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American International Group, Inc.

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16 December 2008

Michael Quade, Stefanie Huthmacher, Simon Lutz, Simon Nikles 2

Agenda

Overview

AIG the Company

AIG’s Situation in the Financial Crisis

Research Approach

– Related Theory

– Research Question, Hypothesis and Specific Aim

Principal – Agent Relationships

– “CDS and CDO Customers (Banks) – AIG Financial Products“ – “AIG Holding – AIG Financial Products (Joseph J. Cassano)“ – “AIG Financial Products – Rating Agencies“

– “AIG Financial Products (Joseph J. Cassano) – Consultant (Gary Gorton)”

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Overview

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AIG the Company

History and Products

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AIG the Company

Vision and Values

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AIG’s Situation in the Financial Crisis

Chain of Events

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AIG’s Situation in the Financial Crisis

Stock Market

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Research Approach

Related Theory

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Research Approach

Research Question, Hypothesis and Specific Aim

Research Question

– Were too high risk aversion, moral hazard and blind confidence responsible for the financial crisis of AIG

– and how would it be possible to prevent such problems in their principal-agent relationships in the future?

Hypotheses

– The risks of failure which may result out of hidden information and hidden action must be shared up equally between principal and agent. One result from the spread of the risk will be lesser moral hazard.

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Research Approach

Research Question, Hypothesis and Specific Aim

Specific Aim: Proof the research question and hypotheses

– Analyse four specific principal – agent relationships – Identify possible agency problems

– Find solutions and approaches to reduce possible agency problems – Analyse whether and what kind of risk guidelines and means to spread

the risk are feasible against found problems

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AIG’s Situation in the Financial Crisis

Income Situation

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Principal – Agent Relationship

“CDS and CDO Customers (Banks) – AIG Financial Products“

Michael

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Principal – Agent Relationship

“AIG Holding – AIG Financial Products (Joseph J. Cassano)“

Steffi

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Principal – Agent Relationship

“AIG Financial Products – Rating Agencies“

Simon L.

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Principal – Agent Relationship

“AIG Financial Products (Joseph J. Cassano) – Consultant (Gary Gorton)”

Joseph Cassano

– former CEO AIGFP, known from other relations

Gary Gorton

– Joined AIGFP as consultant in the late 1990s

– devised computer models to gauge risk of CDS deals

– Professor of Finance at Yale University, former Pennsylvania

– Several functions in financial institutions and research organisations

Principal: Cassano – Agent: Gorton

– “The principal/agent framework applies whenever one party (the agent) is hired by another (the principal) to take actions or make decisions that

affect the payoff to the principal.” (Besanko et. al., 2007)

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Principal – Agent Relationship

“AIG Financial Products (Joseph J. Cassano) – Consultant (Gary Gorton)”

The agent’s objectives and interests

– Prove / apply research theories and risk models – Gain reputation

– Additional income (secondary)

The principal’s objectives

– Obviously strive for profit

– Legitimate business and convince customers

current measures

– Payment on hourly basis, details on agreements are unknown

possible hidden information

– Best knowledge on the models he designed

– Strong knowledge on financial markets and credit default swaps

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Principal – Agent Relationship

“AIG Financial Products (Joseph J. Cassano) – Consultant (Gary Gorton)”

possible hidden actions

– CDS business and consequently the risk calculation models are highly complex; possibly the management cannot observe and assess his activities concerning model development

cases of adverse selection

– No indication found. Maybe the selection of the consultant?

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Principal – Agent Relationship

“AIG Financial Products (Joseph J. Cassano) – Consultant (Gary Gorton)”

unequal risk and dependency

– There are no visible risks bore by Gorton (as long he can justify his models)

– He even got a position at Yale this year

– Gorton may have become indispensable

– The models he knew best were the basis of a big business

– Cassano, as manager was formally responsible and at least bore the risk of loosing his position

– He therefore lost esteem and power but the financial consequences are worn by AIG and even the FED

– Thus, both of them are suspected for moral hazard

consequences of moral hazard

– Gorton possibility adjusted the calculations in a way, that the business seems very lucrative whilst the probability that his calculations fail is still small

– Not all possible risks have been taken into account

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Principal – Agent Relationship

“AIG Financial Products (Joseph J. Cassano) – Consultant (Gary Gorton)”

Solution goals

– align the agent’s interests to the principal’s objectives – reduce dependency of the agent

– reduce potential of hidden information

Consultant selection

– screening: ‚bid conference‘

Reduce risks hidden information

– cooperation (or competition) of more than one consultant

Contracting

– clear definition of the works scope and purpose  publicity – performance measures not seen as helpful:

– No decision power  not responsible for profit  no direct influence – Correctness of models  hardly measurable: risk probabilities

Regulations

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Principal – Agent Relationship

“AIG Financial Products (Joseph J. Cassano) – Consultant (Gary Gorton)”

Side-effects and risks of solution approaches

– Screening

– some consultants may abstain  possibly positive effect

– Cooperation/competition:

– agents work together against principals goals – double payment

– less performance due to process of reaching consensus

– clear definition of the works scope and purpose

– No effect if the agent can judge their work

Would the agent agree with these proposals?

– Gorton would still have the possibility to approve his models and theories – If a scientist declines cooperation  what is his intention?

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Conclusion

difficult or even impossible to prove cases of moral hazard or adverse selection

Common findings in all cases

– Possible hidden information and hidden actions found – No large risks bore by the agents

– Thus Potential for moral hazard

– We cannot blame a single agent's or principal's behavior for AIG’s fall

We conclude that it was possible to reduce danger of critical situations by

– spreading the risks,

– applying more responsibility and

– enforce regulations regarding calculation of transaction risks

Thus the hypothesis are confirmed by this work, not evidenced but at least not refuted

– first hypothesis (that risk must be shared up) supported by all of the concrete relationships,

– risk guidelines are mainly reckon as helpful regarding AIGFP, namely Joseph Cassano as responsible person for taking over large risks and generally in relation with rating agencies.

Consequently the answer to our research question

– risk aversion, moral hazard and blind confidence are at least partially responsible for AIG's crisis

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References