An AIG Unit's Quest to Juice Profit
Securities-Lending Business Made Risky Bets. They Backfired on Insurer
By SERENA NG and LIAM PLEVEN
Inside American International Group Inc., executives called the goal "10-cubed."
It was shorthand for producing 1,000 million dollars -- $1 billion in annual profit -- from the insurer's AIG Investments unit, which managed money for AIG's own insurance companies and outside investors. In its pursuit of that goal over the past few years, said current and former employees, the unit took on additional risks in a sideline business known as securities lending, traditionally a way for insurers to squeeze a few extra pennies from their investment portfolios.
Accounts of AIG's near collapse have largely focused on soured trades entered into by the company's Financial Products division. But a close look at the 2,000-employee AIG Investments unit shows how this part of the conglomerate made gambles that helped cripple the firm.
In running the securities-lending business, AIG Investments bought tens of billions of dollars in subprime-mortgage bonds. That turned out to be a riskier approach than some rivals', who parked cash from securities lending mostly in low-risk or short-term investments such as Treasury securities and commercial paper, according to analysts.
The idea behind securities lending is to take advantage of large numbers. Insurers like AIG accumulate large quantities of long-term corporate bonds and other securities, earmarked to pay claims down the road. They can goose that return by lending out the securities to banks and brokers in exchange for cash collateral. The insurers then invest that cash to squeeze out a bit more yield for themselves and the securities borrowers. They usually achieve this by parking the cash in other fixed-income investments, such as Treasury bonds or short-term corporate debt.
The extra profits can be just hundredths of a percentage point. But when applied to tens of billions of dollars of securities, the returns can be significant.

At one point, AIG Investments was putting about $70 billion into subprime-mortgage bonds and other higher-risk assets, said people familiar with the matter. These choices helped AIG squeeze an additional 0.2 percentage point in yield, or roughly $150 million in revenue.
AIG's spokeswoman said the firm "invested counterparty cash in highly liquid, floating rate, triple-A-rated" residential mortgage-backed securities.
The approach backfired, exacerbating the liquidity crunch that forced the U.S. government's initial $85 billion bailout of AIG in September. The losses didn't stop then: Besides a $60 billion credit line to AIG, the Federal Reserve last December provided $19 billion to wall off losses purchased by AIG Investments' securities-lending program. In all, the total rescue package now sits at $150 billion.
U.S. taxpayers are shouldering much of the burden of AIG Investments' troubled mortgage assets. If the securities, currently valued at about half their original value, are hit by defaults in the coming years, taxpayers could lose out. But if they bounce back, taxpayers could log gains.
An AIG spokeswoman said its securities-lending portfolio "came under pressure due to extreme market liquidity issues," adding that "it is our expectation that taxpayers could realize material benefits on their investment in this portfolio."

The idea of "10-cubed" was the inspiration of 59-year-old Win Neuger, who joined AIG in the mid-1990s. As chairman and chief executive of the unit, he brought together the investment functions of AIG's global insurance subsidiaries and started a third-party asset-management business within the unit, getting pension funds and other institutions to invest money alongside AIG's. By September 2008, the unit was managing $565 billion in assets for AIG's insurance subsidiaries and $111 billion for external clients. Those numbers have since declined.
In late 2005, Mr. Neuger set the $1 billion profit target, noting in an internal presentation that the unit was "one of the fastest-growing profit contributors" to parent AIG.
Mr. Neuger, who was also AIG's chief investment officer up until last month, was the group's fourth-highest-paid executive with compensation of nearly $7.8 million in 2007, according to an AIG filing with the Securities and Exchange Commission. Much of that compensation was linked to AIG stock, which plunged in value last year, though more than $2.1 million was in salary and bonuses. He declined to comment.
The bulk of AIG Investments' profits came from fees it received for managing money. Another area Mr. Neuger identified for growth was AIG's securities-lending business, said people familiar with the matter.
From $1 billion in 1999, AIG's securities-lending portfolio ballooned to $30 billion in 2003 and $60 billion in June 2005, according to an internal presentation to employees in December 2005. Much of that growth came from lending out corporate bonds owned by AIG's large life-insurance and retirement-services subsidiaries, according to the presentation.
In December 2005, executives from AIG Investments proposed to AIG's credit-risk managers a set of guidelines for the securities-lending business. One was to invest up to 75% of the cash collateral it received in "asset-backed securities," according to people familiar with the matter. These securities are backed by loans including subprime mortgages and credit-card debt, and pay more interest than corporate bonds with similar credit ratings.
Mr. Neuger and Kevin McGinn, who has been AIG's chief credit officer since 2004, signed off on the proposal, agreeing in a memo that the guidelines didn't subject the portfolio to undue risk, according to people familiar with the matter. Around that same time, worries about loose lending standards in the subprime market led managers of a separate AIG division -- AIG Financial Products -- to stop committing to writing credit derivatives on securities backed by subprime collateral.
Mr. McGinn declined to comment.
Following the new guidelines, money managers at AIG Investments ramped up purchases of subprime-mortgage bonds in 2006 and 2007, as the securities-lending portfolio expanded to $94 billion in mid-2007. The additional yield from investing the cash collateral helped boost profits at AIG Investments, which earned pretax profit of $466 million in 2007, up 30% from the previous year.
The securities-lending division was obligated to repay or roll over most of its loans every 30 days. AIG Investments placed much of the cash in subprime debt that matured in two to five years. It didn't have to liquidate the positions, as long as other banks and dealers were willing to place more cash with AIG, according to people familiar with the matter.
Starting in mid-2007, prices of many subprime-mortgage bonds plummeted as loan delinquencies increased and credit markets froze.
In a November 2007 note to AIG Investments' staff, Mr. McGinn wrote, "Senior management was clearly caught off guard by the size of [AIG Investments'] subprime, first-lien [residential mortgage-backed securities] portfolio despite the portfolio's high ratings and credit quality."
As scrutiny over AIG's exposure to the subprime market increased in late 2007, AIG's risk managers instructed the investment unit to start paring its lending portfolio.
An AIG spokeswoman said that, starting in the summer of 2007, it became "increasingly difficult for AIG to meet its liabilities without liquidating asset-backed securities at dislocated market prices."
The securities-lending portfolio had shrunk to roughly $70 billion by September 2008, when AIG's problems reached a critical point. Credit-rating services downgraded AIG's ratings, allowing trading partners on credit derivatives sold by its financial-products unit to demand billions more in collateral from the firm.
The problems in the securities-lending program weren't over. In early October, many dealers returned the securities they had loaned from AIG, demanding their cash back, further straining AIG's finances.
On Oct. 8, AIG announced a deal with the Fed to try to contain the securities-lending problems, a move that expanded the bailout to more than $122 billion. Then, in December, the Fed and AIG bought the distressed investments through an entity they jointly formed. AIG also said it would end its securities-lending program.
AIG is in the process of splitting up AIG Investments as it prepares to sell the business of investing third-party assets, which Mr. Neuger plans to continue overseeing when it is spun off.
Write to Serena Ng at
[email protected] and Liam Pleven at
[email protected]