While its is clear that risk management blunders in AIG’s
Financial Products unit triggered the insurer’s current plight, its
securities lending programme also played a key role. This role was
the focus of testimony presented to the Senate by the
superintendent of the New York State Insurance Department.
With financial disaster engulfing American International Group
(AIG), much of the focus is on damage caused by credit default swap
derivatives, a form of insurance offering protection against
default of credit instruments written by AIG Financial Products
(AIGFP), a unit regulated the federal Office of Thrift Supervision.
Less attention has been paid to damage running into billions of
dollars done by AIG’s securities lending programme which affected
only its life insurance operations.
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Now, far more clarity on the securities lending programme has
been provided by the superintendent of the New York State Insurance
Department (NYSID), Eric Dinallo, in testimony he presented to the
Senate Committee on Banking, Housing and Urban affairs on 5
March.
At the outset, Dinallo conceded: “There is justified concern
about AIG’s securities lending program.”
However, he stressed that problems the programme confronted were
not the result of slack regulatory action. Providing committee
members with insight into securities lending, Dinallo explained the
basics of the widely used market. In essence, securities lending
involves financial institution A lending a share or bond it owns to
financial institution B, said Dinallo.
In return, B gives A cash collateral worth generally about 102
percent of the value of the security it is borrowing. A then
invests the cash to gain a small additional return. A still owns
the security and will benefit from any growth in its value.
“Securities lending is an activity that has been going on for
decades without serious problems,” stressed Dinallo. “Many, if not
most, large financial institutions, including commercial banks,
investment banks and pension funds, participate in securities
lending.”
Though the size of the market is not precisely known the
International Securities Lending Association estimates that in 2007
the balance of securities on loan globally was in excess of $2
trillion.
“It is important to understand that securities lending did not
cause the crisis at AIG. AIG Financial Products did,” stressed
Dinallo in his testimony.
“If there had been no Financial Products unit and only the
securities lending programme as it was, we would not be here today.
There would have been no federal rescue of AIG. Financial Products’
trillions of dollars of transactions created systemic risk.
Securities lending did not.”
And indeed AIG’s securities lending programme fell victim to
systemic risk triggered by AIGFP.
Securities lending not to blame
Dinallo explained that under normal conditions in the securities
lending market when the financial institution (B) that borrowed the
security wants to return it to the lender (A) there is no
problem.
However, he continued, if there is “a run” in which many of the
borrowers return the securities and demand cash, A may not be able
to quickly sell enough assets to obtain the cash it needs or may
have to sell assets at a loss before they mature. This is the
situation AIG’s securities lending programme faced.
Though at the insistence of the NYSID and other state insurance
regulators AIG’s US securities lending programme had been run down
from a peak of $76 billion, it still stood at $58 billion when the
financial crisis surrounding AIGFP erupted in September 2008. The
US programme consisted of 12 life insurers, including three
regulated by the NYSID.
“The crisis caused by Financial Products caused the equivalent
of a run on AIG securities lending,” said Dinallo. “Borrowers that
had reliably rolled over their positions from period to period for
months began returning the borrowed securities and demanding their
cash collateral.”
From 12 September to 30 September borrowers demanded the return
of about $24 billion in cash, said Dinallo. He added that the AIG
holding company that managed the programme had invested borrowers’
cash collateral in mortgage-backed securities that had become hard
to sell.
“To avoid massive losses from sudden forced sales, the federal
government, as part of its rescue, provided liquidity to the
securities lending program,” said Dinallo.
In the early weeks of the rescue, funds were used to meet the
collateral needs of the programme and eventually the Federal
Reserve Bank of New York created Maiden Lane II, a fund that
purchased the life insurance companies’ collateral at market value
for cash.
Mortgage-backed securities made up 60 percent of the invested
collateral pool, according to Dinallo. Notably, had AIG invested
the collateral in US Treasury securities meeting demands for return
of collateral would have presented no problem. According to the
Federal Reserve Board the daily volume of US treasury securities
traded in 2007 averaged $561.8 billion.
Regulatory action
Dinallo told the Senate committee that the NYSID was aware of
potential stresses at the AIG securities lending programme.
“As early as July 2006, we were engaged in discussions about the
securities lending program with AIG,” he said.
He continued that the NYSID had insisted that the programme be
wound down and began working towards this end with AIG in 2007.
Unfortunately, he added, the programme could not be ended quickly
because beginning in 2007 some of the residential mortgage
securities could not be sold for their full value. Realising the
risk of losses faced by AIG life insurers involved, Dinallo said
NYSID had insisted the AIG holding company provide a guarantee to
the life companies to make up for any losses incurred during the
winding down. The holding company provided a guarantee of first
$500 million, then $1 billion and finally $5 billion.
Dinallo believes regulatory action taken on the programme would
have been effective if not for AIGFP.
“If not for the crisis caused by AIGFP, AIG would be just like
other insurance companies, dealing with the stresses caused by the
current financial crisis, but because of its size and strength,
most likely weathering them well,” he stressed.
Despite this the NYSID is beefing-up its regulatory armoury.
“We are currently drafting regulatory guidelines that will
govern the size and scope of securities lending programmes and will
include best practices,” said Dinallo.
