Economic Occurrences Could Lead the US to Another 2008
This particular piece (or partial) is taken from an article written in 2015. You can pick up the entire piece at “KelloggInsight.” It is an abbreviated version of the article detailing what took place in 2008. Our economy was on the verge of collapse. Goldman Sachs made a collateral call on AIG. The results of which led to Goldman’s collateral disputes with the financial products subsidiary held by A.I.G. It contributed to the government takeover of the insurer after pumping some $180 billion into it.
Why write about this now? I am beginning to think we may be on the path to another economic collapse after watching this administration and the president continuously dabbling in the economy with his on and off tariff demands, etc. His actions promote market instability.
This is not the beginning of the article. I picked up about one third of the way down after the discussion of CDS.
What Went Wrong with AIG?
Over the course of these agreements, the value of the underlying asset will change, and one party will pay the other money, called collateral, based on that change; that collateral can flow back and forth between the two parties as the market moves. AIG’s credit default swaps did not call for collateral to be paid in full due to market changes. McDonald adds . . .
“In most cases, the agreement said that the collateral was owed only if market changes exceeded a certain value or if AIG’s credit rating fell below a certain level.” McDonald says.
AIG was accruing unpaid debts—collateral it owed its credit default swap partners, but did not have to hand over due to the agreements’ collateral provisions. But when AIG’s credit rating was lowered, those collateral provisions kicked in—and AIG suddenly owed its counterparties a great deal of money.
On September 15, 2008, the day all three major agencies downgraded AIG to a credit rating below AA-, calls for collateral on its credit default swaps rose to $32 billion and its shortfall hit $12.4 billion—a huge change from $8.6 billion in collateral calls and $4.5 billion in shortfall just three days earlier. While this debt kicked in automatically because of the provisions in AIG’s agreements, rather than the willful terminations of its securities lending agreements, “it’s still a little like a bank run, in the sense that all of a sudden you’re in trouble, and the fact that you’re in trouble means you get a big call on your assets,” McDonald says.
AB: In other words . . . Goldman Sachs.
McDonald and Paulson’s analysis showed that there was more to the problem than just the credit default swaps. Securities lending lost the company a massive amount of money as well.
Securities lending is a common financial transaction where one institution borrows a security from another and gives a deposit of collateral, usually cash, to the lender.
Say, for instance, that you run a fund with a large investment in IBM. “There will often be reasons people want to borrow your IBM shares, and this is a standard way to make a little extra money on the stock you have,” McDonald says. AIG was primarily lending out securities held by its subsidiary life insurance companies, centralized through a noninsurance, securities lending–focused subsidiary.
Companies that lend securities usually take that cash collateral and invest it in something short term and relatively safe. But AIG invested heavily in high-yield—and high-risk—assets. This included assets backed by subprime residential mortgage loans.
“They had this propensity to invest in real estate,” McDonald says. “There was this idea that real estate investments were safe because the securities had a AAA credit rating.” In the run-up to September 2008, AIG securities lending business grew substantially, going from less than $30 billion in 2007 to $88.4 billion in the third quarter of 2008.
AB: Having the funds available to pay was short circuited.
Borrowers of a security can typically terminate the transaction at any time by returning the security to the lender and getting their collateral back. But since AIG had invested primarily in longer-term assets with liquidity that could vary substantially in the short term, returning cash collateral on short notice was not so easy.
“People were worried about AIG in the summer of 2008,” when an analyst report suggested the company was in for trouble, McDonald said. “AIG’s credit rating had been downgraded by all three major agencies in May and June of 2008, and in August and September, people started to terminate their agreements,” asking for their collateral back.
The values of the securities underlying these transactions were falling, due to falling real estate prices and higher foreclosures. AIG did not have enough of other liquid assets to meet all the redemption requests. And just as a possibly crumbling bank can lead depositors to withdraw their cash in a hurry, AIG’s weakened stance led even more securities lending counterparties to return their securities and ask for their cash, This left AIG worse off still. Problems in both its securities lending business and its credit default business made AIG doubly vulnerable. It had a great deal of outstanding debts.
AB: The results of which lead to . . .
“Everyone wanting to unwind their position with [AIG],” McDonald says. And because of that, the firm “simply had to supply billions of dollars they couldn’t easily come up with.”
McDonald and Paulson elicited help from colleagues in the Federal Reserve system to tap a database that has information about every underlying component in a packaged security—meaning each individual mortgage in a mortgage-backed security—to determine how sound AIG’s securities were. They concluded that the securities were not in fact as sound as AIG’s executives had purported.
McDonald: “The pure liquidity story says that if we’d simply loaned AIG the money and walked away, everything would ultimately have been fine. These underlying assets did end up suffering substantial losses, even though the [government rescue] did save the day. This suggests this wasn’t just about liquidity.”
The AIG executives’ claimed, “the assets were “money-good. However, that premise can be soundly rejected.”
Also: “How Goldman Killed A.I.G.” The New York Times