U.S. regulators failed to spot how much risk insurer AIG was piling on, and by the time they understood, they had no choice but to pour in tens of billions of public dollars, officials said on Thursday.
At a Senate Banking Committee hearing on what went wrong at American International Group Inc
That we find ourselves in this situation at all is ... quite frankly, sickening, said Senator Christopher Dodd, the Democrat who chairs the committee. The lack of transparency and accountability in this process has been rather stunning.
The fact that a multitude of regulators missed the warning signs at AIG highlighted the need to establish a systemic risk regulator to monitor firms that are large and complex enough to destabilize the financial system, said Scott Polakoff, acting director of the Office of Thrift Supervision.
Where OTS fell short, as did others, was in the failure to recognize in time the extent of the liquidity risk to AIG of certain credit default swaps held in the portfolio of the company's financial products division.
That unit, although a small part of the global insurance giant's worldwide operations, racked up such heavy losses that it threatened the entire company's survival, eventually forcing the Treasury Department and Federal Reserve to launch a series of costly bailouts.
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, said Federal Reserve Vice Chairman Donald Kohn.
Under a revised bailout deal announced on Monday, the amount of funds committed to help AIG increased to about $180 billion, although the insurer has not tapped it all and plans to pay back roughly $38 billion soon. The U.S. government holds about an 80 percent stake in the insurer.
AIG sold insurance-like protection, known as credit default swaps, against declines in the value of securities -- including subprime mortgages that began defaulting at an alarming rate when the housing market tumbled.
Fed Chairman Ben Bernanke said earlier this week that the unit operated like an unregulated hedge fund, and he expressed anger that its risky behavior put taxpayers on the hook.
But Republican Senator Bob Corker questioned whether the central bank could have safeguarded the financial system at considerably lower cost by guaranteeing AIG's credit default swaps rather than paying them off.
Couldn't you have just said ... 'We're not going to put up the collateral. I'm 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's ever a credit issue, we'll stand behind it?' he asked Kohn.
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, Kohn replied. It turned out that the problems were deeper, the financial markets were a lot worse, became a lot worse, and the whole situation deteriorated badly.
OTS' Polakoff detailed the agency's interaction with AIG going back to 1999. But despite that, OTS still failed to understand that the insurer's finances could be devastated by the activities of the financial products division.
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, he said.
In retrospect, if regulators had recognized that risk, they could have told AIG to reduce its exposure, he said.
New York Insurance Superintendent Eric Dinallo, whose agency oversees AIG's insurance business but was not the primary regulator of the financial products arm, said the unit had written some $440 billion in credit default swaps and should have been subject to more and better regulation.
Polakoff said a key lesson learned from the AIG episode was that the United States needed a systemic risk regulator that would have responsibility for monitoring companies that are so large or so interconnected that their failure would pose a risk to the country's financial stability.
(Additional reporting by Mark Felsenthal; Writing by Emily Kaiser; Editing by Dan Grebler)