Due to the interest (and thanks for all the feedback to tradingtutors.com) in my previous ‘Occupy Wall Street’ articles, I thought I would delve into one of the major catalysts of the Global Financial Crisis and one of the companies at the epicentre, American International Group (AIG).

At one point the world’s largest insurance company, AIG and its executives, among others, have been blamed for the events that created the melt-down of mortgage-backed securities, with tax-payers eventually footing the bill. Frustratingly, nothing was done at the time of de-regulation. Sure, executives were irresponsible and insurers took bets they couldn’t cover, but governments allowed this to happen. And America wasn’t alone.

So where exactly did AIG go wrong? The company gambled, placing an all-in bet on the US housing market. Through a web of complex financial instruments, they placed their bets in the form of Credit Default Swaps (CDS) and other derivatives to insure the buyers of mortgage-backed securities against potential defaults by mortgagors. Speculation through synthetic securities and leverage saw their exposure reach $447 billion at the height of the GFC.

The most toxic form of CDS issued by AIG were Collateralised Debt Obligations (CDOs). Without going into too much detail, CDOs bundle different types of debt, which yield a return based on the associated risk and, in theory, protect financial institutions from the default of illiquid mortgages. AIG simply couldn’t cover this in the event of a crisis. And so the story went…

AIG’s core insurance operation was actually very profitable. Founded in 1919, the company had grown into a global powerhouse and was an industry trailblazer. A small division of AIG, based in London, was responsible for insuring mortgage-backed securities well and truly out of its financial depth. At one stage this division made huge profits for AIG but eventually brought the huge insurance company to its knees. They were nothing more than a betting agent, taking all the bets placed on ‘bundles’ of rated home loans and offering an insurance product without hedging against disaster. This lack of hedging differentiated AIG’s position to that of most other major insurance companies. The mortgage-backed security market was the vehicle that allowed AIG to take large bets with little regard for the potential consequences.

The house of cards began to topple as early as 2007. Losses from CDSs began to mount and AIG attempted to make the problem look smaller than it was, failing to disclose the full extent of the company’s exposure to the falling mortgage market. By 2008, AIG was making huge write-downs and its share price followed suit.

Shares crashed from highs of more than $1,200 in 2008 to just $5.50 in 2009, a spectacular fall for a company that only exists today because tax-payer-funded bailouts.

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So where does AIG stand today? Since the government bailout there has been a cleansing of upper management and directors and the company last week announced a third-quarter loss of $14.11 billion. The AIG insurance business is still performing but its reputation has been tarnished beyond repair.

AIG is currently trading at around $24. Perhaps it bottomed in October this year but they have so many problems that any trade seems (perhaps appropriately) a gamble. AIG may be too big to fail but this is one stock that will not recover easily. The chances of it reaching pre-GFC levels seem very unlikely, at least in our lifetime.

The jury is still out on whether the government’s interference that stopped AIG going down the gurgler will prove beneficial. Some say the recovery in equity values could actually see the taxpayers’ investment yield a positive return. Others see the bailout as a pointless bandage over the inevitable haemorrhaging of a company that should have been laid to rest a long time ago.

Stay ahead of the game,

Lachlan McPherson