Capital Stacking, Cross-guarantees, and Surplus Notes

After the difficulties with securities lending, the next issue reminded me a lot of the first company I worked for: Southmark.  A two-time loser in chapter 11, in their second trip of insolvency, they interlaced the capital of their subsidiaries, forcing them to do business on a thin capital base.  Subsidiary A would own stock of subsidiary B, and B would own stock of A.   They would both look more solvent, but would not be any more solvent.  Neither “asset” could be tapped for liquidity purposes.  In AIG’s case, most of the capital stacking was not so crude.  Most of it was operating subsidiaries owning shares in other subsidiaries, without another transaction going the other way.

Capital stacking increases leverage in a hidden way.  Say Subsidiary A owns Subsidiary B.  The surplus of B not only supports B’s business, but also A’s business.  A downturn in the business of B affects not only the affairs of B, but also A, particularly so if the surplus of B is a large fraction of A’s surplus.

With AIG, many of the operating insurance subsidiaries (OISs) held stakes (usually common stock) in other OISs.  Here’s a table of those subsidiaries with the exposure to the issue:

Some of AIG’s larger OISs have significant exposures to other subsidiaries.  One minor subsidiary, Pacific Union, invested directly in AIG’s common stock.  That subsidiary doesn’t have much business in it, and is in little danger of insolvency, but is the most egregious example of creating capital out of thin air.  (I feel the same way when companies contribute common stock to Defined Benefit plans.)

Other OISs of note: 1) AGC LIC seems to be an intermediate level holding company, with little business of its own.  2) National Union is the biggest P&C company.  3) Alico is the intermediate holding company for most of the International Life business.  4) SunAmerica and American General are holding companies for the companies when they were acquired by AIG.  They have significant business in themselves as well.

There are guarantees as well.  Some of the larger subsidiaries, like National Union, together with AIG, guarantee a number of other domestic and international OISs.

Finally, there are surplus notes, concentrated in the mortgage guarantee subsidiaries.  This is another way of creating capital out of this air.  Surplus notes are considered as surplus, not debt, to the issuer, because any payment of principal or interest must be approved by the state Insurance Commissioner.  Subsidiary A offers surplus notes to Subsidiary B, which sends cash back to subsidiary A.  Subsidiary B gets to admit the surplus note as an asset.  New surplus created, with no transfer of risk to an external party.  Three of the four mortgage guarantee subsidiaries issued surplus notes to other AIG mortgage insurance-related subsidiaries totaling a little less than $900 million.

Now, given all of the complexity and leverage from all of these arrangements, it is all the more stunning that the normally intelligent New York Insurance Department allowed for the OISs of AIG to contemplate lending $20 billion to AIG.  At the time, I thought the idea was dubious.  This article from Enforce (pages 17-20) gives the definitive treatment of the issue, though I disagree with one of their main conclusions.  I don’t think the Federal Government would do a better job regulating insurance than the states currently do.  They have certainly not distinguished themselves in their regulation of depositary institutions.