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Merrill Lynch Vs AIG
- 1. Merrill Lynch Vs AIG RISK ANALYSIS: FINANCIAL CRISIS 2008
- 2. Background Merrill Lynch is the wealth management division of Bank of America. Merrill Lynch is a company in Financial Services it was founded in 1914. Currently, it is headquartered in New York City at Four World Financial Center. Merrill Lynch covers worldwide investment management. It employs 15,100 Financial Advisors as of 2010. (www.ml.com,2016) American International Group, Inc. (AIG) is a leading international insurance organization serving customers in more than 100 countries and jurisdictions. AIG companies serve commercial, institutional, and individual customers through one of the most extensive worldwide property-casualty networks of any insurer.(About Us, www.aig.com,2016)
- 3. ONE High Impact Risk One high Impact risk for both these companies was CREDIT RISK. During the housing bubble in USA most of the investment banks like Merrill Lynch bundled the mortgages into Collateralized Debt Obligation (CDOs). These CDOs were further sold to investors. Banks bought CDS(Credit Default Swaps) from AIG. Credit Default Swap is basically a financial product used to insure Collateralized Debt Obligation (CDO). Due to the SUBPRIME mortgages, the families holding them started to default on their payments. Therefore, the housing market started to collapse. At that point of time the investors and banks were holding on to the CDOs which were worth billions
- 4. Definition of Risk and How they measured it? During the Financial Crisis both these companies were accumulating these toxic assets which eventually was LIQUIDITY RISK, CREDIT RISK and MARKET RISK for each of the firm. In my research I could not find any information regarding how they used to Measure and Manage this risk. In spite of warnings and signs of danger from the experts globally the banks and government and both these firms took no action to curb the risks. Rather, there were more risky assets bought and sold by lending subprime mortgages. Eventually, both the companies had no contingency planning for a disaster such as 2008.
- 5. RISK Comparison Merrill Lynch AIG Risk Identification : Careless Risk Takers Accumulated toxic CDO No Risk Governance Risk Measurement: No specific Information found how this firm used to measure the liquidity risk, credit risk & market risk at that point of time Risk Identification: Careless Risk Takers Accumulated toxic CDS No Risk Governance Risk Measurement: No specific Information found how this firm used to measure the liquidity risk, credit risk & market risk at that point of time
- 6. Moral Hazard and Systemic Risk The event of 2008 created a Moral Hazard and Systemic Risk in the financial industry. It created moral hazard because if government bailed out these companies then the companies would not have learnt their lessons. The companies would have taken more risks in the future. It created system risk for the financial system if the government did not bail out these companies then there would be frozen credit in the financial industry. Frozen credit directly impacts the common people as it creates global recession.
- 7. Contingency Planning and Disaster Recovery Both Merrill Lynch and AIG did not have any contingency and disaster recovery disaster recovery planning. The federal government bailed out AIG to save them from the disaster. When Merrill Lynch was on the verge of bankruptcy it was acquired by Bank of America to save from the disaster. Bank of America later had second thoughts to acquire Merrill Lynch. However, at that time Federal Government stepped it and gave a relief fund called TARP for recovery of Merrill Lynch.
- 8. Reflections Similarities: Careless Risk Takers in terms of CDO and CDS No contingency & disaster recovery planning Ignored increasing credit risk and created moral hazard and systemic risk for the financial system Differences: The US government offered bailout package to AIG otherwise it would be a system risk The US government did not offer bailout package to Merrill Lynch due to Moral Hazard However, the US government released TARP to Bank of America to stabilize the merger of BoFA and Merrill Lynch
- 9. If I was a Leader Risk Appetite: Analyze the risk appetite for both the companies. Set a threshold beyond which the firm does not invest into risky assets. Risk Identification: Scenario Analysis & Stress testing to identify liquidity risk, market risk (housing market) and credit risk Risk Measurement: SVA & VAR for measuring the credit risk. After measuring these Risk Governance: Set up a governance structure Report Risks to the upper level in the hierarchy for example CRO Hold someone responsible in the event of collapse Audits: Schedule regular financial audits
- 10. References About Us - Insurance from AIG in the US. (n.d.). Retrieved from http://www.aig.com/about-us_3171_437773.html?cmpid=KNC-Google-aig- AIG-General-E-aig AIG Announces U.S. Bailout Exit Plan; Shares Climb - Bloomberg Business. (n.d.). Retrieved from http://www.bloomberg.com/news/articles/2010-09- 30/aig-to-convert-preferred-shares-into-common-to-repay-u-s-rescue American General Life Insurance. (n.d.). Retrieved from http://lifeinsuranceguide.net/companies/american-general-life-insurance- companies/ The Crisis of Credit Visualized - HD. (n.d.). Retrieved from https://www.youtube.com/watch?v=bx_LWm6_6tA George G. Kaufman. (n.d.). Banking and currency crises and systemic risk: Lessons from recent events.
- 11. References Home. (n.d.). Retrieved from http://individual.ml.com/index.asp?id=15261_15423 Liquidity Risk Definition & Example | Investing Answers. (n.d.). Retrieved from http://www.investinganswers.com/financial-dictionary/businesses- corporations/liquidity-risk-73 Market Risk � Definition and Other Information. (n.d.). Retrieved from http://www.hedgefund-index.com/d_marketrisk.asp Moral Hazard Definition | Moral Hazard Meaning - The Economic Times. (n.d.). Retrieved from http://economictimes.indiatimes.com/definition/moral-hazard Principles for the Management of Credit Risk - final document. (n.d.). Retrieved from http://www.bis.org/publ/bcbs75.htm U.S. pushed Bank of America to complete Merrill buy: report| Reuters. (n.d.). Retrieved from http://uk.reuters.com/article/us-bankamerica-treasury-idUKTRE5140OA20090205
Hinweis der Redaktion
- Merrill Lynch and AIG were two of the financial industry companies which were on the verge of bankruptcy. Merrill Lynch was an investment bank and AIG was an insurance organization. AIG sold CDS which is a financial switch agreement. CDS were bought against the risky CDOs which the investment sold it to the investors.
- The High Impact Risk Event is the collapse of Housing Market in the USA in 2008. However, in 2006-2008 the housing market failed in the USA and it created a phenomenon called as Frozen Credit. This event affected all the major banks including Merrill Lynch. It also affected AIG as it was connected to all major banks via CDS. ("Crisis of Credit Visualized - HD," n.d.) Basically, in this event the home owners are the people who take mortgages to buy homes. These mortgages are held by lenders. The lenders further sell this mortgages to investment banks. The investment banks creates a pool of mortgages and slices them according to the risks involved in the investment. These slices are then further sold to investors. ("Crisis of Credit Visualized - HD," n.d.) At the bust of Dotcom bubble and after September 11 terrorist attack on World Trade Center, Federal Reserve Chairman Alan Greenspan lowered interest rate to only 1% to keep the economy strong. The banks on the Wall Street started borrowing huge sum of money from the Federal Reserve as the interest rate was pretty low. This rampant borrowing caused the bank to take more risks which gave rise to Subprime Mortgage Crisis in the United States. ("Crisis of Credit Visualized - HD," n.d.) Since banks started taking more risks they also got good returns. This was seen as an opportunity by the investors to invest in the products offered by the banks. This gave rise to new market, the banks could sell the mortgages to the investors. ("Crisis of Credit Visualized - HD," n.d.) The investment banks bundled these mortgages of home owners called as CDOs (Collateralized Debt Obligation). The CDOs were divided according to the risk of the investment and the divisions were rated by a credit rating agency. The least risky investments were rated as AAA. To make these investments safer the banks insured the AAA investment for a small amount called as CDS (Credit Default Swaps). ("Crisis of Credit Visualized - HD," n.d.) This whole process created more demand among the investors to invest in the CDOs. At one point of time when there were fewer families who wanted mortgages. The investment banks at Wall Street and lenders saw SUBPRIME MORTGAGES as a tool for creating altogether a new market. Subprime Mortgages were the mortgages which didn’t require any down payment and any proof of income from the families. Basically, a low income family which didn’t qualify for the loans earlier were now qualified for the subprime mortgage. This is believed to be the turning point in the period of Housing Bubble. ("Crisis of Credit Visualized - HD," n.d.) The subprime mortgage also follows the same process of CDOs, CDS & AAA ratings. Eventually, these CDOs are bought by the investors. Since these were the Subprime Mortgages, the families holding them started defaulting on the payments. Slowly, due to the defaulting of the payments the house prices in the USA started falling. It is also coupled with the increase in the interest rate which caused the variable rate mortgages to pay more. These caused more supply of houses in the market than the demand and the house prices are not rising anymore. At this point of time the investors, the banks, the lenders are holding on to CDOs and mortgages worth billions. The losses were beyond imagination. The consequence of this event was a phenomenon called as Global Recession. ("Crisis of Credit Visualized - HD," n.d.)
- Liquidity Risk: Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process. ("Liquidity Risk Definition & Example | Investing Answers," n.d.) Market Risk: Market risk is the risk that the value of an investment will decrease due to moves in market factors. Volatility frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. ("Market Risk � Definition and Other Information," n.d.) Credit Risk: A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. ("Principles for the Management of Credit Risk - final document," n.d.)
- Liquidity Risk: It was a liquidity risk for Merrill Lynch and AIG because when the housing market collapsed they had billions of assets(CDO and CDS) and they also sold billions of assets to the investors. Once the market failed the assets (CDOs) were worthless. Also, the insurance (CDS) was not able to pay for every investor who bought insurance against the CDO. This disaster happened because no one taught of the SCENARIO of housing market collapse. Market Risk: The values of CDOs decreased as slowly the housing prices started decreasing in USA because many families started defaulting on their loans. Merrill Lynch and AIG were dealing with products that were directly related to the housing market. Therefore, it was a market risk for them. Credit Risk: The investor’s ROI on CDOs was dependent on whether the borrower of house loan paid the loan on time. The home owners started defaulting on payments which caused the market risk and which also caused the liquidity risk.
- “Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.” (Moral Hazard Meaning, The Economic Times) “In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system.” (George G. Kaufman)
- AIG: The US Government had to come with Emergency Economic Stabilization Act of 2008, where it had given $85 billion credit facility, to help AIG meet its collateral obligations. In exchange, the US government received a 79.9% equity interest in AIG. ("American General Life Insurance," n.d.) In Nov 2008, AIG and the US Government reached a new agreement for a total bailout package of $182.3 billion. ("AIG Announces U.S. Bailout Exit Plan; Shares Climb - Bloomberg Business," n.d.) Merrill Lynch: The Troubled Asset Relief Program (TARP) played a key role in stabilizing the financial system during the merger phase. Bank of America received $20 billion from the U.S government through the TARP and this was an addition to the $25 billion given to them in the Fall 2008 through TARP. According to a March 15, 2009, article in The New York Times, Bank of America received an additional $5.2 billion in government bailout money, channeled through American International Group. ("U.S. pushed Bank of America to complete Merrill buy: report| Reuters," n.d.)