/03/25/99039.htm). The government bailed out AIG primarily so it could at least pay a part of what it owed.

As a number of commentators have pointed out, AIG didn’t insure these contracts. It would have been better off, if it had. Then it would have had to establish reserves and would have been subject to regulation. As a result its wholehearted rush into risky investments might have been curtailed.

AIG, however, was a counterparty on innumerable risks. In very simple terms, it bought and sold contracts of one kind or another (default swaps, CDO’s, notes) — it doesn’t matter. On the other side of those transactions were the buyers and sellers — AIG’s counterparties.

The simplest example is currency trading: Bank A needs $1 million for some of its customers; Bank B needs an equivalent amount in Euros. They make a deal to provide the amounts on a certain date, thus becoming counterparties and undertaking to honor their contract. The financial instruments or contracts AIG entered into along with many banks is more complicated, but they remain essentially the same type of transaction.

AIG Financial Products (AIGFP), its financial unit, bought and sold hundreds of thousands of financial instruments all over the world, using the parent company’s ‘AA’ rating to obtain better credit terms for the deals, which in turn made their cost subject to a ratings downgrade. When the originators of those contracts couldn’t pay their obligations, it created a domino effect. The sequential holders, like AIG, couldn’t honor their obligations. The whole system began to collapse, threatening the stability of the entire global financial system.

Whether the financial counterparty is in Paris, Texas, or Paris, France, is immaterial. Financial transactions — as the current crisis proves in spades — are global. One only has to look at the result of the failure to support Lehman Brothers to gauge what effect on world finances a similar failure to support AIG could have had.

Lack of liquidity/lack of credit are now strangling the economies of every country in the world. Fear has replaced trust to the extent that the world’s banks and other financial institutions are afraid to do business, even with sound commercial risks. Their reluctance to enter into counterparty transactions has to be eradicated, if the world is ever to emerge from the current crisis. Supporting AIG and the banks is a necessary, if somewhat unpalatable, step towards global recovery.

Lloyd’s made a lot less money in 2008, than in 2007; still $2.78 billion is not a negligible sum, even if it’s only about half that of the prior record year. Luke Savage, Lloyd’s of London’s finance director is relatively sanguine about the decline. In a telephone interview he acknowledged that we’re in for a “very tough 2009,” but that Lloyd’s 2008 results weren’t all that bad compared to the rest of the market.

He pointed out that the “insurance market is going through a period of uncertainty, and policy holders are hesitant about placing all of their business with one carrier.” The result is what Savage termed “a flight to quality.” With around £2.6 billion ($3.8 billion) in its Central Fund (the facility that assures claims’ payments), Lloyd’s is well positioned to offer just that type of security.

In fact, Lloyd’s structure is tailor-made to solve the problem. “We’re a subscription market,” Savage explained. “A risk is typically shared by more than one Syndicate.” A “lead Syndicate” places the initial coverage. It has standing agreements with a number of other syndicates to take on a certain percentage of the risk and on what terms they will do so.

The policyholder thereby automatically spreads the risk of non-payment of a claim among a number of syndicates, who are in turn backed by a selected number of carriers – all of whom have met Lloyd’s rigid financial standards. In the rare instances when a syndicate can’t pay a claim, the policyholder has recourse to the Central Fund.

Topics Excess Surplus Aviation Lloyd's AIG