Note: The article below was written back in April 2009 and published on my personal blog at StreetSharp.com. Since than certain things have changed for good in AIG. However, the article's main focus was on what exactly happened with AIG and that still holds relevance. If you find it informative, please publish it.
These days AIG, controversy and outrage go hand in hand. The once $150B+ company and one of Dow’s most powerful components is in shambles thanks to it’s imprudent decision of insuring mortgage backed securities. Add to that the controversy of using federal bailout money (a.k.a tax-payer’s money) to payout hefty bonuses and taking expensive resort vacations. But it wasn't always like this for AIG. Until the end of year 2007, AIG used to be a well-respected company. So, what went wrong?
To get to the depth of AIG’s failure, it’s important to understand the concept of Credit Default Swaps – the financial nuclear weapon which destroyed AIG and played a central role in the global meltdown. In a nutshell, a Credit Default Swap is an insurance on debt (bonds). CDS were first introduced in the late 90’s by JP Morgan. The whole idea behind CDS was to insure traditional bonds. Let’s look at an example. You buy bonds from AT&T. AT&T pays you interest for loaning the money. You buy several bonds from AT&T are afraid what would happen if the company ever goes bankrupt. I come to you and offer to guarantee your investment in AT&T bonds for a fee (premium). I just sold you a CDS – Credit Default Swap. You are relieved because now your money is safe and I am happy because I got the premium for literally no down payment. I would have to worry only if AT&T was in financial trouble and not able to repay your debt. But the only reason I sold you the CDS is because I was sure that nothing would happen to AT&T. So, again – I got a premium from you for no money down whereas you are getting some interest for putting a lot of money down to buy AT&T bonds. Which one is more lucrative? You get the idea.
This is a major reason why CDS became very popular in the late 90s and into 2000s. There were billions to be made by selling insurance policies for bonds. History tells us that bond issuers rarely if ever go bankrupt. So banks and hedge funds figured that they could mint money by selling several CDS and keep all the premium since there was zero risk. AIG thought, ‘Hey, we insure everything under the sun so why not insure bonds as well?’ It obviously was a lot easier for AIG, banks and hedge funds to just buy and sell CDS contracts rather than trade actual bonds. The CDS business grew to over $60 Trillion by 2008. The trouble started brewing when Credit Default Swaps were used to insure mortgage-backed securities and collateralized debt obligations (CDO). CDOs were not traditional bonds. AIG made a move from it’s traditional insurance business to a high-risk insurance business involving CDS used to insure CDOs. It failed to realize and manage risk associated with CDOs. Insurance companies have the experience to handle catastrophic risk but AIG was underwriting systemic risk. Instead of diversifying risk like insurance companies are supposed to, AIG concentrated all the risk around toxic mortgage backed securities. The problem obviously went out of control when the housing market collapsed. When a company insures a house or a car, it’s a different story. If someone’s house catches fire, it doesn’t mean that all other houses will catch fire too. It wouldn’t have a domino effect. But with CDOs, once panic hit the markets, they all started losing value rapidly. AIG who sold insurance on those CDOs had to make huge payouts everyday and it soon reached a point where there was no money left. So now the CDS started becoming worthless. This caused a wave of trepidation in the entire world. People now started worrying about their regular insurance policies with AIG. Counties, cities and villages across the world had invested with AIG in some form or the other – either in stocks, bonds, insurance or CDS. That’s one reason why you always hear these words – “AIG is too big to fail”.
So, is AIG too big to fail? In my opinion, no. I have explained this in Part 2. But, first let’s see why most of the experts are of the opinion that AIG should not be allowed to fail. Back in March 2008, the Feds bailed out Bears Stearns and subsequently sold it to JP Morgan. This was the first major bailout and only tip of the subprime iceberg. After that there have been several bailouts and the Feds have received a lot of flak. But there was one firm that wasn’t bailed out – Lehman Brothers. On September 15 2008, Lehman Brothers filed for bankruptcy. Lehman tried every possible resort from federal bailout to putting itself up for sale but nothing worked. According to many expert economists, not saving Lehman was a grave mistake and it took the economic severity to a whole new level. The confidence crisis created by Lehman’s failure led to the general consensus that institutions posing systemic risk should be bailed out. In fact, Ben Bernanke recently mentioned that not saving AIG would have led the economy to severe depression. The fear is multiplied by the fact that thousands of global institutions, governments and people are somehow linked to AIG. Letting AIG fail could lead to severe panic and mass redemption of insurance policies which would further destabilize the global economy. So, is pouring more money into AIG without insight or regulation the only possible solution?(continued in Part 2)