Joe Nocera of the NYT has a good story today explaining the situation around the bailout of AIG, entitled, appropriately enough, “Propping up a House of Cards”. It appears that AIG sold all sorts of ‘financial insurance’ without going to the trouble of keeping any decent reserves in case they had to pay out. Banks and others bought this insurance, making it appear that they were adequately covering their mortgage risk. Here’s Nocera:
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.
Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities. Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them. And again, it assumed that the triggers would never actually kick in and the provisions were therefore meaningless. Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions.
Unfortunately it appears that the domino effect of letting AIG fail would be a devastating series of losses around the world. So we’ll continue to prop up AIG among others. Limited liability for shareholders, but the liability for taxpayers appears to be unbounded.