Lecture Notes – December 3, 2012

I will probably give the midterm back on Friday. I’d rather not discuss it today as there is still one person that needs to take it during my office hours today. This also means that I will not have office hours today.

The schedule for the last two weeks of class will be 4-5 lectures on the financial crisis of the last few years and then 1-2 lectures spent on review. I have sent out an email to everyone asking for topics that you would like to review – please respond so that I do not have to be totally random.

We are going to focus on AIG and background around AIG. We will end up talking about:

  • Insurance Companies
  • A form of financial intermediary
  • History of AIG
  • Securities Lending
  • We’ve touched on this in our discussions of short sales of stocks
  • Subprime mortgages
  • What makes these different from normal mortgages
  • Credit Default Swaps
  • CDOs
  • Credit default swaps on CDOs
  • The role of collateral in these transactions
  • Discussion on a video of Maurice “Hank” Greenberg.

We will use the book for some background but quite a bit of the reading will come from elsewhere.

The reading will consist of pp 514-429 in your book (part of chapter 21 on Insurance), then some pages out of the Congressional Oversight Panel Report from June 2010. This is 300 pages long but I’m going to assign 15-20 pages.

Finally is a video of a lecture by Maurice “Hank” Greenberg the former chairman of AIG. This video is part of an online course from Yale entitled “Financial Markets.” The video gives a very different perspective on what happened than the assigned readings. We will probably spend a bit of time next week going through both.

I’ve placed links to the additional material on the web.

I suspect that we will partially spill into the 5th lecture but I will do my best not to. I will then leave at least part of the 5th lecture and the 6th lecture for class review. What I’d like from your part is what topics you would like to review in those classes. I’m happy to leave them free-form but the classes will work better if I prepare some problems/exercises in advance.

Book reading – pp 514-529

Assigned readings

271-272 – Overview of Securities Lending

251-259 – Overview of CDS

We will cover quite a bit of the material from 17-46 in class.

Let’s start by going back to chapter 2 and review a couple of definitions.

Insurance Companies

An insurance company is in the business of assuming risk on behalf of their customers in exchange for a premium. Most people buy insurance because they are risk-adverse – they would rather pay an amount with certainty than gamble on an unexpected loss. Other types of insurance are heavily regulated – if you own a car then you must have insurance that covers damage to someone else’s car if you crash into it.

In addition there are certain types of catastrophic losses that as individuals we could not cover. For example, you buy a house – if you did not purchase property insurance then losing the house in a fire would be catastrophic. Very few people could afford to buy the house and then completely rebuild it after a fire. On the other hand the probability of losing a house in a fire is fairly small.

There are several basic principles that insurance follows:

  1. There must be a relationship between the insured and the beneficiary.
  2. This was not always the case. Imagine that you could take out life insurance on me. Thus you stand to benefit when I died. If you were a somewhat unsavory character then it might turn out that you had a financial interest to ensure that I met with an accident sooner rather than later – especially after the last mid-term. Thus there are restrictions. For example, you can take out property insurance on your own home but not your neighbor’s. On the other hand your mortgage company also has an insurable interest in your house. Thus they are free to take insurance out as well.
  3. The insured must provide full and accurate information to the insurance company
  4. If and when you take out insurance you will be asked an inordinately large number of questions by the insurance company. If it turns out that you did not tell the truth in this then you may be denied coverage later – even if it is unrelated to the insured event. This is a common problem with health insurance.
  5. The insured is not to profit as a result of the insurance coverage
  6. You cannot take out insurance that gives you more back after the item is gone. For example, you cannot insure your used car for the value of a new car.
  7. If a third party compensates the insured for a loss then the insurance company’s obligation is reduced by the amount of compensation
  8. Again you cannot insure the same item with two different companies and profit from being paid twice for the same loss.
  9. The insurance policy has a large number of insured so that this risk can be spread out.
  10. Diversification is critical for insurance to work.
  11. The loss must be quantifiable
  12. The insurance company must be able to compute the probability of a loss occurring

Adverse Selection and Moral Hazard

If you recall at the beginning of the course we talked about adverse selection and moral hazard. These are both big problems for the insurance industry.

Adverse selection is the problem that the people most likely to apply for insurance or those most likely to need payout – people in poor health will apply for health insurance etc. In the extreme it would better to not insure people who seek insurance because they are more likely to make claims.

In practice insurance companies deal with this via screening. They may also exclude pre-existing conditions. For example, if the roof on your house needs replacing then you may not get insurance for water damage until the roof is repaired.

Moral Hazard is the problem that once someone has insurance they no longer take care of the insured property - for example - Don’t lock your car as you will be reimbursed if the car is stolen. Insurance companies deal with this problem via deductibles.

Types of Insurance

Insurance is classified according to what type of undesirable event is covered.

  • Life Insurance – Pays off a lump sum on death
  • Term Life – insures over a fixed number of years
  • Whole life – insures over life but accumulates cash value as well. Generally one would pay a higher premium at the beginning than a term policy. The theory was that the difference would be invested and thus one would gain access to this accumulated value. The problem was that in the early years these additional funds traditional went as sales commissions to the broker selling the insurance. Compounding this problem was that often these policies would not be held for one’s entire life. Thus the front-loading of fees caused the investment returns to be very poor.
  • Universal Life – similar to whole life but the insurance is more like a term policy. Again as a policy these will be pushed hard by brokers as their commissions are higher than with term policies. There is a positive tax advantage to these in that the saving portion is tax exempt until the funds are withdrawn.

I guess one thing that should be noted – the simpler a product might be – the less a broker is going to push it. For many individuals term life policies are sufficient. The additional investment benefits are better captured through other investment vehicles. There is a very competitive market in term life insurance policies. On the other hand if you speak to an insurance broker they will sell the virtues of whole and universal life policies. The structures are much more complex and thus the broker fees are much higher.

  • Annuity – unlike life insurance this pays out until a person dies.

At this point I have to show you an interesting trade. Let’s say that you have a 5m dollar term life insurance policy with 10 years to run and today you’ve just been diagnosed with a terminal illness and you are going to die in less than a year. What can you do? You can go back to your insurance company and ask how much money will they give you. They of course might pay you a little bit of money but there’s a transaction you can do that works better.

You can:

1 – buy an annuity that pays the premiums on the life policy until you die. This will be cheap because you have a terminal illness and you’ve got a life expectancy of less than a year.

2 – borrow the million dollars secured by the life insurance policy. This should be relatively cheap as its secured.

Thus you can have almost complete access to the value of the life policy to pay medical bills, travel around the world etc.

As a business model it is slightly morbid of course….

Back to types of insurance.

  • Health Insurance – covers health benefits. Extremely complex
  • Property and Casualty Insurance – protects property against fire, theft, storm, explosions etc. Casualty covers against liability for harm the insured may cause to others.
  • Reinsurance – One way that an insurance company may reduce its exposure is by selling part of its policies onwards.

History of AIG

In 1919 Cornelius Vander (CV) Starr established an insurance agency in Shanghai, China. He was the first westerner to sell insurance in Chinese and stayed in China until 1939.

He then moved the headquarters of the company to NY. The NY division of the company was failing and in 1962 he put Maurice “Hank” Greenberg in charge of the company. CV Starr retired in 1968 and chose Greenberg as his successor. The company went public in 1969.

It went on to become one of the largest insurance companies in the world. Here’s a chart of its market cap from 1994 to present.

In 1987 AIGFP – AIG Financial Products was formed to specialize in interest rate and currency swaps and more broadly the capital markets. It’s primary focus was the OTC derivatives markets and this division was a key driver of the issues that led to the bailouts in 2008.

Prior to the bailout AIG was the world’s largest insurance company with over $1tr in assets, 76 million customers in over 130 countries.

It should be noted that the regulatory structure under which AIG ran was reasonably convoluted.

In September 2008 the US government knew that both Lehman Brothers and AIG were on the verge of collapse. They decided that the collapse of Lehman Brothers would cause larger systemic issues and thus focused efforts on a rescue of that institution. When the Fed Reserve decided to change directions and allow Lehman Brothers to collapse it was very late to focus on AIG.

The government then put the rescue in the hands of two banks – JP Morgan Chase and Goldman Sachs – both of these companies would be the largest beneficiaries of a government rescue. They had significant conflicts of interest not to organize a private rescue.

The bailout of AIG was incredibly complex so I will try to layout a timeline. I have attached a slide from the treasury that details this.

September 16, 2008 – Fed establishes an $85bn credit facility for AIG

October 8, 2008 – Fed commits an additional $37.5bn for securities lending

November 10th, 2008 – US treasury makes a $40bn TARP investment in AIG to reduce the Fed’s credit facility. Fed authorizes loans to Maiden II and Maiden III to purchase securities from AIG.

  • Maiden Lane II was set up to buy residential mortgage backed securities from various insurance subsidiaries
  • Maiden Lane III was set up to buy multi-sector CDOs from AIGFP counterparties to allow AIGFP to terminate the associated CDS.

March 2, 2009 – Treasury commits an additional $30bn of TARP investment to AIG. Fed reduces its credit facility in exchange for preferred interests in two SPVs.

Jan 14, 2011 – Fed loans to AIG paid off, Loans to Maiden Lane II and III remain, Fed’s SPV interests transferred to the treasury and treasury receives 92% of common stock. Previously committed but unspent TARP funds are used to complete the transaction

May 2011 – Treasury sells 5.8bn of common stock and cancels unused TARP Commitments.

Feb 2012 – Sale of final securities in Maiden Lane II. Total gain from portfolio is 2.8bn on 22.5bn portfolio (return of 11%)

March 2012 – Treasury sells an additional 6bn of common stock

May 2012 – Treasury sells an additional 5.75bn of common stock

Aug 2012 – Treasury sells an additional5.75bn of common stock

Aug 2012- Sale of final remaining securities in Maiden Lane III. Total gain on portfolio is 6.6bn on a 30bn portfolio (a 22% return)

Sep 2012 – Sale of 20.7bn of common stock.

Remaining stake in AIG is worth around $7.6bn as of Sep 2012.

Securities Lending

An overview of the business…. This is a very basic business in securities

Subprime Mortgages

What’s the difference between subprime and other mortgages

CDOs

What’s a CDO

Credit Default Swap

What is a credit default swap

Super Senior Tranche

What’s a super senior tranche of a security and why did AIG write CDS on them

Derivative Agreements

How a transaction is structured and the role of collateral. Why getting downgraded causes one problems

Greenberg Video

Let’s talk about what Greenberg sees differently. Was he correct or incorrect?