Posted At : March 17, 2009 10:47 AM
The markets are showing another vote of no confidence today, with rising concerns on more bank problems and ANOTHER AIG bailout. The federal government announced yet another new plan to save A.I.G., the third since September. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. It has softened the terms it set for the original $85 billion loan it made back in September. More money for AIG is infuriating, leaving everyone asking whether it is worth it. Unfortunately, it is.
After the mess of the fall of Lehman, which was far less enmeshed in the global financial system than A.I.G., the government must act. Most of A.I.G. operates the way it always had, like a normal, regulated insurance company, but one division, its financial practices unit in London, had derivative specialists who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold CDS or Credit Default Swaps.
These exotic investments are a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance those mortgage-backed securities suffered losses, the company would be on the hook for the losses. Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets, specifically housing, could only go up in price.
When a company insures cars or homes against fire, floods or earthquakes, it has to put money in reserve in case a flood happens. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.
The banks have been brought down because they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., which made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, leading the banks to increase their leverage and buy yet more assets.
This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began. (see my Critical Economic and Market Commentary, 2/28/09). At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.
Currently, the government has to keep them going and cannot let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing.