AIG: Thoughts and Perspective
With so much unhappiness over AIG, I thought I would write some thoughts and perspective about who they are and how their problems came about.
What is AIG?
AIG is the American International Group. They sell insurance to customers around the world – individual, corporate, non-profit, and more.
In the past AIG’s business depended on their AAA debt rating which allowed them to borrow money very cheaply. Whenever they had to pay out for claims (accidents, disasters, etc), they would borrow the money they needed from the markets. The insurance premiums they charged their customers more than covered the debt repayments while leaving plenty leftover for profit.
That AAA debt rating seems kind of silly now, huh?
Yup. But people have been skeptical about it for a while.
What’s a CDS?
A CDS is a Credit Default Swap. It’s basically insurance on a bond. If a bond defaults (can’t make its payments), then the insurer will pay some agreed upon value to the CDS buyer. In exchange, the buyer pays the insurer some kind of premium.
What did AIG do?
They sold lots of CDSs. Lots and lots and lots of CDSs. More than a trillion dollars worth of them. Most of these were viewed as safe bets during the good times because AIG never expected the economy as a whole to fall apart. In exchange, they basically viewed the premiums as free money.
That didn’t really work, did it?
Nope. AIG made a very classic mistake in that it did not realize that all of its CDS contracts were highly correlated. In other words, they thought that only a few bonds they insured would ever default. What they didn’t realize was that these bonds were all so related that one failure would mean lots of failures.
So where is all of this government money going?
Because so many bonds are defaulting, AIG is on the hook for a huge number of CDS claims. There’s no way they could borrow the money from the markets (their AAA debt rating is now a joke), so they have essentially defaulted. The government is now providing AIG with funding to pay for their CDS obligations.
What if the government just stopped funding AIG?
Then all of the banks, pension funds, and other bond holders would be required to take the losses from the bond defaults. Right now, AIG is meeting its obligations to cover all of these bond defaults with government funds while taking the corresponding losses. For all of the banks and other institutions around AIG, even though their bonds are worthless, AIG is providing them with the required insurance payouts.
How bad would it be if the government stopped funding AIG?
That depends, but probably bad. All of the losses that AIG is incurring (and the government is supporting) would be spread around all of the banks instead. In the best case, the government would bail out all of the banks. In the worst case, the banks would fail.
What most people don’t realize is that every bank owes money to practically every other bank. Their debt agreements usually have terms like “if your stock drops below $X, then you have to pay back $Y early.” Things like large losses to their bond portfolios can force banks to pay back huge sums of money that they just don’t have right now. This essentially forces the banks to default, which forces more banks to default, and so on.
American law makes it pretty much impossible for a bank to ever “restructure” in bankruptcy. Regular companies can do the Chapter 11 bankruptcy thing, fight off their creditors, make a new plan, and come out stronger and better. Banks are pretty much required to die and liquidate. For that reason, bank defaults are really really really bad. Really bad.
Shouldn’t the banks have known better themselves?
Yeah, probably.
Did AIG actually cause any of this overall economic mess?
Not really. They were just well positioned to take all of the losses and pain.
So that makes AIG…?
The fall guy. Yeah, they’re pretty much the fall guy for this whole mess.
When will this all end? We can’t keep paying them billions of dollars!
There are two ways to end this. One is for the economy to improve, meaning the bonds will stop defaulting. The other is for the government to stop paying AIG, but that means having a plan somewhere for supporting the banks and institutions that rely on AIG’s CDSs.
The other possibility is for banks to restructure themselves so that a total failure at AIG wouldn’t impact them as strongly. The good banks (JP Morgan, Goldman) are probably already doing this. The bad banks (Citi, Bank of America) likely have too much else to worry about right now.
Either way, beware of a plan that stops paying money to AIG that doesn’t at least address what happens to the various CDS holders. They would need funding and various legal changes to allow for restructuring. Alternatively, they would need to announce that they’re ok now, and the loss of AIG would not adversely impact them.
What about those bonuses?
Many of the top AIG executives were awarded large year-end bonuses. Honestly, they’re a drop in the bucket in the grand scheme of things. Those bonuses were originally agreed upon by Henry Paulson during the Bush administration as a way of retaining staff at AIG to help manage things while the government dealt with other problems. One of the concessions was that AIG CEO Robert Willumstad was forced to leave (making the whining about how Obama is treating GM so much more harshly than the banks very perplexing – he’s treating them nearly the same).
The bonuses were almost all returned, but frankly they’re irrelevant in the grand scheme of things.
What will happen to AIG?
Ironically, the rest of AIG was relatively profitable, and their regular insurance businesses could probably survive on their own. Expect the government to break apart the company and create several mini-AIGs that offer various different insurance products.
