On AIG, paper losses and why make a return to securities lending

One of the stepping stones in the publicly reported collapse of AIG in 2008 was losses in their securities lending program. These were actually losses in subprime mortgage investments made in the collateral holdings for AIG’s program. The loans were arranged largely by insurance affiliates in the subsidiaries of AIG proper and were not a part of the financial institutions group responsible for the major CDS debacle. Now, the Wall Street Journal reports that AIG is beginning its securities lending program once again. A brief review of the history and current conditions of lending gives a good understanding of why this is happening.

Before the crisis, AIG was typical of aggressive securities lenders in that cash collateral was invested in subprime mortgages. These portfolio investments had very high returns, in some cases over 100 basis points. With such easy money available from theoretically safe credit instruments, there was no reason why not to engage in these transactions. Of course, history showed clearly that subprime mortgages were not good bets at least in the short term. In 2008, AIG reported paper losses of US$5 billion from its subprime mortgage collateral holdings. Rather than sell the investments” loss, AIG instead insight decided to temporarily write down the value of those holdings and provide cash liquidity to its insurance subsidiaries. This ultimately became part of AIG’s cash shortage that led to its collapse.

Between now and today, some of AIG’s paper collateral losses have recovered in value. AIG said in 2008 that they thought this would happen, and we have seen cases of public pension plans where paper losses have also been reversed. Of note, CalPERS reported paper losses of US$854.3 million from securities lending collateral in 2008. By 2010, this figure had already shrunk to US$127.6 million. Incidentally, this latter figure is roughly 50% of what CalPERS earns in one year from its securities lending program.

AIG’s current securities lending activity now has a balance of US$1.2 billion, as reported by the WSJ, and is meant to provide liquidity to the insurance divisions and to generate income against unneeded tax-advantaged positions. This is typical behavior of insurance companies, particularly life insurance companies that look to generate cash or treasuries to offset OTC derivatives collateral requirements. Also in keeping with the times, the lending divisions will no longer be able to manage their own cash collateral; the cash will be held in a third party custodial account.

Our observation is that AIG’s return to securities lending is a normal and healthy activity for a diversified financial services company. The primary concern here is the management of cash collateral; we look forward to disclosure on the holdings in AIG’s new collateral accounts as proof positive that the company is following a more conservative path in this investment activity.

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