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C. DINESEN
AIG had another major exposure to subprime completely unrelated to credit default swaps. As a major insurer, it was a major investor and AIG had investments of $70 billion in highly rated mortgage-backed securities (Blair and McNichols 2009). The incentive plans of the capital markets division were unique within AIG. The incentive plans originally retained close to two fifths of profits up front including for longer-term contracts for payment to employees and then passed on the rest to the parent company. In 1994, this was changed to a one-third, two-third split with part of the retained compensation deferred over several years. But the capital markets activities remained highly incentivised to grow. The United States government decided that AIG’s bankruptcy would have catastrophic consequences for the banking industry because of the close to half trillion of credit default swaps sold by AIG. A rarely used Federal Reserve act enables the Federal Reserve to lend AIG $85 billion, receiving a stake of four fifths of AIG’s equity capital in return. By November 2008, the deterioration in AIG’s results meant that the total rescue package had to be increased to $153 billion including from the government’s Troubled Asset Release Program, which will be described later. AIG’s $62 billion loss for 2008 was the largest of any company in history. Eventually the rescue was estimated at $182 billion. There was significant poor management in the failure of AIG. The incentive schemes for the capital market division were one example. When these schemes were left in place, after the failure of the company, with the argument that staff that knew what had gone wrong needed to be retained, this caused a public outrage. The absent management in the failure of AIG was due to complexity and uncontrolled growth. Entering into capital market activities involved a level of complexity beyond the capabilities of AIG’s top management. The four levels of complexity between a subprime loan and the credit default swap sold by AIG, with the packaging and repackaging, tranching and associated credit ratings, were supposed to provide diversity and remoteness from loss. But the need to post collateral to counterparties when AIG itself was downgraded and the requirement to value its exposures in deteriorating markets were completely different from its insurance business. The uncontrolled, but incentivised, growth of this highly complex and different business resulted in absent management and the largest corporate loss and bailout at the time. Such large losses requiring an enormous government rescue, starting on the same day Lehman Brothers failed, significantly added to the size and impact of the crisis.
