1

2

Contents

Executive Summary 3

Introduction 3

Identification of Problem 3

Analysis 4 Quality of Source of Income 6

Degree of Operational Uncertainty 8

Accelerant of Operational Disintegration 8

Timing of Contingency Forecast 8

Solutions 6 Improving Quality of Source of Income 9

CDOs’ 9

Ban of CDSs’ 10

Regulate CDSs’ as Insurance Contracts 10

Improve Timing of Contingency Forecast 10

Reinstating Operational Certainty 10

Strategic Planning 10

Prudential Supervision 10

Conclusion 12

Appendix 13

References 24

3

Executive Summary

A Collateralized Debt Obligation (CDO) is a bond backed by income produced by the repayment of secured debt (Thoyts 2010). This CDO

is bundled and sold through financial services institutions to investors. As borrowers repay their loans, investors experience a return on

investment.

AIG’s operational analysis

Due to legislation changes in 2000 by the government from a stand point of banning the regulation of derivatives, AIG were

selling CDS’s as insurance policies against CDO’s defaulting. CDS were now legal without regulation, CDSs’ were also sold to

investors who did not have ownership of the underlying CDO and who no longer wanted to invest in the national treasury

due to the new 1% return rates established by Alan Greenspan in pre-2000.

Stemming from the “Commodities Future Modernization Act in 2000”, AIG were also no longer required legally to carry

enough safe reserves in order to meet any anticipated claims on CDS, condemning this was the fact that now AIG would

have to payout every CDS insurance on CDO plus interest.

AIGFP, were selling CDSs’ based on speculative risk taking and calling them safe, furthermore they were selling them as

“insurance policies” to any investor. Information asymmetry existed when AIG sold CDSs’ for CDOs’, knowing they were

protecting subprime loans.

AIG’s operational highlights

The following highlight global mismanagement as the core underlying results of operational failure of AIG in 2007-2008

Net Income in 2008 fell to -1701%

AIGFP was dissolved

Total of $2.7 trillion CDS trades (with 1 trillion still on balance sheet)

Net Operating cash flow fell to -97% in 2008

AIG was bailed out by the US Treasury for $85 Billion because its operations were tightly integrated in a global

financial system and its bankruptcy would create a global financial catastrophe

Solutions

Strategic planning should involve all hierarchical levels

Close prudential supervision to monitor and prevent financial disruption and excessive risk taking

Managers allocate a percentage of their salary into the investments they manage

Require CDS trades to be approved by financial regulatory body

CEO’s and board of directors should have vision to anticipate an oncoming accelerant of operational failure (See

Appendix 4) and decrease operational uncertainty and improve the quality of the source of income.

4

Introduction

The purpose of this report is to identify a strategic problem faced by a company, analyse what caused

this problem and then establish and justify solutions.

The overall goal is to highlight and analyze the critical cause behind AIG’s failure and its global

mismanagement. The report also proposes the Causality Framework of Organizational Failure (See

Appendix 4) which synthesizes cause and effect relationships between the key elements surrounding

organizational failure.

After clarifying this main operational failure and its provenance, solutions and justifications on how this

endeavor could have been avoided and how those solutions should have been implemented.

It should be noted that the complex nature of the financial products & services industry in which AIG

operates in requires extensive analytics; beyond the capacity of this report.

Identification Of Problem AIG, being the largest financial institution in the world offered a Credit Default Swap for owners of CDOs. If the

CDO defaulted or its’ value fell, AIG would be liable to reimburse the owner of the CDS. This shows that AIG sold

the CDS as an insurance product.

The operational problem faced by AIG was that it sold these CDS products, became illiquid and terminated the

special purpose entity (SPE) responsible for issuing this product- AIG Financial Services in London (AIGFP). AIG

mismanaged, globally, where it failed to hedge itself against its risky operations and anticipate failure.

AIG was part of a key firm cluster in the financial industry that led to the collapse of the global economy in 2008.

5

Analysis The following analysis is structured as per the Causality Framework of Organizational Failure (please see

Appendix 4)

Quality of Source of Income

The quality of source of income is the value of a specific revenue generating stream in an organization.

In 2000, the US congress passed the Commodities Futures Modernization Act (See Appendix 8, CFMA),

banning derivatives regulation. This allowed AIGFP to repackage a derivatives’ product known as a

Credit Default Swap (CDS) and sell it as insurance against CDOs’ (See Appendix 1) defaulting without

adequate regulation (Thoyts, 2010, See Appendix 2).

AIG were no longer legally bound to have operating reserves to cover anticipated claims (See Appendix

9). This created a risky insurance product which was a poor source of income. The excessive risk of the

CDS meant that it could fail because AIG may not be able to satisfy its repayments (Thoyts, 2010).

Consequently, this shows that AIG had a poor source of income because it was not able to satisfy CDS

repayments.

Accelerant of Operational

Disintegration

Accelerant of Operational

Disintegration

Quality of Source of Income

Quality of Source of Income

Timing of Contingency

Forecast

Timing of Contingency

Forecast

Degree of Operational Uncertanity

Degree of Operational Uncertanity

6

If any investor could purchase a CDS even if they did not own the underlying asset (See Appendix 10,

Hedging and Speculation) then in the event that a CDO defaults, all CDS owners would have to be

reimbursed the value of the CDO, plus the interest rate it was supposed to deliver. In consequence,

heightening AIG’s liabilities. If CDSs’ are a poor quality source of income then this also shows that CDSs’

defaulting caused this poor quality source of income by the cumulative reimbursements to investors.

Rajan (2005) concurs that firms were using this method to “goose up” returns. This flawed business

model also shows uncertainty in AIG’s operations.

Dudley and Hubbard (2009) correctly attest that frequent mortgage approvals pre 2008 led to “dramatic

drops in the costs of mortgages”. The investment firms packaged different

types of loans into a derivatives product known as a

Collateralized Debt Obligation. These were sold to

investors who preferred them to the 1% return on

government bonds at the time. CDO’s are split into

three “tranches”- high, medium and low risk. The

highest risk proportion offered the highest return.

Additionally, loan institutions were executing risky

lending because they were part of a securitization

food chain (See Appendix 14). In this chain,

investment firms were offering to buy mortgages

and other loans from lending institutions. This was

a valuable way for the lending firm to transfer the

risk to the large financial firms and therefore, they

were no longer liable to loans defaulting. As CDOs’ are created in the securitization process and CDSs’

insure CDOs’ then if CDSs’ are a poor quality source of income then this shows that the poor quality

income was sourced from risky lending practices by loan institutions. Allan Sloan, Senior Editor at CNN

concurs that “lenders of mortgages were greedy and that they signed irresponsible borrowers who had

no chance of repaying for their loans”.

If CDSs insure CDOs and Rajan (2005) claims that CDOs are speculative risks then CDSs must be insuring

a speculative risk; a practice incompatible with insurance law, as claimed by Thoyts (2010). A CDS also

requires collateral posting obligations from the issuer- AIGFP. If the value of the CDO or AIGs debit

rating downscaled then AIG would be obligated to post more and more cash collateral. As AIG had its

debit rating downgraded (Sjostrum, 2009), cumulative numbers of investors were obliged to additional

cash collateral. Hence, AIG speculated the risk against CDO downscale and did not anticipate the

demand for collateral postings when it was issuing CDSs. Sjostrum (2009) argues that this was the core

reason that AIG almost went bankrupt.

In disparity, if the International Swaps and Derivatives Association (2012) emphasizes that CDSs’ offer

unique value to economic activity by enabling participants to better manage risk, then it delivers

incredible value to the global economy. In addition, if CDSs’ create a liquid marketplace then this

provides more capital for financing (ISDS, 2012). However, if AIG became illiquid and failed to manage

Goldman Sachs (2004)

7

its risk then the ISDA’s emphasis may be questionable. Ultimately this shows that CDSs’ may not be of

“incredible value” to the global economy.

Degree of Operational Uncertainty

The degree of operational uncertainty is the extent to which there exists ambiguity of the direction of

an organizations’ operations.

If Dudley and Hubbard (2009) demonstrate that the housing market was stable then this should result

in reliable CDOs’ and thus CDSs’. Additionally, if Sjostrum (2009) asserts that AIGFP’s statistical risk

models depicted low risk in the CDS market then these products and AIG should not have encountered

the risk of failure. But as shown before, CDOs’ and CDSs’ were not reliable products and AIG failed,

therefore AIG’s risk models were inaccurate and the housing market was volatile. Despite this the notion

stands that this contradictory information creates a strong scenario of operational uncertainty. Rajan

(2005) concurs by explaining the lack of transparency and the moral hazard that existed within the

securitization chain.

Accelerant of Operational Disintegration

The accelerant of operational disintegration is the ultimate and critical event which leaves an

organizations’ operations in irreparable condition.

Sjostrum (2009) identifies that on September 15th 2008, AIG had its long term debt rating downgraded

by Moody’s and Fitch and these downgrades triggered over $20 billion in additional collateral postings.

Additionally, if AIG was not able to economically match these demands and could not continue its

operations further then this shows AIG’s rating downgrade caused the discontinuation of AIG’s

operations. This key event accelerated the rate of operational disintegration as it could not continue

its operations any further. Hence this shows how the CDS product with significant vulnerabilities to

collapse leads to operational uncertainty and finally AIG faced the critical event which depicted its

providence.

Timing of Contingency Forecast

The timing of contingency forecast refers to exactly when the organization attempts to execute a

contingency plan. This may be before or after the accelerant of operational disintegration. Executing

the plan after may lead to failure.

Sjostrum (2009) further states that on September 16th AIG attempted to execute a contingency plan to

raise capital to prevent its collapse. This contingency plan was executed after AIGFP encountered its

accelerant of operational disintegration and thus shows that senior level executives reacted rather than

forecasted a contingency plan to save AIGFP, which should have been done pre 2008.

8

Solutions Improving Quality of Source of Income

CDOs’

If financial institutions had not been providing excessive incentive in the form of bonuses to trigger irrational risk

taking then incentives would be lower, there would be less subprime mortgages; hence, CDOs’ and ultimately

CDSs’ would be of higher quality and stability. Additionally, if financial institutions’ excessive lending incentives

were the source of failing CDSs’ then this would be solved by lowering incentives (Rajan, 2005).

One way this may be done is to require managers have some of their own wealth in the funds they manage

(Rajan, 2005). Rajan goes on to state that industry groups could require managers to allocate a certain amount

of their salaries into the funds they manage. He argues that this practice could prove to create an entry barrier.

If requiring managers to invest a proportion of their pay in the investments they sell should reduce irrational risk

taking then managers will have less incentive to undertake risky investments. These measures should help

introduce a degree of risk aversion as this exposes the managers’ personal finance to risk. Therefore, this shows

that requiring managers to allocate a proportion of their pay into the investments they sell should introduce risk

aversion. These stances may be effective in eliminating incentive to excessive risk and ultimately create stable

CDO and CDS products. Deutsche Bank (2012)

A more rigid stance is portrayed by the UN Department of Economic and Social Affairs (2012) from a thematic

review by the financial Stability Board. It highlights the ban of guaranteed multi-year bonuses, requiring

compensation payments in line with the firms’ performance. An appointment of a board to govern compensation

within the firm on behalf of its board of directors is also emphasized.

9

If governing compensation board can be beneficial in overseeing who gets bonus payments and can effectively

lower bonus payments for managers who complete deals with risky financial products then this proves that the

governing compensation board can be effective in reducing risk.

The Deutche Bank paper adds risk management mandates such as conducting due diligence on emerging

financial products and the construction of robust capital liquidity and resolution paths to safeguard against

unexpected volatility such as when AIG saw rapidly aggregating CDO defaults and value drops. The FSOC also

states that during the financial crisis, parties involved in CDSs did not have transparent information about the

environment they were in and the FSOC hopes to solve this problem by developing a system to increase the

transparency of the financial industry. The Economist (2012) approves, stating that the opacity of derivatives

products was the source of financial instability.

If this system had been in place, it could have prevented CDS issuers like AIG from operating in a volatile financial

system. Hence, creating a better quality source of income. This means that AIG would have avoided operational

disaster and failure.

Ban of CDSs’

AIGFP was set up as a special purpose entity (SPE) in London, UK. If this was beneficial for AIGFP because it

allowed it to circumvent unfavorable regulation, (See Appendix 7 & 13) then as the Insurance Journal (2011)

ascertains; AIG conducted regulatory arbitrage (See Appendix 12). This derives that a solution to this problem

would be to increase the regulation of SPE operations which could have prevented AIG from trading poor quality

CDSs’. Therefore this shows that increased regulation of the actual SPE’s would prevent them from trading with

poor quality sources of income, in this case, CDSs’. The Financial Services Authority (FSA) is attempting to ban

SPE issued structured products (Millers, 2012). If regulatory bodies such as the FSA had anticipated the effects of

degrading CDOs’ and CDSs’ then a regulatory reform of CDS trading may have met resistance but would have

been the cure to the unstable CDS market and prevent AIGFP from causing global financial cataclysm.

Regulate CDSs’ as Insurance Contracts

The Insurance Journal (2011) states that if AIGs’ CDS products were regulated as insurance contracts then its

failure could have been prevented. This would be possible because regulated insurance contracts require the

issuer to maintain cash reserves proportional to the value of contracts issued. Therefore AIG would have had

enough capital reserve to sustain its operations without requiring a bailout and ultimately terminating AIGFP.

Improve Timing of Contingency Forecast

If AIG’s contingency plan was executed after the accelerant of operational disintegration then AIG should have

planned to raise capital from an earlier date. Additionally, if the U.S. Department of Treasury and the N.Y. Federal

Reserve announced an $85 billion credit facility then this proves that the meeting with Goldman Sachs, J.P.

Morgan and the NY Federal Reserve to raise capital was unfruitful, as Sjostrum (2009) concurs. Conversely, this

shows that if AIG’s attempt to raise capital was fruitful then it would not have required a credit facility from the

N.Y. Federal Reserve. Thereby eliminating the enforcement by the N.Y. Fed of a covenant onto AIG stating that

AIG would have to hire a new CEO and renew the composition of its board of directors and prohibit AIG from

dealing CDS’s unless approved by the N.Y. Fed. Ultimately, this confirms that AIG needed to improve the timing

10

of its contingency forecast by planning to raise capital from an earlier date; before its final debit rating downgrade

by rating agencies.

Ultimately, if poor quality source of income and operational uncertainty lead to an accelerant of operational

disintegration and if an accelerant of operational disintegration leads to organizational failure, then if the above

stated solutions create a good quality source of income and operational certainty then this would not have led

to organizational failure.

Reinstating Operational Certainty

Strategic Planning

In order to prevent organizational failure, key elements need to be addressed as per the Causality Framework.

These include addressing operational uncertainty and the quality of the source of income. Several methods may

have been deployed to reinstate operational certainty. From a broad point of view, AIGFP seemed susceptive to

an information overload. In his book “The Rise and Fall of Strategic Planning”, Henry Mintzberg (2000) states that

organizations’ may become detached from reality. He further elaborates that when organizations have too much

information about their markets, they can fail to derive clarity and the strategic importance of the information.

As stated earlier, AIGFP had noted a deteriorating housing market in its 2007 annual report. Many academics

had simultaneously advocated and demonstrated a concerning environmental scan. On the other hand, there

also existed information that countered the above information. This came in the form of political opposition from

The Financial Services Roundtable (2012). In addition to this, there also existed contradictory reason to sell CDSs’

from AIG’s risk models which showed low risks of CDSs’ (Sjostrum, 2009). Johnson et.al (2008) state, that strategic

planning can provide a sense of security and logic for an organization and Mintzberg (2000) contests such

benefits by attesting that these may not be realized if there is an information overload. Given the evidence of

such faced by AIG, it may be reasonable to state that AIG executed poor strategic planning. Mintzberg further

states that all members of the organization must be involved in this strategic planning process.

AIGFPs’ entire workforce was terminated. AIGFP should not have centrally planned its strategy. If the planning

was decentralized, the outcome strategy should have helped evoke earlier contingency plans as careers would

be at stake and this provides a strong incentive to plan against failure. Ultimately, this depends on AIGFP

management and unfortunately their conflict of interest for higher bonuses opposed the sustainability of

operations.

Prudential Supervision

AIG’s problems may have been prevented if it is tackled from through an external environment. This involves the

reform of regulatory bodies to govern the operations of AIG. If Rajan (2005) attests tighter regulation to prevent

excessive risk taking in the finance industry, then this should reduce operational uncertainty. As stated earlier,

AIGs’ operational problems were created by the mismanagement of risk. Additionally, if Rajan also attests that

prudential supervision may be helpful in preventing excessive risk taking within the industry then this would limit

the financial risk from widespread disruptions in the global financial system (Kern, 2012) and also AIG. Thus, this

shows that prudential supervision may help to reduce operational uncertainty by limiting risk taking.

11

A 2012 Deutche Bank research paper outlines the establishment of the Financial Stability Oversight Council

(FSOC) under the Dodd-Frank Act, mandated to identify risks of financial transparency in the USA and respond

to subsequent emerging threats. It also states that it approaches to promote market discipline (See Appendix 9,

Basel II); backed by a “Comply or Explain” procedure. In this procedure, an organization must comply with FSOC

mandates and if it determines that it does not, it needs to submit a public justification for its determination and

related parties.

In addition to this, if AIG also reassessed its operations earlier by submitting to public justification; knowing its’

CDS trading would come under greater levels of critical scrutiny and opposition by the public then robust capital

and liquidity requirements enforced by a supervisory body could have ensured that AIG had enough promissory

notes (See Appendix 12) to keep itself operational while also having sufficient reserves to meet the collateral

posting volatility for CDSs’; improving operational certainty.

The following plan of action may have proved beneficial for AIG:

Reduce Operational Uncertainity

Distribute Strategic planning

across organization

Manditory compliance with FSOC

Manditory capital and

liquidity requirements

Improve Quality of Source of Income

Reduce Incentives for

Managers

Due Diligence on Financial

Products

CDS Trading allowed only

with permission

from regulatory

body

Tightly Regulate

SPVs'

Improve transparency of products

Improve Contingency Forecast

Hire directors who can vision an

accelerant of operational

disintegration

Plan liquidity requirements ahead of time

Make regular assessments

of Operational Certainity

Make Regular assessments of the quality of source of

income

12

Conclusion In conclusion, it can be seen that CDOs’ created from risky mortgage lending became popular investments

compared to government bonds due to their higher return on investment. AIG issued CDSs’ to hedge the risks

of CDOs’ defaulting. Unfortunately AIG was not able to stop CDS trading when it saw rapid cumulative numbers

of CDOs’ defaulting. This poor global financial mismanagement required AIG to pay out on CDS insurance, post

collateral it did not have and terminate AIGFP. This occurred because CDS were deregulated and therefore AIG

did not need to have reserves to back its insurance products. Its stock price rapidly fell and required a bailout to

prevent further erosion of the global financial system. Prudential supervision coupled with mandatory financial

products regulation and due diligence on AIG may have prevented this. Proper contingency and risk planning

could also have prevented AIG from collapse. The source of AIGs’ troubles could have also been remedied by

reducing the incentive for managers to take risky investments such as compiling sub-prime mortgages into

CDOs’. This would have lowered AIGs’ CDS payouts.

13

Appendix Appendix 1 Collateralized Debt Obligation

A Collateralized Debt Obligation (CDO) is a bond backed by income produced by repayment of secured

debt (Thoyts 2010). This CDO is packaged and sold through financial services institutions to investors.

As borrowers repay these loans, investors experience a return on investment. In 1998, JP Morgan

approached AIG, proposing that, for a fee, AIG insure JP Morgan’s complex corporate debt, in case of default.

According to computer models devised by Gary Gorton, a Yale Business Professor and consultant to the unit,

there was a 99.85 percent chance that AIGFP would never have to pay out on these deals. Essentially, this

would happen only if the economy went into a full-blown depression, in which case, the AIG believed, the

counter-parties would be wiped out, and therefore would hardly be in a position to demand payment

anyway. With the backing of Cassano, then the COO, Savage greenlighted the deals. Credit default swaps

were born (Roth, Buchwalter, 2009).

14

Appendix 2 Credit Default Swap

A swap designed to transfer the credit exposure of fixed income products between parties. A credit default swap is also referred to as a

credit derivative contract, where the purchaser of the swap makes payments up until the maturity date of a contract. Payments are made

to the seller of the swap. In return, the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is considered

insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third party will indeed default

(Investopedia, 2012).

Appendix 3 Subprime Loan

A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. Quite often,

subprime borrowers are often turned away from traditional lenders because of their low credit ratings or other factors that

suggest that they have a reasonable chance of defaulting on the debt repayment (Investopedia, 2012).

Read more: http://www.investopedia.com/terms/s/subprimeloan.asp#ixzz2DTRnop7P

15

Appendix 4 Causality Framework of Operational Failure

The following framework has been designed for the purpose of this report to analyze organizational failure. The

framework has been generalized from the patterns found in the analysis of this report, however, it has been

reapplied to the report to demonstrate its use and purpose. The framework may also be applicable for analyzing

organizational failure of other organizations. The framework uses four key components to analyse organizational

failure. These are modelled as follows:

This framework overviews critical causality issues that can lead to organizational failure. The abstract

conceptualization is explained as follows:

This framework looks at the quality of the source of the income of the organization. If the source of

income is vulnerable to collapse; then organization has a poor source of income. The income may also

be struggling to generate adequate income to sustain operational activities. In addition to this, the quality

of the source of income may degrade if this source is the product of a moral hazard, for example, in the

case of subprime lending. Degradation may also occur if this source is the product of information

asymmetry, for example, if a car parts supplier knowingly supplies a part which operates in temperature

conditions of 10-100 degrees C, the OEM car manufacturer may sell the car in a country where

Accelerant of Operational

Disintegration

Accelerant of Operational

Disintegration

Quality of Source of Income

Quality of Source of Income

Timing of Contingency

Forecast

Timing of Contingency

Forecast

Degree of Operational Uncertanity

Degree of Operational Uncertanity

16

temperatures drop below freezing and therefore cause the part to malfunction. The non-disclosure of key

information by one party to the organization being analyzed may cause this degradation in income

quality, thereby creating information asymmetry. Any credible reasoning and evidence of poor quality of

the source of income is applicable to this section. Products that are unlikely to succeed or are risky

investments also degrade the quality of the source of income. Ultimately this may lead to operational

uncertainty.

This framework looks at the degree of operational uncertainty. Operational uncertainty can occur if

there exists evidence of doubt of the future of the organization, for example, academics or financial

analysts may question the current operations or employees may not be satisfied with the direction of the

organization. Investor confidence may also be low. Simultaneously, there may also exist credible evidence

to contradict this doubt. Existence of contradictory information of an organisation’s operations introduces

uncertainty. This contradictory information may be published by the organization itself in the form of

confidence building gesticulations for concerned parties. The purpose of any business should be to fill a

need. Profit maximization should come second if the growth and sustainability is a strategic purpose of

the organization. Therefore, the organization may be operating under operational uncertainty if there

exists a principal agent or conflict of interest problem within the organization where its operations do not

concur with the sustainability of the organization. This may be reflected in excessive risk taking by

management to maximize profit or the operation of a complex and opaque business model. Sustainability

of the organization may also be vulnerable to conflicts of interests by strategic planning or line

management. Evidence of above mentioned and similar factors show operational uncertainty. This area

may be influenced by PESTLE threats.

The timing of contingency forecast refers to exactly when the organization reacts to an accelerant of

operational disintegration. This accelerant of operational disintegration is the specific event or “the

last straw” which causes the organization to fail, for example, a team of scientists establish on the 14th of

March 2020 that the drinking water reserves have become virally contaminated. A water purification firm

may execute a contingency plan on the 15th of March 2020, by requesting a substantial government loan

to finance the supply of drinking water from elsewhere. The firm is in high risk of failing as it can no longer

supply water from any of its contaminated reserves. Its stock price may plummet. If the firm anticipated

the event on the 14th of March , for example, in January that year, it may have been able to execute a

gradual contingency plan without severely disrupting its operations. Therefore if an organization executes

a contingency plan by anticipating the event which is the accelerant of operational disintegration, it may

prevent itself from failing in the long run.

In illustration, for the case of Enron, despite accounting fraud being a key cause of failure, Enron also had

a poor quality source of income from its failed projects and it’s highly complex and unethical operations

created operational uncertainty. After its credit rating downgrades, Dynegy proposed to buy Enron in

order to save it. Unfortunately Dynegy remained unaware of the complete extent of accounting fraud

Enron had committed and cancelled the deal. Enron was already in a state of operational disintegration,

however the cancellation of the Dynegy deal caused Enron to go bankrupt and hence this specific event

17

created an accelerant of operational disintegration. Enron could have anticipated that they may have

to be bought by another firm to survive and develop a contingency plan earlier but unfortunately the

failure to time its contingency forecast effectively gave it no time to gradually establish operational

certainty if not rectify its source of income.

In consolidation, this framework draws out key elements that lead to organizational failure. It couples the

quality of an organizations source of income with how unsure the organization is of its current

operations. The determinant of organizational failure will depend on whether the organization has the

vision to anticipate the critical event which will create severe and irreparable damage to the

organization. If anticipation is possible, the organization should attempt to decrease operational

uncertainty and the improve quality of its source of income before the accelerant of operational

disintegration occurs.

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Appendix 4 AIG Stock Fall in 2008

Appendix 5 AIG Cash Flow Statement

19

20

Appendix 6 AIG

Balance Sheet

21

Appendix 7 Special Purpose Entity

Also referred to as a "bankruptcy-remote entity" whose operations are limited to the acquisition and financing of specific

assets. The SPE is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations

secure even if the parent company goes bankrupt (Investopedia, 2012).

A subsidiary corporation designed to serve as a counterparty for swaps and other credit sensitive derivative instruments.

Also called a "derivatives product company."

Read more: http://www.investopedia.com/terms/s/spv.asp#ixzz2DTXekFUP

Appendix 8 Commodities and Futures Modernization Act

An act passed in 2000 by the U.S Government that reaffirmed the authority of the Commodity Futures Trading Commission

for five years as the regulatory body of the American futures markets. The most significant outcome from this act was the

allowance for the trading of single stock futures.

Read more: http://www.investopedia.com/terms/c/cfma.asp#ixzz2DTYnbmb2

Appendix 9 BASEL Accords

A set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on

banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure

that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.

Read more: http://www.investopedia.com/terms/b/basel_accord.asp#ixzz2DTZIltcE

The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital adequacy of financial

institutions. The capital adequacy risk, (the risk that a financial institution will be hurt by an unexpected loss), categorizes

the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are

required to have a risk weight of 8% or less.

BASEL II

The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including

minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of

this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements.

Read more: http://www.investopedia.com/terms/b/basel_accord.asp#ixzz2DTbV9RbT

22

Appendix 10 CDSs’ for speculation purposes

A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed

securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract,

who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative

"credit event." The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a

periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is

important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond

involved in the transaction is called the "reference obligation." A contract can reference a single credit, or multiple credits.

As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of the transaction,

when the reference entity (the issuer) has a negative credit event. If such an event occurs, the party that sold the credit

protection, and who has assumed the credit risk, must deliver the value of principal and interest payments that the

reference bond would have paid to the protection buyer. With the reference bonds still having some depressed residual

value, the protection buyer must, in turn, deliver either the current cash value of the referenced bonds or the actual bonds

to the protection seller, depending on the terms agreed upon at the onset of the contract. If there is no credit event, the

seller of protection receives the periodic fee from the buyer, and profits if the reference entity's debt remains good

through the life of the contract and no payoff takes place. However, the contract seller is taking the risk of big losses if a

credit event occurs.

Hedging and Speculation

CDS have the following two uses.

A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or

company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract.

This may be preferable to selling the security outright if the investor wants to reduce exposure and not eliminate

it, avoid taking a tax hit, or just eliminate exposure for a certain period of time.

The second use is for speculators to "place their bets" about the credit quality of a particular reference entity. With

the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that

speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to

take a view on the credit of a reference entity. An investor with a positive view on the credit quality of a company

can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on

the company's bonds. An investor with a negative view of the company's credit can buy protection for a relatively

small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event. A

CDS can also serve as a way to access maturity exposures that would otherwise be unavailable, access credit risk

when the supply of bonds is limited, or invest in foreign credits without currency risk.

An investor can actually replicate the exposure of a bond or portfolio of bonds using CDS. This can be very helpful in a

situation where one or several bonds are difficult to obtain in the open market. Using a portfolio of CDS contracts, an

investor can create a synthetic portfolio of bonds that has the same credit exposure and payoffs.

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Appendix 11 AIG’s inability to access capital markets due to decline in stock price

Capital Market

A market in which individuals and institutions trade financial securities. Organizations/institutions in the public and private

sectors also often sell securities on the capital markets in order to raise funds. Thus, this type of market is composed of

both the primary and secondary markets.

Read more: http://www.investopedia.com/terms/c/capitalmarkets.asp#ixzz2DTdiZwqj

Appendix 12 Promissory Notes

A written, dated and signed two-party instrument containing an unconditional promise by the maker to pay a definite sum

of money to a payee on demand or at a specified future date.

The only difference between a promissory note and a bill of exchange is that the maker of a note pays the payee

personally, rather than ordering a third party to do so.

When a bank is the maker promising to repay money it has received plus interest, the promissory note is called a

certificate of deposit (CD).

Promissory notes may be critical for financing day to day operations of a business.

Read more: http://www.investopedia.com/terms/p/promissorynote.asp#ixzz2DTeIqjnD

Appendix 12 Regulatory Arbitrage

A practice whereby firms capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulation.

Arbitrage opportunities may be accomplished by a variety of tactics, including restructuring transactions financial

engineering and geographic relocation. Regulatory arbitrage is difficult to prevent entirely, but its prevalence can be

limited by closing the most obvious loopholes and thus increasing the costs associated of circumventing the regulation.

Read more: http://www.investopedia.com/terms/r/regulatory-arbitrage.asp#ixzz2DTf30rfO

Appendix 13 AIGFP as a SPE

In 2002, the Justice Department charged that AIGFP had illegally helped another firm, PNC Financial Services, to hide bad

assets from its books. To do so, AIGFP had set up a separate company, known as a “special purpose entity” to take on the

assets. It had violated securities law, the Feds alleged, by setting up sham “companies” to invest in the entities, making them

appear real. In 2004, AIG settled the charges by paying an $80 million fine, and gave back over $45 million in fees and

interest it had earned on the deal. By the terms of its “deferred prosecution” agreement, it was placed on a short leash by

the Justice Department. There is no evidence that anyone at AIGFP was formally sanctioned as a result of the episode.

http://tpmmuckraker.talkingpointsmemo.com/2009/03/the_rise_and_fall_of_aigs_financial_products_unit.php

Appendix 14 Securitization

The process through which an issuer creates a financial instrument by combining other financial assets and then marketing

different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and

promotes liquidity in the marketplace. Mortgage-backed securities are a perfect example of securitization. By combining

mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual

mortgage's inherent risk of default and then sell those smaller pieces to investors.

The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-

backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without

the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

Read more: http://www.investopedia.com/terms/s/securitization.asp#ixzz2EZ99fTpZ

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