Academic journal article Risk Management and Insurance Review

What Effect Did Aig's Bailout, and the Preceding Events, Have on Its Competitors?

Academic journal article Risk Management and Insurance Review

What Effect Did Aig's Bailout, and the Preceding Events, Have on Its Competitors?

Article excerpt

ABSTRACT

We examine the effect of American International Group's (AIG) bailout, and the events leading up to it, on its insurance industry rivals. The reaction of rivals to AIG-related events depends on the relative strength of two competing effects. The contagion effect implies that rival returns will decrease following negative events affecting AIG. In contrast, competitive effects will occur if investors expect that rivals will be able to benefit from AIG's downfall. Using three-factor multivariate regression model event study methodology, we find evidence of both effects around several key dates in AIG's decline.

INTRODUCTION

On September 16, 2007, American International Group's (AIG) stock price was $63.44 per share. In its quarterly report released later that month, AIG reported assets of $1.07 trillion and 9-month net income of over $3 billion. AIG was the largest insurance company in the United States and was renowned for its international presence in over 130 countries.1

Exactly 1 year later (on September 16, 2008), its stock price had fallen by 94 percent to $3.75. Later that evening (September 16, 2008 at 9 p.m. EST) the Federal Reserve Bank's Board of Governors announced a bailout plan to rescue AIG from imminent failure because it feared that AIG's collapse would threaten the overall economy.2 In terms of the bailout, AIG received access to an $85 billion credit facility, and in exchange, the U.S. government received warrants for a 79.9 percent equity stake in AIG and the ability to suspend dividend payments to shareholders. On October 8, 2008 the Federal Reserve expanded the loan by adding an additional $37.8 billion to the available loan amount.3

What effect did the bailout, and the events leading up to it, have on AIG's competitors? Theory suggests that the overall industry impact of events leading to AIG's considerable decline depends on the relative strength of two competing effects - contagion and competitive. Contagion effects occur when a negative shock to one firm leads to decreased stock returns for its rivals, even if they are relatively unaffected by the firm-specific negative event. In contrast, competitive effects occur when rivals experience higher stock returns because investors expect them to benefit from the demise of a competitor.

We use event study methodology to examine the relative impacts of these effects around several key dates during AIG's considerable decline. The first date examined provides one of the earliest signs of impending financial difficulties associated with AIG's credit default swap (CDS) portfolio. On February 11, 2008, AIG wrote down $4.88 billion in its CDS portfolio exposed to the U.S. subprime mortgage market. The second date included in our analysis is September 15, 2008, when reports said that AIG was scrambling to raise capital in an effort to stave off looming credit downgrades. The third date analyzed is September 17, 2008 (the first trading day following the after-hours bailout announcement), and the fourth event date is October 9, 2008, the first trading day after the Fed's after-hours announcement of the bailout extension.

We find evidence of both contagion effects and competitive effects. For the entire period under scrutiny (February 11, 2008 to October 9, 2008) we observe positive cumulative abnormal returns (CARs) for AIG's rivals, suggesting that positive competitive effects outweighed any negative contagion effects. When examining (cumulative) abnormal returns for each of the key events we find evidence of net contagion effects around the February 11 CDS write-down and the October 9 bailout extension and some evidence of net competitive effects for the September 15 capital crisis. Our cross-sectional analysis of event-day abnormal returns provides further support for contagion effects on February 11 and competitive effects on September 15, and provides some evidence of competitive effects on the day of the bailout and the bailout extension. …

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