[Senate Hearing 111-69]
[From the U.S. Government Publishing Office]

                                                         S. Hrg. 111-69




                               before the

                              COMMITTEE ON
                          UNITED STATES SENATE


                             FIRST SESSION


                           FUTURE REGULATION


                             MARCH 5, 2009


  Printed for the use of the Committee on Banking, Housing, and Urban 

      Available at: http: //www.access.gpo.gov /congress /senate/

51-303                    WASHINGTON : 2009
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               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
JON TESTER, Montana                  DAVID VITTER, Louisiana
HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas

                 Colin McGinnis, Acting Staff Director

              William D. Duhnke, Republican Staff Director

                      Aaron Klein, Chief Economist

                       Deborah Katz, OCC Detailee

                   Charles Yi, Senior Policy Advisor

                  Drew Colbert, Legislative Assistant

                Mark Oesterle, Republican Chief Counsel

           Andrew Olmem, Republican Professional Staff Member

                   Hester Peirce, Republican Counsel

                    Jim Johnson, Republican Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor


                            C O N T E N T S


                        THURSDAY, MARCH 5, 2009


Opening statement of Chairman Dodd...............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     4
        Prepared statement.......................................    42
    Senator Johnson
        Prepared statement.......................................    44


Donald Kohn, Vice Chairman, Board of Governors of the Federal 
  Reserve System.................................................     6
    Prepared statement...........................................    44
Scott M. Polakoff, Acting Director, Office of Thrift Supervision.     8
    Prepared statement...........................................    49
Eric Dinallo, Superintendent, New York State Insurance Department     9
    Prepared statement...........................................    56
    Response to written questions of:
        Senate Banking Committee.................................    60




                        THURSDAY, MARCH 5, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:06 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.


    Chairman Dodd. The Committee will come to order. Senator 
Shelby will be along in a minute or so, and we will just get 
underway because I know people have busy schedules for the day.
    How we will proceed is I will make some opening comments, 
and when Senator Shelby comes on in, obviously he will have 
some opening comments to make. And then given the number of 
people here this morning, I am going to go right to our 
witnesses and then ask my colleagues' indulgence to use their 
time for opening statements on the matter as well as getting to 
the questioning; otherwise, we might be here an hour and a half 
before we got to questioning. So depending on--Richard, how are 
    Senator Shelby. Good morning.
    Chairman Dodd. Good morning. I was just saying both of us 
will make opening statements, then get right to our witnesses, 
if that is all right with you.
    Senator Shelby. Sure.
    Chairman Dodd. And then we will proceed along the lines, 
and, again, we will try and keep the questioning somewhat 
limited in time so we can get to everyone here this morning.
    Well, this morning the Committee comes together to examine 
what went wrong with American International Group, what lessons 
can be drawn from this situation, and where the Government 
overseers are headed. We have before us representatives from 
the State and Federal regulators of this insurance giant, as 
well as the Federal Reserve that decided to launch the 
Government rescue of AIG last September.
    I want the Committee to be aware that we invited the 
Treasury Department to send a witness to testify here this 
morning, but they are unable to send anyone to the Committee 
this morning. And given the Treasury's increasing 
responsibilities, effectively the owner and overseer of AIG--
although that issue is one we will discuss this morning as to 
actually where that ownership lies--I regret the Treasury did 
not have someone here this morning.
    In fairness to them, they are in a transitional period and 
obviously putting a team together, and so I think there is some 
respect for whether or not they have the personnel on hand to 
be here. But, nonetheless, I would be remiss if I did not say 
that I am not pleased by the fact that we do not have someone 
here from Treasury to do some explaining as to what their role 
in this is and what role there will be in the coming weeks and 
months in all of that.
    Obviously, again, my colleagues are as aware of these 
statistics as anyone. We have 10,000 foreclosures a day in the 
country--these numbers get repeated all the time--20,000 
layoffs each and every day happening all across our country. I 
think all of us wish we were here today instead talking about 
how to help those struggling to get by through no fault of 
their own, not an institution indebted to sophisticated 
investors who should have known better and in many cases did 
know better. Instead we are here in the wake of the fourth plan 
to rescue AIG, once again committing tens of billions of 
dollars to a massive, failed institution, because, as reported 
recently last week, it effectively ``has the world financial 
system by the throat.'' And that we find ourselves in this 
situation at all is, in my mind, and the minds of many of my 
constituents, quite frankly, sickening.
    How did we come to this? That is the question this 
Committee seeks to answer today. Certainly there are an awful 
lot of reasons. If the financial meltdown was a man-made 
disaster due in part to bad mortgages, then AIG's collapse was 
predicated in part on the company's decision to essentially 
ensure securities backed by those mortgages and sell those 
derivatives to speculators, thus encouraging more and more 
risky investments.
    When the credit markets seized up last September, AIG found 
itself on the verge of bankruptcy. In the wake of the decision 
by then-Secretary Paulson and Fed Chairman Bernanke to allow 
Lehman Brothers to declare bankruptcy, the Federal Reserve 
decided to exercise its authority as lender of last resort by 
lending AIG up to $85 billion.
    In exchange, the Government took approximately 80-percent 
ownership of AIG, effectively taking over the company. At the 
time, the Fed, in their report required by Congress, told this 
Committee that they did not believe this deal with result in 
any ``net cost to the taxpayers.'' With that rosy projection, 
AIG went on to have the single worst quarter of any corporation 
in American history, losing over $60 billion. That effectively 
means that during the final 3 months of last year, after the 
Government had effectively taken it over, AIG lost more than 
$450,000 per minute, every minute of every day. And while the 
Federal Reserve and then-Secretary Paulson continued to provide 
additional Government funds to the company, the AIG ordeal has 
now required the taxpayers to put up upwards of $150 billion to 
keep the company from bankruptcy.
    Indeed, the Fed has provided another almost $40 billion to 
AIG through two separate Fed-owned and operated special purpose 
vehicles: Maiden Lane II and Maiden Lane III. Maiden Lane II 
was designed to absorb the problems associated with AIG's 
secured lending facility, which State insurance commissioners 
allowed to be heavily leveraged to mortgage-backed securities, 
the value of which, of course, disintegrated. Maiden Lane III 
was designed to absorb the losses AIG incurred through writing 
credit default protection against mortgage-backed securities in 
AIG's Financial Products office, which was not directly 
regulated. It was through that facility that the Fed has paid 
out at par the holders of credit default swaps and 
corresponding securities, and it is reasonable to ask why 
holders who would have received only pennies on the dollar for 
their credit default swaps, absent any Government intervention, 
would expect or deserve payments from what essentially is a 
bankrupt company.
    It is not clear who we are rescuing, whatever remains of 
AIG or its trading partners. This Committee would like to know, 
and the taxpayers certainly have a right to know who they are 
effectively funding and how much they have already been given. 
Again, AIG's trading partners were not innocent victims here. 
They were sophisticated investors who took enormous 
irresponsible risk with the blessing of AIG's AAA rating.
    The lack of transparency and accountability through this 
process has been rather stunning. Throughout the entire fourth 
quarter last year, it was, frankly, never clear who owned AIG 
or who was in charge. It is well documented that AIG management 
was allowed to pay extravagant bonuses. Their employees went on 
some trips all over the world. Little wonder it took almost 5 
months for the Fed to select a single trustee to manage the 
Government's interest in AIG, and during that time it seems 
clear the foxes were truly guarding the henhouse.
    So to say we have questions would be an understatement, to 
put it mildly. What were the State insurance commissioners 
doing while AIG was building up this large exposure in the 
secured lending program which was under their watch? Where was 
the Office of Thrift Supervision as AIG's holding company 
regulator throughout all of this? What coordination occurred 
between the Fed, the OTS, and the State insurance regulators? 
Was there any coordination at all, in fact? And, finally, who 
has been in charge of AIG these last few months, and who will 
be going forward? Who is in charge, in effect?
    Unwinding AIG's assets will be extraordinarily difficult, 
to put it mildly, and it is certainly not going to happen 
overnight, regretfully. And for months the Fed and Secretary 
Paulson of Treasury were, it seemed to me, pointing fingers at 
each other. It is time someone assumed responsibility for the 
Government's ownership of AIG.
    I have many questions--and I know my colleagues do--for 
Treasury, and, again, I regret they are not here this morning. 
I encourage Members to submit questions directed to them for 
the record, as I will be doing, and submit them for answers.
    One question that already has a clear answer is why we need 
a vibrant insurance industry, and I would add that many in the 
industry, including many of those in my home State, are as 
aghast at AIG's behavior as all of us are. If credit is the 
lifeblood of our economy and a healthy banking system is the 
heart that pumps credit to our economy, then our insurance 
industry are the lungs that provide the oxygen we need to make 
sure that credit flows. For businesses to function and create 
jobs, they need access to insurance to protect those 
investments. That requires a robust insurance industry capable 
of providing insurance on fair and sound terms, to allow 
construction projects to be built, businesses to employ 
workers, and families to ensure against unexpected events.
    As such, we are here today not just to better protect the 
taxpayer funds that have been put at risk to prop up AIG, but 
also to draw upon this experience and examine what our future 
regulatory structure must look like so that insurance will be 
readily available, consumers and policy holders would be 
adequately protected, and our Nation's economy can be rebuilt.
    With that, I turn to my colleague from Alabama, Senator 


    Senator Shelby. Thank you, Mr. Chairman.
    The collapse of the American International Group is the 
largest corporate failure in American history. Once a premier 
global insurance and financial services company, with more than 
$1 trillion in assets, AIG lost nearly $100 billion last year. 
Over the past 5 months, it has been the recipient of four 
bailouts. To date, the Federal Government has committed to 
provide approximately $170 billion in loans and equity. Given 
the taxpayers' dollars at stake and the impact on our financial 
system, this Committee has an obligation to thoroughly examine 
the reasons for AIG's collapse and how Federal regulators have 
    I also hope that today's hearing will shed new light on the 
origins of our financial crisis as well as inform our upcoming 
discussions on financial regulatory reform. In reviewing our 
witnesses' testimony here today and AIG's public filings, it 
appears that the origins of AIG's demise were twofold: First, 
as has been widely reported, AIG suffered huge losses on credit 
default swaps written by its Financial Products subsidiary on 
collateralized debt obligations.
    AIG's problems, however, were not isolated to its credit 
default swap business. Significant losses in AIG's State-
regulated life insurance companies also contributed to the 
company's collapse. Approximately a dozen of AIG's life 
insurance subsidiaries operated a securities lending program 
whereby they loaned out securities for short periods in 
exchange for cash collateral. Typically, an insurance company 
or bank will lend securities and reinvest the cash collateral 
in very safe short-term instruments. AIG's insurance companies, 
however, invested their collateral in riskier long-term 
mortgage-backed securities. And although they were highly rated 
at the time, approximately half of them were backed by subprime 
and Alternate-A mortgage loans.
    When the prices for mortgage-backed securities declined 
sharply last year, the value of AIG's collateral plummeted. The 
company was rapidly becoming unable to meet the demands of 
borrowers returning securities to AIG. By September, it became 
clear that AIG's life insurance companies would not be able to 
repay collateral to their borrowers. Market participants 
quickly discovered these problems and rushed to return borrowed 
securities and get back their collateral.
    Because AIG was unable to cover its obligations to both its 
securities lending and derivatives operations, it ultimately 
had to seek Federal assistance. In total, AIG's life insurance 
companies suffered approximately $21 billion in losses related 
to securities lending in 2008. More than $17 billion in Federal 
assistance has been used to recapitalize the State-regulated 
insurance companies to ensure that they are able to pay their 
policy holders' claims. In addition, the Federal Reserve had to 
establish a special facility to help unwind AIG's securities 
lending program.
    The causes of AIG's collapse raise profound questions about 
the adequacy of our existing State and Federal financial 
regulatory regimes. With respect to AIG's derivatives 
operations, the Office of Thrift Supervision was AIG's holding 
company regulator. It appears, however, that the OTS was not 
adequately aware of the risks presented by the companies credit 
default swap positions. Since AIG's Financial Products 
subsidiary had operations in London and Hong Kong, as well as 
in the U.S., it is unclear whether the OTS even had the 
authority to oversee all of AIG's operations. It is also 
unclear whether OTS had the expertise necessary to properly 
supervise what was primarily an insurance company.
    Additionally, did AIG life insurance companies obtain the 
approval of their State regulators before they participated in 
securities lending? If so, why did the State insurance 
regulators allow AIG to invest such a high percentage of the 
collateral from its securities lending program in longer-term 
mortgage-backed securities? Also, did the insurance regulators 
coordinate their oversight of AIG's securities lending since it 
involved life insurance regulated by at least five different 
    While I hope we can get some answers to these and many 
other questions today, I believe we are just beginning to 
scratch the surface of what is an incredibly complex and, on 
many levels, a very disturbing story of malfeasance, 
incompetence, and greed.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Shelby. And as 
I mentioned earlier, we will go right to our witnesses, and 
then we will get to the question period.
    Our first witness is Donald Kohn, Vice Chairman of the 
Board of Governors of the Federal Reserve, who has been before 
this Committee many times, and we thank you for being with us 
this morning. As many people know, before becoming a member of 
the Board, he served on its staff in various positions, 
including Secretary of the Federal Open Market Committee, 
Director of the Division of Monetary Affairs, and Deputy Staff 
Director for Monetary and Financial Policy.
    Next we have Mr. Scott Polakoff. He is the Acting Director 
and the Senior Deputy Director and Chief Operating Officer of 
the Office of Thrift Supervision. Prior to his work at OTS, Mr. 
Polakoff assumed a variety of positions at the FDIC, including 
Deputy Regional Director.
    And, finally, we will hear from Superintendent Eric 
Dinallo, who is the Superintendent of the New York State 
Insurance Department. Prior to this appointment, Mr. Dinallo 
was general counsel for Willis Group Holdings, the world's 
third largest insurance broker. We welcome him to the 
Committee. Thank you for being with us this morning.
    Mr. Kohn, we will begin with you.


    Mr. Kohn. Thank you, Mr. Chairman.
    Chairman Dodd, Ranking Member Shelby, other Members of the 
Committee, I appreciate having this opportunity to discuss the 
role of the Federal Reserve in American International Group. My 
written testimony provides full detail about the support the 
Federal Reserve, working alongside the Treasury, has given AIG 
and the reasons for each of our actions. In my oral statement 
this morning, I would like to touch on the broader themes and 
provide the context that underlay the actions.
    Over the past year-and-a-half, this Committee, the 
Congress, the Treasury, and financial regulators have all been 
dealing with the ongoing disruptions and pressures engendered 
by an extraordinary financial crisis. The weaknesses at 
financial institutions, resulting constraints on credit, 
declines in asset prices, and erosion of household and business 
confidence have in turn led to a sharp weakening in the U.S. 
economy. In addition to the extraordinary assistance provided 
by the Congress in approving the Emergency Economic 
Stabilization Act last fall and implemented by the Treasury, 
the Federal Reserve has employed all the tools at our disposal 
to break this spiral and help address the many challenges of 
the crisis and its effects on the economy.
    One of the most important tools of the Federal Reserve is 
our authority under section 13(3) of the Federal Reserve Act to 
lend on a secured basis under ``unusual and exigent'' 
circumstances to companies that are not depository 
institutions. And since last fall, in order to foster the 
stability of the financial system and mitigate the effects of 
ongoing financial stresses on the economy, we have used that 
authority to help to stabilize the financial condition of AIG. 
My full written statement provides a detailed chronology of our 
actions. I want to put these actions and the reasons for them 
in context.
    AIG is the largest insurance company in the United States, 
controlling both the largest life and health insurer and the 
second largest property and casualty insurer. It is also one of 
the largest insurance companies in the world, conducting 
insurance and finance operations in more than 130 countries, 
with more than 74 million customers and 116,000 employees 
globally, including 30 million customers and 50,000 employees 
in the U.S. As of September 30, 2008, it reported consolidated 
total assets of slightly more than $1 trillion; it is also the 
major provider of guaranteed investment contracts and products 
that protect participants in 401(k) retirement plans.
    In addition, AIG is the leading commercial insurer in the 
U.S., insuring operations on more than 180,000 entities. Thus, 
millions of individual small businesses, municipalities, and 
corporate customers in the United States rely on AIG for 
insurance protection on their lives, homes, vehicles, business 
operations, pensions, investments, and other insurance risks.
    But AIG is more than just a large insurance company. AIG 
has been a major participant in many derivatives markets 
through its Financial Products business unit. Unlike its 
regulated insurance company affiliates, Financial Products and 
its activities are not regulated. Financial Products is the 
counterparty on over-the-counter derivatives to a broad range 
of hundreds of customers, including many major national and 
international financial institutions, U.S. pension plans, 
stable value funds, and municipalities. Financial Products also 
provided credit protection through credit default swaps it has 
written on billions of dollars of multi-sector collateralized 
debt obligations.
    While Financial Products has been winding down and exiting 
many of its trades, it continues to have a very large notional 
amount of derivatives contracts outstanding with numerous 
counterparties. And it is against this background that the 
Federal Reserve and the Treasury Department have taken a series 
of unusual actions to stabilize the company and prevent its 
disorderly collapse from infecting the broader financial 
system. These actions have entailed very difficult and 
uncomfortable decisions for a central bank, as well as the 
Treasury, because they involved addressing systemic problems 
created largely by poor decisionmaking by the company itself. 
Moreover, many of these decisions involved an unregulated 
business entity that exploited the strength, and threatened the 
viability, of affiliates that were large, regulated entities in 
good standing.
    However, we believe we had no choice if we are to pursue 
our responsibility for protecting financial stability. Our 
judgment has been and continues to be that, in this time of 
severe market and economic stress, the failure of AIG would 
impose unnecessary and burdensome losses on many individuals, 
households, and businesses, disrupt financial markets, and 
greatly increase fear and uncertainty about the viability of 
our financial institutions. Thus, such a failure would deepen 
and extend market disruptions and asset price declines, further 
constrict the flow of credit to households and businesses in 
the United States and in many of our trading partners, and 
materially worsen the recession our economy is enduring.
    To mitigate these risks, the Treasury felt compelled to 
provide equity capital to AIG and the Federal Reserve to 
provide liquidity support backed by the assets of AIG. We have 
restructured our assistance in response to changing economic 
conditions and, as needed, to mitigate potential risks. These 
restructurings reflect our continued belief that the disorderly 
failure of AIG during this period of severe economic stress 
would harm numerous consumers, municipalities, small 
businesses, and others who depend on AIG protection, and it 
would deepen the current economic recession. Taking these 
actions, we are also committed to protecting the interests of 
the U.S. Government and the taxpayer.
    Thank you very much. I would be pleased to take your 
    Chairman Dodd. Thank you very much.
    Mr. Polakoff.

                       THRIFT SUPERVISION

    Mr. Polakoff. Good morning, Chairman Dodd, Ranking Member 
Shelby, and Members of the Committee. Thank you for inviting me 
to testify about the oversight of AIG by the Office of Thrift 
    The scope of the Government intervention on behalf of AIG 
has generated enormous public interest and acute attention by 
policymakers. I welcome the opportunity to present facts 
available to OTS and answer the important questions surrounding 
    The OTS granted a Federal savings bank charter to AIG in 
1999, and the bank opened for business in 2000. The OTS is the 
primary Federal regulator for this $1 billion FDIC-insured 
depository institution and the consolidated regulator for the 
savings and loan holding company. In January 2007, the OTS was 
informed that its holding company supervision was deemed 
equivalent to that required by the coordinator under the 
European Union's Financial Conglomerates Directive.
    My written testimony goes into detail about OTS' oversight 
of AIG, including our annual examinations of the company; 
targeted reviews of its subsidiaries, including the AIG 
Financial Products operating business; our reports on the 
findings of those supervisory activities; and follow-up 
communications with AIG's management and board of directors to 
address OTS concerns.
    In my statement today, I would like to highlight just a few 
    The rapid decline of AIG stemmed from liquidity problems in 
two AIG business lines:
    One, credit default swaps. A credit default swap is 
derivative instrument that provides insurance-like protection 
to investors against credit losses from the underlying 
obligations which were typically mortgage loans.
    And, two, securities lending, a business strategy 
implemented by a handful of AIG State insurance subsidiaries.
    It is important to note that AIG stopped originating credit 
default swaps that were linked to subprime borrowers in late 
2005. By that time, however, the company already had $50 
billion worth of such instruments on its books. AIG halted 
these activities while the housing market was still going 
strong, but the company's model forecasted trouble ahead.
    Another important point is that AIG's credit default swaps 
were protecting against credit losses on the highest rates, 
super-senior, AAA-rated tranche of collateralized debt 
obligations. This segment of the securitization poses the least 
credit risk. In fact, as of September 30 of 2008, there have 
been no actual realized credit losses from the underlying CDOs.
    AIG's crisis resulted from the enormous sums of liquidity 
required to meet collateral calls triggered by one of the 
following events: a rating agency downgrade of the company, a 
rating agency downgrade of the underlying CDO, a reduction in 
the market value of the underlying CDO.
    AIG's securities lending program, which began prior to 
2000, lent securities from the State insurance companies to 
third parties who provided cash collateral in return. As a 
general theme, the cash collateral was reinvested in 
residential mortgage-backed securities. With the turmoil in the 
housing and mortgage markets over the past 2 years, these 
mortgage-backed securities experienced sharp declines in value. 
When the trades expired or were unwound, the cash collateral 
had to be returned to the counterparty. This created 
unprecedented liquidity pressure for the company. The cash 
requirements of the program significantly contributed to AIG's 
    I think these are the keys to understand how we got to 
where we are today. As to where we go, I see two lessons.
    Number one, the credit default swaps at the center of AIG's 
problems continue to be unregulated products. New regulations 
governing these complex derivative products are essential. The 
announcement of the President's Working Group on Financial 
Markets in November of last year to implement a central 
counterparty service for the CDS is a good beginning.
    The AIG story makes a compelling argument for establishing 
a systemic risk regulator with the authority to examine the 
sources to address temporary liquidity crises and the legal 
authority to perform receivership activities if failure is 
    Thank you, Mr. Chairman, for inviting me to testify this 
morning. I look forward to responding to your questions.
    Chairman Dodd. Thank you very much.
    Mr. Dinallo, welcome to the Committee.


    Mr. Dinallo. Thank you, Chairman Dodd, Ranking Member 
Shelby, and other Senators.
    I think that to some extent, AIG is a microcosm of our 
regulatory regime, love it or hate it, and I want to try to 
explain what I think were the roles of at least the State 
insurance regulators here and try to clear up any confusion 
about responsibility that I know existed a couple of days ago, 
although it sounds like a lot of that has been clarified.
    I think the State regulators did a very good job on what 
their main assignment is, which is solvency and policy holder 
protection. I think that the operating companies of AIG, 
particularly the property companies, are in excellent 
condition. The life insurance companies are experiencing a lot 
of the same stresses that other life insurance companies are 
experiencing across the country and the world.
    I think that it is important to put some of these numbers 
in context, because I disagree with the concept that the 
securities lending program had much of anything to do with the 
problems at AIG. We calculate that without the Federal 
intervention, the life insurance companies are approximately 
$10 billion solvent, so they were solvent prior to the 
    The amount that was written, on Senator Shelby's numbers, 
the amount that was written and put into the securities lending 
pool wasn't a leveraging, it was a direct undertaking, would 
be, say, I think $40 billion was invested in RMBS. That would 
be against $400 billion of assets in the life insurance 
company. So there was 10 percent invested in AAA-rated RMBS. 
The loss, as you say, we will adopt the number of $17 billion. 
So that is less than 5 percent of the losses of the assets at 
the life insurance companies could be laid at the door of 
securities lending investing in RMBS, which I submit $17 
billion is a big number, but as a percentage basis, I think it 
is not an overwhelming number. I would say that the securities 
lending business was used to expose itself to RMBS businesses. 
But if you look at the entirety of the assets as invested by 
life insurance companies, it was a modest percentage.
    I think the Financial Products division had a huge 
causation on this. I think that Chairman Bernanke was correct a 
couple days ago when he described that causation. And the 
amounts of money are staggering. The securities lending 
business, as I said, you would put somewhere in the $75 billion 
range. The Financial Products division had notional exposure 
through CDSs and derivatives of $2.7 trillion. That is larger 
than the gross national debt of Germany, Great Britain, or 
    I do agree with both of your statements that what they 
essentially did was they wrote a form of insurance without 
anywhere near the capitalization that you would have for such 
an activity if you were in a regulated insurance company. They 
are the ones that created the systemic risk, and that systemic 
risk rolled through the operating companies, including causing 
the run that you described, Senator, on the securities lending 
    The securities lending business, which is something that I 
am happy to discuss with you, although New York only had about 
8 percent exposure to it, is not the purpose or the reason for 
the Federal bailout. If there had been no Financial Products 
division involvement, I don't think there would have been any 
bailout of AIG's operating companies, certainly not the 
securities lending business.
    I think it was caused by, A, the run on the bank, and also, 
of course, the Federal Government had to detangle it in order 
to sell the operating companies. So they essentially removed 
the remaining securities from the operating companies in the 
securities lending business in order to sell the assets. Those 
assets are the ones that are going to go to pay off the loan. 
So it is the solvency in the operating companies that are going 
to go to pay off the Federal loan that is necessary because of 
what Chairman Bernanke described as essentially a bolted-on 
hedge fund of Financial Products division.
    When we came into the department, we did begin to take 
seriously some of the issues around securities lending, and I 
can detail that during question and answer. But we began to 
work it down starting in the beginning of 2007 by 25 percent. 
We got the holding company to guarantee $5 billion of the 
losses. And in July, we sent a circular letter to all of our 
companies saying this is something that you need to start to 
examine. It does have exposure to the mortgage underwritings 
and securitization.
    And indeed, I will just tell you that we have subsequently 
sent out 25 letters to our regulated entities to look into 
securities lending businesses. Frankly, they have actually 
performed pretty well across the board. AIG is the lone 
securities lending business that has had this kind of problem 
of the 25 that we looked at, and I would hypothesize that it is 
because of the run on it and the run on it came directly 
because of the need for massive collateral and the run on 
Financial Products division.
    I think that there are some lessons that we can discuss. I 
certainly think that one of them is a revisitation of Gramm-
Leach-Bliley. We did not completely abrogate Glass-Steagall, 
thank God, or you would have the operating dollars of policy 
holders being used for the hedge fund activities. But we have, 
I think, seen for the first time that the creation of financial 
supermarkets can have a, what I would almost call a knock-on 
effect on the operating companies to which they are related.
    The portions of the company that involves itself in 
leverage, which securities lending did not do any leverage, has 
the potential to commit itself so heavily that when there is a 
financial downturn and there is a need for liquidity which they 
simply didn't have, the operating companies are looked to as an 
opportunity for that liquidity, but because they are regulated, 
fortunately, against that, they can't put up the liquidity and 
you have a downgrade. You have people asking for collateral 
which doesn't exist at the holding company level, which the 
State regulators do not regulate. And you have the systemic 
effects of basically some of these companies' future being 
questioned, whereas actually the underlying solvency of them 
and the quality of them as operating companies, as Chairman 
Bernanke said 2 days ago, I think are actually--should be 
    Thank you.
    Chairman Dodd. Thank you very much, and again, we welcome 
the presence of all of you here this morning.
    Let me begin. I have basically four questions that I would 
like to address. The first is who owns AIG? Second, who did the 
Fed rescue, in a sense? Who regulates AIG? And what has been 
the legal authority for the Fed activities?
    So let me begin with you, Vice Chairman Kohn. Does the 
Federal Reserve Bank, do you own AIG?
    Mr. Kohn. No, sir. The U.S. Treasury has the equity 
interest in AIG.
    Chairman Dodd. So the Treasury owns AIG?
    Mr. Kohn. Owns 79.9, up to 79.9 percent.
    Chairman Dodd. The Fed required AIG to give 80 percent 
ownership to the government as part of receiving a loan from 
the Fed in September. It took almost 4 months, until January, 
for the New York Fed to select trustees--it is the Fed's 
responsibility to select the trustees--to represent the 
interest of the government. Between September and January, AIG 
went on record with the largest quarterly loss in corporate 
history in the United States. I might point out, it also set 
aside $1 billion in lavish payments to employees.
    During the fourth quarter of 2008, who represented the 
government's 80 percent ownership of AIG?
    Mr. Kohn. The Federal Reserve was deeply involved in 
interacting with AIG through this period. The Federal Reserve 
Bank of New York put a number of people onsite at AIG, and 
people at the Federal Reserve Bank of New York, in close 
consultation with the Treasury, were interacting with AIG as 
they were putting together their plans for selling off parts of 
the company in order to repay the loan.
    So it is true that the trustees were not named until 
January, but on September 16, the government in the form of the 
Federal Reserve, working with the Treasury, became very deeply 
involved in the overall strategy of the company.
    Chairman Dodd. Why did it take so long to name the 
trustees? Explain that to us here. This is really a massive 
amount of money being involved and----
    Mr. Kohn. I don't know. I don't know what was the delay in 
naming the trustees, but I know that the fact that the trustees 
weren't named until January is not indicative of any absence of 
concern by the Federal Reserve and the Treasury or absence of 
oversight by them.
    Chairman Dodd. I mentioned in my opening statement that the 
Federal Reserve made a decision to pay off at par value 
sophisticated investors who owned credit derivative swaps 
underwritten by AIG and who could also give to the Fed the 
security that those CDSs covered.
    Mr. Kohn. Right.
    Chairman Dodd. The Fed created Maiden Lane II to conduct 
this operation. In most cases, those securities were trading 
well above par, sometimes--excuse me, well below par, sometimes 
50 cents or lower on the dollar. And in bankruptcy, the CDS 
holders could have only expected pennies on the dollar, given 
AIG's financial situation.
    Specifically, who were the largest counterparties that 
Maiden Lane III bought securities from, and will you provide, 
that is the Fed to the Committee, a full list of all those 
companies that sold securities to Maiden III, including the 
price at which those assets were sold?
    Now, I know the question will be, we were providing loans 
here. This was loans, and providing loans is a different matter 
than owning them. But it seems to me that these were--these 
transactions by an SPB that is wholly owned and controlled by 
the Fed, there is no stigma for those who sold to this entity. 
Therefore, the objection, it seems to me, would be obviated or 
gone that historically has been given in matters like this. And 
I know in the past that the Fed, in responding to other 
Congressional committees, has indicated they would provide 
those names. What is the response of the Fed this morning to 
that inquiry?
    Mr. Kohn. Mr. Chairman, I agree that the Federal Reserve 
needs to think very carefully about what it is revealing, the 
transparency of its operations across a broad range of our 
operations today. We are in a new world and new types of 
transparency are required. In fact, Chairman Bernanke has put 
me in charge of a committee to look at how we can be more 
transparent about a variety of our operations.
    With regard to these particular operations, there are a lot 
of counterparties benefiting from the efforts of the government 
and the Federal Reserve to stabilize AIG, not just a few, but 
many of the pension funds, households, businesses, and people 
with insurance policies, 401(k)s, et cetera, and a whole 
variety of counterparties here. These counterparties, I think, 
entered into their transactions with AIG as normal commercial 
transactions, expecting confidentiality, as you would in a 
normal commercial transaction.
    In fact, AIG and the Federal Reserve went to these 
counterparties to tear up the credit default swap arrangements 
because they were draining liquidity from the company, and we 
thought that canceling those arrangements, buying the CDOs, 
would protect the taxpayers and stabilize the company as best 
we could under those circumstances.
    So they didn't approach us and say, we want to tear up 
these contracts. We approached them because we were trying to 
help the company and help the U.S. taxpayer and take some of 
the downside risk off AIG's balance sheet.
    I would be very concerned that if we started revealing 
lists of names who did transactions with companies who later 
came under government protection, got capital, that sort of 
thing, that people just wouldn't want to do transactions with 
companies. We need AIG to be a vital part of our credit 
markets. As you said, Mr. Chairman, insurance companies are 
absolutely essential to keeping credit flowing.
    We need AIG to be stable and to continue in a stable 
condition, and I would be very concerned that if we started 
giving out the name of counterparties here, people wouldn't 
want to do business with AIG. We need people to do----
    Chairman Dodd. I understand that----
    Mr. Kohn. ----business with AIG, and I would be concerned 
that other people, fearing that some other entity that they 
were doing business with who now was getting TARP capital, 
might in the future get TARP capital, that the same demands 
would be made on them. They would draw back from doing business 
with those folks.
    So I think not being transparent about those 
counterparties, not revealing the names of those 
    Chairman Dodd. But these are counterparties to Maiden----
    Mr. Kohn. Maiden Lane III, that is right.
    Chairman Dodd. ----not AIG.
    Mr. Kohn. But they started as counterparties to AIG----
    Chairman Dodd. It is very----
    Mr. Kohn. ----and they became counterparties to Maiden Lane 
III as part of the government's effort to stabilize AIG.
    Chairman Dodd. I understand the rationale, but to make the 
case here that we can't reveal these, now we have got a lot of 
taxpayer money tied up in this. They were being paid at par at 
the time we clearly knew these securities were worth a lot less 
than par.
    Mr. Kohn. We paid them market value for the securities, but 
they had already collected more from AIG in margin payments.
    Chairman Dodd. All the more reason that we ought to know 
who they are. So the answer from the Fed is, despite earlier 
testimony, we will not get the names of these counterparties?
    Mr. Kohn. My judgment would be that giving the names would 
undermine the stability of the company and could have serious 
knock-on effects to the rest of the financial markets and the 
government's efforts to stabilize them.
    Suppose you were doing business with another large 
systemically important financial institution that already has 
government support or might later get government support and 
you didn't know what form that would take. It could take the 
form of another Maiden Lane----
    Chairman Dodd. I understand that. Just understand, as well, 
that public confidence in what we are doing is at stake and 
that right now, the public is deeply, deeply troubled by all of 
this, and it is their money that is being poured into these 
operations. And they, frankly, don't understand, nor do we, 
understand the legal arguments you are giving. But at a time we 
need to engender public trust and confidence in these very 
difficult steps, that kind of an answer undermines that effort 
very significantly.
    And so I would urge you here--and others may have a 
different point of view--that you go back and review the answer 
you have just given with the Chairman and other Members to 
determine whether or not there is a better answer to this 
question, because again, in the absence of it, it is going to 
be extremely difficult, in my view, for the coming requests I 
am sure will be made of us and this body to be supportive of 
the efforts to provide the resources, to provide some hope that 
we will get out of this mess.
    But we are going to have an awfully difficult time doing 
that, it seems to me, an awfully difficult time anticipating 
Congressional support here to provide that kind of financial 
backing if, in fact, we can't get answers to this, why someone 
was being paid at par, in a sense, when the value was far less 
and we now can't find out who they were and the answer to who 
was actually being rescued.
    Now, I have additional questions and my colleagues do, as 
well, but that is not a satisfactory answer, I would say to 
you, Mr. Vice Chairman, and I would urge you to review that 
answer and see if there can't be a better one. I know that in 
the other committee in the other body, a more favorable 
response was given, but no answers have been provided, and I am 
sure for the very reasons you have outlined, and I appreciate 
your answer, but I don't consider that an adequate one, to put 
it mildly.
    I have additional questions here, but I have already taken 
up a lot of time on this point alone and so I will turn to my 
colleagues, but we will have a second round. Clearly, we will 
have that.
    Senator Shelby.
    Senator Shelby. Governor Kohn, I just want to pick up on 
what Senator Dodd is talking about. If the American taxpayers' 
money is at stake, and it is, big time, I believe the American 
taxpayers and people in this Committee, we need to know who 
benefited, where this money went. There is no transparency 
here. And we are going to find out. The Fed and Treasury can be 
secretive for a while, but not forever. I think your answer 
here today is very disturbing.
    As Senator Dodd has already alluded to, you are going to be 
coming back for more money and more money and more money, and 
the people want to know what you have done with this money, but 
more than that, like Senator Dodd just brought up, who 
benefited from this, because a lot of the people don't believe 
that the American people have benefited. At least they haven't 
felt it. So your answer might be the Fed answer, but it is not 
going to be the answer we are going to accept, and the American 
people aren't going to accept.
    I want to now pose some questions to the Superintendent. 
Superintendent Dinallo, do you agree with all of the following 
statements. First, the New York Insurance Department reviewed 
and monitored AIG's securities lending program. Second, AIG's 
securities lending program heavily invested in long-term 
mortgage-backed securities. Three, AIG Life Insurance suffered 
approximately $20 billion in losses related to their securities 
lending operations last year. And fourth, the Federal Reserve 
has provided approximately $17 billion to recapitalize AIG Life 
Insurance Companies?
    Mr. Dinallo. I think those are fair statements. The only 
    Senator Shelby. What is your answer?
    Mr. Dinallo. Well, yes, but on the very first one, I would 
say that when we--prior to 2007, I don't think it was monitored 
as well as it should have been, so I am actually agreeing--what 
you want to get from me, I will agree with you. I don't think 
it was as coordinated and as monitored, given it was a group 
activity, as you pointed out, as it could have been----
    Senator Shelby. So my question was, did the New York 
Insurance Department, which you headed, reviewed and monitored 
AIG's securities lending program, and you say not adequately, 
is that right?
    Mr. Dinallo. Well, for the--no. For the 10 percent--our 
companies had 8 percent exposure to it. For that 8 percent, we 
did monitor it, yes. So we were not responsible for the whole 
securities lending program, sir. I just--I am just telling you 
what we did was about 8 percent. As I said, we have about 10 
percent of the life insurance companies we regulate in the AIG 
holding empire and we monitored that 8 percent exposure.
    Senator Shelby. Your testimony, I believe, is ambiguous as 
to whether you believe AIG's securities lending facilities were 
activities of its insurance companies or of a non-insurance 
subsidiary. I think it is clear that they were activities of 
the insurance companies. Do you agree with that or disagree?
    Mr. Dinallo. I, in part, disagree.
    Senator Shelby. And how do you disagree?
    Mr. Dinallo. Well, because it was coordinated--it was 
orchestrated and coordinated by the holding company, by the 
holding company management, by the management of the holding 
company. They essentially set up a securities lending pool. You 
could not do it without holding company support. In fact, our 
agreements with the holding company under the ``make whole'' 
clauses that we established for $5 billion were with the 
holding company. So it is not--again, I am not trying to be 
evasive. It is not that clear. It is true that we were 
responsible for our exposures----
    Senator Shelby. Are you trying to evade your 
    Mr. Dinallo. Oh, no. I am fully--I take as an agency full 
responsibility for the, I think percentage-wise, small losses 
in securities lending that our insurance companies--well, it is 
by a percentage, Senator, you are talking on your own telling, 
it is about $17 billion out of a 400----
    Senator Shelby. You call that small, $17 billion?
    Mr. Dinallo. Seventeen-billion out of a 400-500 billion 
dollar portfolio of assets is about less than 5 percent, and I 
think that although it is unfortunate they invested in any 
RMBS, those are very small percentages compared to other 
institutions that have been completely blown out and decimated 
literally by RMBS. So I think I am just telling you the honest 
    Senator Shelby. OK.
    Mr. Dinallo. It is true that the RMBS exposure for the 
securities lending business was about 60 percent, but that 
still is a very small piece. That $40 billion was only 10 
percent, or actually about 8 percent of the total life 
insurance assets.
    Senator Shelby. So if you are not taking the responsibility 
or accepting all of it, aren't you, in a sense, saying you are 
handing over the assets to a non-insurance entity? AIG insurers 
got the upside. The taxpayers got the downside. And you can 
claim here today that you have little responsibility, if any, 
for all of these problems.
    Mr. Dinallo. No, I don't agree with that--I am sorry, 
Senator. I do not agree with that----
    Senator Shelby. Are you accepting responsibility----
    Mr. Dinallo. The insurance companies maintained ownership 
and control of the assets. We monitored the amounts. We 
monitored the amounts for the New York State domestics. Do we 
take responsibility? I would first say that management should 
take responsibility for the losses, but we were the regulator. 
There is no dispute about that. But the losses are not a very 
large percentage of the operating companies' total assets, and 
I think that is an important fact. You had an amount that is 
about $40 billion as opposed to the notional exposure of 
Financial Products division, which is $2.7 trillion. You are 
dealing with a peanut across a trillion-dollar asset balance 
    Senator Shelby. Would you like to comment on that, Scott?
    Mr. Polakoff. Yes, Senator. When you look through the 
weeds, it is clear that the various insurance subsidiaries that 
participate in the security lending business, the insurance 
commissioners had responsibility for understanding and 
approving any agreements between the insurance companies and 
the entity that was formed for the security lending business 
and any of the losses that were recorded were recorded on the 
insurance company's books. The Insurance Commissioner's staff 
would have known that when they looked at the books and 
    Senator Shelby. Were these securities lending losses 
greater than the statutory cap? For example, in 2008, it is my 
understanding that American International Life's statutory cap 
was 662 and the losses were 771.
    Mr. Dinallo. No. As I said in my opening statements, our 
calculations are that even after taking into account the losses 
for the securities lending, the U.S. life insurers were $11 
billion to the solvent side. They were not insolvent. And that 
would be going to statutory accounting, yes.
    Senator Shelby. Governor Kohn stated in his testimony that, 
quote, ``A substantial contributor to AIG's massive fourth 
quarter losses were the losses on AIG's investment portfolios 
that are primarily, primarily attributable to its insurance 
subsidiary's holdings.'' In light of those facts, do you care 
to modify your prior testimony that AIG's problems did not come 
from its insurance operations? This is your testimony----
    Mr. Dinallo. I fundamentally----
    Senator Shelby. ----Governor----
    Mr. Dinallo. I fundamentally believe that the problems at 
AIG had absolutely nothing to do--the problems for which we are 
on a national stage here had nothing to do with the operating 
companies. There are--by the way, there are problems with State 
insurance regulation. I have been a proponent of us revisiting 
it. I think it is clunky. I think it has issues. But the 
solvency, the capital requirements of these insurance companies 
were done well and I am proud of how the regulators maintained 
themselves. I don't understand--I am not of any other opinion 
that the operating companies' ex-Financial Products division 
would have been just fine. In fact, arguably, AIG would be 
flourishing in this environment.
    Senator Shelby. Sir, AIG's most recent annual report states 
that, quote, ``The two principal causes for its unprecedented 
strain on liquidity during the second half of 2008,'' and these 
are their words, ``were a demand for the return of cash 
collateral under the U.S. securities lending program and 
collateral calls on credit default swaps issued by the 
Financial Products subsidiary.''
    Mr. Dinallo. And I agree with that. I am sorry.
    Senator Shelby. ----with the firm's analysis of its own 
    Mr. Dinallo. No, I don't actually disagree with that. I 
agree with it. The only difference is causation. As I said, the 
25 other domestic life insurance companies that we have 
examined have not had a problem with their securities lending. 
The causation of AIG's problem with its securities lending 
business was essentially the run on the entire company caused 
by its exposure from Financial Products division.
    Senator Shelby. Could you briefly walk us through the 
balance sheets for the life insurance companies under your 
jurisdiction? What was their capital at the start of 2008 and 
what were their losses in securities lending in that year? If 
you would take just a second. I know my time is up, but I think 
that is important.
    Mr. Dinallo. The capital surplus at the end--capital and 
surplus at the end of December 31, 2007, was $1.7 billion. And, 
Senator, sorry, what did you want me to--and what else do you 
want to know? I apologize.
    Senator Shelby. I thought you could walk--I know that our 
time is very important here. If you could walk through the 
balance sheets of the life insurance companies under your 
jurisdiction, what was their capital at the start of 2008 and 
what were their losses----
    Mr. Dinallo. $1.7 billion.
    Senator Shelby. That is all of them? And the losses were 
    Mr. Dinallo. Yes, and then you had a loss of $1.8 billion 
for that year. You had a contribution of 0.7. You had a net 
surplus of 0.5. So you ended up with--yes, right, I am sorry. 
So the net surplus at the end, including the contribution, is 
$500 million. So there was a net surplus of $500 million.
    Senator Shelby. Was that before or after the Fed put their 
money in?
    Mr. Dinallo. After.
    Senator Shelby. After the Fed----
    Mr. Dinallo. No, I am sorry. I am sorry. It was before, and 
then the capital contribution was--yes, and then the Fed put in 
1.9 afterward. So it was a $500 million surplus, and then on 
top of that the Fed put in 1.9 to basically buy and unwind the 
    As I said, there was--I believe our calculations across all 
the life insurers, there was an $11 billion surplus. And for 
the New York insurance companies, of which it is 8 percent of 
the total, 8 percent of the total was $500 million surplus, and 
the Fed then bought off the books, basically, the securities, 
the remaining securities.
    So as I have said, I am not ungrateful for what the Fed did 
because it permitted us to untangle this. But there would have 
been solvency with or without the Fed action. That is all that 
I am pointing out.
    Senator Shelby. Have you untangled it, or are you in the 
process of untangling it?
    Mr. Dinallo. It is completely severed now. So the concept 
of continued systemic risk from securities lending, to the 
extent anyone thought there was--and I would not agree that 
there was--it is a completely severed situation, because in 
order to sell the operating companies to various buyers to pay 
off the loan that you authorized them to give, you had to 
untangle the operating companies from the securities lending 
pool, and that required the Fed to buy $20 billion at face 
value of the securities. Those may actually perform well. They 
may not. But they were bought at the market price so we could 
unwind securities lending pool so we could sell the operating 
companies that have huge value.
    Senator Shelby. Thank you.
    Chairman Dodd. Thank you.
    Senator Johnson.
    Senator Johnson. Mr. Kohn, on Tuesday, Chairman Bernanke 
testified before the Senate Budget Committee and said that AIG 
exploited a huge gap in the regulatory system. Can you expand 
on Chairman Bernanke's statement about regulatory gaps?
    Mr. Kohn. Yes, I can, Senator. I think the problem here--
and it has been a little bit illustrated by the back-and-forth 
we have heard this morning about who was responsible for what--
is that no one was responsible for the whole company. There was 
no umbrella regulator over the whole company, and there was a 
piece of the company, Financial Products, that really was not 
being supervised and regulated by anybody. And that piece of 
the company was able to exploit the AAA rating which arose from 
the insurance entities to get what looked like a very 
profitable business for a while in writing this credit 
protection, these CDSs. But they did not take appropriate 
account of the risk. They did not protect themselves against a 
very unlikely event, which was a massive weakening in the 
housing market and the economy. That unlikely event has come to 
pass, and those losses have come back to the whole company, 
weakening the entire company.
    There are a number of things that contribute to this, as 
the previous dialog suggested, but this unregulated piece of 
the company certainly was a major contributor to the weakening. 
So I think the gap is that that piece was not regulated. It was 
part of a systemically important financial institution, the 
largest insurance company in the United States, one of the 
largest in the world, and no one was minding the whole company 
and looking at how things interacted and whether the whole 
company would under some circumstances put the financial system 
at risk. So I think----
    Mr. Polakoff. Senator, may I make a comment?
    Senator Johnson. Yes, please.
    Mr. Polakoff. There may be a slight difference of opinion, 
and it is time for OTS to raise their hand and say we have some 
responsibility and accountability here. This entity was deemed 
a savings and loan holding company. We were deemed an accepted 
regulator for both U.S. domestic and international operations. 
The segment, this AIG Financial Products, was an unregulated, 
as that term is defined, subsidiary of AIG, but part of the 
overall consolidated regulator responsibilities of OTS.
    Senator Johnson. Mr. Kohn, on Monday, the Federal 
Government announced revised terms of its assistance to AIG in 
order to strengthen the company's restructuring efforts and to 
further protect taxpayers from future losses and reduce the 
risk of further destabilizing the broader economy. How will the 
new terms protect taxpayers and help stabilize the economy?
    Mr. Kohn. I think a major effort in the new terms, first of 
all, the Treasury put some contingent capital in. They made 
capital available to help protect the company and stabilize the 
company, which the company will draw on over time as it needs 
    Second, the Federal Reserve restructured its debt to really 
facilitate this process of breaking apart pieces of the company 
and taking them public or finding buyers--getting them in a 
condition that they might be more attractive to outside sources 
of capital to others who might be interested in buying these 
pieces of AIG, which would then help to repay the debt and earn 
a return for the taxpayers.
    So we did that in part by transferring some of our debt to 
a preferred interest in two major insurance companies operating 
outside the U.S., to a trust that owns those. We did that in 
part by taking security for some of our debt as to the cash-
flows on life insurance policies, securitization of life 
insurance policies, gradually helping the company prepare 
itself for getting down to its core businesses, selling the 
other businesses so it could return the cash.
    Senator Johnson. As Congress considers regulatory 
modernization, is there a need for Federal insurance 
    Mr. Kohn. I think that is something that should be 
considered, but I do not have a strong view. I think that is 
something that should be considered as part of the overall look 
at regulation. I think my first priority would be to get some 
overall regulator for every systemically important institution, 
wherever that might be. But the Federal charter is an option 
you should be looking at, I think.
    Senator Johnson. I yield back.
    Chairman Dodd. Thank you very much, Senator.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Dr. Kohn, we are miscommunicating. You are not 
communicating with the Committee, and the Committee must not--
you must not be hearing what we are saying. We have put in 
approximately $170 to $180 billion into one corporation, and 
you are telling us that the counterparties--the counterparties 
that got par for their bonds or for whatever should not be--the 
American taxpayer should not know who they are. And then you 
may come back to us and ask for more money for more banks and 
more corporations. You will get the biggest ``No'' you ever 
got. I will hold the bill. I will do anything possible to stop 
you from wasting the taxpayers' money on a lost cause. And that 
is what AIG is. It is a lost cause.
    The other day in the Budget Committee someone said, ``What 
is the bottom line on AIG?'' Is it $1 trillion? Is it $2 
trillion? Where is the bottom line as far as the American 
taxpayer is concerned? Do you have an answer for that?
    Mr. Kohn. I cannot give you a number, Senator Bunning. We 
have done with the Treasury what we can to stabilize the 
company. I think the exit strategy here is clear: stabilize the 
company, have it sell off non-core businesses, use that money 
to repay the taxpayer. As our press release said, I cannot 
guarantee you that----
    Senator Bunning. I am not interested in a press release. I 
am interested in facts. We all give out press releases. Factual 
numbers and factual data in the press release are not 
necessarily what the real facts are.
    Can any of you give us an estimate of potential future 
losses at AIG? In other words, how much more public money is 
going to be needed to keep it afloat?
    Mr. Kohn. I think I already responded----
    Senator Bunning. I just asked could anybody.
    Mr. Kohn. No, sir.
    Mr. Dinallo. Senator, the only facts I could give you on 
this that might be helpful are twofold: The securities lending 
issue is over, and it cost about $17 billion. And the second 
fact is that, to the extent the American public are ever repaid 
on this, it will be from the proceeds of selling the insurance 
operating companies, and----
    Senator Bunning. That is why the stock is at 50 cents?
    Mr. Dinallo. Yes, the stock--well, that is a very good 
point, because, I will tell you, the markets--that reflects a 
belief by the markets that at the end of all these 
transactions, there will be little equity value. But that does 
not--but first you pay off the Federal Government before you 
would see equity. So that is actually--the fact that the 
markets even think there is 50 cents at this point is 
    Senator Bunning. That is only because $170 to $180 billion 
has been put into the company by the Federal Government.
    Have any of you seen a document titled ``AIG: Is the Risk 
Systemic?'' It was supposedly written by AIG to justify Federal 
support. Have any of you seen that document?
    Mr. Polakoff. I have not.
    Senator Bunning. You have?
    Mr. Dinallo. I have seen it, Senator, yes.
    Senator Bunning. Would you please furnish a copy of that 
document to this Committee?
    Mr. Dinallo. Should I give it to you right now?
    Senator Bunning. Well, the Committee.
    Mr. Dinallo. I have it.
    Senator Bunning. OK, we would like to have a copy of that. 
Thank you very much.
    Senator Bunning. I heard from Dr. Kohn that he thought 
somebody should be given super-regulatory powers over entities 
like AIG that were in more than one jurisdiction, New York 
regulation of their insurance company, the chairman in England 
that was in the credit default swap business, and all these 
other things. Who do you think that should be?
    Mr. Kohn. I do not know, Senator. I think that is something 
that you and the regulators need to talk about and think about. 
I have no firm view on who that should be. I think the most 
important thing is that for systemically important 
organizations that there be one.
    Senator Bunning. Thank you very much. My time has expired.
    Chairman Dodd. Thank you very much, Senator Bunning.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Governor Kohn, after listening to Mr. Polakoff describe his 
responsibilities, do you still stand by the statement that 
Financial Products is an unregulated entity that exploited a 
    Mr. Kohn. I think--Mr. Polakoff can answer this better than 
I can--but I think that the focus of the regulation that 
existed under Gramm-Leach-Bliley was focused very sharply on 
the depository institution, and the theory was that if we 
protect the depository institutions, then we have protected the 
taxpayer so we do not have a repeat of 1991 in FDICIA and the 
taxpayer coming in. And the depository institutions are key to 
protecting the stability of the financial system. And I think 
what we have learned over the last 18 months is that the focus 
of the systemic regulator, the umbrella regulation authority, 
needs to be very wide. They need to be looking at all kinds of 
interactions that are not necessarily related to the depository 
    I think there was some oversight by OTS, but it really was 
not focused where we needed to focus.
    Senator Reed. Well, I am alarmed, because if the Fed has 
that position, it seems to contradict exactly what Mr. Polakoff 
said he did. In fact, OTS was recognized as an equivalent 
regulator for the purposes of AIG consolidated supervision--not 
regulating the Federal savings bank, consolidated supervision 
by EU; that, in fact, in 2005 OTS conducted several targeted 
risk-focused reviews of various lines of business, including 
AIG Financial Products; made numerous recommendations to AIG.
    In your view, Mr. Polakoff, were you simply responsible for 
the depository institution and everything else was sort of free 
    Mr. Polakoff. I do not think the Governor and I are 
differentiating too much, but we were clearly responsible as 
the consolidated regulator for FP. We in 2004 should have taken 
an entirely different approach than what we wound up taking 
regarding the credit default swaps, but, nonetheless, we should 
have taken a different approach.
    Senator Reed. You were also engaged in terms of as an 
international regulator, at least participating, as you point 
out in your testimony, you would have conferences with other 
regulators, including the FSA. One of the operations was in 
London. Can you describe the insight you had into the London 
    Mr. Polakoff. We had regular contact with the FSA. We would 
send examiners over there to look at operations. The FSA would 
reciprocate and send examiners here. We had annual supervisors 
conferences where all the foreign regulators, the State 
insurance commissioners came, at least once a year. We had 
regular contact throughout the year, certainly as things 
deteriorated with all of the regulators and 
PricewaterhouseCoopers, the external auditors.
    Senator Reed. So the perception that this London operation 
was some rogue sort of group that were unsupervised, that you 
had no access to, that your regulatory authority did not reach 
there, is not accurate?
    Mr. Polakoff. Correct. That would be a false statement.
    Senator Reed. You say that the biggest fault of OTS was not 
recognizing the magnitude of the situation developing with 
respect to credit default swaps. In which way were you 
prevented by your regulatory structure or by your resources 
from recognizing the magnitude? Which I think Mr. Dinallo 
estimates about $2.7 trillion.
    Mr. Polakoff. It was neither, and I think it is important 
for us to remember that the issue with the credit default swaps 
is $80 billion worth of credit default swaps that were written 
on CDOs that were multi-section CDOs. Really what we are 
talking about is $80 billion worth of credit default swaps.
    These were written on AAA, super-senior tranches of the 
CDOs. The company stopped writing these in 2005. The holders of 
the CDOs still have not sustained an actual loss. All the 
losses that we are talking about, all of the collateral calls, 
represent market value deterioration. If these instruments are 
held to maturity, these instruments could pay out at par. It is 
a market value issue as we speak today.
    Senator Reed. Let me raise a question with Mr. Dinallo.
    As Mr. Polakoff pointed out, in 2005 AIG Financial Products 
made the decision--I think there was--at your suggestion or 
    Mr. Polakoff. Independently. I give the company credit for 
    Senator Reed. To stop investing in mortgage-backed 
securities. But at that very time, in the securities lending 
program, the individual running that program decided to 
aggressively get into mortgage-backed and asset-backed 
securities. You have already indicated that your stewardship 
before 2007 was--you would like to have seen it a bit better, 
to be polite, but did you have any knowledge that one part of 
AIG had made a determination that these investments were too 
risky and another part of AIG that you had access to decided to 
aggressively get involved?
    Mr. Dinallo. Well, I was not aware of those decisions of 
the Financial Products Division. Starting in 2007, we did begin 
to wind down--the New York Insurance Department led the group 
that began to wind down this securities lending. We brought it 
down by 25 percent. We began coordination that I would say 
probably did not exist before, as the Senators have pointed out 
    But there is a difference, I think, there is a difference 
between managing down an investment and having already 
committed to default protection across--I think it was about 
$460 billion in credit default swaps.
    Senator Reed. Let me pose just one quick question to you, 
Mr. Polakoff. This goes to kind of the management of the 
company. There was a conscious decision made by Financial 
Products that it is too risky to stay engaged in these asset-
backed CD--mortgage-backed securities and this type of credit 
default swap. But another division plows into it with great 
gusto. Were you aware of that? Did you try to communicate to 
other regulators or do you find that alarming, that within the 
company there was a conscious decision independently made to 
stop doing this, and at the same time they allowed others to do 
    Mr. Polakoff. Well, I think our respective staffs certainly 
at the annual conferences that we held communicated the various 
risks within this complex company. There is a difference 
between, as you know, underwriting credit default swaps and 
actually investing in residential mortgage-backed securities. 
Nonetheless, Senator, as you described, the theme should have 
been consistent in both parties. And certainly, in listening to 
the testimony today, I think it is worthy for us to go back and 
chat with our staffs as to what was communicated.
    Clearly, we know in the supervisors' college in 2007 we 
discussed the risks of the credit default swaps in FP, and I 
suspect that the various State insurance commissioners had 
ample opportunities to discuss in the supervisory colleges the 
risks that they were identifying.
    Senator Reed. Thank you very much.
    Mr. Chairman, thank you.
    Chairman Dodd. Thank you.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman.
    Mr. Polakoff, I am a little confused by the testimony. You 
keep referring to the fact that there have been no losses 
whatsoever in the super-senior AAAs, but there were credit 
default swap losses in the other segment, the second loss 
segment. Is that correct?
    Mr. Polakoff. Yes, sir. It is a complicated subject. If I 
could offer----
    Senator Corker. I do not want--my point--I do not want to 
go down that path, really, but so when you keep saying that, it 
is, I think, somewhat confusing because there were credit 
default swap losses on a portion, a large portion of what they 
were selling. Is that correct? Just not the AAA, super-senior.
    Mr. Polakoff. There was credit default swap exposure based 
on the market value depreciation, not on the credit losses in 
the CDOs.
    Senator Corker. On none of them?
    Mr. Polakoff. Correct.
    Senator Corker. There have been no losses--this is kind of 
interesting. So you are saying that there have been no losses 
whatsoever on any of those obligations as far as the debt 
actually not being repaid to these particular individuals.
    Mr. Polakoff. As of September 30, on the super-senior, AAA-
plus tranches, I am saying that there was no credit loss.
    Senator Corker. OK. So let me move over to the Fed then. 
So, in essence, all of our losses, all the money the Federal 
Government has put--I think that is a real key point. It has 
all been about us--these--I mean, AIG was the only entity in 
the world, I think, that sold these as insurance products where 
they would have to--and that were not--that were naked. In 
other words, they did not hedge off their risk. So, in essence, 
they had to keep--we have to keep on their behalf putting up 
collateral because of the way these products were written so 
that they would get a high rating. But yet the holders of this 
actually have not had any losses, credit losses yet. Is that 
    Mr. Kohn. I believe that is correct, but let me clarify one 
point. The Federal Reserve--the taxpayers through the Federal 
Reserve--now own these CDOs against which the credit default 
swaps are written.
    Senator Corker. Right.
    Mr. Kohn. So if, in fact, there are no credit losses on 
them and they pay off at par in the end, the taxpayer will 
realize the gain on that, because we paid market price for them 
when we bought them from the counterparties, who already had 
margins. So if they go up in value, five-sixths of that 
increase will belong to the taxpayers.
    Senator Corker. I have a hard time understanding the 
systemic risk issue then. The company was bankrupt. It could 
not meet its obligations. So, in our wisdom, we decided to fund 
all of this--this insurance product was drawn up so they had to 
put up collateral every time the value went down. If we had not 
funded that, there still was no systemic risk that I 
understand. If we would have had long on insurance, like most 
of Buffett's companies and others are, if we were long on 
insurance instead of this crazy mechanism that AIG had come up 
with, there still were no losses. So if we had just said we are 
not going to fund these, we will stand behind these as the 
Federal Government, but we are not going to fund the collateral 
in the interim, what would have been the systemic risk?
    Mr. Kohn. If AIG had been unable to meet its obligations, 
it had an obligation to put up money not only for the CDS but 
for the RMBS that the securities lending was invested in----
    Senator Corker. I want to----
    Mr. Kohn. ----and on Monday, September 15, it could not 
access the credit markets to get the funds that it needed, and 
Tuesday, September 16. If it had been unable to do that, if we 
had not extended the credit at that time, it would have had to 
go into bankruptcy court, and there would have been millions of 
counterparties to the insurance, the pension funds, all those 
folks would have been--as well as the counterparties on the----
    Senator Corker. But couldn't you have just----
    Mr. Kohn. ----small part of it.
    Senator Corker. But couldn't you have just said this 
product was written up in an inane way, it is a ridiculous 
concept to have created an insurance product like this, we are 
not going to put up the collateral, I am sorry, the company is 
bankrupt. But what we will do as the Fed is we will stand 
behind the obligation so that in the event there is ever a 
credit issue, we will stand behind it. Wouldn't that have been 
a more intelligent thing to do?
    Mr. Kohn. Our authority under the Federal Reserve Act is to 
make loans. We thought it was a short-term liquidity 
situation--in mid-September, this is what we thought--and that 
if we could bridge this situation with liquidity, then the 
company could make the adjustments to keep itself a going 
    It turned out that the problems were deeper, the financial 
markets became a lot worse, and the whole situation 
deteriorated badly. I do not think we had the authority 
    Senator Corker. Well, it may not--I think this whole issue 
of authority is pretty incredible, and I think all of us 
realize that the Fed nor anyone else has the authority not only 
to deal with AIG but Citigroup or Bank--there is nobody. I 
mean, I think that is an amazing thing that for some reason 
only hits my alarm bell, nobody else's. But there is no entity 
in our country that has the ability to deal with an AIG, a 
Citigroup, a Bank of America, anybody. I find that pretty 
incredible. OK?
    But I want to go back to this still. So the holders of 
these policies--most of us call it ``credit default swaps,'' 
but these policies--have had no losses.
    Mr. Kohn. That is right.
    Senator Corker. But in our wisdom, we decided on that 
fateful day, instead of just standing behind those, that we 
would fully fund those. And so that is also--I mean, we all 
thought--I guess AIG's whole thinking about this was the 
blunder of most major proportions in modern history, and I hate 
to say this because I like working with you and Chairman 
Bernanke. But it also sounds like that on that day, 
representatives of the U.S. Government made an equally large 
blunder of modern--largest in modern history. I mean, is that a 
fair assessment? Because if you had just stood behind it, we 
would not have any money out.
    Mr. Kohn. Well, I do not agree with that assessment, 
Senator. This was before you had passed the EES Act, so the 
Treasury did not have the authority to go in and help with the 
credit risk the way it has under TARP. All we had was our 
lending authority under the Federal Reserve Act. Things have 
changed since September 16.
    I agree with everybody that Financial Products was a major 
contributor to the problems of the company, but I think as 
people got in there, they saw that there were other 
contributors. So I do not think just taking that one piece--
having the taxpayers take the risk for that one piece and made 
people whole at that time--would have been enough to stanch the 
bleeding. I think that was a serious situation. The financial 
markets were in very dire straits and becoming worse all the 
time. I think the problems were deeper and broader than just 
that one thing.
    Senator Corker. Mr. Chairman, I look forward to the second 
round. I think the line of questioning that you had on the 
front end regarding the payment of full value, when we all know 
these folks had hedges themselves--OK, I mean, they mostly were 
far more intelligent in thinking than AIG was, they all had 
hedges--and I think that line of questioning needs to be 
pursued further and I thank you for going that path.
    Chairman Dodd. Thank you very much.
    Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    This is an area that I share Chairman Bernanke's comments 
about being angry. I am angrier than hell at what AIG has been 
able to get away with, and I am angry that regulators who, in 
my mind, should have seen the regulatory arbitrage that was 
taking place didn't bring it to the Congress's attention and 
say, hey, this is a gap that should be closed. The reason we 
have regulators is for them to be on the beat, not to be asleep 
at the switch.
    We keep hearing that AIG has systemic risk. Well, even 
systemic risk has to be quantifiable. So my question is, after 
having given them another $30 billion to supposedly stop them 
from collapse, the fourth bailout that they have had, there are 
those who are asking when is the fifth and how much. So you 
must all, I assume, if we are doing our jobs here, thinking 
about best and worst case scenarios, and so what is the 
quantifiable risk here, particularly in your minds, in the 
worst case scenario, what are AIG's assets really worth, or do 
you even know?
    Mr. Kohn. I don't have a calculation of a severe stress 
kind of scenario, what AIG's assets would be worth in those 
situations. I think what AIG is worth depends very, very 
importantly on the course of the economy and the financial 
markets from here on out.
    Senator Menendez. But shouldn't we be putting AIG through 
the same stress test that we are talking about in terms of 
financial institutions?
    Mr. Kohn. We should be seeing what the----
    Senator Menendez. But I get a sense we are not.
    Mr. Kohn. Well, I think we have done some of that, Senator, 
not to the same----
    Senator Menendez. Some of it? I mean, how can you keep 
coming back and asking for monies in which you cannot quantify 
for us the systemic risk and the assets here? You are asking 
for an open-ended check, and gentlemen, you are not going to 
get that, even from those of us who have supported this overall 
effort, forgetting about AIG for the moment. You are not going 
to get that.
    You have got to quantify this risk. You have to tell us 
what is the level of the systemic risk. You have to give us a 
stress test analysis, as best as can be created, for us to 
quantify and figure out where we are going from here. But that 
doesn't seem to be the case right now.
    I am also concerned--you can't give me what they are asking 
for. I am also concerned of what is happening in the property 
casualty insurance market here as a result of the government 
actions that we are taking with AIG. What steps--and I know 
that there is a GAO report underway, an inquiry underway to 
assess the impact of all of the aspects of the financial rescue 
package for AIG and the United States insurance marketplace, 
and it seems to me that because we are giving them all this 
money, they keep pricing their products in ways that would not 
be sustainable for any other insurance company in the 
marketplace and therefore becomes anti-competitive with the 
rest of the industry.
    What steps are being taken to ensure that AIG's property 
casualty business is not being weakened, because at the end of 
the day, we may be the owners of it, and shouldn't there be an 
independent actuarial evaluation of their reserving and pricing 
practices here? Does anybody want to step up to the plate and 
answer that question?
    Mr. Dinallo. I can answer some of that, Senator, if you 
would like me to. As far as the second part, we have received 
some of the competitors' allegations that you entail. We have 
been responsive to GAO. We are looking at them. In the property 
and casualty area, a lot of the rates are subject to prior 
approval, which means they can only actually come down--it is 
as dangerous, as you point out, to underprice as it is for 
consumers to overprice, because you could have an insolvency, 
so we are as mindful that companies aren't permitted to go down 
in pricing as much as we also worry about them pricing too 
high. And so I think we are being responsive to that.
    Senator Menendez. Is there any doubt in your mind that AIG 
is underpricing compared to----
    Mr. Dinallo. I am not----
    Senator Menendez. ----marketplace?
    Mr. Dinallo. I think that is subject to some debate and we 
are looking at it. I am not disagreeing that there have been 
allegations. I am sure you have heard from the same companies, 
Senator, and we are looking at it.
    Senator Menendez. Well, it seems to me that there is a real 
risk here that we are, by Federal money, providing AIG with the 
wherewithal to unfairly compete in this marketplace, and at the 
same time inheriting the risk of underfunding those 
    So if you tell me you can't quantify the systemic risk, if 
you tell me you haven't done a full stress test analysis of 
what AIG is actually worth, if you tell me that you are not 
quite sure yet where they are in terms of this whole property 
and casualty markets, that is a recipe for disaster. It is just 
a recipe of throwing more money in a process in which we don't 
have a quantifiable baseline to determine where we should be 
    And gentlemen, if that doesn't happen yesterday, then I 
think we are in a set of circumstances in which you can't see 
any greater assistance here coming from the Congress. It is 
just not acceptable, and I think I will leave it at that, Mr. 
    Chairman Dodd. Senator Martinez.
    Senator Martinez. Thank you, sir.
    Director Polakoff, I wanted to ask you, I was struck by 
your acknowledgement that perhaps you are the regulator that we 
have been looking for. I think that we had assumed that there 
wasn't one for the whole book of business. I want to delve into 
that and have you, as a follow-up to your statement, whether 
you can explain to the Committee what role you thought OTS has 
had in this company and whether you had the ability to look at 
the broadness of the whole entity and the multiple lines of 
business, particularly the one that seems to be the one that 
got them in trouble. So if you could please enlighten us and 
deepen a little bit on that comment.
    Mr. Polakoff. Sure, Senator. I will give it----
    Senator Martinez. ----by the way, to say, me, I am the one.
    Mr. Polakoff. I am the one, sir. This complex company is a 
savings and loan holding company, so at the very top----
    Senator Martinez. Define that a little more for me. What is 
a savings and loan holding company? Is it a company that--well, 
go ahead, if you would.
    Mr. Polakoff. Any company that owns a Federal savings bank, 
i.e. an OTS-regulated entity, is by definition a savings and 
loan holding company.
    Senator Martinez. OK.
    Mr. Polakoff. So in 1999, when OTS granted the Federal 
Savings Bank Charter, and when the institution opened in 2000, 
this entity became a savings and loan holding company, and that 
requires an application. We start obviously making sure that we 
understand the operations of this $1 billion Federal savings 
bank, because it is an insured institution. Then at the 
consolidated holding company level we look to the functional 
regulated entities to understand, supervise, and communicate 
the risk products to us.
    For example, AIG, as a consolidated entity, is 85 percent 
represented by the insurance companies. We would look to the 
various State insurance commissioners to define the risk and 
then to communicate with us periodically throughout the year or 
at the supervisory college that we hold once a year, but 
throughout the year, what the risk is and what is being done. 
The issue becomes what is OTS doing for what we will call the 
entities that are not functionally regulated, and FP would be 
    Senator Martinez. The non-insurance business?
    Mr. Polakoff. Correct. Correct. The FP is the one that is 
under the most intense scrutiny today. I go back and I look at 
what we did over the years as we examined this company on a 
consolidated basis. We had throughout the years, many times, 
recommendations for action either at the consolidated level or 
at the FP level for better risk management practices within FP.
    I stand on my prior statement, sir, that in 2004, we should 
have done a better job in identifying what the liquidity risk 
was associated with these credit default swaps and insisted on 
a plan to mitigate that risk. When the business stopped in 
2005, what we had post-2005 was how do we handle this risk that 
is now on the books.
    I would also--I have to remind myself and others that in 
2004, this was a AAA-rated company and we were in an entirely 
different financial environment than we are now. Many of our 
models, many of our analyses, many of our discussions were 
driven by the economy that we were operating in in 2004 and 
2005. It is easy to look back now in 2009 with some, we should 
have done X, Y, and Z, and we should have. A post-mortem is 
absolutely appropriate in this case.
    Senator Martinez. I think that is fair, and I think Monday 
morning quarterbacking is always a much easier thing to do. I 
think that also applies to Governor Kohn and some of the things 
that we have been discussing about what did or didn't take 
place in September of 2008. I understand that.
    Now, tell me the relationship between the S&L holding 
company and the FMP part of the business. Was there a 
connection between the two, other than the fact that they were 
both part of the same holding company?
    Mr. Polakoff. AIG FP was a subsidiary of the holding 
company, so----
    Senator Martinez. Of the S&L holding company?
    Mr. Polakoff. No, no, of AIG Inc., the big holding company.
    Senator Martinez. Right.
    Mr. Polakoff. FP was one of the subsidiaries.
    Senator Martinez. And the S&L?
    Mr. Polakoff. Correct.
    Senator Martinez. Was another?
    Mr. Polakoff. Correct. It is a very complex organization, 
    Senator Martinez. Right, but they were parallel entities, 
but you felt you had the regulatory authority to look beyond 
the S&L business to the FMP business because it impacted the 
    Mr. Polakoff. By statute and by regulation, we have 
absolute authority to operate as a consolidated regulator to 
work with the other functional regulators in assessing risk.
    Senator Martinez. So when we say that the financial 
products part of the AIG business was unregulated, we would be 
wrong to say that?
    Mr. Polakoff. That would be correct.
    Senator Martinez. I mean, it might not have been regulated 
as it should have been or as we look over the situation, maybe 
the regulator was not as prudent as maybe we should have been 
with hindsight, but there was a regulation in place, a 
regulator in place, maybe not in the way we would want to go 
into it in the future, but there was--you were the regulator--
    Mr. Polakoff. Yes, sir.
    Senator Martinez. ----for that part of the business?
    Mr. Polakoff. Yes, sir.
    Senator Martinez. Mr. Dinallo, I wanted to ask you about--
well, I guess my time is up. May I just take another moment? 
OK. The unregulated derivatives have been identified as a 
significant factor in the turmoil that AIG had and I am really 
leading to the area of derivatives investment model regulation 
that was developed by the National Association of Insurance 
Commissioners, I presume you are aware of that, back in 1996. 
Are you aware of that?
    Mr. Dinallo. No, I am not exactly aware of that. I think we 
may be talking about the ability for insurance companies to use 
derivatives to hedge, but I am not certain. I apologize.
    Senator Martinez. Well, apparently there was a derivatives 
investment model regulation developed and adopted by the 
National Association of Insurance Commissioners, which I 
presume you are a member of.
    Mr. Dinallo. I am, sir.
    Senator Martinez. And as part of that--that was back in 
1996--apparently the State of Illinois was the only State that 
actually adopted that regulation. I guess my question was going 
to be, but if you don't know of the existence of it, whether 
more States having adopted that, and particularly New York, 
whether that would have been of help in----
    Mr. Dinallo. I don't think--Senator, honestly, I don't 
think that would have been the issue here. Most States have 
some rules around how much derivatives an insurance company can 
use to hedge. They are generally prohibited from investing 
directly in derivatives.
    What I think I would just modestly--what I would focus on a 
little bit in history here is two things. You have a situation, 
and as you go forth and work on this--I know that the Committee 
wants to get this right--the concept that AIG could pick its 
regulator, essentially, that the holding company could 
essentially obtain an S&L and then choose the OTS is something 
that I think is something that really--I do agree that there is 
something that has to be looked at transcendentally about 
companies this size, who should regulate them, especially from 
a systemic risk aspect.
    And second, although I think it is pretty impressive that 
the OTS is coming here and saying, we were ultimately 
regulating over the FP, let us be clear, though. Most of the 
products in FP were by the country's decision unregulated 
derivatives. We chose to make them unregulated. And what that 
essentially means, it is not about finger pointing. It means 
that we decided that there was going to be extremely little 
capital requirements behind those, as Senator Corker said, 
insurance--what they really are are financial guaranty 
obligations that act like insurance without any of the solvency 
    So through the CFMA, we made some radical decisions about 
how to--what to regulate and what not to regulate, but almost 
most importantly, how to capitalize those regulatory decisions 
and the products that go with them. I think that is really 
important historically here.
    Senator Martinez. I think I agree with you, and I think it 
translates also to thinly capitalized entities like Fannie Mae 
and Freddie Mac, as well, who were so thinly capitalized that 
they really would not have ever been able to operate as a bank 
would operate.
    Thank you.
    Chairman Dodd. Thank you, Senator.
    Senator Warner.
    Senator Warner. Thank you, Mr. Chairman.
    I would like to come back to the line that Senator Corker 
and you, Mr. Chairman, and the Ranking Member were addressing. 
Mr. Kohn, I think you are hearing enormous frustration, 
obviously, and I guess I want to just put this in a little 
context. I mean, it wasn't like--even before the meltdown, it 
wasn't like there was huge amounts of surprise from the 
financial markets. AIG was a high-flying company. You have 
described, or I think some of the panel has described it as an 
insurance company with a hedge fund bolted onto it.
    Mr. Kohn. Exactly.
    Senator Warner. And that AIG's practices, whether it would 
be in effect a mortgage securities lending business that went 
from $1 billion of exposure to about $100 billion of exposure 
between 1999 and 2007, it was a huge rise.
    Mr. Kohn. Right.
    Senator Warner. And it basically, as Senator Corker pointed 
out, did something that the rest of the market would have 
viewed as kind of crazy, on these credit default swaps where 
they would, in effect, sell this quasi-insurance product and 
not even have the good sense to hedge on the downside the risk.
    Mr. Kohn. Right.
    Senator Warner. So I guess where our frustration is, at 
least my frustration comes in two parts. One is that all of the 
counterparties that took advantage of this high-flying entity, 
in effect buying or renting their AAA rating to take their 
perhaps equally bad or worse products to elevate how those 
products would be viewed. Now these counterparties, who have 
done pretty well, one, not only do we not know who those 
counterparties are and how we, the Federal Government and the 
taxpayers, are bailing them out, but two, I believe you are 
also saying that these counterparties are being paid in full. 
Did they not have some obligation to do some level of due 
diligence themselves?
    So would it not be fair--now, I understand at that moment 
of crisis in September when you had to act. We could agree or 
disagree. But even if we grant you that you had to act at that 
point, AIG still racked up subsequent to that, wasn't it north 
of $64 billion in losses? So why are we continuing in honoring 
these obligations at close to par, or as you say, market price, 
but it is not really market price because these counterparties 
are already able to keep whatever collateral has been issued to 
    Mr. Kohn. That is correct.
    Senator Warner. So they are getting a better deal. Why has 
there not been a more focused effort on making sure that some 
of these counterparties--you are not even going to tell us who 
they are--at least take a haircut?
    Mr. Kohn. I share your frustration and the frustration of 
everybody else on this Committee. This has been a most 
unpleasant and difficult situation, to be dealing with this 
company that, as you say, people knew was kind of a high-flyer, 
was taking some risks. They still had until very shortly before 
their fell their AAA rating, which they were exploiting for 
    I wish with every fiber in my body that we didn't have to 
come in and do what we did. Our judgment was that if we had 
inflicted losses on counterparties, not only on September 16 
but subsequently, that it would undermine confidence not only 
in AIG, but in other critical U.S. financial institutions. So 
we have----
    Senator Warner. So the vast majority of these 
counterparties are U.S., not foreign?
    Mr. Kohn. I wasn't worried so much about the 
counterparties. I am worried more about other U.S. institutions 
operating in the financial market. So we are in the middle of a 
very severe crisis with confidence in a lot of important U.S. 
institutions eroded significantly, as reflected in the equity 
markets and elsewhere.
    And our concern was that if we imposed losses on the 
counterparts for AIG, not so much worried about those 
particular counterparties. I actually don't know what the list 
is, but my guess is many of them can handle it themselves. I am 
worried about the knock-on effects in the financial markets. So 
now would other people be willing to do business with other 
U.S. financial institutions? Forget AIG. Forget the 
counterparties. Think about the systemic risk here if they 
thought that in a crisis like this, they might have to take 
some losses.
    There is a huge moral hazard here. We have made those 
credit counterparties whole in ways that will reduce their 
incentive to be careful in the future----
    Senator Warner. So we have, sir, if I can just--what I 
think you are saying is we, the American taxpayer, have taken a 
high-flying company that was doing what most of us would 
believe in a normal market circumstance was high risk---
    Mr. Kohn. Right.
    Senator Warner. ----counterparties that should have 
recognized that high risk of what they were buying, this 
insurance product they were buying----
    Mr. Kohn. They were relying on----
    Senator Warner. and we have to step up and make those 
counterparties whole because--the counterparties again that you 
won't share who they are--we have to make them whole because, 
again, the kind of amorphous need that there might be lack of 
confidence going forward. And there is no sense, and I think 
you are hearing great concern from this Committee and I can 
assure you there is going to be even more from non-committee 
members, that if there are additional counterparty obligations 
out there that maybe a little tighter and tougher negotiation 
with those going forward rather than paying out at par or close 
to par, I really would hope you would also not only consider 
sharing that information, but reconsider some of your 
negotiating strategy.
    Mr. Kohn. I think I will do that and certainly take this 
message back and the request for additional information, as 
Chairman Dodd said, back to the Federal Reserve Board and we 
will consider it.
    I think if you step back just a second, the real problem 
here is we have this systemically important institution that 
was allowed to get large. Mr. Polakoff admits that they weren't 
exercising really sufficient oversight over this institution. 
That cannot be allowed to repeat itself and we need to change 
our laws----
    Senator Warner. But I think what you are also saying--I 
know my time is up, I apologize, Mr. Chairman--but you are 
telling us, Congress, go fix this, and I believe there will 
clearly be under the Chairman and the Ranking Member's 
leadership a good fix prospectively, but until that time, you 
can't share with us how much more we are on the hook for this 
too-big-to-fail institution. You can't share with us who we are 
paying off. And you can't share with us that we are going to 
renegotiate at anything other than par for risky, what should 
have been at least viewed in the marketplace as risky bets made 
by these counterparties buying up AIG's AAA rating.
    Mr. Kohn. I think we need to do our best to realize the 
best returns, minimize any losses to the taxpayer, through any 
avenue we can do. I do think another issue that is highlighted 
by this whole situation is the lack of a resolution regime for 
anything but banks. So we have, for systemically important 
banks, through the FDIC, we have a way of resolving banks. We 
have an exception to the least-cost resolution for systemically 
important banks. Another thing on the to-do list for the 
administration, the Federal Reserve, and the Congress is a 
regime where whoever is designated--it doesn't matter who--
could come in and figure out how to stabilize the system, 
impose some losses on some of the creditors. That regime, those 
authorities don't exist right now without----
    Senator Warner. And my last--my time is up, but if in just 
maybe a straight yes or no on whether I am hearing you 
correctly. What we must do prospectively in terms of fixing 
that, I fully understand. But until that time, and with the 
case of AIG, we have no option other than what appears to be a 
bottomless pit with no knowledge of who we are helping out and 
that we are going to continue to pay off 100 cents on the 
    Mr. Kohn. I will re-raise all those issues back at the 
Federal Reserve and with the Treasury. I think we are working 
very, very hard to limit any losses to the taxpayers. That is 
how we and why we did the restructuring we did, in order to 
facilitate the sale, the shrinkage of this organization----
    Senator Warner. Obviously, I think some on the Committee 
question that----
    Mr. Kohn. I understand.
    Senator Warner. I wanted to come back at some point, Mr. 
Chairman, and ask, 79 percent, and we have just put in 
additional funds, why aren't we actually bumping up much higher 
than that 79 percent, but thank you.
    Chairman Dodd. And again, looking at the statement by Mr. 
Dinallo, and they argue this, we all accept, I think you have 
heard it said, the primary source of the problem was the FP, 
AIG's Financial Products, which had written credit default 
swaps, derivatives, and futures with a notional amount of about 
$2.7 trillion, including $440 billion of credit default swaps. 
That is equal to the gross national product of France. And the 
question is, are we going to pay par for that and for all of 
this. In the absence of some response, that is a staggering 
    Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    It has been mentioned in several cases that holes in the 
regulatory system were exploited, leading us to the situation 
we are in now. I had an interesting conversation the other day 
with a senior member of the New York Stock Exchange. I was 
asking the question why these are called swaps rather than 
credit default insurance, and his response was very simple. The 
term ``swap'' was used because if the term ``insurance'' was 
used, the New York Insurance Agency would be engaged and would 
have exercised some regulatory oversight.
    I am not sure this point has really been addressed and I 
just want to ask the question, had they called these things, 
these insurance contracts insurance, would they have been 
regulated by your agency, Mr. Dinallo?
    Mr. Dinallo. Yes. There has been discussion about whether 
you could have categorized credit default swaps as insurance. I 
have always felt that there is a view that when you have a 
covered, as opposed to the naked variety the Senator described, 
you have arguably an insurance product. But the CFMA made it 
clear that they wanted these to be essentially exempted, and 
the only question that we were ever asked was about a naked 
credit default swap, which clearly is a form of speculation. 
You could even call it gambling, by the way, because there were 
laws that prohibited that kind of activity, that speculation on 
securities without actually owning the security, which is 
essentially what a naked credit default swap is. Those were 
preempted by the CFMA. They were called the Bucket Shop laws of 
the various States.
    So yes, there is--you could, and I think that there has 
been discussion. But then what happens to them is that they 
become very expensive to use as a hedging instrument because 
you have to capitalize them like an insurance product. 
Therefore, the belief was from, I think, the Federal regulators 
and the CFMA that they would be too expensive to use as a 
hedging instrument if they were regulated as insurance 
    Senator Merkley. Were there folks within your agency who 
asserted that the agency should, in fact, exercise some 
regulation of----
    Mr. Dinallo. Well, I was not----
    Senator Merkley. ----insurance compacts?
    Mr. Dinallo. I was not there in 2000. I don't think any 
insurance regulator was--I don't think our opinions were 
solicited when the CFMA was passed, frankly. I don't think 
anyone thought about the possibility that this was essentially 
the kind of insurance that financial guaranty firms write. But 
it had been moved over to an entirely unregulated area on 
Congressional decision.
    Senator Merkley. Does anyone else want to comment on this 
    Mr. Polakoff. Senator, I believe the Chair of the CFTC 
brought forward to Congress a number of years ago the idea and 
the recommendation to indeed regulate credit default swaps. 
These instruments need to be regulated. They are too 
individualized. There is not a central clearing. There is not a 
secondary market. I think that most regulators, whether Federal 
or State, would say that credit default swaps need to be 
regulated as a product.
    Senator Merkley. I will say it is kind of a sad commentary 
on our regulatory system if all it takes is changing the name 
from insurance to swap in order to bypass regulation.
    One of the things I am concerned about is the role that 
these insurance contracts had in essentially putting lipstick 
on a pig. That is, CDOs and CDO-Squared that were then insured, 
and by insuring them you were able to say to pension funds and 
other financial entities that were buying these contracts, or 
buying these products, that, look, don't worry, they are 
insured. And yet the insurance was unregulated. That sounds 
like a house of cards. I am speaking really in kind of simple 
terms here to try to characterize this.
    Is that kind of a fair way to portray it, that we had in 
some cases CDO-Squared that had 100 pieces of bonds offering 
from the lower tranches and then each of those might hold 
other, in some cases, 20,000, 25,000 pieces of low-quality 
bonds piled together, but then you put this insurance on them 
and say to investors, look, these are safe. Did this play a 
major role in creating this house of cards?
    Mr. Polakoff. Senator, I do not believe so. These CDOs 
absolutely were complex, but the credit default swap portion 
was written on the super-senior AAA-plus tranche of it. And 
these ratings were assigned to these super-senior tranches 
before the credit default swaps were written.
    Mr. Dinallo. Senator, I have testified before the Senate 
and in Congress on credit default swaps specifically, and I 
have called them the ``great enablers'' of this financial 
catastrophe, because many people thought that they had 
essentially an insurance policy when, in fact, they did not 
have near the solvency behind it. There are two ways that you 
could write--essentially, there are some companies that engage 
in bond insurance. They do financially guarantee default on the 
bonds, and there are certain solvency requirements that go 
there. AIG in a sense, by writing credit default swaps, was 
guaranteeing the default on these CDOs. And I believe that to 
the extent you and Senator Warner are correct, they were 
essentially loaning their AAA over, that happened. And the 
question is: Well, why did anyone let this happen? Because I 
think what was going on was there was an assumption that the 
AAA came from an ability to reach into that $1 trillion balance 
sheet you heard about to be able to pay for any liquidity 
problems. But the money was in these regulated entities that, 
of course, thankfully just do not let the capital flow out 
because that is policy holder premium.
    So I think actually the world kind of understood in a way 
that was never very clear that when the operating companies are 
actually depository institutions or insurance companies, you do 
not really have access to it for liquidity the way you would in 
a normal widget-producing company.
    Senator Merkley. Mr. Dinallo, can you repeat that phrase, 
``great enabler''?
    Mr. Dinallo. Yes. I think that when you look at what 
happened historically, I think you see the worst form of moral 
hazard and the lack of any kind of retention of exposure in the 
underwriting process, which would be kind of a short story for 
the mortgage meltdown. But at the end, when people finally 
bought those securitized instruments, they went into the 
marketplace and thought that they were essentially safe because 
they had credit default insurance on those----
    Senator Merkley. I just wanted to make sure I captured your 
comment correctly, that the credit default swaps were the great 
enabler of the major financial meltdown we are experiencing.
    Mr. Dinallo. Absolutely, because every asset manager who 
was holding those CDOs essentially turned to his risk manager 
and said, ``I have insurance on these. I have the downside 
covered.'' But there was not near the capital behind them.
    Senator Merkley. So just to follow up on this, Mr. 
Polakoff, I think you disagree with that point of view.
    Mr. Polakoff. Yes, sir. I would once again offer that there 
were no realized credit losses on the CDOs, at least as of 
September 30 of 2008. These were AAA-rated, super-senior 
tranches, and while the market value may have moved, the 
underlying value from cash stream of the borrowers remained 
    Mr. Dinallo. We do not disagree----
    Senator Merkley. If I could ask one more----
    Mr. Dinallo. Senator, I just want to point out, we actually 
do not disagree. I do not disagree with that. There have been 
no realized losses, but in order to keep those positions, you 
needed a certain amount of capital or liquidity, which they 
simply did not have at the holding company or in FP. That is 
the only distinction.
    Senator Merkley. So several people have spoken to the role 
of the AAA rating as being borrowed or used, if you will. We 
have an inherent conflict of interest in which rating agencies 
are paid by the firms that they are rating. We are all trying 
to learn lessons from this on how we are going to go forward 
and do this far, far better to restore a financial system with 
    How are we going to resolve this issue of the inherent 
conflict of interest in the rating agencies and the use of AAA 
ratings in apparently inappropriate circumstances?
    Mr. Dinallo. Well, this week I had an op-ed published in 
the Wall Street Journal about our proposal to create a buy-side 
rating agency so that the interests are aligned between the 
purchasers of the securities or the bonds and the rating 
    Right now you have this inherent conflict because 
essentially the issuers of the products pay for the ratings. 
And our proposal is that the insurance industry is large enough 
and a big enough user, as are the regulators, of both the 
ratings and municipal bonds and other structured instruments--
in fact, I think it is about $3 trillion--that a very modest 
amount paid by the insurance industry could fund such a rating 
agency, and the problem of free riding would be taken away 
because the regulators would essentially require it and require 
it as part of the capital calculation of the insurance 
company's assets.
    And then you could expand that to all financial services. 
You could essentially have all financial services paying in a 
very modest amount to fund buy-side ratings and make it 
required by the regulator, used by the regulator, so you take 
out the free-riding problem.
    Senator Merkley. Do you all share that strategy, Mr. Kohn 
and Mr. Polakoff?
    Mr. Kohn. I think it is a strategy worth pursuing. The SEC 
has proposed a series of changes in the regulation of the 
credit rating agencies to make them more transparent, to have 
them publish the history of what they have rated so people can 
judge, to make it so that if somebody starts shopping around 
from credit rating agency to credit rating agency, they have to 
publish that amount.
    So I think meanwhile there is a lot we can do to make the 
credit rating agencies better.
    Senator Merkley. Thank you.
    Chairman Dodd. Thank you, Senator.
    Senator Bennet.
    Senator Bennet. Thank you, Mr. Chairman. I know we are 
short on time, and I will have some questions I will submit in 
writing. But I think as I sit through these hearings, Mr. 
Chairman, what is so frustrating is that you get a very strong 
sense that there was nothing inevitable about any of this 
stuff; that people understood in the case of AIG and the market 
how reckless their behavior was; that somehow we did not 
realize this, I think, in sufficient detail so that, come 
September, we spent 2 days trying to get the market or somebody 
in the private sector to figure out how to fix this. They 
cannot. We make a decision that to the American--it may have 
been the right decision. I am not saying that it is not. But 
the American public saw it as a very hasty decision. I think 
they still do not understand it. I think commitments were made 
that they do not feel are being honored. And that is the 
difficulty that you are facing here and the frustration that 
you are hearing here.
    To think that these guys, even the reckless people that 
were writing these credit default swaps, finally in 2005 said, 
you know what, maybe we should stop writing this stuff because 
our model is starting to show that there may be a deterioration 
in the housing market, and we have no capacity, the regulators 
seemed to not have a capacity to detect that they are going 
to--that they have stopped writing the paper themselves--and I 
will make that into a question--just is terribly worrisome. 
Because I do not think this really is, you know, Monday morning 
quarterbacking, because what we are trying to figure out is how 
to do the regulation a way that makes sense. If we are not 
going to figure it out prospectively, there is no point in 
having regulators at all.
    So I guess one question I would ask here--and I have got 
another one, so I do not want to take too much time with it. Is 
there a way to detect when people are doing things like 
stopping writing a bunch of credit default swaps which ought to 
set off alarm bells about what is happening in the market?
    Mr. Kohn. I think there are ways of trying to do that. One 
can look at the spreads, look at the activity, see that unusual 
things are going on. Think of the leverage in the U.S. 
financial system that was growing exponentially.
    Senator Bennet. Another great example.
    Mr. Kohn. The maturity mismatches that were going on. So I 
think there are a variety of early warning signs that we should 
have perhaps looked at a little harder, that there perhaps 
should have been a systemic risk regulator, as some of the 
Senators have talked about, who had the authority and 
opportunity to call out the problem, take some actions to do 
    But I also think that there is never going to be a fail-
safe system.
    Senator Bennet. And I agree with that. I think that one 
would have hoped--it obviously did not happen in this case 
maybe until it was too late--that the boards of directors of 
these companies would have exercised the fiduciary duty on 
behalf of everybody and said, you know what, we are getting 30 
times the leverage, maybe that is too much, 25 times the 
leverage, maybe that is too much. But I for one--and I am sure 
other people up here--will be interested to know how the 
regulator can create its own set of stoplights to be able to 
say, you know, we feel like we are moving directionally in the 
wrong place--or maybe in the right place--prospectively, so 
that our only answer to the American people is not, Sorry, we 
missed this and now we have to respond in a way that may or may 
not work, where we could maybe not predict, for example, what 
the underlying assets are worth here. So I for one look forward 
to working with you on that.
    Let me go to a second question here before my time is 
expired. Mr. Kohn, this is for you. I was not here in 
September, but I gather there was testimony in September from 
the Fed that the credit facility would result in no loss, no 
net loss to the taxpayer. And I am wondering whether there is a 
change in the testimony today when what I think you are saying 
is that we are trying to mitigate whatever loss there may be. 
Is that a shift in the position of the Fed? Or are we still 
telling the taxpayers there is not going to be any net loss 
after all this is----
    Mr. Kohn. I think the credit facility per se, the credit 
that the Federal Reserve has given, is fully securitized, and 
we do not expect a net loss from that.
    I think the open question is how much of the equity that 
the Treasury has put in, part of which went to pay off the 
Federal Reserve in November, will come back to the taxpayers.
    Senator Bennet. So the Fed may be OK, but the Treasury may 
    Mr. Kohn. Well, and the way to look at it--you are 
absolutely right, Senator--is for the taxpayers as a whole. And 
I think that depends on how this company is handled from here 
on out. That is what I mean when I say we are trying to do our 
best to make it so that any losses to the taxpayer are 
minimized. That along with financial stability of the system 
and jobs for Americans are the motivators behind our actions 
    Senator Bennet. The last thing, Mr. Chairman--and I will 
submit it in writing with my other colleagues--I really am 
interested in hearing some testimony at some point on how these 
workouts are actually happening. In other words, who really is 
figuring out what residual value there is in these operating 
units in AIG but, for that matter, some of the other things we 
may be looking at. Whose eyes are getting cast on that both in 
the Government and in the private sector to be able to assure 
that when the time comes, the taxpayers really are getting the 
best return we can get on these sales?
    I will not wait for an answer on that, but I will say I am 
very interested in it. Mr. Chairman, thank you very much for--
    Chairman Dodd. Well, thank you very much. We have got a 
vote that has come on. I know Senator Corker has additional 
questions he would like to ask. We will try to figure out how 
to do this. It will not go on much longer.
    I had one quick question, and then I will turn to Senator 
Corker and see if we cannot get both of them in here before we 
wrap up and submit questions.
    Vice Chairman Kohn, the Fed is under the authority legally, 
as I understand it, to only provide resources to creditworthy 
companies. Is that traditionally true? Am I missing some point 
before I----
    Mr. Kohn. We lend on a secured basis.
    Chairman Dodd. To creditworthy companies?
    Mr. Kohn. Generally to creditworthy companies. We have, I 
would say, pushed the boundaries in dealing with this crisis.
    Chairman Dodd. Well, that is the question I was going to 
ask, because if we are an 80-percent shareholder, in effect, of 
AIG, and you have got to securitize the additional loans, I am 
just mystified as to how we could do that. I understand if 
their numbers were lower somehow, but it seems to me that it is 
awfully difficult to achieve that result. How do you believe 
these loans that have been made by the Fed during the fourth 
quarter of 2008 were adequately secured given that AIG was 
losing about $450,000 a minute?
    Mr. Kohn. I think there are more than enough assets, even 
at these distressed market values, to repay the Federal 
Reserve's loans. We have tried to structure them that way. 
Senator Shelby does not believe me. As I answered Senator 
Bennet, we have several outside advisers looking at this. We 
have outside advisers managing Maiden Lanes II and III that 
have these CDOs. We have outside advisers advising us on the 
restructuring, and the company itself has several sets of 
outside advisers. There are many, many pairs of eyes on this, 
and our outside advisers believe that we will be repaid out of 
the assets of AIG and the assets of Maiden Lane I and Maiden 
Lane II. This is not just an assertion that we are making.
    But I also recognize that how much of the $40 billion that 
the Treasury has advanced and potentially another $30 billion, 
how much that return to the taxpayers will depend critically on 
how this company winds itself down.
    Chairman Dodd. Well, I would like to pursue that, maybe in 
a written question, but trying to get this completed here 
before we go. A quick question from Senator Shelby, then 
Senator Corker.
    Senator Shelby. I will be fast. Governor Kohn, are you 
telling us and the American people that you believe that the 
Government, the taxpayers is going to recoup their money they 
have invested or they have loaned or given or whatever to AIG, 
billions and billions of dollars? Are you saying that money is 
    Mr. Kohn. We are working very hard to make it safe, 
    Senator Shelby. Well, I hope you are right, but I believe 
you are totally wrong.
    Thank you.
    Chairman Dodd. Senator Corker.
    Senator Corker. Thank you. I just want to get back to the 
systemic risk issue, and I know that you mentioned that you did 
not have some facilities in place in September. I do want just 
for the record--you all have taken numbers of actions since 
that time that were not made in haste and continue down the 
same path.
    Mr. Kohn. That is right, but one of the distinguishing 
characteristics of the actions since that time is bringing in 
the TARP money.
    Senator Corker. Right. And I was in the country of Ukraine 
when that happened and got the call. The fact was that TARP 
money never was ever supposed to be used for something that was 
not buying something of value. So that was a huge departure, a 
huge departure, but I know that is out of your bailiwick. That 
is in the Treasury's area.
    I still do not understand what the systemic risk would have 
been if you all would have said that on an actual call on the 
CDS will make it good. I do not understand what systemic risk 
possibly could have been in place there.
    Mr. Kohn. First of all, as I understand it, there is no 
legal mechanism to impose losses outside of bankruptcy, and 
bankruptcy, we believe, would have been a major systemic event 
for the U.S. financial system.
    Senator Corker. Even though you could have said Chapter 11 
will stand behind any real----
    Mr. Kohn. There are literally millions of counterparties to 
AIG. AIG is a global company. I think we experienced some 
things over with the Lehman Brothers bankruptcy that suggested 
that it would have been a disorderly thing. I think it would--I 
    Senator Corker. How much of your actions, then--because we 
keep coming back to the fact that there is no entity, there is 
no way to actually deal with an entity--how much of your 
actions have been because of the fact that there is no Federal 
entity to actually orderly unwind an organization like this?
    Mr. Kohn. I think particularly early on, that was a major 
part of our actions, but let me be clear again. Our actions 
were not aimed at AIG and its counterparties. Our actions were 
aimed at the U.S. financial system and the knock-on effects of 
imposing losses on counterparties. Would those counterparties 
or others be willing to do business with other U.S.--
systemically important U.S. institutions that might someday end 
up in the Government's hands? I think it would have accelerated 
what was a very, very bad situation, caused more of a 
withdrawal from taking risk, a shift of business toward a very 
few financial institutions that were clearly going to survive 
the maelstrom.
    Senator Corker. We have ended up buying stock, and instead 
of having our money be backing up this collateral that went to 
these counterparties that really have made out like bandits, 
and I can see why--they really have made out like bandits in 
this particular atmosphere.
    Mr. Kohn. They have realized the value that they would 
realize over time if AIG was a surviving firm.
    Senator Corker. Which they are not, and so I would guess 
that these CDOs were selling, let us say 6 months leading up to 
this, at a great discount then. So they have actually made out 
like bandits twice. OK? They have gotten--because of our 
involvement, the face value of these has risen to probably 100 
cents on the dollar, and this crazy collateral that we have had 
to put up, which was part of the contract, has been there, too. 
But the fact is our Federal investment has now been made in 
stock, OK?
    It seems to me that that is another step that we have made 
that has greatly put taxpayer monies at risk, and I just wonder 
why we would have done that.
    Mr. Kohn. We thought we needed to do that to stabilize the 
company; to prevent a flight of creditors from the company, 
they needed some protection underneath them in the capital 
structure. And if we had not provided the protection in the 
capital structure to creditors, they would not have advanced 
credit to AIG, AIG would have had a disorderly failure, and 
there would have been severe consequences. The U.S. Government 
is on record saying that it will not countenance, it will not 
allow a disorderly failure of a systemically important 
institution. I think that is absolutely critical at this time.
    Chairman Dodd. Well, listen, this could be a week-long 
hearing rather than a few hours.
    Mr. Kohn. It could be. It feels like a week, Mr. Chairman, 
but it has only been 2 hours.
    Chairman Dodd. I am sure. We will have you back here 
because, obviously, the question is what we do as we learn 
about what happened, but clearly what steps we need to take to 
see to it, and we did not get to as many questions as I wanted 
to raise with OTS because obviously here, by your own 
admission, this was a major gap in all of this. So there will 
be additional written questions, I am sure. We will be back at 
this issue again as we look forward to writing the 
modernization of regulations here that Senator Shelby and I 
will be deeply involved in.
    We thank you for being here today, but a very troubling 
hearing, I must say. Very troubling hearing in terms of where 
we are, and some steps need to be taken, maybe more quickly, in 
light of the fact we are looking at the potential exposure 
here. And if we are going to be paying at par, these numbers 
here, they are just not sustainable under any set of 
circumstances. And so we need some corrections, whether it 
takes legislation to do it or by regulation or by the existing 
powers you have, but the current course of action is 
unsustainable and must change. And so we need to hear from the 
Fed very quickly whether or not you need our authority to 
change; and if you do not, what are the steps you intend to 
take, because the present path here is just unacceptable.
    I do not think those are my own views. I think these are 
views probably shared by all of us. So we need a very quick 
response from the Fed on this.
    The Committee would stand adjourned.
    [Whereupon, at 12:24 p.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follow:]
    Thank you, Mr. Chairman.
    The collapse of the American International Group is the greatest 
corporate failure in American history. Once a premiere global insurance 
and financial services company with more than one trillion dollars in 
assets, AIG lost nearly $100 billion last year. Over the past 5 months 
it has been the recipient of four bailouts. To date, the Federal 
Government has committed to provide approximately $170 billion in loans 
and equity to AIG. Given the taxpayer dollars at stake and impact on 
our financial system, this Committee has an obligation to throughly 
examine the reasons for AIG's collapse and how Federal regulators have 
    I also hope that today's hearing will shed new light on the origins 
of our financial crisis, as well as inform our upcoming discussions on 
financial regulatory reform. In reviewing our witnesses' testimony and 
AIG's public filings, it appears that the origins of AIG's demise were 
two-fold. First, as has been widely reported, AIG suffered huge losses 
on credit default swaps written by its Financial Products subsidiary on 
collateralized debt obligations.
    AIG's problems, however, were not isolated to its credit default 
swap business. Significant losses at AIG's State-regulated life 
insurance companies also contributed to the company's collapse. 
Approximately a dozen of AIG's life insurance subsidiaries operated a 
securities lending program, whereby they loaned out securities in 
exchange for cash collateral. Typically, an insurance company or bank 
will lend securities and reinvest the cash collateral in very safe, 
short-term instruments. AIG's insurance companies, however, invested 
their collateral in riskier long-term mortgage-backed securities. 
Although they were highly rated securities, approximately half of them 
were backed by subprime and alt-a mortgage loans.
    When the prices for mortgage-backed securities declined sharply 
last year, the value of AIG's collateral plummeted. The company was 
rapidly becoming unable to meet the demands of borrowers returning 
securities to AIG. By September, it became clear that AIG's life 
insurance companies would not be able to repay collateral to their 
borrowers. Market participants quickly discovered these problems and 
rushed to return borrowed securities and get back their collateral.
    Because AIG was unable to cover its obligations to both its 
securities lending and derivatives operations, it ultimately had to 
seek Federal assistance. In total, AIG's life insurance companies 
suffered approximately $21 billion in losses related to securities 
lending in 2008. More than $20 billion dollars in Federal assistance 
has been used to recapitalize the State-regulated insurance companies 
to ensure that they are able to pay their policyholders' claims. In 
addition, the Federal Reserve had to establish a special facility to 
help unwind AIG's securities lending program. I am submitting for the 
record a document from AIG that shows the losses from securities 
lending suffered by each AIG subsidiary that participated in AIG's 
securities lending program and the impact those losses had on its 
statutory capital. (See Exhibit A, below.)
    The causes of AIG's collapse raise profound questions about the 
adequacy of our existing State and Federal financial regulatory 
regimes. With respect to AIG's derivatives operations, the Office of 
Thrift Supervision was AIG's holding company regulator. It appears, 
however, that the OTS was not adequately aware of the risks presented 
by the company's credit default swap positions. Since AIG's Financial 
Products subsidiary had operations in London and Hong Kong, as well as 
in the U.S., it is unclear whether the OTS even had the authority to 
oversee all of AIG's operations. It is also unclear whether OTS had the 
expertise necessary to properly supervise what was primarily an 
insurance company.
    According to the National Association of Insurance Commissioners, a 
life insurance company may participate in securities lending only after 
it obtains the approval of its State insurance regulator. If so, why 
did State insurance regulators allow AIG to invest such a high 
percentage of the collateral from its securities lending program in 
longer-term mortgage-backed securities? Also, how did insurance 
regulators coordinate their oversight of AIG's securities lending since 
it involved life insurers regulated by at least five different States?
    While I hope we can get answers to these and many other questions 
today, I believe we are just beginning to scratch the surface of what 
is an incredibly complex and, on many levels, a very disturbing story 
of malfeasance, incompetence, and greed.
    Thank you, Mr. Chairman.
    Thank you, Mr. Chairman and Ranking Member Shelby for holding this 
hearing today. I was concerned last fall when the American 
International Group, a non-federally regulated insurance company, 
received an $85 billion bailout from the Federal Reserve. Now, we have 
seen four bailouts in 6 months totaling $160 billion dollars. This is a 
breathtaking amount of taxpayer money, and AIG's announcement this week 
of the largest corporate quarterly loss for any company ever is even 
more stunning. I hope we will find out more from today's witnesses 
about how we got to this point.
    Americans are angry about taxpayer money going to financial 
institutions and other companies like AIG, with what appears to be 
little improvement in our economic situation. This anger is warranted--
the largest bailout to date has gone to a business run in such an 
irresponsible manner, not only in the risks it took with its products, 
but the actions of its CEOs after it received taxpayer money, that if 
it were a Main Street small business it would have been forced to close 
its doors long ago.
    I hope to hear from the witnesses about the steps the Government 
has taken to keep AIG afloat, particularly the newest actions announced 
earlier this week. I do not think it would be an exaggeration to say 
that the ``bailout'' of AIG remains the least transparent of all the 
bailouts we have witnessed in the past 6 months.
    I also look forward to working with my colleagues on this Committee 
on regulatory modernization and ask that insurance regulation is not 
left out of our efforts. For many years I have advocated for a 
modernized system of Federal insurance regulation; I am even more 
convinced after the past 6 months that our current, outdated, State-by-
State regulatory system is ill-equipped to deal with a 21st century 
insurance company. We cannot afford another situation like AIG and we 
must ensure that our regulators can assess the risks across all 
financial services including insurance.
                             Vice Chairman,
            Board of Governors of the Federal Reserve System
                             March 5, 2009
    Chairman Dodd, Ranking Member Shelby, and other Members of the 
Committee, I appreciate having this opportunity to discuss the role of 
the Federal Reserve in stabilizing American International Group, Inc. 
(AIG). In my testimony, I will detail the support the Federal Reserve, 
working alongside the Treasury, has given AIG and the reasons for each 
of our actions. Before I go into the extended narrative, however, I 
think it would be useful to briefly put our decisions in their broader 
    Over the past year and a half, we have all been dealing with the 
ongoing disruptions and pressures engendered by an extraordinary 
financial crisis. The weaknesses at financial institutions and 
resulting constraints on credit, declines in asset prices, and erosion 
of household and business confidence have in turn led to a sharp 
weakening in the economy. The Federal Reserve has employed all the 
tools at its disposal to break this spiral and help address the many 
challenges of the crisis and its effects on the economy. One of the 
most important of these tools is the Federal Reserve's authority under 
section 13(3) of the Federal Reserve Act to lend on a secured basis 
under ``unusual and exigent'' circumstances to companies that are not 
depository institutions. Since last fall, in order to foster the 
stability of the financial system and mitigate the effects of ongoing 
financial stresses on the economy, we have used that authority to help 
to stabilize the financial condition of AIG.
    AIG is a widely diversified financial services company that, as of 
September 30, 2008, which is the reporting date closest to the date we 
first provided it assistance, reported consolidated total assets of 
more than $1 trillion. AIG was at that time, and continues to be, one 
of the largest insurance companies in the world and, in terms of net 
premiums underwritten, is both the largest life and health insurer in 
the United States and the second largest property and casualty insurer 
in the United States. It conducts insurance and finance operations in 
more than 130 countries and jurisdictions and has more than 74 million 
individual and corporate customers and 116,000 employees globally. In 
the United States, it has approximately 30 million customers and 50,000 
employees. AIG is the leading commercial insurer in the United States, 
providing insurance to approximately 180,000 small businesses and other 
corporate entities, which employ approximately 106 million people in 
the United States. It is also a major provider of protection to 
municipalities, pension funds, and other public and private entities 
through guaranteed investment contracts and products that protect 
participants in 401(k) retirement plans.
    AIG has also been a major participant in many derivatives markets 
through its Financial Products business unit (Financial Products). 
Financial Products is an unregulated entity that exploited a gap in the 
supervisory framework for insurance companies and was able to take on 
substantial risk using the credit rating that AIG received as a 
consequence of its strong regulated insurance subsidiaries. Financial 
Products became the counterparty on hundreds of over-the-counter 
derivatives to a broad range of customers, including many major 
national and international financial institutions, U.S. pension plans, 
stable value funds, and municipalities. Financial Products also 
provided credit protection through credit default swaps it has written 
on billions of dollars of multi-sector collateralized debt obligations 
(CDOs). Financial Products did not adequately protect itself against 
the effects of a declining economy or the loss of the highest ratings 
from the credit rating agencies, and thereby was a source of weakness 
to AIG. While Financial Products has been winding down and exiting many 
of its trades, it continues to have a very large notional amount of 
derivatives contracts outstanding with numerous counterparties.
    It is against this background that the Federal Reserve and the 
Treasury Department have taken a series of unusual actions to stabilize 
the company. These have entailed very difficult and uncomfortable 
decisions for a central bank. These decisions were particularly 
difficult and discomforting because they involved addressing systemic 
problems created largely by poor decision-making by the company itself. 
Moreover, many of these decisions involved an unregulated business 
entity that exploited the strength, and threatened the viability, of 
affiliates that were large, regulated entities in good standing. 
However, uncomfortable as this was, we believe we had no choice if we 
are to pursue our responsibility for protecting financial stability.
    Our judgment has been and continues to be that, in this time of 
severe market and economic stress, the failure of AIG would impose 
unnecessary and burdensome losses on many individuals, households, and 
businesses; disrupt financial markets; and greatly increase fear and 
uncertainty about the viability of our financial institutions. Thus, 
such a failure would deepen and extend market disruptions and asset 
price declines, further constrict the flow of credit to households and 
businesses in the United States and in many of our trading partners, 
and materially worsen the recession our economy is enduring. To 
mitigate these risks, the Treasury provided equity capital to AIG and 
the Federal Reserve provided liquidity support backed by the assets of 
    The Federal Reserve's involvement in AIG began in mid-September of 
2008. AIG's financial condition had been deteriorating for some time. 
The financial and credit markets were experiencing severe stress due to 
various economic problems arising out of the broad-based decline in 
home prices, rise in delinquencies and foreclosures, and substantial 
drop in values of mortgages as well as mortgage-backed securities and 
other instruments based on such assets. In short-term funding markets, 
very high spreads between lending rates and the target Federal funds 
rate and very illiquid trading conditions in term money markets had 
come to prevail. AIG was exposed to these problems because of the 
protection Financial Products had written on mortgage-related 
securities, because of investments AIG had made in mortgage-related 
securities in connection with its securities lending program, and 
because its counterparties had begun to withdraw funding. These 
pressures mounted through September. The private sector worked through 
the weekend of September 13-14 to find a way for private firms to 
address AIG's mounting liquidity strains. But that effort was 
unsuccessful in a deteriorating economic and financial environment in 
which firms were not willing to expose themselves to risks--a risk 
aversion that greatly increased following the collapse of Lehman 
Brothers on September 15.
    Under these circumstances, on September 16, 2008, acting with the 
full support of the Treasury, the Board authorized the Federal Reserve 
Bank of New York (New York Reserve Bank) pursuant to section 13(3) to 
lend up to $85 billion to AIG through a revolving credit facility 
(Revolving Credit Facility) in order to ease the liquidity strain on 
AIG. The liquidity pressures experienced by AIG during that time of 
fragile economic markets threatened its ability to continue to operate, 
and the prospect of AIG's disorderly failure posed considerable 
systemic risks in various ways as a consequence of its significant and 
wide-ranging operations. Such a failure would also have further 
undermined business and household confidence and contributed to higher 
borrowing costs, reduced wealth, and general additional weakening of 
the economy. Moreover, at the time the Board extended the Revolving 
Credit Facility, there was no Federal entity that could provide capital 
to AIG to help stabilize it. The Troubled Asset Relief Program (TARP) 
legislation was requested in part to fill that void and authorized by 
Congress on October 3, 2008.
    The Revolving Credit Facility was established with the purpose of 
assisting AIG in meeting its obligations when due and facilitating a 
restructuring whereby AIG would sell certain businesses in an orderly 
manner, with minimal disruption to the overall economy. AIG would repay 
the Revolving Credit Facility over a period of two years as it sold 
assets. Importantly, the Revolving Credit Facility was (and remains) 
secured by a pledge of a substantial portion of the company's assets, 
including AIG's ownership interests in its domestic and foreign 
insurance subsidiaries. As additional compensation for the Revolving 
Credit Facility, AIG agreed to issue to a trust for the benefit of the 
Treasury, preferred stock convertible into 79 percent of AIG's 
outstanding common stock. With these protections, the Board believed 
that the authorization of the Revolving Credit Facility would not 
result in any net cost to taxpayers.
    In connection with the extension of credit, AIG's CEO was replaced. 
In addition, the New York Reserve Bank established a team to review the 
financial condition of AIG, and monitor the implementation of AIG's 
plan to restructure itself and repay the Revolving Credit Facility. 
Furthermore, as an ongoing condition of the Revolving Credit Facility, 
the New York Reserve Bank staff established an on-site presence to 
monitor the company's use of cash flows and progress in pursuing its 
restructuring and divestiture plan. The Federal Reserve does not have 
statutory supervisory authority over AIG or its subsidiaries as we 
would over a bank holding company or State chartered bank that is a 
member of the Federal Reserve System. Rather, the rights of the Federal 
Reserve are those typical of a creditor and are governed by the credit 
agreement for the Revolving Credit Facility. Using these rights, the 
Federal Reserve works with management of AIG to develop and oversee the 
implementation of the company's business strategy, its strategy for 
restructuring, and its new compensation policies, monitors the 
financial condition of AIG, and must approve certain major decisions 
that might reduce its ability to repay its loan.
    The Federal Reserve has a team of about 15 staff members, led by 
senior officials, who conduct oversight of the company pursuant to the 
credit agreement. The team has frequent on site contact at the company 
to make sure the Federal Reserve is adequately informed on funding, 
cash flows, liquidity, earnings, asset valuation, and progress in 
pursuing restructuring and divestiture. Federal Reserve staff is also 
assisted by qualified advisers in its monitoring and coordinates with 
officials of the Treasury.
    We routinely make our views known on key issues, such as major 
incidents of corporate spending and executive compensation. For 
example, we pressed for the company to ensure that robust corporate 
governance surrounds all compensation actions and worked with AIG 
management on limits to executive compensation that restrict salary and 
bonuses for 2008 and 2009. The Treasury has also imposed standards 
governing executive compensation that are broader than the general 
restrictions under the TARP Capital Purchase Program. The Treasury has 
also required a comprehensive written policy on corporate expenses that 
may be materially amended only with the Treasury's prior consent.
    Following the establishment of the Revolving Credit Facility, AIG 
accessed its funds to meet various liquidity needs and by October 1, 
2008, the company had drawn down approximately $61 billion. In part 
these draws were used to settle transactions with counterparties 
returning securities they had borrowed from AIG entities under a 
securities lending program used by AIG insurance subsidiaries. The cash 
collateral received by AIG in these lending programs was used to 
purchase a portfolio of residential mortgage-backed securities (RMBS). 
As the value of RMBS declined, these transactions became a significant 
source of liquidity strain on AIG. When securities borrowing 
counterparties chose to terminate their securities borrowing 
transactions with AIG, AIG was unable to immediately dispose of the 
illiquid and price-depressed RMBS as a source of repayment to 
securities borrowers without realizing substantial losses. As a result, 
AIG had to supply cash from its own resources to repay the securities 
borrowing counterparties.
    To reduce these liquidity pressures, the Board approved an 
additional credit facility (the Secured Borrowing Facility) that 
permitted the New York Reserve Bank to lend to certain AIG domestic 
insurance subsidiaries up to $37.8 billion in order to allow them to 
return the cash collateral they received from their securities 
borrowing counterparties. The Secured Borrowing Facility was designed 
to provide the company additional time to arrange and complete the 
orderly sales of RMBS and other assets in a manner that would minimize 
losses to AIG and disruption to the financial markets. AIG borrowed 
approximately $20 billion under the Securities Borrowing Facility by 
November of 2008. State insurance authorities of AIG's regulated 
insurance subsidiaries participating in the securities lending program 
supported the Board's action.
    Additionally, toward the end of October, four AIG affiliates began 
participating in the Federal Reserve's Commercial Paper Funding 
Facility (CPFF) on the same terms and conditions as other participants. 
The CPFF is a generally available program that involves the purchase, 
through a special purpose vehicle with financing from the Federal 
Reserve, of 3-month unsecured and asset-backed commercial paper 
directly from eligible issuers. As of February 18, 2009, the AIG-
affiliated CPFF participants had borrowed approximately $14 billion in 
the aggregate from the facility.
    During the month of October, credit markets continued to be 
severely stressed and liquidity pressures on AIG did not abate even 
with access to government credit. The company was negatively affected 
by the decline in market value of many assets owned by AIG entities or 
to which AIG entities were exposed through derivatives. Losses on the 
RMBS portfolios in the securities borrowing program and credit default 
swap protection Financial Products had written on multi-sector CDOs 
together accounted for approximately $19 billion of the $24.5 billion 
in losses announced by the company for the third quarter of 2008. The 
losses experienced through the third quarter, and the consequent 
capital erosion placed in jeopardy the credit ratings of AIG. Had the 
credit ratings agencies downgraded AIG in November, AIG would have been 
required to find additional funds to meet collateral calls and 
termination events on the exposures held by Financial Products alone.
    The Board and Treasury therefore took a series of actions, 
announced on November 10, 2008, to mitigate the effect of third quarter 
losses and liquidity drains on AIG and its subsidiaries, and provide 
for a more stable capital structure. These actions were designed to 
facilitate AIG's execution of its divestiture plan in an orderly 
manner, and thereby protect the interests of the taxpayers, both by 
preserving financial stability and by giving AIG more time to repay the 
Federal Reserve and return the Treasury's investment.
    As part of the set of actions, Treasury invested $40 billion in 
newly issued Senior Preferred Stock of AIG under its recently granted 
TARP authority. In connection with that investment, the Federal Reserve 
modified the terms of the Revolving Credit Facility to be more 
sustainable: The maturity of loans extended under the facility was 
extended to 5 years (due 2013), the maximum amount available was 
reduced from $85 billion to $60 billion, and the interest rate and 
commitment fees were reduced. The facility remained secured by 
substantially all of AIG's assets, and the company continued to be 
required to apply proceeds of asset sales to permanently repay any 
outstanding balances under the facility.
    At the same time, the Board approved the establishment of an 
additional lending facility that would provide a permanent solution to 
the AIG securities lending program's losses and liquidity drains, thus 
eliminating the need for the Securities Borrowing Facility. Under the 
new facility, the New York Reserve Bank extended approximately $19.5 
billion in secured, non-recourse credit to a special purpose limited 
liability company in which AIG would hold a $1 billion first-loss 
position (Maiden Lane II). Maiden Lane II then purchased, at market 
prices, RMBS with a par value of $39.3 billion from certain AIG 
domestic insurance company subsidiaries. This facility allowed AIG to 
terminate its securities lending program and to repay fully all 
outstanding amounts under the Securities Borrowing Facility, which was 
then terminated.
    The Federal Reserve also took steps to help address the drain of 
liquidity on AIG arising from potential collateral calls associated 
with credit default swap contracts written by Financial Products on 
multi-sector CDOs. The New York Reserve Bank made a secured, non-
recourse loan in the amount of $24.3 billion to another special purpose 
limited liability company (Maiden Lane III). Maiden Lane III then 
purchased, at market prices, multi-sector collateralized debt 
obligations with a par value of approximately $62 billion from credit 
default swap counterparties of Financial Products in return for the 
agreement of the counterparties to terminate the credit default swaps. 
AIG provided $5 billion in equity to Maiden Lane III to absorb future 
losses on the CDOs held by Maiden Lane III.
    The Federal Reserve loans to Maiden Lane II and III have a term of 
6 years and are secured by the entire portfolio of each company. The 
Federal Reserve reports the amount of the loans to these facilities and 
the value of the supporting collateral regularly on its Web site. The 
investment manager to the New York Reserve Bank for these entities 
projects that, even under very stressed scenarios, the loans to Maiden 
Lane II and Maiden Lane III will be repaid over time with no loss to 
the taxpayer.
    On Monday, March 2, 2009, AIG announced a loss of approximately $62 
billion for the fourth quarter of 2008, ending a year in which AIG 
suffered approximately $99 billion in total net losses. As a 
consequence of increased economic weakness and market disruption, the 
insurance subsidiaries of AIG, like many other insurance companies, 
have recorded significant losses on investments in the fourth quarter 
of 2008. Commercial mortgage-backed securities and commercial mortgages 
have experienced especially severe impairment in market value, 
requiring a steep markdown on the companies' books, despite a lack of 
significant credit losses on these assets to date.
    The loss of value in the company's investment portfolios, which 
totaled approximately $18.6 billion pre-tax, was primarily attributable 
to the insurance subsidiaries' holdings. This loss was a substantial 
contributor to AIG's fourth quarter loss. The remainder of the fourth 
quarter loss was significantly associated with the mark to market of 
assets transferred to Maiden Lane II and Maiden Lane III during the 
middle of that quarter, losses due to accounting on securities lending 
transactions that occurred during the fourth quarter, impairment of 
deferred tax assets and goodwill, and other market valuation losses. At 
the same time, general economic weaknesses, along with a tendency of 
the public to pull away from a company that it viewed as having an 
uncertain future, hurt AIG's ability to generate new business during 
the last half of 2008 and caused a noticeable increase in policy 
    In addition, these extreme financial and economic conditions have 
greatly complicated the plans for divestiture of significant parts of 
the company in order to repay the U.S. Government for its previous 
support. Would-be buyers themselves are experiencing financial strains 
and lack access to financing that would make such purchases possible.
    To address these weaknesses, the Federal Reserve and Treasury, in 
consultation with management of AIG and outside advisers retained by 
the Federal Reserve, announced on March 2, 2009, a plan designed to 
provide longer-term stability to AIG while at the same time 
facilitating divestiture of its assets and maximizing likelihood of 
repayment to the U.S. Government. The plan involves restructuring the 
current obligations of AIG to the Federal Reserve and Treasury, 
additional capital contributions by Treasury, and continued access to 
Federal Reserve credit on a limited basis for ongoing liquidity needs 
of AIG.
    Under the plan, Treasury will create a new capital facility that 
would allow AIG to issue to the Treasury up to $30 billion over 5 years 
in new preferred shares under the TARP as liquidity and capital needs 
arise. This brings the total equity support of the Treasury to $70 
    Additionally, Treasury will restructure the $40 billion in 
preferred equity AIG issued to the Treasury in connection with the 
actions taken to aid the company in November. This restructuring, along 
with the injections of capital from the new preferred shares, will 
bolster AIG's capital position and reduce its leverage, bolstering 
confidence in the company.
    Under the plan, the Federal Reserve also has agreed to reduce and 
restructure AIG's outstanding debt under the Revolving Credit Facility. 
Capacity under the Revolving Credit Facility will be reduced from $60 
billion to $25 billion. The current outstanding debt of $39.5 billion 
will be restructured in several ways. First, up to about $26 billion 
will be satisfied by providing the Federal Reserve with preferred 
equity interests in AIG's two largest life insurance subsidiaries, 
American Life Insurance Company (ALICO) and American International 
Assurance Company (AIA). The actual amount will be a percentage of the 
fair market value of AIA and ALICO based on valuations acceptable to 
the Federal Reserve. This action would be a positive step toward 
preparing these two valuable AIG subsidiaries for sale to third parties 
or disposition through an initial public offering, the proceeds of 
which would return to the Federal Reserve through its preferred equity 
interest stake in these two companies.
    Another component of the debt restructuring involves the use of an 
insurance industry tool to monetize cash flows on a specified block of 
life insurance policies already in existence. Under the plan, the 
Federal Reserve would extend up to $8.5 billion in credit to special 
purpose vehicles (SPV) that would repay the obligation from the net 
cash flows of identified blocks of life insurance policies previously 
issued by certain AIG domestic life insurance subsidiaries. The total 
amount of principal and interest due to the Federal Reserve on this 
credit would represent a fixed percentage of the estimated net cash 
flow from the underlying policies that would flow to the borrowing 
SPVs. This ``buffer'' between the amount of the credit and the net cash 
flow would provide the Federal Reserve with security and provide 
reasonable assurance of repayment.
    Each of the decisions to provide assistance to AIG has been 
difficult and uncomfortable for us. However, the Federal Reserve and 
the Treasury agree that the risks and potential costs to consumers, 
municipalities, small businesses and others who depend on AIG for 
insurance protection in their lives, operations, pensions, and 
investments, as well as the risks to the wider economy, of not 
providing this assistance during the current economic environment are 
unacceptably large. The disorderly failure of systemically important 
financial institutions during this period of severe economic stress 
would only deepen the current economic recession. We have been and will 
continue to work alongside the Treasury and other Government agencies 
to avoid this outcome. At the same time, in exercising the tools at our 
disposal, we are also committed to acting only when and to the extent 
that our assistance is necessary and can be effective in addressing 
systemic risks and we are committed to protecting the interests of the 
U.S. Government and taxpayer.
                            Acting Director,
                      Office of Thrift Supervision
                             March 5, 2009
    Good morning, Chairman Dodd, Ranking Member Shelby, and Members of 
the Committee. Thank you for inviting me to testify regarding the 
Office of Thrift Supervision's (OTS) examination and supervisory 
program and its oversight of American International Group, Inc. (AIG). 
I appreciate the opportunity to familiarize the Committee with the 
complex, international operations of AIG as well as the steps the OTS 
took to oversee the company.
    At the Committee's request, in my testimony today, I will discuss 
the complicated set of circumstances that led to the government 
intervention in AIG. I will provide details on our role as the 
consolidated supervisor of AIG, the nature and extent of AIG's 
operations, the risk exposure that it accepted, and the excessive 
concentration by one of its companies in particularly intricate, new, 
and unregulated financial instruments. I will also outline the Agency's 
supervisory and enforcement activities.
    I will describe some lessons learned from the rise and fall of AIG, 
and offer my opinion, in hindsight, on what we might have done 
differently. Finally, I will outline some needed changes that could 
prevent similar financial companies from repeating AIG's errors in 
managing its risk, as well as actions Congress might consider in the 
realm of regulatory reform.
History of AIG
    AIG is a huge international conglomerate that operates in 130 
countries worldwide. As of year-end 2007, the combined assets of the 
AIG group were $1 trillion. The AIG group's primary business is 
insurance. AIG's core business segments fall under four general 
categories (e.g., General Insurance, Life Insurance and Retirement 
Services, Financial Services, and Asset Management). AIG's core 
business of insurance is functionally regulated by various U.S. State 
regulators, with the lead role assumed by the New York and Pennsylvania 
Departments of Insurance, and by foreign regulators throughout the 130 
countries in which AIG operates.
    My testimony will focus primarily on AIG, the holding company, and 
AIG Financial Products (AIGFP). Many of the initial problems in the AIG 
group were centered in AIGFP and AIG's Securities Lending Business.
    It is critically important to note that AIG's crisis was caused by 
liquidity problems, not capital inadequacy. AIG's liquidity was 
impaired as a result of two of AIG's business lines: (1) AIGFP's 
``super senior'' credit default swaps (CDS) associated with 
collateralized debt obligations (CDO), backed primarily by U.S. 
subprime mortgage securities and (2) AIG's securities lending 
commitments. While much of AIG's liquidity problems were the result of 
the collateral call requirements on the CDS transactions, the cash 
requirements of the company's securities lending program also were a 
significant factor.
    AIG's securities lending activities began prior to 2000, Its 
securities lending portfolio is owned pro-rata by its participating, 
regulated insurance companies. At its highest point, the portfolio's 
$90 billion in assets comprised approximately 9 percent of the group's 
total assets. AIG Securities Lending Corp., a registered broker-dealer 
in the U.S., managed the much larger, domestic piece of the securities 
lending program as agent for the insurance companies in accordance with 
investment agreements approved by the insurance companies and their 
functional regulators.
    The securities lending program was designed to provide the 
opportunity to earn an incremental yield on the securities housed in 
the investment portfolios of AIG's insurance entities. These entities 
loaned their securities to various third parties, in return for cash 
collateral, most of which AIG was obligated to repay or roll over every 
two weeks, on average. While a typical securities lending program 
reinvests its cash in short duration investments, such as treasuries 
and commercial paper, AIG's insurance entities invested much of their 
cash collateral in AAA-rated residential mortgage-backed securities 
with longer durations.
    Similar to the declines in market value of AIGFP's credit default 
swaps, AIG's residential mortgage investments declined sharply with the 
turmoil in the housing and mortgage markets. Eventually, this created a 
tremendous shortfall in the program's assets relative to its 
liabilities. Requirements by the securities lending program's 
counterparties to meet margin requirements and return the cash AIG had 
received as collateral then placed tremendous stress on AIG's 
    AIGFP had been in operation since the early 1990s and operated 
independently from AIG's regulated insurance entities and insured 
depository institution. AIGFP's $100 billion in assets comprises 
approximately 10 percent of the AIG group's total assets of $1 
    AIGFP's CDS portfolio was largely originated in the 2003 to 2005 
period and was facilitated by AIG's full and unconditional guarantee 
(extended to all AIGFP transactions since its creation), which enabled 
AIGFP to assume the AAA rating for market transactions and counterparty 
    AIGFP's CDS provide credit protection to counterparties on 
designated portfolios of loans or debt securities. AIGFP provided such 
credit protection on a ``second loss'' basis, under which it repeatedly 
reported and disclosed that its payment obligations would arise only 
after credit losses in the designated portfolio exceeded a specified 
threshold amount or level of ``first losses.'' Also known as ``super 
senior,'' AIGFP provided protection on the layer of credit risk senior 
to the AAA risk layer. The AIGFP CDS were on the safest portion of the 
security from a credit perspective. In fact, even today, there have not 
been credit losses on the AAA risk layer.
    AIGFP made an internal decision to stop origination of these 
derivatives in December 2005 based on their general observation that 
underwriting standards for mortgages backing securities were declining. 
At this time, however, AIGFP already had $80 billion of CDS 
commitments. The housing market began to unravel starting with subprime 
defaults in 2007, triggering a chain of events that eventually led to 
government intervention in AIG.
OTS's Supervisory Role and Actions
Supervisory Responsibilities
    Mr. Chairman, I would like next to provide an overview of OTS' 
responsibilities in supervising a savings and loan holding company 
(SLHC). In doing so, I will describe many of the criticisms and 
corrective actions OTS directed to AIG management and its board of 
directors, especially after the most recent examinations conducted in 
2005, 2006, and 2007.
    As you will see, our actions reveal a progressive level of severity 
in our supervisory criticism of AIG's corporate governance. OTS 
criticisms addressed AIG's risk management, corporate oversight, and 
financial reporting, culminating in the Supervisory Letter issued by 
OTS in March 2008, which downgraded AIG's examination rating.
    You will also see that where OTS fell short, as did others, was in 
the failure to recognize in time the extent of the liquidity risk to 
AIG of the ``super senior'' credit default swaps in AIGFP's portfolio. 
In hindsight, we focused too narrowly on the perceived creditworthiness 
of the underlying securities and did not sufficiently assess the 
susceptibility of highly illiquid, complex instruments (both CDS and 
CDOs) to downgrades in the ratings of the company or the underlying 
securities, and to declines in the market value of the securities. No 
one predicted, including OTS; the amount of funds that would be 
required to meet collateral calls and cash demands on the credit 
default swap transactions. In retrospect, if we had identified the 
absolute magnitude of AIGFP's CDS exposures as a liquidity risk, we 
could have requested that AIGFP reduce its exposure to this 
    OTS' interaction with AIG began in 1999 when the conglomerate 
applied to form a Federal Savings Bank (FSB). AIG received approval in 
2000, and the AIG FSB commenced operations on May 15, 2000. OTS is the 
consolidated supervisor of AIG, which is a savings and loan holding 
company by virtue of its ownership of AIG Federal Savings Bank.
    OTS supervises savings associations and their holding companies to 
maintain their safety, soundness, and compliance with consumer laws, 
and to encourage a competitive industry that meets America's financial 
services needs. As the primary Federal regulator of savings and loan 
holding companies, OTS has the authority to supervise and examine each 
holding company enterprise, but relies on the specific functional 
regulators for information and findings regarding the specific entity 
for which the functional regulator is responsible.
    Once created, a holding company is subject to ongoing monitoring 
and examination. Managerial resources, financial resources and future 
prospects continue to be evaluated through the CORE holding company 
examination components (i.e., Capital, Organizational Structure, Risk 
Management and Earnings). The OTS holding company examination assesses 
capital and earnings in relation to the unique organizational structure 
and risk profile of each holding company. During OTS's review of 
capital adequacy, OTS considers the risk inherent in an enterprise's 
activities and the ability of the enterprise's capital to absorb 
unanticipated losses, support the level and composition of the parent 
company's and subsidiaries' debt, and support business plans and 
    The focus of this authority is the consolidated health and 
stability of the holding company enterprise and its effect on the 
subsidiary savings association. OTS oversees the enterprise to identify 
systemic issues or weaknesses, as well as ensure compliance with 
regulations that govern permissible activities and transactions. The 
examination goal is consistent across all types of holding company 
enterprises; however, the level of review and amount of resources 
needed to assess a complex structure such as AIG's is vastly deeper and 
more resource-intensive than what would be required for a less complex 
holding company.
OTS Supervisory Actions
    OTS's approach to holding company supervision has continually 
evolved to address new developments in the financial services industry 
and supervisory best practices. At the time AIG became a savings and 
loan holding company in 2000, OTS focused primarily on the impact of 
the holding company enterprise on the subsidiary savings association. 
With the passage of Gramm-Leach-Bliley, not long before AIG became a 
savings and loan holding company, OTS recognized that large corporate 
enterprises, made up of a number of different companies or legal 
entities, were changing the way such enterprises operated and would 
need to be supervised. These companies, commonly called conglomerates, 
began operating differently from traditional holding companies and in a 
more integrated fashion, requiring a more enterprise-wide review of 
their operations. In short, these companies shifted from managing along 
legal entity lines to managing along functional lines.
    Consistent with changing business practices and how conglomerates 
then were managed, in late 2003 OTS embraced a more enterprise-wide 
approach to supervising conglomerates. This shift aligned well with 
core supervisory principles adopted by the Basel Committee and with 
requirements adopted by European Union (EU) regulators that took effect 
in 2005, which required supplemental regulatory supervision at the 
conglomerate level. OTS was recognized as an equivalent regulator for 
the purposes of AIG consolidated supervision within the EU, a process 
that was finalized with a determination of equivalence by the French 
regulator, Commission Bancaire.
    Under OTS's approach of classifying holding companies by 
complexity, as well as the EU's definition of a financial conglomerate, 
AIG was supervised, and assessed, as a conglomerate. OTS exercises its 
supervisory responsibilities with respect to complex holding companies 
by communicating with other functional regulators and supervisors who 
share jurisdiction over portions of these entities and through our own 
set of specialized procedures. With respect to communication, OTS is 
committed to the framework of functional supervision Congress 
established in Gramm-Leach-Bliley. Under Gramm-Leach-Bliley, the 
consolidated supervisors are required to consult on an ongoing basis 
with other functional regulators to ensure those findings and 
competencies are appropriately integrated into our own assessment of 
the consolidated enterprise and, by extension, the insured depository 
institution we regulate.
    Consistent with this commitment and as part of its comprehensive, 
consolidated supervisory program for AIG, OTS began in 2005 to convene 
annual supervisory college meetings. Key foreign supervisory agencies, 
as well as U.S. State insurance regulators, participated in these 
conferences. During the part of the meetings devoted to presentations 
from the company, supervisors have an opportunity to question the 
company about any supervisory or risk issues. Approximately 85 percent 
of AIG, as measured by allocated capital, is contained within entities 
regulated or licensed by other supervisors. Another part of the meeting 
includes a ``supervisors-only'' session, which provides a venue for 
participants to ask questions of each other and to discuss issues of 
common concern regarding AIG. OTS also uses the occasion of the college 
meetings to arrange one-on-one side meetings with foreign regulators to 
discuss in more depth significant risk in their home jurisdictions.
    As OTS began its early supervision of AIG as a conglomerate, our 
first step was to better understand its organizational structure and to 
identify the interested regulators throughout the world. In this 
regard, AIG had a multitude of regulators in over 100 countries 
involved in supervising pieces of the AIG corporate family. OTS 
established relationships with these regulators, executed information 
sharing agreements where appropriate, and obtained these regulators' 
assessments and concerns for the segment of the organization regulated.
    As OTS gained experience supervising AIG and other conglomerates, 
we recognized that a dedicated examination team and continuous onsite 
presence was essential to overseeing the dynamic and often fast-paced 
changes that occur in these complex structures. In 2006, OTS formally 
adopted a risk-focused continuous supervision program for the oversight 
of large and complex holding companies. This program combines on- and 
off-site planning, monitoring, communication, and analysis into an 
ongoing examination process. OTS's continuous supervision and 
examination program comprises development and maintenance of a 
comprehensive risk assessment, which consists of: an annual supervisory 
plan; risk-focused targeted reviews; coordination with other domestic 
and foreign regulators; an annual examination process and reporting 
framework; routine management meetings; and an annual board of 
directors meeting.
    OTS conducted continuous consolidated supervision of the AIG group, 
including an onsite examination team at AIG headquarters in New York. 
Through frequent, ongoing dialogue with company management, OTS 
maintained a contemporaneous understanding of all material parts of the 
AIG group, including their domestic and cross-border operations.
    OTS's primary point of contact with the holding company was through 
AIG departments that dealt with corporate control functions, such as 
Enterprise Risk Management (ERM), Internal Audit, Legal/Compliance, 
Comptroller, and Treasury. OTS held monthly meetings with AIG's 
Regulatory and Compliance Group, Internal Audit Director, and external 
auditors. In addition, OTS held quarterly meetings with the Chief Risk 
Officer, the Treasury Group, and senior management, and annually with 
the board of directors. OTS reviewed and monitored risk concentrations, 
intra-group transactions, and consolidated capital at AIG, and also 
directed corrective actions against AIG's Enterprise Risk Management. 
OTS also met regularly with Price Waterhouse Coopers (PwC), the 
company's independent auditor.
    Key to the continuous supervision process is the risk assessment, 
resulting supervisory plan, and targeted areas of review for each year. 
OTS focused on the corporate governance, risk management, and internal 
control centers within the company and completed targeted reviews of 
non-functionally regulated affiliates within the holding company 
    In 2005, OTS conducted several targeted, risk-focused reviews of 
various lines of business, including AIGFP, and made numerous 
recommendations to AIG senior management and the board with respect to 
risk management oversight, financial reporting transparency and 
corporate governance. The findings, recommendations, and corrective 
action points of the 2005 examination were communicated in a report to 
the AIG Board in March 2006.
    With respect to AIGFP, OTS identified and reported to AIG's board 
weaknesses in AIGFP's documentation of complex structures transactions, 
in policies and procedures regarding accounting, in stress testing, in 
communication of risk tolerances, and in the company's outline of lines 
of authority, credit risk management and measurement.
    Our report of examination also identified weaknesses related to 
American General Finance (AGF), another non-functionally regulated 
subsidiary in the AIG family that is a major provider of consumer 
finance products in the U.S. These weaknesses included deficiencies 
regarding accounting for repurchased loans, evaluation of the allowance 
for loan losses: Credit Strategy Policy Committee reporting, 
information system data fields, and failure to forward copies of State 
examination reports and management response to the Internal Audit 
    The examination report also noted weaknesses in AIG's management 
and internal relationships, especially with the Corporate Legal 
Compliance Group and the Internal Audit Division, as well as its anti-
money laundering program.
    In 2006 OTS noted nominal progress on implementing corrective 
measures on the weaknesses noted in the prior examination; however, the 
Agency identified additional weaknesses requiring the board of 
directors to take corrective action. Most notably, OTS required the 
board to establish timely and accurate accounting and reconciliation 
processes, enhance and validate business line capital models, address 
compliance-related matters, adopt mortgage loan industry best 
practices, and assess the adequacy of its fraud detection and 
remediation processes.
    During 2007, when there were signs of deterioration in the U.S. 
mortgage finance markets, OTS increased surveillance of AGF and AIGFP. 
OTS selected AGF for review because of its significant size and scope 
of consumer operations, and to follow up on the problems noted in prior 
    OTS also has supervisory responsibility for AIG Federal Savings 
Bank. OTS took action against AIG FSB in June, 2007, in the form of a 
Supervisory Agreement for its failure to manage and control in a safe 
and sound manner the loan origination services outsourced to its 
affiliate, Wilmington Finance, Inc. (WFI). The Agreement addressed loan 
origination activities and required AIG FSB to identify and provide 
timely assistance to borrowers who were at risk of losing their homes 
because of the thrift's loan origination and lending practices. OTS 
also required a $128 million reserve to be established to cover costs 
associated with providing affordable loans to borrowers.
    Later, in light of AIG's growing liquidity needs to support its 
collateral obligations, OTS took action in September 2008 at the FSB 
level to ensure that depositors and the insurance fund were not placed 
at risk. OTS actions precluded the bank from engaging in transactions 
with affiliates without OTS knowledge and lack of objection; restricted 
capital distributions; required maintenance of minimum liquidity and 
borrowing capacity sensitive to the unfolding situation; and required 
retention of counsel to advise the board in matters involving corporate 
reorganization and attendant risks related thereto. AIG FSB continues 
to be well capitalized and maintains adequate levels of liquidity.
    After a 2007 targeted review of AIGFP, OTS instructed the company 
to revisit its modeling assumptions in light of deteriorating subprime 
market conditions. In the summer of 2007, after continued market 
deterioration, OTS questioned AIG about the valuation of CDS backed by 
subprime mortgages. In the last quarter of 2007, OTS increased the 
frequency of meetings with AIG's risk managers and PwC. Due to the 
Agency's progressive concern with corporate oversight and risk 
management, in October 2007 we required AIG's Board to:

    Monitor remediation efforts with respect to certain 
        material control weaknesses and deficiencies;

    Ensure implementation of a long-term approach to solving 
        organizational weaknesses and increasing resources dedicated to 
        solving identified deficiencies;

    Monitor the continued improvement of corporate control 
        group ability to identify and monitor risk;

    Complete the holding company level risk assessment, risk 
        metrics, and reporting initiatives and fully develop risk 

    Increase involvement in the oversight of the firm's overall 
        risk appetite and profile and be fully informed as to AIG 
        Catastrophic Risk exposures, on a full-spectrum (credit, 
        market, insurance, and operational) basis; and

    Ensure the prompt, thorough, and accountable development of 
        the Global Compliance program, a critical risk control function 
        where organizational structure impediments have delayed program 

    OTS further emphasized to AIG management and the board that it 
should give the highest priority to the financial reporting process 
remediation and the related long-term solution to financial reporting 
weaknesses. In connection with the 2007 annual examination, the 
Organizational Structure component of the CORE rating was downgraded to 
reflect identified weakness in the company's control environment.
    Shortly after OTS issued the 2007 report, AIG disclosed its third 
quarter 2007 financial results, which indicated for the first time a 
material problem in the Multi Sector CDS portfolio evidenced by a $352 
million valuation charge to earnings and the disclosure that collateral 
was being posted with various counterparties to address further market 
value erosion in the CDS portfolio.
    As PwC was about to issue the accounting opinions on the 2007 
financial statements, the independent auditor concluded that a material 
control weakness existed in AIGFP's valuation processes and that a 
significant control deficiency existed with Enterprise Risk 
Management's access to AIGFP's valuation models and assumptions. Due to 
intense pressure from PwC, in February 2008, AIG filed an SEC Form 8K 
announcing the presence of the material weakness. AIG pledged to 
implement complete remediation efforts immediately.
    OTS's subsequent supervisory review and discussions with PwC 
revealed that AIGFP was allowed to limit access of key risk control 
groups while material questions relating to the valuation of super 
senior CDS portfolio were mounting. As a result of this gap, corporate 
management did not obtain sufficient information to completely assess 
the valuation methodology. In response to these matters, AIG's Audit 
Committee commissioned an internal investigation headed by Special 
Counsel to the Audit Committee to review the facts and circumstances 
leading to the events disclosed in the SEC Form 8K. The Special Counsel 
worked with OTS to evaluate the breakdown in internal controls and 
financial reporting. Regulatory entities such as the Securities 
Exchange Commission and Department of Justice then also commenced 
    The OTS met with AIG senior management on March 3, 2008, and 
communicated significant supervisory problems over the disclosures in 
the SEC Form 8K and the unsatisfactory handling of the Enterprise Risk 
Management relationship with AIGFP. OTS downgraded AIG's CORE ratings 
and communicated the OTS's view of the company's risk management 
failure in a letter to AIG's General Counsel on March 10, 2008.
    As part of this remediation process and to bolster corporate 
liquidity and oversight, AIG successfully accessed the capital markets 
in May of 2008 and raised roughly $20 billion in a combination of 
common equity and equity hybrid securities. This action coupled with 
existing liquidity at the AIG parent, provided management with 
reasonable comfort that it could fund the forecasted collateral needs 
of AIGFP. AIG also added a Liquidity Manager to its corporate 
Enterprise Risk Management unit to provide senior management with more 
timely stress scenario reporting and formed a liquidity monitoring 
committee composed of risk managers, corporate treasury personnel, and 
business unit members to provide oversight.
    On July 28, 2008, AIG submitted a final comprehensive remediation 
plan, which OTS reviewed and ultimately accepted on August 28, 2008. 
The AIG audit committee approved the company's remediation plan, which 
also was used by PwC to assess AIG's progress in resolving the material 
control weakness covering the valuation of the CDS portfolio and the 
significant control deficiency attributable to AIG's corporate risk 
oversight of AIGFP, AGF, and International Lease Finance Corporation 
(ILFC). OTS continues to monitor these remediation efforts to this day, 
notwithstanding AIG's September 2008 liquidity crisis.
    As AIG's liquidity position became more precarious, OTS initiated 
heightened communications with domestic and international financial 
regulators. Through constant communication, OTS monitored breaking 
events in geographic areas where AIG operates, kept regulators in those 
jurisdictions informed of events in the U.S. and clarified the nature 
of AIG's stresses. OTS's identification of AIGFP as the focal point of 
AIG's problems added perspective that allowed foreign regulators to 
more accurately assess the impact on their regulated entities and to 
make informed supervisory decisions.
    In September 2008 the Federal Reserve Bank of New York (FRB-NY) 
extended an $85 billion loan to AIG and the government took an 80 
percent stake in AIG. On the closure of this transaction? Federal 
statute no longer defined AIG as a savings and loan holding company 
subject to regulation as such. This result would be true whether AIG 
had been a savings and loan holding or bank holding company subject to 
regulation by the Federal Reserve Board. Nonetheless, OTS has continued 
in the role of equivalent regulator for EU and international purposes. 
FRB-NY's intervention had no impact on OTS's continued regulation and 
supervision of AIG FSB.
    Although OTS has scaled back some regulatory activities with regard 
to AIG, the Agency continues to meet regularly with key corporate 
control units and receive weekly reports on various exposures and 
committee activities. OTS closely monitors the activities at AIGFP to 
reduce risk, as well as the divesture efforts of the holding company. 
OTS will continue to focus on Residential Mortgage Backed Securities 
exposures and the ultimate performance of underlying mortgage assets. 
OTS is tracking AIG's remediation efforts. Finally, OTS continues to 
work with global functional regulators to keep them apprised of 
conditions at the holding company, as well as to learn of emerging 
issues in local jurisdictions.
Lessons Learned
    Despite OTS's efforts to point out AIGFP's weaknesses to the 
company and to its Board of Directors, OTS did not foresee the extent 
of the risk concentration and the profound systemic impact CDS products 
caused within AIG. By the time AIGFP stopped originating these 
derivatives in December 2005, they already had $65 billion on their 
books. These toxic products posed significant liquidity risk to the 
holding company.
    Companies that are successful have greater opportunities for 
growth. AIG was successful in many regards for many years, but it had 
issues and challenges. OTS identified many of these issues and 
attempted to initiate corrective actions, but these actions were not 
sufficient to avoid the September market collapse.
    It is worth noting that AIGFP's role was not underwriting, 
securitizing, or investing in subprime mortgages. Instead; AIGFP simply 
provided insurance-like protection against declines in the values of 
underlying securities. Nevertheless, in hindsight, OTS should have 
directed the company to stop originating CDS products before December 
2005. OTS should also have directed AIG to try to divest a portion of 
this portfolio. The pace of change and deterioration of the housing 
market outpaced our supervisory remediation measures for the company. 
By the time the extent of the CDS liquidity exposure was recognized, 
there was no orderly way to reduce or unwind these positions and the 
exposure was magnified due to the concentration level. The CDS market 
needs more consistent terms and conditions and greater depth in market 
participants to avoid future concentration risks similar to AIG.
    I believe it is important for the Committee to understand the 
confluence of market factors that exposed the true risk of the CDS in 
AIGFP's portfolio. OTS saw breakdowns in market discipline, which was 
an important element of our supervisory assessment. Areas that we now 
know were flawed included: overreliance on financial models, rating 
agency influence on structured products, lack of due diligence in the 
packaging of asset-backed securities, underwriting weaknesses in 
originate-to-distribute models, and lack of controls over third party 
(brokers, conduits, wholesalers) loan originators.
    Shortcomings in modeling CDS products camouflaged some of the risk. 
AIGFP underwrote its super senior CDS using proprietary modeling 
similar to that used by rating agencies for rating structured 
securities. AIGFP's procedures required modeling based on simulated 
periods of extended recessionary environments (i.e., ratings downgrade, 
default, loss, recovery). Up until June 2007, the results of the AIGFP 
models indicated that the risk of loss was a remote possibility, even 
under worst-case scenarios. The model used mainstream assumptions that 
were generally acceptable to the rating agencies, PwC, and AIG.
    Following a targeted review of AIGFP in early 2007, OTS recommended 
that the company revisit its modeling assumptions in light of 
deteriorating subprime market conditions. In hindsight, the banking 
industry, the rating agencies and prudential supervisors, including 
OTS, relied too heavily on stress parameters that were based on 
historical data. This led to an underestimation of the unprecedented 
economic shock and misjudgment of stress test parameters.
    Approximately 6 months after OTS's March 2008 downgrade of AIG's 
examination rating, the credit rating agencies also downgraded AIG on 
September 15, 2008. That precipitated calls that required AIGFP to post 
huge amounts of collateral for which it had insufficient funds. The 
holding company capital was frozen and AIGFP could not meet the calls.
    From the lessons learned during our involvement with supervising 
AIG, we would like you to consider two suggestions in your future 
exploration of regulatory reform.
Systemic Risk Regulator
    First, OTS endorses the establishment of a systemic risk regulator 
with broad authority, including regular monitoring, over companies that 
if, due to the size or interconnected nature of their activities, their 
actions, or their failure would pose a risk to the financial stability 
of the country. Such a regulator should be able to access funds, which 
would present options to resolve problems at these institutions. The 
systemic risk regulator should have the ability and the responsibility 
for monitoring all data about markets and companies, including but not 
limited to companies involved in banking, securities, and insurance.
Regulation of Credit Default Swaps--Consistency and Transparency
    CDS are financial products that are not regulated by any authority 
and impose serious challenges to the ability to supervise this risk 
proactively without any prudential derivatives regulator or standard 
market regulation. We are aware of and support the recent efforts by 
the Federal Reserve Bank of New York to develop a common global 
framework for cooperation. There is a need to fill the regulatory gaps 
the CDS market has exposed.
    We have also learned there is a need for consistency and 
transparency in CDS contracts. The complexity of CDS contracts masked 
risks and weaknesses in the program that led to one type of CDS 
performing extremely poorly. The current regulatory means of measuring 
off-balance sheet risks do not fully capture the inherent risks of CDS. 
OTS believes standardization of CDS would provide more transparency to 
market participants and regulators.
    In the case of AIG, there was heavy reliance on rating agencies and 
in-house models to assess the risks associated with these extremely 
complicated and unregulated products. I believe that Congress should 
consider legislation to bring CDS under regulatory oversight, 
considering the disruption these instruments caused in the marketplace. 
Prudential supervision is needed to promote a better understanding of 
the risks and best practices to manage these risks, enhance 
transparency, and standardization of contracts and settlements. More 
and better regulatory tools are needed to bring all potential 
instruments that could cause a recurrence of our present problems under 
appropriate oversight and legal authority.
    A multiplicity of events led to the downfall of AIG. An 
understanding of the control weaknesses and events that transpired at 
AIG provides an opportunity to learn to identify weaknesses and 
strengthen regulatory oversight of complex financial products and 
companies. OTS has absorbed these lessons and has issued risk-focused 
guidance and policies to promote a more updated and responsive 
supervisory program.
    Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the 
Committee, for the opportunity to testify on behalf of the OTS on the 
collapse of AIG.
    We look forward to working with the Committee to ensure that, in 
these challenging times, thrifts and consolidated holding companies 
operate in a safe and sound manner.
                  New York State Insurance Department
                             March 5, 2009
    I would like to thank Chairman Christopher Dodd, Ranking Member 
Richard Shelby, and the Members of the Senate Committee on Banking, 
Housing, and Urban Affairs for inviting me to testify today at this 
hearing on ``American International Group: Examining What Went Wrong, 
Government Intervention, and Implications for Future Regulation.''
    My name is Eric Dinallo and I am Insurance Superintendent for New 
York State.
    I very much appreciate the Committee holding this hearing so that 
we can discuss what has happened at AIG and how to improve financial 
services regulation in the future.
    I would like to start by taking this opportunity to clear up some 
confusion. I have read a number of times statements that the New York 
State Insurance Department is the primary regulator of AIG.
    The New York Insurance Department is not and never has been the 
primary regulator for AIG. AIG is a huge, global financial services 
holding company that does business in 130 countries. Besides its 71 
U.S.-based insurance companies, AIG has 176 other financial services 
companies, including non-U.S. insurers.
    State insurance departments have the power and authority to act as 
the primary regulator for those insurance companies domiciled in their 
State. So the New York Department is primary regulator for only those 
AIG insurance companies domiciled in New York.
    Specifically, the New York Insurance Department is the primary 
regulator for 10 of AIG's 71 U.S. insurance companies: American Home 
Assurance Company, American International Insurance Company, AIU 
Insurance Company, AIG National Insurance Company, Commerce and 
Industry Insurance Company, Transatlantic Reinsurance Company, American 
International Life Assurance Company of New York, First SunAmerica Life 
Insurance Company, United States Life Insurance Company in the City of 
New York, and Putnam Reinsurance Company. AIG's New York life insurance 
companies are relatively small. The property insurance companies are 
much larger. Other States act as primary regulator for the other U.S. 
insurance companies.
    State insurance regulators are not perfect. But one thing we do 
very well is focus on solvency, on the financial strength of our 
insurance companies. We require them to hold conservative reserves to 
ensure that they can pay policyholders. That is why insurance companies 
have performed relatively well in this storm. One clear lesson of the 
current crisis is the importance of having plenty of capital and not 
having too much leverage.
    The crisis for AIG did not come from its State regulated insurance 
companies. The primary source of the problem was AIG Financial 
Products, which had written credit default swaps, derivatives and 
futures with a notional amount of about $2.7 trillion, including about 
$440 billion of credit default swaps. For context, that is equal to the 
gross national product of France. Losses on certain credit default 
swaps and collateral calls by global banks, broker dealers and hedge 
funds that are counterparties to these credit default swaps are the 
main source of AIG's problems.
    Faced with ratings downgrades, AIG Financial Products and AIG 
holding company faced tens of billions of dollars of demands for cash 
collateral on the credit default swaps written by Financial Products 
and guaranteed by the holding company.
    Federal Reserve Chairman Bernanke recently said, ``AIG had a 
financial products division which was very lightly regulated and was a 
source of a great deal of systemic trouble.'' This week, Chairman 
Bernanke accurately called the Financial Products unit ``a hedge fund 
basically that was attached to a large and stable insurance company, 
made huge numbers of irresponsible bets, took huge losses.''
    The main reason why the Federal Government decided to rescue AIG 
was not because of its insurance companies. Rather, it was because of 
the systemic risk created by Financial Products. There was systemic 
risk because of Financial Products relationships and transactions with 
virtually every major commercial and investment bank, not only in the 
U.S., but around the world. I would like to note that insurance 
companies were not the purchasers of AIG's toxic credit default swaps.
    To quote Chairman Bernanke again, Financial Products ``took all 
these large bets where they were effectively, quote, `insuring' the 
credit positions of many, many banks and other financial 
    By purchasing a savings and loan in 1999, AIG was able to select as 
its primary regulator the Federal Office of Thrift Supervision, the 
Federal agency that is charged with overseeing savings and loan banks 
and thrift associations. The Office of Thrift Supervision is AIG's 
consolidated supervisor for purposes of Gramm-Leach-Bliley.
    AIG Financial Products is not a licensed insurance company. It was 
not regulated by New York State or any other State.
    We all agree that AIG Financial Products should have been subject 
to more and better regulation. A major driver of its problems stemmed 
from its unregulated use of credit default swaps, which were exempted 
from regulation by Federal legislation in the late nineties.
    Some have tried to use AIG's problems as an argument for an 
optional Federal charter for insurance companies. I am open to a 
Federal role in regulating insurance and the non-insurance operations 
of large financial services groups such as AIG. I have said as much in 
prior testimony to other Congressional committees.
    But an optional Federal charter is the wrong lesson to learn from 
AIG for two very clear reasons.
    One, when you permit companies to pick their regulator, you create 
the opportunity for regulatory arbitrage. The whole purpose of 
financial services regulation is to appropriately control risk. But 
when you allow regulatory arbitrage, you increase risk. Because you 
create the opportunity for a financial institution to select its 
regulator based on who might be more lenient, who might have less 
strict rules, who might demand less capital.
    This is not a theoretical contention. I refer the Committee to a 
January 22, 2009, article in the Washington Post titled ``By Switching 
Their Charters, Banks Skirt Supervision.'' The article reports that 
since 2000 at least 30 banks switched from Federal to State supervision 
to escape regulatory action. The actual number is likely higher because 
the newspaper was only able to count public regulatory actions. They 
could not discover banks that acted to pre-empt action when they saw it 
coming. In total, 240 banks converted from Federal to State charters, 
while 90 converted from State to Federal charters. The newspaper was 
unable to discover if any of those formerly State banks were avoiding 
State action.
    Two, what happened at AIG demonstrates the strength and 
effectiveness of State insurance regulation, not the opposite.
    The only reason that the Federal rescue of AIG is possible is 
because there are strong operating insurance companies that provide the 
possibility that the Federal Government and taxpayers will be paid 
back. And the reason why those insurance companies are strong is 
because State regulation walled them off from non-related activities in 
the holding company and at Financial Products.
    In most industries, the parent company can reach down and use the 
assets of its subsidiaries. With insurance, that is greatly restricted. 
State regulation requires that insurance companies maintain healthy 
reserves backed by investments that cannot be used for any other 
purpose. I've said that the insurance companies are the bars of gold in 
the mess that AIG has become.
    There are activities that the States need to improve, such as 
licensing and bringing new products to market. But where we are strong 
has been in maintaining solvency.
    I would note that at a time when financial services firms are in 
trouble because they do not have adequate capital and are too highly 
leveraged, at a time when commercial banks and investment banks have 
very serious problems, insurance companies remain relatively strong.
    There is justified concern about AIG's securities lending program, 
which affects only AIG's life insurance operations. I would like to 
review for you some facts about that program and the actions the New 
York Department has taken in regards to that program.
    It is important to understand that securities lending did not cause 
the crisis at AIG. AIG Financial Products did. If there had been no 
Financial Products unit and only the securities lending program as it 
was, we would not be here today. There would have been no Federal 
rescue of AIG. Financial Products' trillions of dollars of transactions 
created systemic risk. Securities lending did not.
    If not for the crisis caused by Financial Products, AIG would be 
just like other insurance companies, dealing with the stresses caused 
by the current financial crisis, but because of its size and strength, 
most likely weathering them well.
    Securities lending is an activity that has been going on for 
decades without serious problems. Many, if not most, large financial 
institutions, including commercial banks, investment banks and pension 
funds, participate in securities lending.
    Securities lending involves financial institution A lending a stock 
or bond it owns to financial institution B. In return, B gives A cash 
worth generally about 102 percent of the value of the security it is 
borrowing. A then invests the cash. A still owns the security and will 
benefit from any growth in its value. And A invests the cash to gain a 
small additional amount.
    Problems can occur if B decides it wants to return the security it 
borrowed from A. A is then required to sell its investment to obtain 
the cash it owes B. Generally, in a big securities lending program, A 
will have some assets it can easily sell. But if there is a run, if 
many of the borrowers return the securities and demand cash, A may not 
be able to quickly sell enough assets to obtain the cash it needs or 
may have to sell assets at a loss before they mature.
    AIG securities lending was consolidated by the holding company at a 
special unit it set up and controlled. This special unit was not a 
licensed insurance company. As with some other holding company 
activities, it was pursued aggressively rather than prudently.
    AIG maintained two securities lending pools, one for U.S. companies 
and one for non-U.S. companies. At its height, the U.S. pool had about 
$76 billion. The U.S. security lending program consisted of 12 life 
insurers, three of which were from New York. Those three New York 
companies contributed about 8 percent of the total assets in the 
securities lending pool.
    The program was invested almost exclusively in the highest-rated 
securities. Even the few securities that were not top rated, not triple 
A, were either double A or single A. Today, with the perfect clarity of 
hindsight, we all know that those ratings were not aligned with the 
market value of many mortgage-backed securities, which made up 60 
percent of the invested collateral pool.
    The New York Department was aware of the potential stresses at the 
AIG securities lending program and was actively monitoring it and 
working with the company to deal with those issues. Those efforts were 
working, but were thwarted by the Financial Products crisis in 
September 2008.
    As early as July 2006, we were engaged in discussions about the 
securities lending program with AIG. In 2007, we began working with the 
company to start winding down the program.
    Unfortunately, the securities lending program could not be ended 
quickly because beginning in 2007 some of the residential mortgage 
securities could not be sold for their full value. At that time there 
were still few if any defaults, the securities were still paying off. 
But selling them would have involved taking a loss.
    Still, we insisted that the program be wound down and that the 
holding company provide a guarantee to the life companies to make up 
for any losses that were incurred as that happened. In fact, the 
holding company provided a guarantee of first $500 million, then $1 
billion and finally $5 billion.
    In 2008, New York and other States began quarterly meetings with 
AIG to review the securities lending program. Meanwhile, the program 
was being wound down in an orderly manner to reduce losses. From its 
peak of about $76 billion it had declined by $18 billion, or about 24 
percent, to about $58 billion by September 12, 2008.
    At that point, the crisis caused by Financial Products caused the 
equivalent of a run on AIG securities lending. Borrowers that had 
reliably rolled over their positions from period to period for months 
began returning the borrowed securities and demanding their cash 
collateral. From September 12 to September 30, borrowers demanded the 
return of about $24 billion in cash.
    The holding company unit that managed the program had invested the 
borrowers' cash collateral in mortgage-backed securities that had 
become hard to sell. To avoid massive losses from sudden forced sales, 
the Federal Government, as part of its rescue, provided liquidity the 
securities lending program. In the early weeks of the rescue, holding 
company rescue funds were used to meet the collateral needs of the 
program. Eventually the Federal Reserve Bank of New York created Maiden 
Lane II, a fund that purchased the life insurance companies' collateral 
at market value for cash.
    There are two essential points about this. First, without the 
crisis caused by Financial Products, there is no reason to believe 
there would have been a run on the securities lending program. We would 
have continued to work with AIG to unwind its program and any losses 
would have been manageable. In fact, the New York Department has worked 
and continues to work with other insurance companies to unwind their 
securities lending programs with no serious problems.
    Second, even if there had been a run on the securities lending 
program with no Federal rescue, our detailed analysis indicates that 
the AIG life insurance companies would not have been insolvent. 
Certainly, there would have been losses, with some companies hurt more 
than others. But we believe that there would have been sufficient 
assets in the companies and in the parent to maintain the solvency of 
all the companies. Indeed, before September 12, 2008, the parent 
company contributed slightly more than $5 billion to the reduction of 
the securities lending program.
    But that is an academic analysis. Whatever the problems at 
securities lending, they would not have caused the crisis that brought 
down AIG. And without Financial Products and the systemic risk its 
transactions created, there would have been no reason for the Federal 
Government to get involved. State regulators would have worked with the 
company to deal with the problem and protect policyholders.
    I would like to also review briefly what the New York Department 
has done generally about securities lending in the insurance industry.
    Based on what we were seeing at AIG, but before the Financial 
Products crisis in September, we warned all licensed New York companies 
that we expect them to prudently manage the risks in securities lending 
programs. On July 21, 2008, New York issued Circular Letter 16 to all 
companies doing business in New York which indicates Department 
concerns about security lending programs. We cautioned them about the 
risks, reminded them of the requirements for additional disclosure and 
told them we would be carefully examining their programs.
    On September 22, 2008, the Department sent what is known as a 
Section 308 letter to all life insurance companies licensed in New York 
requiring them to submit information relating to security lending 
programs, financing arrangements, security impairment issues and other 
liquidity issues. My staff then conducted a thorough investigation of 
the securities' lending programs at New York life insurance companies. 
The results were reassuring. Almost all of the companies had modest 
sized programs with highly conservative investments, even by today's 
standards. Companies with larger programs had ample liquidity to meet 
redemptions under stress. What became clear was that AIG, because of 
the Financial Products problems, was in a uniquely troubling situation.
    In the succeeding months we have continued to analyze the 
securities lending programs at New York companies. We are currently 
drafting regulatory guidelines that will govern the size and scope of 
securities lending programs and will include best practices. We will 
also continue to enforce our legal authority to shut-down any programs 
that we believe endanger policyholders.
    Also, as chair of the National Association of Insurance 
Commissioners Statutory Accounting Practices Working Group, we have 
successfully worked to have the NAIC adopt increased disclosure rules 
for securities lending programs.
    Our primary principle throughout the effort to assist AIG has been 
to continue to protect insurance company policyholders and stabilize 
the insurance marketplace. And it is appropriate to recognize that all 
our partners in this effort, including officials from the Federal 
Reserve Bank of New York, the Federal Reserve Board, the U.S. Treasury, 
AIG executives and their financial advisors, investment and commercial 
bankers, private equity investors, other State regulators at all times 
understand and agree that nothing should or would be done to compromise 
the protection of insurance company policyholders. The dependable moat 
of State regulation that protects policyholders remains solid.
    We will continue to evaluate any transactions involving AIG 
insurance companies on that basis.
    Thank you and I would be happy to answer your questions.
                       FROM ERIC DINALLO

Q.1.a. State Rescue Plan: Superintendent Dinallo, it has been 
reported that last year you and the Pennsylvania Insurance 
Commissioner sought to save AIG by allowing AIG's property and 
casualty insurers to transfer $20 billion in liquid government 
securities to AIG's holding company in exchange for stock in 
AIG's domestic life insurers. On September 15, 2008, New York 
Governor David Paterson issued a press release stating that he 
had instructed you to permit AIG's parent company to access the 
$20 billion from its subsidiary property-casualty insurance 
    Please provide the Committee with a complete description of 
this plan, including the documents you presented to Governor 
Paterson to obtain his approval for the plan.

A.1.a. The basic terms of the initial proposed plan provided 
for three distinct elements: (1) the parent company American 
International Group, Inc. (AIG) raising equity capital from 
commercial sources, (2) AIG quickly selling a significant 
business unit or units, and (3) AIG property casualty companies 
exchanging liquid assets for equally valuable, but less liquid, 
assets owned by the parent and the parent in turn converting 
those liquid assets to cash. The plan was discussed at length 
over the weekend of September 12-14, 2008, and into Monday, 
September 15, 2008, as described below, but was supplanted by 
other actions and not implemented.
    This was not a formally developed ``Plan'' with lengthy 
development or long written analyses. The plan was a constantly 
evolving, working response developed during a rapidly changing 
crisis. We were aware of and engaged in discussions concerning 
all three parts of this plan. It was always our expectation and 
understanding that all three elements were required and that we 
would not implement the third element unless there was a 
comprehensive solution for the crisis. In addition, the third 
element was itself never finalized. One of the conditions for 
our final approval was the company providing assets that would 
be, in our estimation, of sufficient value to protect the 
property casualty companies and their policyholders.
    Governor Paterson's direction was to ensure that 
policyholders inside and outside New York were protected. The 
Governor's press release on Monday, September 15, reflected an 
agreement in principle. It was clearly not a final approval.
    As the weekend of September 12 to 14 progressed, AIG's 
projected cash needs grew substantially. By early Tuesday, it 
was clear that, even if possible to complete, this plan would 
not suffice and all parties focused on other actions.
    For the first element of the plan, AIG discussed raising 
equity capital from a variety of commercial sources. If a 
capital raise resulted in another entity acquiring control, as 
defined in Article 15 of the New York Insurance Law (the 
``Insurance Law''), of New York licensed insurance companies, 
New York State Insurance Department (the ``Department'') 
approval would have been required. While we were not 
negotiating the terms of any prospective capital raises, we 
were periodically updated on the progress of those discussions.
    For the second element of the plan, AIG was discussing 
possible imminent business unit sales. As noted above, another 
entity acquiring control, as defined in Article 15 of the 
Insurance Law, of New York licensed insurance companies would 
have required Department approval. As with AIG's capital 
raising efforts, while we were not negotiating the terms of any 
prospective sales, we were periodically updated on the progress 
of these discussions.
    For the third element of the plan, AIG sought to have 
certain of its property casualty companies exchange municipal 
bonds they owned for stock in AIG Life Holdings (U.S.), Inc. 
and AIG Retirement Services, Inc. (the ``Life Company Stock''), 
intermediate holding company subsidiaries of AIG which own 
substantial operating insurance companies, and for other assets 
including certain real estate interests and other investments. 
AIG would then seek to post these municipal bonds with the 
Federal Reserve Bank of New York in exchange for cash. That 
would allow AIG to use the cash to post cash collateral for its 
AIG Financial Products collateral calls.
    Among the property casualty companies considered for this 
exchange (as providers of municipal bonds and receivers of life 
insurance company stock) were American Home Assurance Company 
(AHAC) and Commerce and Industry Insurance Company (C&I), each 
a New York domiciled property casualty company. Additionally, 
three Pennsylvania domiciled property casualty companies were 
also considered, National Union Fire Insurance Company of 
Pittsburgh, Pa., New Hampshire Insurance Company, and The 
Insurance Company of the State of Pennsylvania.
    The stated goal of AIG for the proposed transactions in 
this third element of the plan was to provide $20 billion of 
liquidity to AIG. An aggregate purchase price for the Life 
Company Stock of approximately $15 billion dollars was proposed 
by AIG. The additional asset sales sought by AIG had a proposed 
aggregate purchase price of approximately $5 billion dollars. 
By Monday, September 15, as the plan evolved, the Department 
was considering only that the New York domiciled property 
casualty companies might purchase a portion of the Life Company 
Stock, and not any other assets.
    The plan contemplated that if the exchange were completed, 
the Life Company Stock would then be sold to third party 
purchasers over a longer sale period, with the sale proceeds 
retained by the property casualty companies. The discussions 
contemplated that the groups of New York and of Pennsylvania 
property casualty companies would each purchase approximately 
50 percent of the Life Company Stock.
    Throughout Saturday and Sunday, September 13 and 14, my 
staff and I had many discussions with AIG and its advisors. We 
reviewed and discussed their various proposals and ideas for 
implementing the exchange. We did not at any time give final 
approval for the proposed exchange. Indeed, we were at all 
times clear that the proposal had to be part of a holistic 
solution and had to over-protect policyholders, or it would not 
be approved.
    As my statement in Governor Paterson's press release, 
issued on the morning of September 15, noted, as of Monday 
morning we continued ``working closely with AIG'' on its 
proposal. As the Governor stated in that release on the morning 
of September 15, I was, at the Governor's direction, working 
with the Federal Reserve Bank of New York (FRBNY) in response 
to the rapidly changing crisis.
    As my discussions with the FRBNY, the U.S. Treasury 
Department and numerous other parties continued through Monday 
afternoon and well into Monday night, other plans developed. 
The primary alternative considered was a commercial line of 
credit provided by commercial lenders. Through roughly midnight 
Monday or 1 a.m. on Tuesday, when I left AIG's offices, that 
appeared to be the most likely option. By the time of a meeting 
commencing at 7:30 a.m. Tuesday morning, that alternative 
appeared to have failed. Discussion then turned to possible 
Federal Reserve and Federal Government actions and 
consideration of the credit facility announced that night. The 
three part plan that is the subject of your question was not 
further pursued.

Q.1.b. Which other State and Federal regulatory agencies, 
private sector firms and banks were involved in preparing this 

A.1.b. Concerning our own advisors, in addition to Department 
resources, we retained the law firm of Fried, Frank, Harris, 
Shriver, and Jacobson as outside counsel. We later retained 
Centerview Partners as outside financial advisors, although 
such retention was not in effect during the period that your 
question covers.
    We dealt with many parties between September 12 and 
September 16. To say that they were each ``involved in 
preparing this plan'' is an overstatement and a more formal 
characterization than would be accurate. Each of them, however, 
played a role in those 5 days and our own response and actions 
incorporated, at least indirectly, our dealings with a broad 
range of other firms and agencies.
    Concerning commercial parties, these included AIG, JPMorgan 
Chase and Blackstone as advisors to AIG, Sullivan & Cromwell as 
counsel to AIG, Simpson Thacher & Bartlett as counsel to the 
AIG board of directors, J.C. Flowers & Co., Texas Pacific 
Group, Kohlberg Kravis & Roberts, and Berkshire Hathaway as 
prospective investors and/or purchasers. On September 15 and 
16, these also included Goldman Sachs. I do not recall any 
other firms or banks as being involved, but only AIG and the 
other parties can say definitively whether they retained or 
engaged any other firms or banks.
    Concerning other government agencies, we dealt with the 
Federal Reserve Bank of New York, the FRBNY's financial 
advisors Morgan Stanley, the FRBNY's legal counsel Davis Polk & 
Wardwell, the United States Treasury Department, the 
Pennsylvania Department of Insurance, the National Association 
of Insurance Commissioners (including the then-NAIC president 
Sandy Praeger, who is the Kansas Insurance Commissioner and the 
NAIC president-elect, and now president, Roger Sevigny, who is 
the New Hampshire Insurance Commissioner), and a number of 
other State insurance departments. I have subsequently learned 
that a staff member of the United States Office of Thrift 
Supervision contacted one of my staff late on Sunday, September 
14. I was unaware of that contact at the time and I had no 
contact with the Office of Thrift Supervision during the period 
covered by your question.

Q.1.c. Did any State insurance regulators object to or express 
any concerns about this plan?

A.1.c. Accurately answering your question requires separating 
it into two parts, the first being whether any insurance 
regulators ``object[ed] to'' such plan and the second being 
whether any insurance regulators ``express[ed] any concerns.''
    On the first part, I do not recall any State insurance 
regulator saying that they objected to the plan.
    On the second part, all State insurance regulators I spoke 
with expressed concerns. Indeed, I had great concerns and 
worked virtually around the clock beginning Friday evening in 
response to those concerns. Our shared concerns were 
policyholder protection and the solvency of the licensed 
insurance companies. As Governor Paterson stated in his press 
release on the morning of September 15, protection of 
policyholders was a pre-condition for any approval and we 
focused intently on such protection. We worked to evaluate the 
possible asset exchange in detail, including whether the assets 
to be received by the property and casualty companies were of 
sufficient value, and continued doing so through late Monday, 
September 15.

Q.2.a. Securities Lending: Superintendent Dinallo, according to 
AIG corporate records, AIG's securities lending program 
invested more than 60 percent of its collateral in long-term 
mortgage-backed securities. More than 50 percent of its 
mortgage-backed securities were comprised of subprime and alt-a 
mortgages. Since AIG loaned out securities for typically less 
than 180 days, there was a significant asset-liability mis-
match in AIG's securities lending program.
    Why was AIG allowed to invest such a large percent of the 
collateral from its securities lending program in long-term 
    When did you first become aware that AIG had invested such 
a high percentage of the collateral from its securities lending 
program in mortgage-backed securities? Did it raise any 
concerns at the time? If so, what specific steps did your 
Department take to address those concerns?

A.2.a. Based on what we were seeing at AIG, but before AIG 
Financial Products caused a crisis in September 2008, we warned 
all licensed New York companies that we expect them to 
prudently manage the risks in securities lending programs. On 
July 21, 2008, the New York Department issued Circular Letter 
16 to all insurance companies doing business in New York, 
indicating Department concerns about securities lending 
programs. We cautioned them about the risks, reminded them of 
the requirements for additional disclosure and told them we 
would be carefully examining their programs. The Department 
does not issue many circular letters and they are understood by 
the industry to be important communications.
    Immediately after the AIG crisis began, on September 22, 
2008, the Department sent what is known as a Section 308 letter 
to all life insurance companies licensed in New York, requiring 
them to submit information relating to securities lending 
programs, financing arrangements, security impairment issues 
and other liquidity issues. My staff then conducted a thorough 
investigation of the securities lending programs at New York 
life insurance companies. Besides gathering information from 
all companies, the Department met with 25 New York life 
insurance companies which have a securities lending program. 
The results were reassuring. Almost all of the companies had 
modest sized programs with highly conservative investments, 
even by today's standards. Companies with larger programs had 
ample liquidity to meet redemptions under stress. None of them 
had the same issues as the AIG program.
    In the succeeding months we have continued to analyze the 
securities lending programs at New York companies. We are 
currently drafting regulatory guidelines that will govern the 
size and scope of securities lending programs and will include 
updated best practices. We will use our legal authority to shut 
down any programs that we believe endanger policyholders.
    AIG's securities lending program was operated by a special 
unit created by the holding company, rather than by each 
individual AIG life insurance company. No other New York 
insurance company operates its securities lending at the 
holding company.
    The New York Insurance Department began discussing 
securities lending with AIG in 2006 in the context of applying 
risk-based capital. Risk-based capital looks at the risk of a 
particular investment and requires the company to hold capital 
against that investment based on an analysis of the risk. For 
securities lending, the Department took the position that 
insurers with securities lending programs had counterparty risk 
and should take a risk-based capital charge on that basis. AIG 
in particular, and the industry in general, disagreed with our 
position. Taking a charge would have protected the company and 
its policyholders, but would also have reduced the amount 
earned from securities lending.
    In early 2007, AIG gave the Department a presentation about 
its securities lending program. The intent of the presentation 
was to explain why there should be no risk-based capital 
charge. The company explained that they had reinvested the cash 
collateral largely in asset-backed and mortgage-backed 
securities. They explained to us that they maintained 
sufficient liquidity to meet ``normal'' collateral calls and 
that the reinvested assets were in AAA-rated, highly-liquid 
assets. At the time of the presentation, these assertions 
seemed valid and in fact the market value of the securities was 
sufficient to cover the liability, that is, the return of the 
cash collateral.
    The issue of a risk-based capital charge for securities 
lending was settled to our satisfaction in 2007. The 
Department, as chair of the NAIC Capital Adequacy Task Force, 
spearheaded a subgroup to review the risk-based capital formula 
to ensure that the appropriate charge was taken by all 
companies for their securities lending programs. The subgroup 
completed its work in 2007, and recommended changes that were 
adopted and effective for the 12/31/08 annual statement filing.
    The bad news about the residential mortgage-backed 
securities market began to become serious in the summer of 
2007. Because of that, we conducted further discussions with 
AIG in September 2007. In those discussions, we focused on the 
percentage of the investments in mortgage-backed securities and 
their terms and maturity.
    At that time, the AIG U.S. securities lending program 
reached its peak of $76 billion. AIG stated that the program 
was structured to ensure that sufficient liquidity was 
maintained to meet the cash calls of the program under ``normal 
circumstances.'' At that time, AIG's securities lending program 
held 16 percent cash and cash equivalents, 33 percent 
securities with 2 years or less maturity, 34 percent securities 
with 3 to 5 years maturity, 15 percent securities with 5 to 10 
years to maturity and only 2 percent securities with more than 
10 years maturity.
    It was then clear that the program should be reduced. The 
holding company promised at that time to pay the securities 
lending program for any losses on sales of securities up to $1 
billion, which later was increased to $5 billion, to protect 
the life insurance companies. We began to work with the company 
on reducing the size of the program. \1\
     \1\ According to an unofficial transcript, in my oral statement to 
the Committee on March 5, which I did not read, but presented from 
brief notes, I stated that we began working with the company to reduce 
the securities lending program ``starting in the beginning of 2007.'' 
Later in my testimony, I stated more precisely that ``starting in 2007, 
we did begin to wind down'' the program. While we were working with AIG 
on issues related to the securities lending program in early 2007, in 
fact, as noted, we began working with the company specifically on 
reducing the size of the program towards the end of 2007.
    In March 2008, New York and other States began quarterly 
meetings with AIG to review the securities lending program. 
Meanwhile, the program was being wound down in an orderly 
manner to reduce losses. Because of the size of the program and 
the bad market conditions, the company had to proceed slowly 
with sales of assets in order to reduce losses on those sales. 
Despite those problems, the company was able to make 
substantial progress. From its peak of about $76 billion in 
September 2007, the securities lending program had declined by 
$18 billion, or about 24 percent, to about $58 billion by 
September 12, 2008.
    At that point, the crisis caused by Financial Products 
caused the equivalent of a run on the AIG securities lending 
program. Securities borrowers that had reliably rolled over 
their positions from period to period for months began 
returning the borrowed securities and demanding their cash 
collateral. From September 15 to September 30, borrowers 
demanded the return of about $24 billion in cash.
    The holding company unit managing the program had invested 
the securities borrowers' cash collateral in mortgage-backed 
securities that had become hard to sell. To avoid massive 
losses from sudden forced sales, the Federal Government, as 
part of its rescue, provided liquidity to the securities 
lending program. In the early weeks of the rescue, holding 
company rescue funds were used to meet the collateral needs of 
the program. Eventually the FRBNY created Maiden Lane II, a 
special purpose vehicle which, according to AIG, purchased the 
life insurance companies' securities lending collateral at an 
average price of about 50 percent of par.
    If not for the Financial Products crisis, we believe that 
AIG could have continued to manage the reduction of its 
securities lending program. It would have incurred some losses, 
but they would have been manageable. There is no doubt in my 
mind that the Federal Government would not have stepped in to 
rescue AIG if the company only had its securities lending 
    It is also important to note that despite the fact that New 
York life insurance companies are relatively small and made up 
only 8 percent of the AIG securities lending program, the New 
York Insurance Department was active from the start in dealing 
with the issues related to the program.

Q.2.b. How does the reinvestment strategy of AIG's securities 
lending program compare with those of other insurance 
companies? Are you aware of any other companies having a 
similarly risky reinvestment strategy?

A.2.b. In September and October 2008, the Department met with 
25 New York life insurance companies which have a securities 
lending program. In addition, the Department sent out 134 
letters (Section 308 requests) to New York insurance companies 
to obtain information on securities lending programs, as well 
as other liquidity issues. The review indicated that none of 
the New York companies had a similar reinvestment strategy.

Q.3. Holding Company Supervision: Superintendent Dinallo, what 
authority does New York insurance law give your office to 
examine the activities of insurance holding companies and their 
    Did your office ever exercise this authority with respect 
to AIG?

A.3. Beginning nearly two generations ago, most if not all 
States in the Nation, New York included, enacted a ``holding 
company act'' to ensure that any authorized (i.e., licensed) 
insurance company that is part of a holding company system is 
subject to scrutiny by insurance regulators. The purpose of 
these holding company acts is to ensure, first and foremost, 
that insurance companies can meet their obligations to 
policyholders, and are not exploited in ways that inure to 
policyholder detriment. Thus, under holding company acts, 
insurance regulators must review, among other things, the 
financial condition and trustworthiness of any person or entity 
that seeks to acquire control of an authorized insurer, as well 
as significant transactions within a holding company system.
    New York's holding company act is codified at Article 15 of 
the New York Insurance Law. Section 1504(b) sets forth the 
Insurance Superintendent's authority to examine holding 
companies themselves: ``Every holding company and every 
controlled person within a holding company system shall be 
subject to examination by order of the superintendent if he has 
cause to believe that the operations of such persons may 
materially affect the operations, management or financial 
condition of any controlled insurer within the system and that 
he is unable to obtain relevant information from such 
controlled insurer'' (emphasis added). This power does not 
provide that such non-licensed holding companies or other 
affiliates are regulated by the Department. It is a far more 
narrow authority providing for an ability to examine such 
entities under the specified conditions.
    In the case of AIG, the New York Insurance Department did 
not exercise its authority under section 1504(b) to examine the 
holding company. First, the AIG holding company and its 
Financial Products unit were regulated by the Federal Office of 
Thrift Supervision. AIG chose OTS as its primary regulator in 
1999 based on the fact that the company owned a tiny savings 
and loan. It is worth noting that the courts have stopped other 
State agencies that tried to take action against federally 
regulated companies. Second, at no time did the Department 
request ``relevant information'' from an insurer in the AIG 
holding company system that we were ``unable'' to obtain from 
that insurer. To the contrary, the AIG insurance entities 
domesticated in New York have been responsive to requests for 
information from the New York Insurance Department. Further, 
insurers like American Home Assurance in AIG's commercial 
insurance group have had such strong financial positions--with 
billions of dollars of policyholder surplus, and, until 
September 2008, top credit ratings from rating agencies--that 
the Superintendent had no ``cause to believe that the 
operations'' of AIG's holding company might ``materially affect 
the operations, management or financial condition of any 
controlled insurer within the system.''

Q.4. AIG Securities Lending Operations: Based on data provided 
by the company, it appears that several insurers suffered 
losses on their securities lending during 2008 that exceeded 
the amount of their total adjusted capital at the start of 
2008. Due to the Fed's loan, these companies have been 
recapitalized. If the Fed had not intervened, however, it 
appears several companies, including New York insurers, could 
have been close to insolvency.
    Had the Fed not intervened to rescue AIG, was the New York 
State Guaranty Fund prepared to handle the insolvency of one or 
more AIG companies? Please provide data to support your answer.

A.4. The data provided below do not support the view that AIG's 
life insurance companies would have been insolvent both before 
and after the Financial Products crisis without the 
intervention of the FRBNY. As of the end of 2007, the companies 
had adjusted capital and surplus (inclusive of asset valuation 
reserves) of $27 billion. Their aggregate securities lending 
losses in 2008 totaled $21 billion, leaving them with remaining 
adjusted capital and surplus as a group of about $5.8 billion. 
The AIG parent company contributed $5.3 billion apart from any 
action by the FRBNY. So without accounting for any action by 
the Federal Reserve, and without accounting for any ordinary 
course earnings during 2008, the life insurance companies had 
total adjusted capital and surplus of $11 billion. As a result 
of the Federal Reserve action, that total increased to $19 

         Adjusted Capital & Surplus for AIG Life Insurance Companies Participating in Securities Lending
                                                 ($ in billions)
                               Total Adj.
                              Capital  12-
                                  31-07      Securities                    Parent      Net Surplus    12-31-08
    State        % of Pool      (includes      Lending      Gross Cap      Capital        (Gap)      After FRBNY
                                  asset     Losses  2008  (C&S-losses)    Infusions   Before FRBNY     Capital
                                valuation                                 pre-FRBNY                   Infusions
   3 NY Co's           8.4%        $1.682       ($1.82)       ($.138)         $.722         $.584        $1.901
     All AIG           100%       $27.078     ($21.305)        $5.773        $5.387        $11.16       $19.069

    As noted, the New York domestic companies would not have 
been insolvent without Federal Reserve intervention. As to the 
New York State Life Insurance Guaranty Fund, under the Life 
Insurance Company Guaranty Corporation of New York, the basic 
answer is that the New York Department was and is prepared to 
deal with the potential insolvency of a life insurer. 
Generally, the first effort is to determine if the parent 
company has the ability to cure the insolvency. If that is not 
possible, the second step is usually to seek a buyer. This is 
often possible. The final step is to take a company into 
rehabilitation or liquidation. Since life insurance obligations 
extend over a long period, there is generally some time to 
determine the extent to which a company's assets are 
insufficient to meet its liabilities.
    Had it been necessary to take the three AIG New York life 
insurance companies into rehabilitation and/or liquidation, the 
Department would have been ready for such action. It is 
important to note that two of the three New York domestic 
companies are licensed in all 50 States and would be subject to 
the guaranty funds of the 50 States, not just the New York 
Guaranty Fund. The third company is licensed in three States, 
so the guaranty funds of the three States would be involved. In 
New York, as well as the other 49 States, the guaranty funds 
are funded by assessments from its licensed companies. Even if 
a company is deemed insolvent, assessments may not be required 
immediately. Generally, assessments are only imposed as they 
are actually needed. The Department believes that the guaranty 
funds would have been ready to handle the insolvency of one or 
more AIG companies.