Reading assignment on “The AIG Bailout”

You are required to write a summary report (at least 3 typed pages in length) on the reading of the following article by W.K. Sjostrum, Jr.,

“The AIG bailout,” 66 Washington and Lee Law Review 943 (2009).

The article summarizes the causes and events leading to the AIG (American International Group) bailout on September 16, 2008. The principal cause of the AIG’s cash woes was the collateral posting obligations on the senior credit default swaps (CDSs) that AIGFP (AIG Financial Products Corp., subsidiaries of AIG) wrote on large volumes of multi-sector Collateralized Debt Obligations (CDOs). On top of that, AIG also faced with the collateral-return obligations in its securities lending programs. In historical record, AIG was on the verge of bankruptcy and had to be rescued by the United States Government through an $85 billion loan. Government aid had since grown to $182.5 million. The share price of AIG at time of bailout fell to less than 2% that of 7 months ago.

In your reading report, please give your summary and comments of the various issues discussed in the article, addressing the relevant topics listed below as guidelines

Relevant topics and questions:

1.  What are the structural features of CDO? This well-known financial instrument was once a popular structured credit instrument which is commonly used in the securitization process for residential mortgage loans before the 2008 financial tsunami?

2.  Why did AIG consider selling protection on super senior tranches in CDOs as “gold” and “free money”, which was very similar to its usual excess casualty insurance business (a business in which AIG had been profitably engaging for years)?

3.  How did the meltdown of sub-prime mortgage loans and the collateral posting obligations in AIGFP’s CDSs trigger the cash woes faced by AIG? Worst comes to worst, AIG also faced with the collateral-return obligations in its securities lending programs. At the end, why this strategy of selling protection on senior CDSs, coupled with the securities lending program, was proven to be a disaster?

4.  Why did the United States Government decide to bail out AIG and what are the procedural events in the bailout?

5.  What are the regulatory gaps in the regulation of CDSs that lead to the bailout of AIG?

You may find additional information on CDO, CDS and sub-prime mortgages meltdown from various web sites.