Question

Ben Bernanke, Chairman of the Federal Reserve Bank, said,

"AIG exploited a huge gap in the regulatory system. There was no oversight of the financial products division (referred to as "AIG FP" in the text). This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets...if there's a single episode in this entire 18 months that has made me more angry, I can't think of one, than AIG" (March 3, 2009)

Develop a discussion of these comments in the forum: this may be done by commenting on or interpreting what Bernanke meant in these statements. In your commentary and interpretation select at least one idea and expand on it. For instance:

What does it mean to say that "AIG exploited a huge gap in the regulatory system"?

What does it mean to say that "this was a hedge fund"?

What were the "irresponsible bets"?

Why would AIG make Bernanke "angry"?

Answer 1

Before going to the actual answer, let me give you a brief introduction to AIG:

American International Group (AIG) is a multinational insurance company, which has its operations in more than 80 countries. It is based in New York, United States of America.

Ben Bernanke, the chairman of the Federal Reserve Bank, said “AIG exploited a huge gap in the regulatory system”. This means AIG took the loop holes in the regulatory system as an advantage and violated the rules. There was a loop hole in the financial system, i.e., there was no proper risk-based transparency mechanism to make the stakeholders aware of the business models and financial firms’ risks. That means, there was no clear, direct and complete descriptions of the sources of revenues of the financial firms and their risk coverages or exposures and the mechanisms of generating economic value for the firms. So, the risks taken by AIG was not noticeable to the outside world. AIG’s financial disclosures were not sufficient to describe its exposures.

Ben Bernanke said “this was a hedge fund”. This means that AIG did not work like an insurance company, AIG worked like a hedge fund company, made reckless investments, took huge risks which ultimately caused massive loss to the company. A unit of AIG in London had decided to block huge amount of mortgage backed financial assets through some deals, which were known as credit-default swaps (An insurance company is not supposed to do this). So, to rescue the company from neck deep trouble, the government of United States had to offer a lifeline through bailouts, when the value of the underlying securities plummeted.

The irresponsible bets of AIG were, AIG worked like a hedge fund company that took huge risks which ultimately caused enormous loss to the company. As an insurance company, AIG had large amount of securities, and it lent those securities to other institutions, in this process, AIG took aggressive steps rather than being prudent. AIG invested lot of money in credit defaults market, which plummeted badly and during that time other institutions sought to return these financial securities to AIG. Just in September 2008, they demanded around $24bn, which AIG could not pay as AIG did not have sufficient funds to return them back. At the same time, the investments of AIG’s like mortgage securities also had lost their value. So that point of time the government had to intervene to rescue the company.

AIG made Ben Bernanke angry, because it had violated the rules and regulations of the insurance companies and it acted like a hedge fund. AIG took the advantage of the loop holes in the system. AIG was given many lifelines by the government in the form of bailouts, the government had pumped around $150bn into AIG to rescue the business, and even then AIG could not keep itself on right track. Since, AIG is the largest company, the failure of that company will have several adverse consequences on the insurance industry all over the world and it may lead to another financial crisis. AIG was in huge losses. During the fourth quarter of 2008, AIG incurred losses of around $61.7bn, which was the biggest ever loss for an US firm in a quarter. There was no transparency in the company. The risks taken by AIG were not noticeable to the outside world. AIG’s financial disclosures were not sufficient to describe its exposures. That’s why he said nothing had bothered him so much during the financial crisis than the AIG episode.