Wednesday, March 4, 2009


Last September, the government put together an $85 billion bailout package for AIG and it was called, by the NYTimes, "the most radical intervention in private business in the central bank’s history." However, the term "bailout" is controversial because the $85 billion came with punitive interest rates and the government was given nearly 80% ownership of AIG.
In October, AIG was received $38 billion. Earlier this week, AIG received an additional $30 billion.

AIG only started to package credit default swaps relatively recently, but its CDSs were enough to make the insurer insolvent when margin calls were made. Although other parts of AIG were still profitable [like traditional life insurance, retirement plans, etc], its assets were not enough to cover its losses.

CDSs are "credit default swaps" and they are also what caused Lehman Brothers to go bankrupt. Basically, credit default swaps were securities that insured investors against losses on mortgage backed securities and other CDOs. The proliferation of mortgage backed securities created a market for credit default swaps, which grew to be roughly twice the size of the U.S. stock market. Like mortgage-backed securities, these credit default swaps were also under-capitalized. The trend seems to be that Wall Street depended too heavily on debt instruments that were not financed with appropriate amounts of collateral.

AIG basically did not enforce high enough marginal requirements, thinking that housing prices would continue to rise. Marginal requirements are a way of minimizing counter-party risk and when housing prices fell instead, AIG found itself too highly leveraged. Mortgages have natural marginal requirements [the value of the homes], so when home values fall, it is essentially a drop in the value of collateral. When the value of collateral falls, counter-party risk , which is the risk that one of the two parties of a financial contract defaults, increases.

So why is the government so keen on saving this financial institution?
AIG was not allowed to fail in the first place because its financial activities were so pervasive in the global economy. AIG's inability to pay out its insurance claims may have led to a domino effect in which other institutions would have been forced to revalue those securities and the capital of those institutions would have decreased as well.

But don't worry. Ben Bernanke's still really upset and is aware of the potential "moral hazard" in saving AIG.

AIG is currently priced at $0.43 per share.

Contrast AIG to Goldman Sachs which stood out among other investment banks for having hedged itself against mortgage backed securities and escaping herd mentality. While other i-banks were buying more MBSs, Goldman Sachs decided to take a bet that those MBSs would become illiquid assets. Too bad they were right.

P.S. NPR's Planet Money #12 was about AIG.
So was everything else in the news this week...

In other news: Kimberly Dozier is Class of Green Commencement speaker!

1 comment:

  1. why?

    explain plz