What the Hell is Going on With AIG

I have talked to a couple of people recently who have expressed surprise at all of the new information coming out about the counter parties that AIG is paying money out to. I was actually surprised that people where surprised since I had understood that the entire point of bailing out AIG was to actually bail out all of the banks. For example, normally in an insurance agreement, say when you get insurance on your car, the insurance company does not specifically need to have the money that could be paid out to you tied to your policy. What they do have to have is enough money so that if a certain number of policies came due at the same time then they could pay them all off. Normally there is not much chance of this happening but the government regulates the process so that there is enough cash on hand so that there normally isn't a problem.

What actually happens though, most of the time, is rather than have that much free cash lying around, an insurance company will buy insurance on its own policies so that if a huge catastrophe did happen one insurance company wouldn't be on the hook for all of the policies. This was a problem after 9/11. Many insurance companies called reinsurers came calling to the government to be bailed out because they had never considered that there was the chance that that catastrophic of an event could happen. The actuary tables don't normally consider suicide bombers, though I'm sure they do now.

Well AIG's Financial Products division had a lot of fun selling insurance to multiple other companies to cover their loans. The reason that all of the banks wanted this insurance was to make sure that the capital requirements set up in their countries regulations where covered. A capitol requirement is basically a requirement that you have enough liquid assets i.e. an asset you can sell easily on hand in a particular ratio to your liabilities or whatever money you owe to someone else. Basically you need have half the value of your liabilities in liquid assets. Or some other ratio it depends on the country.

Normally they wouldn't be allowed to do this because any old insurance on a bond or loan doesn't necessarily mean that it will be paid out. AIG, though, at the time had a Triple A rating from Moodys, the rating company. How Moodys calculates their ratings is unknown to me but there are normally very few companies that have a Triple A rating, having one means that you can borrow money at extremely low rates because everyone believes that you will always be able to pay it off. It also means that if you offer insurance on something it is considered to no longer be a risk and instead can be considered capital.

The insurance contracts that AIG was offering also, because this was all a way for the banks to get around normal capitol requirements, had clauses in them that said that if AIG lost its triple A rating then it would have to begin paying out in order to satisfy the capitol requirements that had been satisfied by the very fact that AIG had a Triple A rating. Right before the United States took over AIG, AIG lost its triple A rating.

Remember how when a company normally sells insurance on something it is supposed to have the money on hand to pay off a certain number of the contracts in case of catastrophe? Well these insurance contracts where called Credit Default Swaps. In the Financial Services Modernization Act of 1999 there was language in the bill that said essentially that there would be no regulation of CDS's. This means that there was no regulation of, well capital requirements on CDS's. Thus, there was no money to pay off these contracts when they came due. The ironic thing is that AIG's credit rating was lowered in large part because of all of these CDS's and because their credit rating was lowered they didn't have the money to pay out all of the CDS contracts.

The ENTIRE REASON WE BAILED OUT AIG was because of the other banks. If they all of a sudden lost all of their capitol because AIG died then they would flood the market with assets in order to recapitalize. If they did that then banks not even involved with this stuff would see their own asset pools fall in value, possibly making the entire banking sector insolvent.

And all of this is why even though I believe that the people who ran AIG into the ground need to drawn and quartered, and by that I mean that need to have their limbs pulled in all different directions until their joints all snap and then they need to be cut into four different pieces, it was neccessary to bail out AIG.

For Elliot Spitzer to be walking around saying that it is horrible that banks are getting money from the AIG bailout, well that was the damn point of the whole bailout. To be upset about it now seems odd.

The Bonuses on the other hand, that is a different story.

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