Presentation on theme: "FNCE 4070 – Financial Markets and Institutions"— Presentation transcript:
1 FNCE 4070 – Financial Markets and Institutions AIGFNCE 4070 – Financial Markets and Institutions
2 Insurance CompaniesInsurance companies assume the risk of their clients in return for a fee, called the premium.Most people purchase insurance because they are risk-averse—they would rather pay a certainty equivalent (the premium) than accept a gamble
3 Fundamentals of Insurance Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to:There must be a relationship between the insured and the beneficiary. Further, the beneficiary must be someone who would suffer if it weren’t for the insurance.
4 Fundamentals of Insurance The insured must provide full and accurate information to the insurance company.The insured is not to profit as a result of insurance coverage.If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation.
5 Fundamentals of Insurance The insurance company must have a large number of insured so that the risk can be spread out among many different policies.The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field.The insurance company must be able to compute the probability of the loss’s occurring.
6 Adverse Selection and Moral Hazard in Insurance As we have seen in previous chapters, asymmetric information plays a large role in the design of insurance products. As with other industries, the presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.
7 Adverse Selection in Insurance The adverse selection problem raises the issue of which policies an insurance company should accept:Those most likely to suffer loss are most likely to apply for insurance.In the extreme, insurance companies should turn anyone who applies for an insurance policy.
8 Adverse Selection in Insurance However, insurance companies have found reasonable solutions to deal with this problem:Health insurance policies require a physical exam.Preexisting conditions may be excluded from the policy.
9 Moral Hazard in Insurance Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy.Insurance companies use deductibles to help control this problem.
10 AIG History 1919 – CV Starr establishes an insurance agency in China 1939 – Company headquarters move to NY from China1949 – Company leaves China completely1962 – Maurice “Hank” Greenberg put in charge of the failing US business1967 – AIG incorporates in Deleware1968 – Maurice “Hank” Greenberg succeeds CV Starr.1969 – AIG goes public
11 AIG Businesses General Insurance Life Insurance and Retirement ServicesFinancial ServicesAsset ManagementProperty/CasualtyIndividual/Group LifeCapital MarketsInvestment AdvisoryCommercial/IndustrialRetirement ServicesConsumer financeBrokerageSpecialtyAnnuitiesInsurance Premium financePrivate BankingReinsurnanceAircraft Leasing
12 AIGFP 1987 – AIG Financial Products is formed To specialize in interest rate and currency swaps and more broadly the capital markets.Business set up to take advantage of AIG’s AAA rating.Given a unique profit sharing arrangement38% of upfront profits go to AIGFP and 62% go to AIG.Long-term trades so AIGFP get the immediate upside and AIG get the long-term downside1998 – AIG FP transacts the first credit default swap
13 AIG History Continued2005 – Amid an investigation into accounting irregularities Greenberg steps down from the company.2005 – Due to heightened risks to sub-prime AIGFP stop writing Credit Default Swaps$80bn remain on the booksIn August 2007 CEO states “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions”
14 AIG History ContinuedThroughout 2007 and 2008 AIGFP repeatedly posts additional collateral against these trades.In September 2008 AIG executives learn that the rating agencies are going to downgrade them again. This will trigger significant collateral calls for which AIG does not have the cash.
15 MortgagesA conforming loan is one that matches various criteria. These include:Limits on the size of the mortgage – for a single family home the mortgage cannot be more than 417KCredit quality of the borrowerDebt to income ratios for the borrowerLoan to value ratio (depends on the mortgage could be up to 95%)
16 Subprime MortgageA subprime mortgage is one for which the borrower has poor credit. For example due to:Missing payments on existing debtLack of a credit historyOften LTV is high
17 2-28 Mortgage 2 year fixed rate Usually below a longer-term rate but higher than prime mortgage rateAfter 2 years would switch to a variable rateResets every 6 months or 1 yearTypically to 6 month LIBOR + 6%A rate reset cap would allow rate to move by no more than 2-3% for each reset
18 2-28 Mortgage The positives: The negative: build up some equity in your home – home prices going up helped herebuild up some credit history.hopefully after the initial two-year period you would qualify for a conventional mortgage.The negative:If you could not refinance after 2 years you would see a significant increase in the cost of your mortgage
19 2-28 mortgage After two years there are many possibe outcomes The borrower has better credit history now, the house is worth more or the same as before and they can refinance into a traditional mortgage at a much lower rate.The borrower does not have better credit history and they can afford to pay the higher rates. This seems like an unlikely scenario.The borrower does not have better credit history and cannot afford the higher payments but the house is worth more than before.They can refinance into another subprime mortgage, possibly take cash out of the home and use some of that cash to afford the next couple of years of paymentsIf lending standards have tightened so that they cannot take out a new mortgage then they can sell the house and pay off the mortgage.
20 2-28 MortgageThe borrower does not have better credit history, cannot afford the higher payments, and the house is worth less than before.Unscrupulous mortgage originator who will earn a 1% fee on originating a new loan gives a higher appraisal, adds the 1% fee to the balance of the mortgage and issues a new mortgageIf they do not meet mortgage lending standards (esp LTV requirements) then they will be forced into default.
21 Mechanics of Short Sale (www.interactivebrokers.com)
22 Securities Lending A typical lender is a A typical borrower Mutual or pension fundInsurance companyCustodian bank holding securities for third partiesA typical borrowerHedge fundProprietary trading desk of an investment bank
23 Securities Lending Collateral Generally % of value of securitiesLender can take assets as collateral in which case they are paid a feeLender can accept cash as collateral in which case they pay sub-market interest rates on the collateralThey can then invest the cash, earn market rates and earn the spread.
24 Uses of Securities Lending Pairs tradingseeking to identify two companies, with similar characteristics, whose equity securities are currently trading at a price relationship that is out of line with the historical trading range. The apparently undervalued security is bought, while the apparently overvalued security is sold short.
25 Uses of Securities Lending Convertible bond arbitragebuying a convertible bond and simultaneously selling the underlying equity short.Merger arbitragefor example, selling short the equities of a company making a takeover bid against a long position in those of the potential acquisition companyIndex arbitrage:selling short the constituent securities of an equity price index [e.g. SP500] against a long position in the corresponding index futures contract
26 Uses of Securities Lending Short positions arise as a result offailed settlement (with some securities settlement systems arranging for automatic lending of securities to prevent chains of failed trades) andwhere dealers need to borrow securities in order to fill customer buy orders in securities where they quote 2-way prices.
27 Uses of Securities Lending The lender is seeking to borrow cash against the lent securitiesTransfer ownership temporarily to the advantage of both lender and borrowerFor example, some investors might be subject to withholding tax on dividends whereas others are not.Some investors might have access to cheap reinvestment plans for the dividends while others may not.
28 AIG’s Securities Lending Various insurance company subsidiaries of AIG held large numbers of securitiesAIG Securities Lending Corporation was set up to centrally manage lending arrangements
29 AIG’s Securities Lending Beginning in late 2005 AIG started to use the cash to invest in RMBS.At its peak AIG had $76bn invested of which 60% was in RMBS.The securities were AAA rated when they were purchased.
30 AIG’s Securities Lending As more businesses entered into the securities lending businessCollateral requirements were lowered. Sometimes as little as 90% of the value of the asset was received in collateralAIG would step in and provide the other 12-15%
31 AIG Rescue First the Fed set up a securities lending facility AIG lent RMBS securities to Fed in exchange for cashThen Fed set up Maiden Lane IIThis entity bought $22.5bn of RMBS securities from AIGIn addition AIG made a $5bn capital injection into the securities lending programAllowed the return of all assets to AIG insurance companiesThe last securities were sold to the market in Feb 2012 for an overall profit of $2.8bn a return of 12% for a 4-year commitment.
32 Credit Default SwapCredit default swaps (CDSs) are privately-negotiated bilateral contracts that obligate one party to pay another in the event that a third party cannot pay its obligationsIn essence, the purchaser of protection pays the issuer of protection a fee for the term of the contract and receives in return a promise that if certain specified events occur, the purchaser of protection will be made whole.
34 Credit Derivatives General Usage The liquidity of the CDS market compared to the corporate bond market makes it more efficient to obtain an exposure to a reference entity through CDS rather than the cash marketConditions in the corporate bond market may make it difficult to sell a bond for which a manager is concerned about the credit of an issuerIf a portfolio manager believes that an issuer may have credit issues in the future then CDS allow him to express this view. Alternatively the manager may short the bond but this is difficult in the corporate bond marketA portfolio manager may seek a leveraged position in a corporate bond.
35 Credit Default Swap Reference Entity Reference Obligation Maturity The issuer of the debt instrument to be protectedReference ObligationThe particular debt issue for which the credit protection is being sought.Generally more than one issue will be acceptable as a reference obligationMaturityThe standard is 5 years
36 Premium Payments CDS will trade with either a: Upfront 100 basis point spread for investment grade names500 basis point spread for high yield namesUpfrontAn upfront payment will also be made to cover the difference between a fair spread and the actual spread
37 Credit Event Bankruptcy Credit event upon merger Cross Acceleration Cross DefaultDowngradeFailure to payRepudiation/moratoriumRestructuring
38 RestructuringA restructuring occurs when the terms of the obligation are altered so as to make the new terms less attractive to the debt holder than the original terms.Reduction in interest rateReduction in principalRescheduling of principal or interest paymentsA change in the level of seniority
39 SettlementThe protection buyer pays the accrued premium until the default date.The protection buyer delivers a specified amount of the face value of bonds to the protection seller.The protection seller pays the protection buyer the face amount of the bonds
40 Mechanics of a Credit Default Swap Cash flows before a credit eventProtection BuyerProtection SellerQuarterly swap Premium
41 Mechanics of a Credit Default Swap Cash flows after a credit eventQuarterly swap premium up to date of credit eventProtection BuyerProtection SellerFace amount of bondsCash equal to face amount of bonds
42 Credit Default SwapsIn December 2011 there were an estimated $25.9tr gross notional of CDS written and $2.7tr net notional.It is an OTC market so it is difficult to have an exact figure.International Swaps and Derivatives Association (ISDA)Trade organization working to make derivatives marketplace safer and more efficientGreat source of data about Credit Default SwapsBad decisions about credit have been expressed through many different instruments, but it is important to note, it is the decisions NOT the instruments that led to losses.
43 Gross Notional Amounts Reference EntityGross Notional (USD EQ)Number of ContractsTOTAL14,308,888,918,9352,080,796REPUBLIC OF ITALY390,375,710,03912,859KINGDOM OF SPAIN211,134,101,60410,102FRENCH REPUBLIC176,920,996,7197,481FEDERATIVE REPUBLIC OF BRAZIL159,785,661,39810,210FEDERAL REPUBLIC OF GERMANY152,364,159,8815,744REPUBLIC OF TURKEY144,308,263,3199,958UNITED MEXICAN STATES120,972,922,0828,754RUSSIAN FEDERATION115,724,374,9309,676REPUBLIC OF KOREA84,531,510,5699,105
44 Net Notional Amounts Reference Entity Net Notional (USD EQ) Number of ContractsTOTAL1,064,084,678,2202,080,796Residential Mortgage Backed Securities21,266,290,1936,338REPUBLIC OF ITALY21,257,642,11012,859FRENCH REPUBLIC17,370,144,6667,481FEDERATIVE REPUBLIC OF BRAZIL16,794,932,40710,210FEDERAL REPUBLIC OF GERMANY16,043,048,2135,744KINGDOM OF SPAIN12,664,529,34410,102JAPAN10,101,733,8687,460PEOPLE'S REPUBLIC OF CHINA9,233,518,5558,175GENERAL ELECTRIC CAPITAL CORPORATION9,194,757,1426,424
46 What do you do with non-AAA tranches? ABS #1AAA/AaaAA/Aa2A/A2BBB/Baa2ResidualABS CDO Collateral PoolABS #2AAA/AaaAA/Aa2A/A2BBB/Baa2ResidualABS CDOClass AClass BClass CClass DEquityBBB/Baa #1BBB/Baa #2A/A2 #3ABS #4AAA/AaaAA/Aa2A/A2BBB/Baa2ResidualBBB/Baa #4BBB/Baa #5Mark Adelson, “Collateralized Debt Obligations and Their Connection to Sub-prime Mortgages,” LexisNexis/Mealeys Conference Presentation, 6 March 2008
47 Multi-sector CDO A multi-sector CDO These are transactions that include a variety of structured finance collateral:asset-backed securities (e.g. securitizations of auto receivables, credit cards, etc.),commercial mortgage- backed securities,CDOs andvarious types of residential mortgage-backed securities including prime and subprime RMBS.
49 AIG Credit Default Swaps AIG wrote credit default swaps on:Super Senior, “high grade,” and mezzanine tranches of multi-sector CDOsAnother company involved in writing these was MBIAIt was a great businessUntil it destroyed the company it generated a regular income stream and
50 AIGFP CEO CommentIt is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions
51 Collateral Postings Collateral postings for AIG were based on: The difference between the notional amount of the CDS and the value of the reference obligations.Not the value of the underlying derivative.In addition there were rating triggers:These cause additional problems because a company already in trouble has greater difficulties because a downgrade increases its need for cash collateral.During the 9 months ending September 2008 AIG posted in excess of $52bn of collateral
52 Maiden Lane IIIBought $30bn of multi-sector CDOs in order to allow AIG to cancel CDS contractsLast assets sold August Total gain on the portfolio $6.6bn.