AIG Exposed Lack of Oversight: Officials

American International Group ( AIG) exploited the fact that there is too little regulatory oversight of complex financial businesses, but its failure would have caused "unnecessary and burdensome losses," Federal Reserve and other officials said Thursday.

In a hearing before the U.S. Senate Banking Committee that sought to examine the collapse of AIG, government intervention to save it from complete failure and implications for future regulation, Fed Vice Chairman Donald Kohn said the central bank made "very difficult and uncomfortable decisions" in order to stabilize the struggling insurer.

On Monday, the Fed and Treasury Department announced they were increasing the U.S. government's bailout of AIG by $30 billion in additional capital, increasing taxpayer exposure to the firm to $163 billion.

"These decisions were particularly difficult and discomforting because they involved addressing systemic problems created largely by poor decision making by the company itself," Kohn said. "Moreover, many of these decisions involved an unregulated business entity that exploited the strength, and threatened the viability, of affiliates that were large, regulated entities in good standing.

"However," Kohn added, "uncomfortable as this was, we believe we had no choice if we are to pursue our responsibility for protecting financial stability."

Kohn added that the failure of AIG would force losses on many individuals, households and businesses, disrupt financial markets, and greatly increase fear and uncertainty about the viability of financial institutions.

"Thus, such a failure would deepen and extend market disruptions and asset price declines, further constrict the flow of credit to households and businesses in the United States and in many of our trading partners, and materially worsen the recession our economy is enduring," Kohn said.

Scott Polakoff, acting director of the Office of Thrift Supervision, acknowledged in his testimony that regulatory oversight failed to recognize AIG's exposure to the complex financial instruments, and that his agency did not foresee the impact that credit-default swaps would have on the insurance business.

Polakoff said that "where OTS fell short, as did others, was in the failure to recognize in time the extent of the liquidity risk to AIG of the 'super senior' credit default swaps" in the company's portfolio.

"No one predicted, including OTS, the amount of funds that would be required to meet collateral calls and cash demands on the credit default swap transactions," Polakoff said, adding that in hindsight, agencies focused too narrowly on the perceived creditworthiness of the underlying securities and "did not sufficiently assess" highly illiquid financial instruments like credit default swaps and collateralized debt obligations.

Eric Dinallo, New York Insurance Superintendent, used his testimony to fire back at those who blamed his office for not regulating AIG, arguing that his department "is not and never has been the primary regulator for AIG. State insurance departments have the power and authority to act as the primary regulator for those insurance companies domiciled in their state."

Dinallo also reiterated comments Fed Chairman Ben Bernanke made earlier this week that AIG was "a hedge fund basically that was attached to a large and stable insurance company, made huge numbers of irresponsible bets, took huge losses."

On Tuesday, Bernanke appeared before the Senate Banking Committee and criticized AIG's bailout as one that had made him angrier than anything else during the financial crisis of the last 18 months, although it was necessary to prevent markets from collapsing, he said.

Dinallo also argued that AIG's collapse did not emanate from its state-regulated insurance companies. "The primary source of the problem was AIG Financial Products, which had written credit default swaps, derivatives and futures with a notional amount of about $2.7 trillion, including about $440 billion of credit default swaps."

Earlier Thursday, Bloomberg reported that AIG suspended talks to sell a foreign life insurance unit and is preparing to take the business public as early as next year.

Shares of AIG were lately down 11.6% to 38 cents a share. The stock is down more than 75% in 2009 and has fallen more than 99% over the last 12 months.

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