The Rescue of American International Group Module B: The Securities Borrowing Facility

Beginning in 1997, AIG Securities Lending Corp. operated a securities lending program whereby high-quality securities were pooled from state-regulated insurance subsidiaries and lent out to counterparties in exchange for cash collateral, which was typically 102% of the value of the securities (Peirce 2014, 18, 21). To generate income, the cash collateral would then be reinvested by another AIG subsidiary, AIG Global Investment Corp. (AIG GIC), which shared the program’s proceeds 50-50 with AIG insurance subsidiaries (Hutchings 2010). In the unexpected event that AIG GIC could not return the cash collateral in a timely manner, cash from the holding company and the assets of the insurance subsidiaries would be available (AIG 2008a, 108; Peirce 2014, 19).

Traditionally, AIG would invest the cash collateral from securities lending conservatively in corporate and sovereign bonds, producing modest returns of only a few basis points (US COP 2010, 33-34). However, in the years before the financial crisis, GIC employees began to invest in other long-term investments as a means of increasing their return on cash collateral reinvestment (US COP 2010, 33-34). AIG GIC therefore began reinvesting primarily in residential mortgage-backed securities (RMBS) and other asset-backed securities (McDonald and Paulson 2015 , 85). By the end of 2007, 65% of AIG’s securities lending cash collateral had been reinvested in these types of assets (AIG 2008a , 108).^FNThese investments included corporate debt, mortgage-backed, asset-backed, and collateralized securities, and cash/short-term investments (AIG 2008a, 108). The buildup of RMBS was gradual, as the limits on reinvestment in ABS holdings was increased from 50% in 1999 to 66% in 2003, and then to 75% in December 2005 (Peirce 2014, 23).

Under pressure from state insurance regulators, the company began to unwind part of its securities lending program in 2007 (Moriarty 2010, 2); the size of the program fell from $76 billion at the end of 2007 to $58 billion on September 12, 2008 (AIG 2008a, 108; Dinallo 2010, 16).

As part of a multinational insurance group and financial institution, AIG insurance subsidiaries were subject to supervision by many state insurance regulators and other regulators across the world (US COP 2010, 16-17). The Office of Thrift Supervision (OTS) supervised the holding company on a consolidated basis because AIG owned a small thrift (Peirce 2014, 8). However, AIG was not subject to regulation by the Federal Reserve (GAO-2011, 143). The Fed had been monitoring the company’s exposures and potential losses in subprime mortgage-linked securities since late 2007, but it was unaware of the company’s liquidity issues stemming from cash collateral reinvestment in RMBS (GAO 2009, 17; GAO 2011, 18).

The heavy focus on long-term investments in RMBS and other illiquid securities forced AIG to realize losses and proved to be a strain on AIG’s liquidity when those markets began to collapse in late 2007 (Peirce 2014, 26-28). AIG recorded net realized losses of $6.7 billion on the cash collateral reinvestment portfolio in the first half of 2008, and the portfolio also suffered rating downgrades—the proportion of securities in the portfolio rated below single-A was less than half a percent at the end of 2007 but had grown to 4.8% by June 30, 2008 (AIG 2008a, 108; AIG 2008b, 111-112). At the end of June 2008, AIG’s total liability for the return of collateral equaled $75.1 billion, while the market value of its investments in RMBS and other securities totaled only $59.5 billion (AIG 2008b, 111). Thus, even if AIG had been able to sell its entire securities lending portfolio, the proceeds at market prices would not have been sufficient to pay off securities borrowers.^FNAt the insistence of local regulators, the AIG holding company provided a guarantee to the life insurance subsidiaries to compensate for the shortfall. Initially the company guaranteed $500 million; however, this guarantee grew to $1 billion and finally $5 billion (Dinallo 2010, 16).

As AIG sought to reduce its total securities lending portfolio in 2008, it had to raise cash by entering new securities borrowing contracts on worse terms (Peirce 2014, 27-28). Traditionally, it had been able to demand 102% of the value of its securities (AIG 2009, 3). But in 2008, the company was forced to offer a haircut on the value of its securities in order to get cash from securities borrowers (AIG 2009, 3). Securities borrowers began to demand these haircuts so that, in case AIG could not repay cash collateral upon termination of their securities lending contracts, proceeds from the sale of securities would make the borrowers whole (Peirce 2014, 28). At some points, AIG accepted collateralization levels as low as 80% (from Credit Suisse) and 73% (from Barclays)^FNFor instance, if AIG were to loan $100 million worth of securities through its lending program, it would typically expect $102 million in cash collateral. However, AIG’s distressed position would have compelled its collateral reinvestment arm to accept as little as $80 million from Credit Suisse or $73 million from Barclays in exchange for the same amount of securities. (Hutchings 2010). Still, AIG would mark their securities to market daily and provide cash from the holding company to ensure that the overall book reflected 102% collateralization based on current market values, as required by state insurance regulators (Hutchings 2010; Peirce 2014, 27; AIG 2008b, 111).

As markets roiled throughout the summer of 2008, AIG’s liquidity problems became increasingly clear to securities borrowers (GAO 2011,19). In July 2008, AIG’s CEO asked the FRBNY to allow the company to access the discount window (GAO 2011, 19). The FRBNY refused, saying that doing so would worsen investors’ concerns about the company’s liquidity (GAO 2011, 20). Three rating agencies downgraded AIG’s credit rating by two to three notches on September 15, 2008, resulting in an additional $20 billion in collateral demands and transaction termination payments (AIG 2009, 4). To improve their own liquidity and reduce exposure to AIG’s credit risk, securities borrowers stepped up their cash demands (McDonald and Paulson 2015, 86-87). On September 15 alone, AIG made payments of $5.2 billion to securities borrowers (AIG 2009, 4). AIG’s lead life insurance regulator testified that securities borrowers demanded a return of about $24 billion between September 12 and 30 (Dinallo 2010, 17).

On the morning of September 15, AIG also met with representatives from Goldman Sachs, JP Morgan, and the FRBNY to discuss a syndicated secured lending facility in the form of a $75 billion bridge loan sponsored by large financial institutions (AIG 2009, 4). These efforts would aim to provide AIG with liquidity relief until it sold sufficient assets to meet its liquidity needs and stabilize (AIG 2009, 4). By the morning of September 16, it became clear that the proposed private-sector solution would not come to fruition (AIG 2009, 4).

Concurrent to the private-sector syndicated loan efforts by Goldman Sachs and JP Morgan, the governor of New York announced a plan created by the New York state insurance regulator to provide AIG with additional liquidity on September 15 (Dinallo 2010, 19). This proposal would allow AIG to access $20 billion of assets from its insurance subsidiaries (Dinallo 2010, 19). For example, AIG’s property insurance subsidiaries had liquid assets above the legal requirement to protect policyholders; regulators would permit the AIG parent company to borrow these liquid assets in exchange for its less-liquid assets (Dinallo 2010, 19). However, this plan was based on the false belief that AIG was experiencing a brief cash flow problem (Dinallo 2010, 19). Once it became clear that this response would be insufficient to resolve AIG’s liquidity issues, the proposal was dropped (Dinallo 2010, 19). On September 16, New York state regulators informed AIG that it would no longer have access to these assets and would be required to repay all loans made under the facility (AIG 2009, 4). The arrangement was formally terminated on September 22 (AIG 2009, 5).

As a consequence of these failed rescue attempts, on September 16, 2008, the Federal Reserve approved an $85 billion emergency Revolving Credit Facility (RCF) for AIG (AIG 2008a; AIG 2009, 5, 201).

By October 1, 2008, AIG had drawn down approximately $62 billion from the RCF (BdofGov 2008c, 2). Approximately $11.5 billion of these funds were used to settle transactions involving the return of securities by counterparties (AIG 2009, 166). However, the situation called for more than a stop-gap solution to stem AIG’s liquidity pressures (BdofGov 2008c, 2). In response, on October 6, 2008, the Fed approved an additional lending facility through which the FRBNY could engage in securities borrowing transactions with AIG (BdofGov 2008c, 1).

The purpose of the new Securities Borrowing Facility (SBF)—sometimes referred to as the Securities Lending Facility—was to provide AIG with cash to pay back securities borrowers that wanted to terminate their securities lending agreements with AIG (BdofGov 2008c, 2; US COP 2010, 137). The SBF would also alleviate the pressure AIG faced to liquidate RMBS that AIG GIC had purchased with securities borrowers’ cash collateral (BdofGov 2008c, 2).

The FRBNY accomplished these goals by effectively taking over the positions of securities borrowers who were returning AIG’s securities (BdofGov 2008c, 3). The FRBNY agreed to make as much as $37.8 billion available to AIG to return cash to securities borrowers (BdofGov 2008c, 1). As collateral, the FRBNY accepted the securities that AIG had lent to those securities borrowers (BdofGov 2008c, 3).

According to the initial conditions of the SBF, transactions would have a term of one day but could be rolled over repeatedly (BdofGov 2008c, 3). The interest rate equaled 100 basis points above the average overnight repo rate offered on the relevant collateral type (BdofGov 2008c, 3). The FRBNY loan was to have a maximum duration of two years (BdofGov 2008c, 3). By the close of business on October 10, 2008, the amount outstanding under the SBF totaled $10.3 billion (BdofGov 2008c, 3).

The Federal Reserve intended the Securities Borrowing Facility to provide temporary stabilization to AIG’s tight liquidity situation (BdofGov 2009, 17). The facility enabled the repayment of cash collateral to securities borrowers and relieved pressure on AIG to liquidate its RMBS holdings in a rapid and disorderly fire sale (BdofGov 2008c, 2). Additionally, the FRBNY stood in a position to replace all AIG counterparties, as it was “prepared to borrow securities to extend AIG’s currently outstanding lending obligations where those obligations are not rolled over or replaced by transactions with other private market participants” (AIG 2008c). Peak government exposure totaled $20.5 billion in November 2008 before the SBF was terminated with the establishment of Maiden Lane II as part of the November restructuring of federal assistance (Bdof Gov 2010). See Figure 1.

Following the launch of the SBF, securities it funded continued to lose market value, stressing AIG’s balance sheet and posing the risk of further downgrades (Peirce 2014, 42; US COP 2010, 68-70). In response, the Fed and Treasury authorized the creation of Maiden Lane II on November 10, 2008 (FRBNY 2008). This new special-purpose vehicle, which was to be funded by a senior loan from the FRBNY and a cash contribution from AIG, was designed to purchase the AIG GIC portfolio of RMBS (FRBNY 2008; US COP 2010, 86-87). With the proceeds received from the establishment of Maiden Lane II, AIG terminated the SBF and repaid all outstanding collateral obligations to the FRBNY as counterparty to the SBF (FRBNY 2008). The FRBNY then returned to AIG the obligations that it had been holding as collateral against the SBF loan (FRBNY 2008; Board of Governors of the Federal Reserve System 2010). Finally, AIG’s entire domestic securities lending program was terminated with the repayment of all debts to the FRBNY (FRBNY 2008).