Joe Nocera does a good job of explaining how AIG is ground zero of the economic melt down. Essentially, it was a linchpin in the process of concentrating and magnifying the risk from questionable mortgage practices.
Step one – a potential homeowner maybe with or without a reasonable expectation of paying a mortgage based on varying levels of information buys a mortgage. The broker and lender take their commission and sell it on up the line; taking the money & running.
Step two – the mortgages get aggregated and sold as a security.
Step three – AIG steps in and sells credit default swaps for these securities. Basically, this is a form of magic dust sprinkled over the mortgage-backed securities to make them look safer than they are. AIG has a AAA rating. It sells these credit default swaps as a form of insurance for the mortgage-backed securities, converting these securities from their natural level of risk to a AAA rated security, ostensibly risk free or close to it.
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 — housing — could only go up in price.
That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. 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. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. 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.
In addition, AIG took extra money for inserting “collateral triggers” into its derivative contracts, meaning that if its rating declined (and by extension the rating of the mortgage securities it was insuring), it had to put up collateral. The credit default swaps let purchasing banks make their own balance sheets look less risky than they really were. Because they weren’t properly accounting for actual risk, these banks were allowed to advance loans without adequate capital.
So, if we let AIG go belly up, then all of that risk transferred to AIG through the magic of credit default swaps suddenly reappears on the bank’s balance sheets, triggering capital requirements for the banks, resulting in a huge crater where our banking system used to be.
Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t 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. It would be funny if it weren’t so awful.
And if we save AIG, we teach that all the bad decisions need not be corrected.
Certainly, though, someone can be sent to prison for fraud. Get the Attorney General busy!
I still don’t buy the line of BS that both the current and previous administrations have been telling us about places like this being “too big to fail”.
Really, is the current situation BETTER than what it would have been if they just let them die 2 months ago? How much worse would it be now?
Assuming we’d survive, I’m sure we would have been better off in the long term if the unhealthy businesses died off.
Jason, you said the key words: “long term”. That’s not how the previous or current administrations are thinking. It’s all about trying to stave off declining numbers in any way possible *right now*. And for that, any justification will do.
Think about this: Americans endured the Great Depression for most of FDR’s first two full terms, plus most of Hoover’s single term. Do you think we have the kind of patience to go through that? We expect our wars won in 100 days, and our recessions to last one quarter, two tops.
Yes, long term we would be far better off letting bad actors pay for their sins. Now we’re throwing good money after bad. Lots of good money after bad. Let people suffer the predictable results of bad decisions, let them learn what happens, let them make corrections.
Long term, we’re telling everybody that they don’t have to correct. BIG mistake.
Line them up against the wall, give them blindfolds, and make them pay.
If you kill a person, you go to prison for life or get the death penalty. What price should you have to pay when you ruin and damage millions of American lives? Not to mention hundreds of millions to billions of people in the world.
Congress needs to pass retroactive legislation to allow for immediate confiscation of all assets of all top executives involved… they do that to drug dealers, why are they any better!
I think we give bonuses for that, Doug…
Avarice knows no boundaries except for those drawn with the sharp edges of the guillotine.
It’s time to take the worst offenders and make an example of them.
I think many people might agree that the damage done to the nation amounts to treason.
Enough, enough, the people want some blood. You can either give them a little now or a lot later.
If Im understanding the gauntlet of outrage against AIG it includes the president,both houses of Congress ,including democrats and republicans, and virtually all the American people but with Wall Street outraged at Obama for his threat to punish AIG with socialistic intervention after having given them huge bailouts.I’m not sure at what stage the Wall Street outrage kicked in.
Let’s keep feeding AIG billions of dollars while citizens lose more jobs and are unable to feed even their children. The government’s policies have all but avoided helping ordinary folks cope with an utter lack of jobs available.
A free market has a way of dealing with these companies. It’s called bankruptcy. AIG, GM, and Chrysler should all follow free market rules and go bankrupt like all the small mom and pop businesses have to.
I think the recent violent protests are an indicator of what is yet to come.