This case is a reference for the funding needs of a CDS seller that posts collateral. It is also a reference for reviewing the contract terms that set the collateral a party gives its counterparties. It also comes up when a clause that raises collateral after a rating downgrade is built into a funding estimate.

The September 2008 liquidity crisis

AIG is a US corporate group built around insurance. Its financial products unit, AIG Financial Products (AIGFP), sold CDS that referenced multi-sector CDOs, a kind of collateralized debt obligation (CDO) that bundles securities from several sectors including residential mortgages1.

On September 15, 2008, three rating agencies downgraded AIG, and AIG needed about USD 20 billion for collateral calls and termination payments2. The next day, the Federal Reserve Board authorized the Federal Reserve Bank of New York (the New York Fed) to lend AIG up to USD 85 billion. The government was to receive a 79.9% equity interest in AIG3.

The main reasons AIG ran short of funds were the collateral calls on its CDS and the return of cash collateral demanded by its securities lending counterparties, who asked for about USD 24 billion between September 12 and 304.

Background

The CDS that AIGFP sold

AIGFP was created in 1987 and sold its first CDS in 19985. It used its parent AIG's guarantee to become a major dealer in over-the-counter derivatives6. AIG's AAA rating helped AIGFP in negotiating when and how much collateral to post7. How CDS work is covered in Credit Default Swaps (CDS).

AIGFP's CDS fell into three groups by reference asset: bundles of corporate bonds and loans, protection bought by banks to reduce their regulatory capital (mostly European banks), and multi-sector CDOs8. At the 2007 peak, the three groups had a combined notional amount of USD 527 billion, which was 20% of AIGFP's total derivatives9.

The losses came mainly from the CDS on multi-sector CDOs. At the end of September 2008, the net notional amount was USD 72 billion, of which USD 55 billion (77%) referenced CDOs holding securities with US subprime mortgage exposure10. More than 90% of the valuation losses in 2007 and 2008 came from these CDS, and the losses came from 125 of about 44,000 contracts11. In December 2005, AIGFP stopped writing new multi-sector CDS with subprime exposure, but the contracts already sold remained12.

AIGFP sold protection on the super senior layer, the top layer in priority. This layer bears losses only after the lower tranches, including AAA-rated ones, have lost. In return for regular payments like insurance premiums, AIGFP promised to cover the losses on this layer13. The protection fee was about 0.12% of the notional amount a year14. An insurer that sells insurance must hold reserves under regulation, but CDS were not regulated insurance contracts, and no such requirement applied15.

The conditions for posting collateral

AIGFP posted no collateral when it sold a CDS. It promised, however, to post collateral if the value of the reference securities fell or if a rating agency downgraded AIG's long-term rating. Financial guarantee insurers known as monolines were barred by insurance regulation from paying until actual losses occurred, but AIGFP's CDS differed in that collateral came before losses16. Figure 1 shows the parties and what they exchange.

CounterpartyCDO holderAIGFPSellerParent AIGPremiumPayoutCollateralGuarantee
Figure 1The parties and flows in AIGFP's CDS
Figure description

The counterparty pays AIGFP a premium, and AIGFP gives the counterparty a payout and collateral. The dotted line is the parent AIG's guarantee of AIGFP's obligations, not a transfer of money. The payout comes after a credit event on the reference CDO. Collateral is posted before any actual loss, when the CDO's market value or AIG's rating falls.

Collateral depended on three things: the CDO's market value, the CDO's rating, and AIG's rating17. The terms were set in a credit support annex (CSA) with each counterparty18. For many multi-sector CDS, the amount depended on the change in value of the protected CDO, not of the CDS. The formula was based on the gap between the net notional amount and the CDO's market value. Some contracts also had a threshold, the amount of exposure left uncollateralized, that varied with the ratings of AIG or the reference CDO19.

A clause that raises collateral when a rating falls is a rating trigger. Rating triggers were not unique to AIG's contracts. In a survey by the International Swaps and Derivatives Association (ISDA), almost all market participants used ratings in setting thresholds20.

Consider a hypothetical example in which AIGFP sells Bank A a CDS referencing a multi-sector CDO with a notional amount of USD 10 billion. Collateral equals the notional amount less the CDO's market value, less the threshold. The CDO's market value is quoted per 100 of face value. The threshold is USD 500 million, and a clause sets it to 0 if AIG is downgraded.

CDO market value Threshold Collateral amount Change from previous row
100 USD 500 million USD 0 USD 0
80 USD 500 million USD 1.5 billion +USD 1.5 billion
80 (after AIG's downgrade) USD 0 USD 2 billion +USD 500 million
60 USD 0 USD 4 billion +USD 2 billion
90 USD 0 USD 1 billion −USD 3 billion

When the CDO's market value falls from 100 to 80, AIGFP posts USD 1.5 billion. If AIG is downgraded, the collateral rises to USD 2 billion at the same market value. At 60 it is USD 4 billion, and if the value recovers to 90 it falls to USD 1 billion, so USD 3 billion comes back. Bank A receives collateral as the market value falls, even if the CDO has not actually stopped paying. The actual AIGFP contracts differed in both the formula and the threshold from trade to trade21.

Timeline

Downgrades began in 200523 and collateral calls in the summer of 200724, and the two overlapped until September 20082526.

March2005S&P downgrades AIG from AAA to AA+December2005AIGFP stops writing new CDS withsubprime exposureSummer 2007First collateral calls fromcounterpartiesMay2008S&P downgrades AIG to AA−September15, 2008Three agencies downgrade AIGSeptember16, 2008The Board authorizes the New YorkFed's loan to AIG
Figure 2Main dates for AIG's ratings and collateral calls
Figure description

The events from 2005 to 2008 are shown in order: the main downgrades and collateral calls, plus the halt in underwriting new CDS and the authorization of the loan. The spacing does not reflect elapsed time. The emphasized events are the key points: the three agencies' downgrades of AIG on September 15, 2008, and the authorization of the New York Fed's loan on the 16th. Other events, such as the June 2005 downgrade, are not shown.

Date Event
2007 Reference CDOs are downgraded and large institutions report losses; two of the three collateral conditions apply27
February 2008 S&P moves the outlook to negative. The 2007 Form 10-K had disclosed a material weakness in the controls over valuing the CDS28
January to June 2008 AIG posts about USD 20.8 billion in cash as collateral on the multi-sector CDS29
End of September 2008 Collateral posted on the multi-sector CDS reaches about USD 31.5 billion30

The course of the Lehman failure is covered on the The Collapse of Lehman Brothers (2008) page.

On September 15, at the New York Fed's urging, a group including JPMorgan Chase and Goldman Sachs examined a rescue funded by private firms. AIG's funding needs grew, and the participating firms put more weight on preserving their own capital, so the plan had not come together by the morning of September 1631.

Rescue and wind-down

The credit facility of up to USD 85 billion

The Federal Reserve Board judged that a disorderly failure of AIG could worsen the fragility of financial markets. It could also lead to higher borrowing costs, lower household wealth, and weaker economic performance. The loan was meant to let AIG meet obligations as they came due and to give it time to sell parts of its business without disruption32.

The facility had a 24-month term, with interest at three-month LIBOR plus 850bp. The collateral was all the assets of AIG and its main non-regulated subsidiaries, including the stock of regulated subsidiaries. The loan was expected to be repaid from the sale of AIG's assets33. AIG borrowed at most USD 72 billion, in October 200834.

The Congressional Oversight Panel (COP), which Congress set up to oversee the Troubled Asset Relief Program (TARP), rejected the government's framing of a binary choice. The choice was between letting AIG fail and rescuing the whole business with full payment to counterparties. COP wrote that there were options to push harder and earlier for a private rescue35.

Resolving the CDS through ML3

On November 10, 2008, the Federal Reserve Board authorized the New York Fed to lend up to USD 30 billion to a special purpose company, Maiden Lane III (ML3). ML3 was set up to buy CDOs from the counterparties to which AIGFP had sold CDS and so end AIGFP's collateral calls. The New York Fed lent ML3 USD 24.3 billion, and AIG contributed USD 5 billion36.

Sixteen counterparties sold CDOs to ML3. They received a purchase price of about USD 27.1 billion at market value, kept the USD 35 billion of collateral AIGFP had posted, and ended their CDS with AIGFP37. The collateral and purchase price together came close to the face value of about USD 62 billion38. Measured by the collateral paid, the CDOs' market value was about 48 cents per dollar of face value39.

The New York Fed asked the counterparties for a reduction in the price. One offered a 2% concession if the others agreed, but the rest did not, and the New York Fed paid an amount that, with the collateral, equaled face value. The Special Inspector General for TARP (SIGTARP) reported that five choices narrowed the room to obtain concessions. The New York Fed did not treat counterparties differently, did not use its role as regulator, and did not interfere with contractual rights. It also did not hint at an AIG bankruptcy, and it was concerned about the rating agencies' reaction40.

About USD 12.5 billion of net notional amount of multi-sector CDS remained outside ML3 at the end of 2008. Most of the remaining CDS referenced synthetic CDOs, not cash CDOs41.

The outcome of the recovery

ML3 repaid the New York Fed's loan with interest on June 14, 2012, and sold its remaining securities on August 23, 2012. After repaying the New York Fed and AIG, the sale proceeds and income from the securities left a net gain of about USD 6.6 billion42.

On December 14, 2012, the US Treasury received the proceeds of its last sale of AIG common stock. The USD 182.3 billion that the Treasury and the Federal Reserve had committed to support AIG was recovered in full, with a further USD 22.7 billion in gains43.

Causes

The main reasons for AIG's liquidity crisis were the collateral calls on its CDS and the return of securities lending collateral44.

Collateral depended on market values and ratings, not on actual credit losses. AIGFP's first loss from non-payment on a reference CDO came in the fourth quarter of 2008, at USD 15 million. By contrast, collateral calls began in the summer of 2007, and the valuation losses on the multi-sector CDS came to nearly USD 40 billion by the end of 200845.

AIGFP's model did not anticipate the effect of falling CDO values and collateral calls on liquidity. In its 2007 Form 10-K, AIG wrote that it saw no probable and reasonably estimable realized loss on these CDS46.

Collateral calls and valuation losses weighed on AIG's own rating, and downgrades produced new collateral calls. COP wrote that the first calls arose from the fall in the CDOs' market value, and that the rating triggers added to the difficulty after AIG was already under strain47.

AIG's CDS book was almost entirely sold protection. Unlike a dealer, it held no offsetting positions, and it put only small hedges in place in 200648. COP wrote that a former senior official of the authority that supervised the holding company admitted it had not foreseen the effect of the concentration in CDS49.

What changed afterward

On rating-linked collateral terms, a report of the Bank for International Settlements (BIS) pointed out that such terms amplify procyclicality (swings in the business cycle) when a systemically important counterparty is in distress. It gave AIG's downgrade as an example50.

In OTC derivatives regulation, the G20 leaders said in the statement from the Pittsburgh Summit in September 2009 that standardized OTC derivatives should be centrally cleared and reported to trade repositories, and that non-centrally cleared contracts should be subject to higher capital requirements51. In the United States, the Dodd-Frank Act was enacted in July 2010.

What this page does not cover

The details of AIG's securities lending losses, the treatment of its insurance subsidiaries, and executive pay are not covered on this page.

Notes

  1. Report of the Congressional Oversight Panel (external site) (the "COP report"), p. 1 (PDF p. 9), p. 15 (PDF p. 23), and p. 21 (PDF p. 29). AIG is built around insurance, and AIGFP's CDS referenced corporate debt, CLOs, and CDOs. ↩

  2. COP report (external site), p. 54 (PDF p. 62). The three agencies were Fitch, Moody's, and S&P; the USD 20 billion cites AIG's 2008 Form 10-K. ↩

  3. Federal Reserve Board press release of September 16, 2008 (external site). It gives the 24-month term, three-month LIBOR plus 850bp, the 79.9% interest, and the veto over dividends. ↩

  4. COP report (external site), p. 35 (PDF p. 43) and p. 36 (PDF p. 44). The main reasons are on p. 36, and the USD 24 billion is on p. 35. ↩

  5. COP report (external site), p. 14 (PDF p. 22) and p. 21 (PDF p. 29). AIGFP was created in 1987 and sold its first CDS in 1998. ↩

  6. FCIC report (external site), p. 140 (PDF p. 169). It says "Relying on the guarantee of its parent, AIG". ↩

  7. COP report (external site), pp. 14–15 (PDF pp. 22–23). The AAA rating gave leverage in negotiating if, when, and under what terms to post collateral. ↩

  8. COP report (external site), p. 23 (PDF p. 31) and p. 32 (PDF p. 40). The regulatory capital CDS became the largest part, reflecting demand from European banks. ↩

  9. COP report (external site), p. 23 (PDF p. 31). The three groups totaled USD 527 billion, 20% of USD 2.66 trillion in total derivatives. ↩

  10. COP report (external site), p. 24 (PDF p. 32). It cites AIG's Form 10-Q for the third quarter of 2008. ↩

  11. COP report (external site), p. 24 (PDF p. 32). It gives the share of over 90% of valuation losses and the 125 of about 44,000 contracts. ↩

  12. COP report (external site), p. 26 (PDF p. 34). AIGFP made no serious effort to reduce or hedge its existing exposures. ↩

  13. COP report (external site), pp. 25–26 (PDF pp. 33–34). AIGFP sold protection on the super senior layer, which bears losses last. ↩

  14. FCIC report (external site), p. 141 (PDF p. 170). AIG's fee is given as about 0.12% of the swap's notional amount a year. ↩

  15. FCIC report (external site), p. 140 (PDF p. 169). Because CDS were not regulated insurance contracts, no reserve requirement applied. ↩

  16. FCIC report (external site), p. 141 (PDF p. 170). AIGFP agreed to post collateral if the securities fell in value or AIG was downgraded; monolines could not pay until actual losses. ↩

  17. COP report (external site), p. 29 (PDF p. 37). Collateral was a function of AIG's rating, the CDO's rating, and the market value of the reference obligations. ↩

  18. COP report (external site), p. 217 (PDF p. 225). Collateral provisions are almost universal in credit derivatives, and each CSA is negotiated privately. ↩

  19. COP report (external site), pp. 217–218 (PDF pp. 225–226). It describes the formula based on the net notional amount and the CDO's market value, and thresholds specific to each transaction. ↩

  20. COP report (external site), p. 218 (PDF p. 226), citing the ISDA survey. Almost all participants used ratings when setting thresholds. ↩

  21. COP report (external site), p. 218 (PDF p. 226). AIG's rating triggers were complex and varied from contract to contract. ↩

  22. COP report (external site), p. 28 (PDF p. 36) describes the summer 2007 valuation negotiation, and p. 218 (PDF p. 226) describes the contract-by-contract differences. ↩

  23. COP report (external site), p. 29 (PDF p. 37), note 80. AA+ on March 30, 2005, and AA in June. ↩

  24. COP report (external site), p. 28 (PDF p. 36). Negotiations over the gap between the model and counterparties' values continued, and AIGFP could settle collateral amounts with them. ↩

  25. COP report (external site), p. 29 (PDF p. 37), note 80. The USD 5.9 billion loss on the CDS portfolio was the main reason. ↩

  26. COP report (external site), pp. 53–54 (PDF pp. 61–62) and p. 29 (PDF p. 37), note 80. It gives S&P's A− and the three agencies' downgrades on the same day. ↩

  27. COP report (external site), p. 29 (PDF p. 37). Downgrades of the reference securities and valuation losses by market participants established two of the three triggers. ↩

  28. COP report (external site), p. 37 (PDF p. 45) and p. 29 (PDF p. 37), note 80. It cites the 2007 Form 10-K. ↩

  29. COP report (external site), p. 30 (PDF p. 38), note 82. About USD 7 billion in March 2008 and about USD 13 billion in June. ↩

  30. COP report (external site), p. 30 (PDF p. 38). The value is for the end of the third quarter (September 30, 2008), citing AIG's Form 10-K. ↩

  31. COP report (external site), pp. 53–56 (PDF pp. 61–64). The private plan failed on the morning of September 16 when participants withdrew. ↩

  32. Federal Reserve Board press release (external site). It states the Board's judgment and the purpose of the loan. ↩

  33. Federal Reserve Board press release (external site). It states the 24-month term, three-month LIBOR plus 850bp, the collateral, and the expected repayment. ↩

  34. COP report (external site), p. 6 (PDF p. 14), table. The peak use of the facility was USD 72 billion in October 2008. ↩

  35. COP report (external site), p. 2 (PDF p. 10). COP rejected the government's "binary choice" and wrote that time to seek a private rescue was short. ↩

  36. New York Fed page on the Maiden Lane transactions (external site) and COP report (external site), p. 74 (PDF p. 82). The November 10 authorization is from the COP report. ↩

  37. Testimony of the Special Inspector General for TARP (external site), p. 3, gives the purchase price of about USD 27.1 billion, the USD 35 billion of collateral kept, and the termination of the CDS. The 16 counterparties are on p. 74 (PDF p. 82) of the COP report (external site). ↩

  38. The New York Fed page (external site) says "overall consideration of par". The USD 62.1 billion of net notional amount terminated is on p. 30 (PDF p. 38), note 83, of the COP report (external site). ↩

  39. Testimony of the Special Inspector General for TARP (external site), p. 6. Based on the collateral payments, the market value was "approximately 48 cents on the dollar". ↩

  40. Testimony of the Special Inspector General for TARP (external site), pp. 5–7. It reports the result of the SIGTARP audit of November 17, 2009; UBS offered the 2% concession. ↩

  41. COP report (external site), pp. 74–75 (PDF pp. 82–83). About USD 12.5 billion remained on December 31, 2008, mostly synthetic CDOs. ↩

  42. New York Fed page on the Maiden Lane transactions (external site). It gives the repayment on June 14, 2012, the sale on August 23, and the net gain of about USD 6.6 billion. ↩

  43. Treasury press release of December 14, 2012 (external site). The sale proceeds were USD 7.6 billion, and the Treasury held no shares afterward; warrants for about 2.7 million shares remain. ↩

  44. COP report (external site), p. 36 (PDF p. 44). The report lists them as the "primary causes of AIG's distress". ↩

  45. COP report (external site), pp. 27–28 (PDF pp. 35–36), note 68, and p. 30 (PDF p. 38). The first loss was USD 15 million in the fourth quarter of 2008. ↩

  46. COP report (external site), p. 27 (PDF p. 35) and p. 28 (PDF p. 36). It cites the 2007 Form 10-K: "no probable and reasonably estimable realized loss". ↩

  47. COP report (external site), p. 29 (PDF p. 37) and p. 219 (PDF p. 227). ↩

  48. COP report (external site), p. 217 (PDF p. 225), and p. 26 (PDF p. 34), note 59. Hedges were small relative to a book of about USD 70 billion. ↩

  49. COP report (external site), p. 44 (PDF p. 52). It cites a former senior official of the Office of Thrift Supervision (OTS), which supervised the holding company. ↩

  50. COP report (external site), p. 219 (PDF p. 227), note 885. It quotes a March 2010 report of the BIS Committee on the Global Financial System (CGFS). ↩

  51. "G20 Leaders Statement: The Pittsburgh Summit" (external site) (September 2009), the paragraph "Improving over-the-counter derivatives markets". ↩