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Markets Plunge After Government Adds Billions to AIG Rescue

March 2, 2009 at 6:00 PM EST
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Stocks tumbled after the government expanded aid to struggling insurer American International Group and the company reported a huge quarterly loss. Analysts examine what this could mean for the broader financial outlook.
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JIM LEHRER: American International Group — AIG, as it’s called — reported huge new losses in its insurance business today. The announcement helped trigger a fourth round of government aid. It also helped push the stock market into another headlong retreat.

Jeffrey Brown has our lead story report.

JEFFREY BROWN: The towering insurance giant began the day by reporting the largest quarterly loss in U.S. history, $61 billion for the final months of 2008. With that, the government announced a new rescue package, amounting to $30 billion. That’s on top of $150 billion AIG has already received.

Chief Executive Edward Liddy, who joined the company in September, spoke on CNBC.

EDWARD LIDDY, CEO, AIG: We are being consumed by the same issues that are driving house prices down, and 401(k) statements down, and Warren Buffett’s investment portfolio down. Asset values are in a free fall around the globe.

We’re the largest insurer in the United States, one of the largest, arguably the largest in the world. We have a massive investment portfolio. All aspects of those assets are going down in value. When they go down in value, we take that decline through our P&L.

JEFFREY BROWN: The housing crisis triggered staggering losses at AIG, leading to the initial government rescue last September. The company was heavily involved in so-called credit default swaps, insuring mortgage-backed securities against default. Ultimately, AIG could not cover billions in swap insurance when that market collapsed.

CEO Liddy said he hoped today’s installment would be the last, but he offered no promises.

EDWARD LIDDY: I would like to say 100 percent yes to that, but it’s difficult to do that. It really depends upon what happens to the capital markets from here. Let me just say, since September, we’ve made enormous progress.

JEFFREY BROWN: Administration officials defended today’s action. White House press secretary Robert Gibbs.

ROBERT GIBBS, White House press secretary: I wonder what we’d be talking about today if we let something like an AIG default on the massive amount of debt that it has and what that might do to the economy and to the markets.

JEFFREY BROWN: Some private analysts echoed the warning that major institutions would have to write off billions in assets insured by AIG if the company goes down.

Just how precarious the system is was evident again today on Wall Street. The Dow Jones Industrial Average dropped 299 points, more than 4 percent, to close at 6,763, the first time it’s finished below 7,000 since 1997. The Nasdaq fell 55 points to close at 1,322.

The sell-off was also fueled by fears over major banks, after HSBC, Europe’s largest bank, reported profits fell 70 percent last year.

Market losses in U.S., Europe

Liz Ann Sonders
Charles Schwab
I would love to know where we go from here. Nobody does. But we have said all along that bottoms are processes over time, not moments in time.

JEFFREY BROWN: And we look first at the markets and another dramatic drop. We're joined by Liz Ann Sonders, chief investment strategist for Charles Schwab.

Well, first, tell us what you're seeing. How broad are the losses in the market in term of sectors?

LIZ ANN SONDERS, Charles Schwab: Well, you know what? That's one thing, if there's any silver linings to what is otherwise a very dire situation market and economically, it's that this latest leg down, which obviously took us down through the lows that we had seen in the latter part of November of last year, that was a very, very broad-based decline.

Interestingly, this time, it's a little bit less broad-based. In fact, if you look at the 10 sectors in the S&P 500, only two of them are down more than the S&P 500 overall, and that would be financials -- not a big surprise -- down 40 percent and industrials down somewhere in the 20s.

Every other sector -- so the remaining eight -- have performance actually better than the market. So the selling seems to be more concentrated in those sectors where the fundamentals are most dire.

JEFFREY BROWN: Well, that's interesting, because you've been on in the past. We've talked about the degree to which some of this is so-called panic-selling. You're not seeing that now?

LIZ ANN SONDERS: Well, I still think that there is an edge of panic, but it seems to be concentrated in those sectors where there seems to be or the perception is that there's absolutely no hope.

I think some of the indiscriminant selling that characterized the fourth quarter of last year was driven by major redemptions coming from -- into mutual funds, into hedge funds, the deleveraging that was contributing to a lot of forced selling.

There seems to be less forced selling now. That doesn't mean we're not getting panic on the part of investors, but they're kind of concentrating their panic a little bit more.

JEFFREY BROWN: Do you sense, though, a new fear that no one seems to know where the bottom is at this point? And this is just a few weeks after it seemed as though the market had gone up for a bit.

LIZ ANN SONDERS: Yes, I think there had been some hope that built when we had a decent 25 percent rally or so off the November 20th lows. And, certainly, that built in some expectations that maybe those lows would hold. And we've clearly wiped out a lot of those expectations.

Look, I would love to know where we go from here. Nobody does. But we have said all along that bottoms are processes over time, not moments in time. And even the bear market, the last bear market that ended in 2002, occurred over a multi-month period where you really had three waterfall declines.

Ultimately, the low was in October '02, but you had one in July of '02, you had one in October of '02, you had one again in March of 2003. And at best, we're probably going to be in a pattern like that, where you don't get this V bottom. You go through an extended period of time where you go through these tests.

JEFFREY BROWN: And, Liz, lastly, I mentioned in our set-up piece, our lead story piece, about the bank in Europe. This is clearly an international story still at this point very much, right?

LIZ ANN SONDERS: No question about it. The crisis really was not solely born in the United States. The European banking system not only had as much exposure to these toxic assets that we're trying to clean up now, but they had leverage ratios quite a bit higher than the U.S. banks.

And, of course, the economic problem is turning out to be a very broad global problem. And there really is almost no one that has been unscathed through this.

JEFFREY BROWN: All right, Liz Ann Sonders, thanks very much.

LIZ ANN SONDERS: My pleasure. Thank you.

Credit default swaps harmed AIG

Frank Partnoy
University of San Diego
AIG was the world's largest insurance company. It was a safe company. It was trusted. It had roughly $1 trillion of value, in terms of assets. And it shifted about a decade ago towards a much riskier business.

JEFFREY BROWN: And now to more on the AIG story. And for that, we turn to Frank Partnoy, director of the Center on Corporate and Securities Law at the University of San Diego, and Joe Nocera, a business columnist for the New York Times. He also writes the paper's online "Executive Suite" blog.

Well, Frank Partnoy, first, remind us what AIG did to get into so much trouble.

FRANK PARTNOY, University of San Diego: The key thing AIG did was to abandon its traditional insurance business in favor of a second business in derivatives, the credit default swaps that were referred to earlier.

AIG was the world's largest insurance company. It was a safe company. It was trusted. It had roughly $1 trillion of value, in terms of assets. And it shifted about a decade ago towards a much riskier business.

Its subsidiary, AIGFP, its AIG Financial Products subsidiary, began writing large numbers of credit default swaps. And that business was largely opaque. It was undisclosed. People didn't know about it. And that's the business that carried the seeds of disaster that we're seeing now and over the recent few months.

JEFFREY BROWN: So, Joe Nocera, what would you add to that? I mean, we keep referring to this as a insurance company. Is that just wrong?

JOE NOCERA, business columnist, New York Times: Well, there's a couple of things I would add to that. First of all, Frank's description is really a good one.

You know, the F.P. unit in London was 350 people out of, you know, 100,000 employees. And, you know, this is typical throughout this crisis. Very small numbers of people have essentially brought down the financial system.

Secondly, you know, credit default swaps are a form of insurance when you really get down to it, because they're basically saying, "I accept the risk of loss in your portfolio." But they were not regulated like insurance products, and AIG was not responsible for having reserves in case there were losses, because they didn't think there would be any losses. That was the absurdity.

So they thought this was free money. And now, of course, it's turned out to be anything but free money. And the reason you have to keep AIG propped up is because, if they were to default, all of the banks on the other sides of those trades would be in even worse trouble than they're in today.

Propping up AIG to help banks

Joe Nocera
The New York Times
It's a bailout of the counterparties. Now, who are these counterparties? In fact, we don't know precisely, because the government won't tell us. And AIG views this information as a trade secret.

JEFFREY BROWN: Well, pick up on that, Frank Partnoy, because that's the next question, is the government had given them a lot of money. Now they're giving them more. It's out of a sense of feeling that it has no other choice? Explain that.

FRANK PARTNOY: I think that's right. I think the government initially decided it was going to have to support AIG. I think AIG was probably insolvent a long time ago, like many of the banks, but the government decided AIG had tentacles stretching to so many institutions that it had to support it, it had to make sure that AIG didn't go under. If AIG goes under, then many other institutions suffer losses...

JEFFREY BROWN: Can you give -- excuse me -- can you give us an example to make that a little bit more concrete? I mean, give us a sense of the chain here if AIG goes down?

FRANK PARTNOY: Yes, absolutely. So, for example, AIG has swap contracts with many banks. It's entered into these private contracts. And payment on those contracts would be triggered if AIG goes into default. In fact, payment on those contracts would be triggered even if AIG's credit rating is downgraded slightly. One notch would trigger an extra $8 billion worth of liabilities at AIG.

And I think the government looked at AIG and said, "There are so many contracts here." The derivatives market overall is $600 trillion, and AIG had $500 billion worth of credit default swaps. And they looked at those mind-boggling numbers and said, "We really don't know what will happen if AIG goes under. And so we have to prop it up; we have to support it because of the worry that the risks would spread."

There was a similar worry before the bankruptcy of Lehman Brothers, and I think the same worry is carried over for AIG.

JEFFREY BROWN: Well, Joe Nocera, do we know yet what happened to the first $150 billion that's been given to AIG? What happened to all that money?

JOE NOCERA: Well, in a general sense, we do know. This gets a little complicated, so bear with me a little, OK?

JEFFREY BROWN: All right.

JOE NOCERA: AIG had something in its contracts called collateral triggers. And that meant, if certain events took place, such as ratings downgrades of AIG or of the securities that they were insuring, that AIG would have to put up cash collateral against the assets, so these events have taken place.

There's been a lot of ratings downgrades. And AIG has had to put up tons and tons and tons of collateral.

Now, that's not where it all went, but that's where a lot of it went. So, basically, the money has been handed over to the counterparties.

You know, there's a saying now you hear on Wall Street, which is that it's not a bailout of AIG. It's a bailout of the counterparties. Now, who are these counterparties? In fact, we don't know precisely, because the government won't tell us. And AIG views this information as a trade secret.

Credit rating declines

Frank Partnoy
University of San Diego
I do think this focus on the credit-rating agencies is important. That they were brought into the fold early on, that they were told about what this new round would look like, and that their agreement was secured initially is really extraordinary.

JEFFREY BROWN: You know, you mention the credit rating downgrades. There was a lot of talk about that today, in terms of a reason for the government stepping in today, in the sense that the credit rating agencies would have downgraded AIG. That would have caused even more problems.

JOE NOCERA: That's right.

JEFFREY BROWN: Can you explain that? Can you explain that, especially for the layman who doesn't understand -- and I mean me -- why the credit rating wouldn't have gone down already, given AIG's problems?

JOE NOCERA: Well, first of all, their credit rating has gone down. It used to be AAA; it isn't anymore.

Second of all, what happened today was really quite different, at least qualitatively different from what's happened in the past. In the past, the money was used basically to shore up this coming disaster, because of the ratings downgrade, to supply the collateral.

This time, what the government did was they said they're going to have the biggest quarterly loss in the history of the world and we need to show the rating agencies that we're doing enough to prevent yet another ratings downgrade.

As I said before, every time there's a ratings downgrade, AIG has to find suddenly tens of billions of dollars and put it up as additional collateral. So what happened today was an effort to prevent a ratings downgrade, which would then prevent more billions upon billions of dollars being handed to the counterparties, which would have been, you know, instead of $30 billion extra, it would have been $50 billion, or $80 billion, or $100 billion. I mean, who knows? It's almost to infinity.

JEFFREY BROWN: Well, Frank Partnoy, who knows? I mean, does anybody know how deep that hole is?

FRANK PARTNOY: Unfortunately, we don't know. People have referred to AIG as being a black hole, and I think that's an apt metaphor. The money keeps going in, and we don't know how much more is needed.

I do think this focus on the credit-rating agencies is important. The fact that they were brought into the fold early on, that they were told about what this new round would look like, and that their agreement was secured initially is really extraordinary.

You think about how poorly the rating agencies have performed, that they rated all of these complex instruments AAA, many of which are now in default, and yet we continue to turn to them, we continue to rely on them. It's not just the government, but it's private individuals and institutions continue to rely on Standard & Poor's and Moody's, yet they've performed so poorly.

And I think one of the big lessons from today and the collapse of AIG is that we need to rely a lot less on credit-rating agencies.

JEFFREY BROWN: Well, Joe Nocera, just to bring us to a conclusion here, I mean, we keep talking about the government stepping in, but this is really taxpayer money that's now more at risk, correct?

JOE NOCERA: Well, it certainly is. And just to -- you know, not to put some small glimmer of hope in, one of the things that did happen today is that two profitable divisions of AIG were put into trust or are going to be put into trust.

And, ultimately, the government is going to be able to sell those divisions. And, you know, they're actually hoping that that's the way they'll be able to pay back some of these loans.

Will the taxpayer wind up losing money because of its involvement in AIG? You bet they are. And, really, what it's all about now is just trying to staunch the bleeding for both the taxpayer and for AIG.

JEFFREY BROWN: All right. Well, on that note, we will end. Joe Nocera and Frank Partnoy, thank you very much.

FRANK PARTNOY: Thank you.

JOE NOCERA: Thank you.