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FNCE 4070 – Financial Markets and Institutions

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1 FNCE 4070 – Financial Markets and Institutions
AIG FNCE 4070 – Financial Markets and Institutions

2 Insurance Companies Insurance 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 China 1949 – Company leaves China completely 1962 – Maurice “Hank” Greenberg put in charge of the failing US business 1967 – AIG incorporates in Deleware 1968 – Maurice “Hank” Greenberg succeeds CV Starr. 1969 – AIG goes public

11 AIG Businesses General Insurance
Life Insurance and Retirement Services Financial Services Asset Management Property/Casualty Individual/Group Life Capital Markets Investment Advisory Commercial/Industrial Retirement Services Consumer finance Brokerage Specialty Annuities Insurance Premium finance Private Banking Reinsurnance Aircraft 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 arrangement 38% 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 downside 1998 – AIG FP transacts the first credit default swap

13 AIG History Continued 2005 – 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 books In 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 Continued Throughout 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 Mortgages A 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 417K Credit quality of the borrower Debt to income ratios for the borrower Loan to value ratio (depends on the mortgage could be up to 95%)

16 Subprime Mortgage A subprime mortgage is one for which the borrower has poor credit. For example due to: Missing payments on existing debt Lack of a credit history Often LTV is high

17 2-28 Mortgage 2 year fixed rate
Usually below a longer-term rate but higher than prime mortgage rate After 2 years would switch to a variable rate Resets every 6 months or 1 year Typically 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 here build 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 payments If 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 Mortgage The 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 mortgage If 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 fund Insurance company Custodian bank holding securities for third parties A typical borrower Hedge fund Proprietary trading desk of an investment bank

23 Securities Lending Collateral
Generally % of value of securities Lender can take assets as collateral in which case they are paid a fee Lender can accept cash as collateral in which case they pay sub-market interest rates on the collateral They can then invest the cash, earn market rates and earn the spread.

24 Uses of Securities Lending
Pairs trading seeking 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 arbitrage buying a convertible bond and simultaneously selling the underlying equity short. Merger arbitrage for example, selling short the equities of a company making a takeover bid against a long position in those of the potential acquisition company Index 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 of failed settlement (with some securities settlement systems arranging for automatic lending of securities to prevent chains of failed trades) and where 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 securities Transfer ownership temporarily to the advantage of both lender and borrower For 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 securities AIG 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 business Collateral requirements were lowered. Sometimes as little as 90% of the value of the asset was received in collateral AIG 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 cash Then Fed set up Maiden Lane II This entity bought $22.5bn of RMBS securities from AIG In addition AIG made a $5bn capital injection into the securities lending program Allowed the return of all assets to AIG insurance companies The 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 Swap Credit 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 obligations In 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.

33 Credit Default Swap

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 market Conditions in the corporate bond market may make it difficult to sell a bond for which a manager is concerned about the credit of an issuer If 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 market A 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 protected Reference Obligation The particular debt issue for which the credit protection is being sought. Generally more than one issue will be acceptable as a reference obligation Maturity The standard is 5 years

36 Premium Payments CDS will trade with either a: Upfront
100 basis point spread for investment grade names 500 basis point spread for high yield names Upfront An 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 Default Downgrade Failure to pay Repudiation/moratorium Restructuring

38 Restructuring A 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 rate Reduction in principal Rescheduling of principal or interest payments A change in the level of seniority

39 Settlement The 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 event Protection Buyer Protection Seller Quarterly swap Premium

41 Mechanics of a Credit Default Swap
Cash flows after a credit event Quarterly swap premium up to date of credit event Protection Buyer Protection Seller Face amount of bonds Cash equal to face amount of bonds

42 Credit Default Swaps In 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 efficient Great source of data about Credit Default Swaps Bad 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 Entity Gross Notional (USD EQ) Number of Contracts TOTAL 14,308,888,918,935 2,080,796 REPUBLIC OF ITALY 390,375,710,039 12,859 KINGDOM OF SPAIN 211,134,101,604 10,102 FRENCH REPUBLIC 176,920,996,719 7,481 FEDERATIVE REPUBLIC OF BRAZIL 159,785,661,398 10,210 FEDERAL REPUBLIC OF GERMANY 152,364,159,881 5,744 REPUBLIC OF TURKEY 144,308,263,319 9,958 UNITED MEXICAN STATES 120,972,922,082 8,754 RUSSIAN FEDERATION 115,724,374,930 9,676 REPUBLIC OF KOREA 84,531,510,569 9,105

44 Net Notional Amounts Reference Entity Net Notional (USD EQ)
Number of Contracts TOTAL 1,064,084,678,220 2,080,796 Residential Mortgage Backed Securities 21,266,290,193 6,338 REPUBLIC OF ITALY 21,257,642,110 12,859 FRENCH REPUBLIC 17,370,144,666 7,481 FEDERATIVE REPUBLIC OF BRAZIL 16,794,932,407 10,210 FEDERAL REPUBLIC OF GERMANY 16,043,048,213 5,744 KINGDOM OF SPAIN 12,664,529,344 10,102 JAPAN 10,101,733,868 7,460 PEOPLE'S REPUBLIC OF CHINA 9,233,518,555 8,175 GENERAL ELECTRIC CAPITAL CORPORATION 9,194,757,142 6,424

45 Securitization

46 What do you do with non-AAA tranches?
ABS #1 AAA/Aaa AA/Aa2 A/A2 BBB/Baa2 Residual ABS CDO Collateral Pool ABS #2 AAA/Aaa AA/Aa2 A/A2 BBB/Baa2 Residual ABS CDO Class A Class B Class C Class D Equity BBB/Baa #1 BBB/Baa #2 A/A2 #3 ABS #4 AAA/Aaa AA/Aa2 A/A2 BBB/Baa2 Residual BBB/Baa #4 BBB/Baa #5 Mark 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 and various types of residential mortgage-backed securities including prime and subprime RMBS.

48 Subprime in CDOs

49 AIG Credit Default Swaps
AIG wrote credit default swaps on: Super Senior, “high grade,” and mezzanine tranches of multi-sector CDOs Another company involved in writing these was MBIA It was a great business Until it destroyed the company it generated a regular income stream and

50 AIGFP CEO Comment 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

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 III Bought $30bn of multi-sector CDOs in order to allow AIG to cancel CDS contracts Last assets sold August Total gain on the portfolio $6.6bn.


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