[Senate Hearing 111-69]
[From the U.S. Government Publishing Office]
S. Hrg. 111-69
AMERICAN INTERNATIONAL GROUP: EXAMINING WHAT WENT WRONG, GOVERNMENT
INTERVENTION, AND IMPLICATIONS FOR FUTURE REGULATION
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
AN EXAMINATION OF WHAT WENT WRONG WITH AMERICAN INTERNATIONAL GROUP,
WHERE GOVERNMENT INTERVENTION IS HEADED, AND THE IMPLICATIONS FOR
FUTURE REGULATION
__________
MARCH 5, 2009
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
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
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
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
(ii)
C O N T E N T S
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THURSDAY, MARCH 5, 2009
Page
Opening statement of Chairman Dodd............................... 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 4
Prepared statement....................................... 42
Senator Johnson
Prepared statement....................................... 44
WITNESSES
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
(iii)
AMERICAN INTERNATIONAL GROUP: EXAMINING WHAT WENT WRONG, GOVERNMENT
INTERVENTION, AND IMPLICATIONS FOR FUTURE REGULATION
----------
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.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
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
you?
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
Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
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
responded.
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
States?
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.
STATEMENT OF DONALD KOHN, VICE CHAIRMAN,
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
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
questions.
Chairman Dodd. Thank you very much.
Mr. Polakoff.
STATEMENT OF SCOTT M. POLAKOFF, ACTING DIRECTOR, OFFICE OF
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
Supervision.
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
AIG.
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
points.
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
crisis.
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
unavoidable.
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.
STATEMENT OF ERIC DINALLO, SUPERINTENDENT,
NEW YORK STATE INSURANCE DEPARTMENT
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
intervention.
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
Italy.
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
business.
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
unquestioned.
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
counterparties----
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
one----
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
responsibility?
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
percentages.
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
sheet.
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
records.
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
problems?
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
what?
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
securities.
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
it.
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
regulation?
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
actually----
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
gap?
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
institutions.
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
game?
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
operation?
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
independently?
Mr. Polakoff. Independently. I give the company credit for
that.
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
before.
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
it?
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
correct?
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
concern.
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
simply----
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
liabilities.
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
going.
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.
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
one----
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,
so----
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
S&L?
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
requirements.
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
them.
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
this.
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
dollar.
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
proposal.
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
products.
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
question?
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
strong.
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
integrity.
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
agencies.
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
that.
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
be----
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
here.
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
safe?
Mr. Kohn. We are working very hard to make it safe,
Senator.
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
really----
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:]
PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
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
responded.
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.
PREPARED STATEMENT OF SENATOR TIM JOHNSON
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.
______
PREPARED STATEMENT OF DONALD KOHN
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
context.
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
AIG.
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
surrenders.
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
billion.
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.
______
PREPARED STATEMENT OF SCOTT M. POLAKOFF
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
liquidity.
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
trillion.
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
negotiations.
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
concentration.
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
strategies.
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
structure.
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
Division.
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
examinations.
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
reporting;
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
enhancements.
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
inquiries.
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.
Recommendations
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.
______
PREPARED STATEMENT OF ERIC DINALLO
Superintendent,
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
institutions.''
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.
RESPONSE TO WRITTEN QUESTIONS OF THE SENATE BANKING COMMITTEE
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
companies.
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
plan?
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
assets?
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
problems.
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
affiliates?
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 $19
billion.
Adjusted Capital & Surplus for AIG Life Insurance Companies Participating in Securities Lending
($ 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
reserve)
----------------------------------------------------------------------------------------------------------------
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
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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.